424B1 1 d772117d424b1.htm 424B1 424B1
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Filed Pursuant to Rule 424(b)(1) under the Securities Act of 1933
Registration Statement File No. 333-198948

 

Wells Fargo Real Estate Investment Corporation

 

LOGO

9,600,000 Shares

6.375% Cumulative Perpetual Preferred Stock, Series A

(Liquidation Preference $25 Per Share)

 

 

Wells Fargo Real Estate Investment Corporation is a Delaware corporation that operates as a real estate investment trust for U.S. federal income tax purposes. Our principal business is to acquire, hold and manage interests in predominantly domestic mortgage loan assets and other authorized investments. The substantial majority of our assets are participation interests in such loans. We may from time to time hold whole loans and/or participation interests in loans, which we generally refer to in this prospectus collectively as “loans.” This is an initial public offering of shares of our 6.375% Cumulative Perpetual Preferred Stock, Series A (the “Series A preferred stock”).

Dividends on the Series A preferred stock will be payable if, when and as declared by our board of directors out of legally available funds, on a cumulative basis, at an annual rate of 6.375% on the liquidation preference of $25 per share quarterly on March 31, June 30, September 30 and December 31 of each year, commencing on March 31, 2015, or the next business day if any such day is not a business day, unless the next business day falls in a different calendar year, in which case the dividend will be paid on the preceding business day.

The Series A preferred stock is not redeemable prior to December 11, 2019, except upon the occurrence of a Tax Event, a Regulatory Event or an Investment Company Act Event (each, as defined below). On and after December 11, 2019, the Series A preferred stock may be redeemed for cash at our option, in whole or in part, at any time and from time to time, at a redemption price of $25 per share, plus an amount equal to the sum of (i) any authorized, declared but unpaid dividends and (ii) any accumulated but unpaid dividends (including, in each case, dividends accrued on any unpaid dividends), plus accrued interest, if any, on the aggregate amount payable from the last dividend payment date to the date of redemption.

We are an “emerging growth company” defined under federal securities laws, and as such, we may elect to comply with certain reduced public company reporting requirements in this prospectus and in our filings.

No current market exists for the Series A preferred stock. We have applied to have the Series A preferred stock listed on the New York Stock Exchange (the “NYSE”) under the symbol “WFE Pr A”.

 

 

Investing in our Series A preferred stock involves risks. See “Risk Factors” beginning on page 16 of this prospectus for a description of certain risk factors that you should consider before investing in our Series A preferred stock.

The Series A preferred stock solely represents an interest in us and is not the obligation of, or guaranteed by, any other entity, including Wells Fargo & Company and Wells Fargo Bank, National Association. Shares of the Series A preferred stock are not deposits or accounts and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

 

 
     Per Share      Total  

 

 

Public offering price

   $ 25.0000       $ 240,000,000   

Underwriting discount (1)

   $ 0.6694       $ 6,425,875   

 

 

Proceeds, before expenses, to us (1)

   $ 24.3306       $ 233,574,125   

 

 

 

(1)

Reflects 2,110,000 shares of Series A preferred stock sold to institutional investors, for which the underwriters received an underwriting discount of $0.2500 per share, and 7,490,000 shares of Series A preferred stock sold to retail investors, for which the underwriters received an underwriting discount of $0.7875 per share. The per-share number does not reflect the exercise of the overallotment option.

We have granted the underwriters the option to purchase up to an additional 1,400,000 shares of our Series A preferred stock for 30 days after the date of this prospectus on the same terms and conditions set forth above.

The underwriters expect to deliver the Series A preferred stock through The Depository Trust Company on or about December 11, 2014.

 

 

Sole Book Running Manager

Wells Fargo Securities

Joint Lead Managers

 

BofA Merrill Lynch   Morgan Stanley   UBS Investment Bank

 

 

Prospectus dated December 4, 2014


Table of Contents

The following table of contents has been designed to help you find important information contained in this prospectus. We encourage you to read the entire prospectus.

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

TABLE OF CONTENTS

 

     Page  

Forward-Looking Statements

     ii   

Prospectus Summary

     1   

Risk Factors

     16   

Use of Proceeds

     36   

Capitalization

     37   

Selected Financial Data

     38   

Business

     39   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     53   

Management

     80   

Executive Compensation

     84   

Certain Relationships and Related Party Transactions

     85   

Beneficial Ownership of Our Capital Stock

     88   

Description of the Series A Preferred Stock

     89   

Description of Other WFREIC Capital Stock

     98   

Global Securities

     101   

Federal Income Tax Considerations

     103   

ERISA Considerations

     119   

Underwriting

     121   

Experts

     126   

Validity of the Series A Preferred Stock

     126   

Where You Can Find More Information About WFREIC

     127   

Index to Financial Statements

     F-1   

 

 

Neither we nor the underwriters have authorized anyone to provide any information other than that contained in this prospectus or in any free writing prospectus prepared by or on behalf of us or to which we have referred you. Neither we nor the underwriters take responsibility for, nor can provide any assurance as to the reliability of, any other information that others may give you. We are offering to sell, and seeking offers to buy, the Series A preferred stock only under circumstances and in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of any Series A preferred stock.

 

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Forward-Looking Statements

This prospectus contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects,” “target,” “projects,” “outlook,” “forecast,” “will,” “may,” “could,” “should,” “can,” and similar references to future periods. Examples of forward-looking statements include, but are not limited to, statements we make about: future results of WFREIC; expectations for consumer and commercial credit performance and the appropriateness of our allowance for credit losses; our expectations regarding net interest income; expectations regarding loan acquisitions and pay-downs; future capital expenditures; future dividends and other capital distributions; the expected outcome and impact of legal, regulatory and legislative developments, as well as our expectations regarding compliance therewith; the outcome of contingencies, such as legal proceedings; and our plans, objectives and strategies.

Forward-looking statements are not based on historical facts but instead represent our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. Our actual results may differ materially from those contemplated by the forward-looking statements. We caution you, therefore, against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. While there is no assurance that any list of risks and uncertainties or risk factors is complete, important factors that could cause actual results to differ materially from those in the forward-looking statements include:

 

 

economic conditions that affect the general economy, housing prices, the job market, consumer confidence and spending habits, including our borrowers’ prepayment and repayment of our loans;

 

 

the effect of the current low interest rate environment or changes in interest rates on our net interest income;

 

 

the level and volatility of capital markets, interest rates, currency values and other market indices that affect the value of our assets and liabilities;

 

 

the effect of political conditions and geopolitical events;

 

 

losses relating to natural disasters, including, with respect to our loan portfolio, damage or loss to the collateral underlying loans in our portfolio or the unavailability of adequate insurance coverage or government assistance for borrowers;

 

 

adverse developments in the availability of desirable investment opportunities, whether they are due to competition, regulation or otherwise;

 

 

the extent of loan modification efforts, as well as the effects of regulatory requirements or guidance regarding loan modifications;

 

 

the availability and cost of both credit and capital;

 

 

investor sentiment and confidence in the financial markets;

 

 

our reputation and the reputation of Wells Fargo and the Bank;

 

 

financial services reform and the impact of other current, pending and future legislation, regulation and legal actions applicable to us, the Bank or Wells Fargo, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and related regulations, and the final definition of qualified mortgage issued by the Consumer Financial Protection Bureau (the “CFPB”);

 

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changes in accounting standards, rules and interpretations;

 

 

various monetary and fiscal policies and regulations of the U.S. and foreign governments;

 

 

a failure in or breach of our, the Bank’s or Wells Fargo’s operational or security systems or infrastructure, or those of third-party vendors and other security providers, including as a result of cyber-attacks; and

 

 

the other factors described in “Risk Factors” in this prospectus.

In addition to the foregoing factors, we also caution that our allowance for credit losses currently may not be appropriate to cover future credit losses, especially if housing prices decline, unemployment worsens or general economic conditions deteriorate. Increases in loan charge-offs or in the allowance for credit losses and related provision expense could materially adversely affect our financial results and condition.

Any forward-looking statement made by us in this prospectus speaks only as of the date on which it is made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to update publicly any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.

 

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Prospectus Summary

Before you decide to invest in the Series A preferred stock, you should carefully read the following summary, together with the more detailed information and financial statements and related notes contained elsewhere in this prospectus, especially the risks of investing in the Series A preferred stock discussed below under “Risk Factors.”

General

Wells Fargo Real Estate Investment Corporation

 

 

We are a Delaware corporation incorporated on August 29, 1996 that operates as a real estate investment trust (“REIT”) for U.S. federal income tax purposes. We changed our name from First Union Real Estate Investment Company of Connecticut to Wachovia Real Estate Investment Corp. on August 19, 2002 and to Wells Fargo Real Estate Investment Corporation on February 20, 2014. We are a direct subsidiary of WPFC and an indirect subsidiary of Wells Fargo and the Bank.

Our principal business is to acquire, hold and manage interests in predominantly domestic mortgage loan assets and other authorized investments.

The substantial majority of our assets are participation interests in such loans. We may from time to time hold whole loans or participation interests in loans, which, unless the context otherwise requires, we generally refer to collectively in this prospectus as “loans.”

As a REIT, we generally will not be required to pay U.S. federal income tax on distributed income if we distribute at least 90% of our earnings to our stockholders and continue to meet a number of other requirements as discussed below.

 

 

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Our Organizational Structure

At September 30, 2014, our organizational structure was:

 

LOGO

Assets

As of September 30, 2014 and December 31, 2013, we had $12.8 billion and $13.0 billion of assets, $0.7 billion and $0.9 billion of liabilities and $12.1 billion and $12.1 billion of stockholders’ equity, respectively. Our assets are primarily comprised of residential mortgage loans secured by 1-4 family real estate properties (which we refer to as “real estate 1-4 family first mortgage loans” for loans secured by first liens and as “real estate 1-4 family junior lien mortgage loans” for loans secured by second or more junior liens, and together as “consumer loans” or “real estate 1-4 family mortgage loans”) and commercial properties secured by real estate loans (“CSRE loans”). We also currently hold a limited amount of commercial and industrial loans (“C&I loans,” and together with CSRE loans, “commercial loans”).

 

 

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We have acquired both conforming and non-conforming real estate 1-4 family mortgage loans from the Bank. The properties underlying real estate 1-4 family mortgage loans consist of single-family detached units, individual condominium units, 2-4 family dwelling units and townhouses. Our portfolio of real estate 1-4 family mortgage loans consists of both adjustable and fixed rate mortgage loans.

Our real estate 1-4 family junior lien mortgage loans are secured by a junior lien mortgage that primarily is on the borrower’s residence and typically are made for reasons such as home improvements, acquisition of furniture and fixtures, purchases of automobiles and debt consolidation. Generally, junior liens are repaid on an amortization basis. As of September 30, 2014, substantially all of our real estate 1-4 family junior lien mortgage loans bear interest at fixed rates.

Our commercial loan portfolio consists of C&I loans and CSRE loans. C&I loans are loans for commercial, financial or industrial purposes, whether secured or unsecured, single-payment or installment. CSRE loans are loans secured by a mortgage or deed of trust on a multi-family residential or commercial real estate property or real estate construction loans secured by real property.

As of September 30, 2014, the majority of the loans in our C&I loan portfolio were unsecured and the remainder were secured by short-term assets, such as accounts receivable, inventory and securities, or long-lived assets, such as equipment and other business assets. Generally, the collateral securing this portfolio represents a secondary source of repayment. Our CSRE portfolio consists of both mortgage loans and construction loans and these loans are primarily secured by real estate.

Our commercial loan portfolio consists of both adjustable and fixed rate loans. As of September 30, 2014, substantially all of our commercial loans bear interest at adjustable rates.

See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy” for more details on our asset portfolio.

Our assets consisted of the following as of September 30, 2014:

 

 

$8.5 billion, or 66%, of our assets were real estate 1-4 family first mortgage loans;

 

 

$1.8 billion, or 14%, of our assets were real estate 1-4 family junior lien mortgage loans; and

 

 

$2.5 billion, or 20%, of our assets were CSRE loans.

In addition, as of September 30, 2014, less than 1% of our assets consisted of C&I loans and less than 1% consisted of other assets.

We generally have acquired, or accepted as capital contributions, participation interests in loans both secured and not secured by real estate along with other assets. We anticipate that we will acquire, or receive as capital contributions, loans or other assets from the Bank pursuant to loan participation and servicing and assignment agreements. The Bank initially transfers the loans to certain subsidiaries of the Bank which then sell (or, in the case of the November 2013 contribution by WPFC, contribute) the loans to us, in each case, in the form of participation interests. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview – Asset Contributions.” We also have the authority to acquire interests in loans and other assets directly from unaffiliated third parties, although we have not done so to date. In addition, we may acquire from time to time mortgage-backed securities and a limited amount of additional non-mortgage related securities from the Bank.

 

 

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In November 2013, WPFC contributed to us approximately $7.1 billion of loans in the form of an assignment of their participation interests from the Bank, consisting of approximately $5.4 billion of consumer loans and the remainder commercial loans, $18.0 million of accrued interest thereon and $2.4 million of foreclosed assets. The contributed assets were recorded at their WPFC book value, including the allowance for credit losses of approximately $197.1 million and unamortized premiums and discounts on loans. We did not issue additional shares of common stock to WPFC in respect of this contribution.

Dividends

We expect to distribute annually an aggregate amount of dividends with respect to our outstanding capital stock equal to approximately 100% of our REIT taxable income for U.S. federal income tax purposes, which excludes capital gains. In order to remain qualified as a REIT, we are required to distribute annually at least 90% of our REIT taxable income to our stockholders, including Wells Fargo, WPFC and the holders of the Series A preferred stock. Assuming we are at that time current on the payment of dividends on the Series A preferred stock, the substantial majority of such dividends will be payable to WPFC as the holder of our common stock.

Dividends will be authorized and declared at the discretion of our board of directors after considering our distributable funds, financial condition and capital needs, the impact of current and pending legislation and regulations, Delaware corporate law, economic conditions, tax considerations, our continued qualification as a REIT and other factors. We currently expect that both our cash available for distribution and our REIT taxable income will be in excess of amounts needed to pay dividends on the Series A preferred stock, at the annual dividend rate of 6.375% on the $25 liquidation preference per share, in the foreseeable future because:

 

 

substantially all of our real estate loans and other authorized investments are interest-bearing;

 

 

while from time to time we may incur indebtedness, we will not incur an aggregate amount that exceeds 20% of our stockholders’ equity;

 

 

we expect that our interest-earning assets will continue to exceed the aggregate liquidation preference of all of our preferred stock; and

 

 

we anticipate that, in addition to cash flows from operations, additional cash will be available from principal payments on the loans we hold.

Management

Our board of directors is currently composed of four members. One member of our board of directors is an executive officer of WFREIC. The three remaining members of our board of directors are not employees or directors of Wells Fargo, and each satisfies the definition of being “independent” as set forth in Rule 10A-3 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We currently have two executive officers. Both of our executive officers are also executive officers of Wells Fargo and executive officers and directors of the Bank. All our day-to-day activities and substantially all of the servicing of the loans we hold currently are administered, pursuant to loan participation and servicing and assignment agreements, by the Bank, which is our indirect parent company, although, in some instances, the Bank has delegated servicing responsibility to third parties.

 

 

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Risk Factors

 

 

A purchase of our Series A preferred stock is subject to a number of risks described in more detail under “Risk Factors.” These risks include:

 

 

You are not entitled to receive dividends unless authorized and declared by our board of directors.

 

 

Regulatory restrictions on the Bank, as well as Wells Fargo, may limit our ability to pay dividends on the Series A preferred stock.

 

 

The holders of our Series A preferred stock have limited voting rights, including that we may liquidate, dissolve or wind up without your approval or consent upon the affirmative vote of a majority of our independent directors.

 

 

Neither the Bank nor Wells Fargo guarantees our obligations on the Series A preferred stock, and neither is prohibited, pursuant to the terms of the Series A preferred stock, from paying dividends at any time, even if we have not paid dividends on the Series A preferred stock.

 

 

We are effectively controlled by Wells Fargo and its other affiliates and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.

 

 

We have not obtained a third-party valuation of any of our assets acquired from affiliated parties. Therefore, there can be no assurance that the terms by which we acquired such assets did not differ from the terms that could have been obtained from unaffiliated parties.

 

 

We may pledge up to 80% of our assets as collateral on behalf of the Bank for the Bank’s access to secured borrowing facilities through Federal Home Loan Banks and Federal Reserve Banks, which subjects us to the Bank’s default risk.

 

 

Legislative and regulatory proposals may restrict or limit our ability to engage in our current business or in businesses that we desire to enter into.

 

 

Our no longer qualifying for an exclusion from the definition of an investment company under the Investment Company Act (as defined below).

 

 

Our financial results and condition may be adversely affected by difficult business and economic and other conditions, particularly if housing prices decline, unemployment worsens or general economic conditions deteriorate.

 

 

We have no control over changes in interest rates and such changes could negatively impact our financial condition, results of operations and ability to pay dividends.

 

 

Due to, among other things, certain changes in legislation, regulations or our capital structure, we could fail to qualify as a REIT. We may suffer adverse tax consequences if we fail to qualify as a REIT.

Conflicts of Interest

Because our day-to-day business affairs currently are managed by the Bank, conflicts of interest will arise from time to time between us and the Bank or its affiliates. These conflicts of interest relate to, among other things:

 

 

the amount, type and price of loans and other assets we acquire from or sell to the Bank;

 

 

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the servicing of the underlying loans, particularly with respect to loans that are placed on non-accrual status;

 

 

the amount of loan servicing costs and management fees paid to the Bank;

 

 

the pledge of our assets on behalf of the Bank;

 

 

the treatment of new business opportunities identified by the Bank or its affiliates; and

 

 

the modification of the loan participation and servicing and assignment agreements.

We have adopted policies with a view to ensuring that all financial dealings between the Bank or its affiliates and us will be fair to both parties and not inconsistent with market terms.

Investment Company Act of 1940

Section 3(a)(1)(A) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), defines an investment company as any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities, which for these purposes includes loans and participation interests therein. Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis.

We believe that we qualify, and intend to conduct our operations so as to continue to qualify, for the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C) excludes from the definition of an investment company entities that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” As reflected in a series of no-action letters, the Securities and Exchange Commission (the “SEC”) staff’s position on Section 3(c)(5)(C) generally requires that in order to qualify for this exclusion, an issuer must maintain

 

   

at least 55% of the value of its assets in “mortgages and other liens on and interests in real estate” (“Qualifying Interests”),

 

   

at least an additional 25% of its assets in other permitted real estate-type interests (reduced by any amount the issuer held in excess of the 55% minimum requirement for Qualifying Interests), and

 

   

no more than 20% of its assets in other than Qualifying Interests and real estate-type assets,

and also that the interests in real estate meet other criteria described in such no-action letters. Mortgage loans that were fully and exclusively secured by real property are typically qualifying for these purposes. In addition, participation interests in such loans meeting certain criteria described in such no-action letters are generally qualifying real estate assets for purposes of the exclusion. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Investment Company Act of 1940.” We believe that our participation interests in mortgage loans satisfy these criteria and that we otherwise qualify for the exclusion provided by Section 3(c)(5)(C) of the Investment Company Act.

 

 

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In August 2011, the SEC issued a concept release which indicated that the SEC is reviewing whether issuers who own certain mortgage related investments that rely on the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act should continue to be allowed to rely on such exclusion. The concept release and the public comments thereto have not yet resulted in SEC rulemaking or interpretive guidance and we cannot predict what form any such rulemaking or interpretive guidance may take. We cannot provide you with any assurance that the outcome of the SEC’s review will not require us to register under the Investment Company Act. If a change in the laws or the interpretations of those laws were to occur, we could be required to either change the manner in which we conduct our operations to avoid being required to register as an investment company or register as an investment company, either of which could have a material adverse effect on us and the price of the Series A preferred stock, and could give us the right and/or cause us to redeem the Series A preferred stock, as applicable. See “Description of the Series A Preferred Stock – Redemption” and “Risk Factors – Risks Relating to the Terms of the Series A Preferred Stock – Holders of the Series A preferred stock have no right to require redemption; however, we may redeem the Series A preferred stock upon certain events, and at any time after December 11, 2019.”

Corporate Information

 

 

Our principal executive offices are located at 90 South 7th Street, 13th Floor, Minneapolis, Minnesota 55402, and our telephone number is (855) 825-1437.

Our executive officers are also executive officers and directors of Wells Fargo Bank, National Association, a national banking organization and our indirect parent, which we refer to in this prospectus as the “Bank.” The Bank currently provides day-to-day management and substantially all of the servicing of the loans in our portfolio.

Our executive officers are also executive officers of Wells Fargo & Company, a Delaware corporation and a financial and bank holding company, which we refer to in this prospectus as “Wells Fargo.”

 

 

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Summary Financial Data

The following summary financial data for the nine-month periods ended September 30, 2014 and 2013 are derived from our unaudited financial statements, and the following summary financial data for the two years ended December 31, 2013 and 2012 are derived from our audited financial statements. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus and financial statements, related notes and other financial information beginning on page F-1 of this prospectus.

In November 2013, WPFC contributed $7.1 billion of consumer and commercial loans in the form of an assignment of their participation interests from the Bank, $18.0 million of accrued interest and $2.4 million of foreclosed assets to us. The contribution of assets was an equity transaction between entities under common control; therefore, the assets were recorded at their WPFC book value, including the allowance for credit losses of $197.1 million and unamortized premiums and discounts on loans.

Summary Financial Data

 

 

 
    Nine months ended
Sept. 30,
   

%

Change

    Year ended Dec. 31,    

%

Change

 
 

 

 

     

 

 

   
($ in thousands, except per share
data)
  2014     2013       2013     2012    

 

 

For the period

           

Net income

  $ 482,929        143,686       236   $ 257,430        143,092        80

Net income applicable to common stock

    482,886        143,643       236        257,373        143,035        80   

Diluted earnings per common share

    748,660        222,702       236        399,028        221,760        80   

Profitability ratios

           

Return on average assets

    5.10     4.22       21        4.49     3.80        18   

Return on average stockholders’ equity

    5.32        4.78       11        4.99        3.86        29   

Average stockholders’ equity to average assets

    95.76        88.18       9        89.88        98.55        (9

Common dividend payout ratio (1)

    92.15        111.39       (17     124.33        130.03        (4

Total revenue

  $ 521,252        170,566        206      $ 297,650        203,913        46   

Average loans

    12,683,939        4,389,530       189        5,599,538        3,286,255        70   

Average assets

    12,669,713        4,553,925       178        5,734,306        3,765,511        52   

Net interest margin

    5.47     5.04       9        5.22     5.39        (3

Net loan charge-offs

  $ 50,915        19,063       167      $ 34,626        46,862        (26

As a percentage of average total loans

    0.54     0.58       (8     0.62     1.43        (57

At period end

           

Loans, net of unearned income

  $ 12,923,416        5,551,385       133      $ 13,120,341        4,112,498        219   

Allowance for loan losses

    194,039        58,479       232        243,752        65,340        273   

As a percentage of total loans

    1.50     1.05       43        1.86     1.59        17   

Assets

  $ 12,834,479        5,547,241        131      $ 12,966,194        4,114,993        215   

Total stockholders’ equity

    12,094,517        4,796,265        152        12,056,631        3,662,622        229   

Total nonaccrual loans and foreclosed assets

    340,555        98,986        244        428,436        109,337        292   

As a percentage of total loans

    2.64     1.78       48        3.27     2.66        23   

Loans 90 days or more past due and still accruing (2)

  $ 19,933        6,283        217      $ 18,182        4,393                314   

 

 

 

(1) Dividends declared per common share as a percentage of diluted earnings per common share.
(2) The carrying value of purchased credit-impaired (“PCI”) loans contractually 90 days or more past due is excluded. These PCI loans are considered to be accruing because they continue to earn interest from accretable yield, independent of performance in accordance with their contractual terms.

 

 

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The Offering

 

Issuer

Wells Fargo Real Estate Investment Corporation, a Delaware corporation that is an indirect subsidiary of Wells Fargo and the Bank, and operates as a REIT for U.S. federal income tax purposes.

 

Securities Offered

9,600,000 shares of 6.375% Cumulative Perpetual Preferred Stock, Series A (or 11,000,000 shares if the underwriters were to exercise in full their option to purchase additional shares of the Series A preferred stock).

 

Dividends

Dividends on the Series A preferred stock will be payable at the annual rate of 6.375% on the liquidation preference of $25 per share, if, when, and as authorized and declared by our board of directors. If declared, dividends will be payable quarterly in arrears on March 31, June 30, September 30 and December 31 of each year, commencing on March 31, 2015. If any such day is not a business day, dividends will be payable on the next business day, unless the next business day falls in a different calendar year, in which case the dividend will be paid on the preceding business day. A business day is any day other than a Saturday, Sunday or day on which banking institutions in Minneapolis, Minnesota, New York, New York or San Francisco, California generally are required by law or other governmental action to close. Dividends will be calculated on a 30/360 basis.

 

  Dividends on the Series A preferred stock are cumulative and will accrue from, and including, the date of original issue. Dividends on the Series A preferred stock will accrue in each quarterly dividend period (as defined below) from the first day of such period, whether or not dividends are paid with respect to the preceding period. If for any reason our board of directors does not declare a dividend on the Series A preferred stock for a particular quarterly dividend period or if our board of directors declares less than a full dividend, we will remain obligated to pay the unpaid portion of the dividend for that period. After the relevant quarterly dividend period, any accumulated but unpaid dividends for such prior period will compound on each subsequent dividend date (meaning that dividends for future quarterly dividend periods will accrue on any unpaid dividend amounts for prior quarterly dividend periods). Dividends on the Series A preferred stock will accrue and accumulate regardless of whether (i) we have earnings, (ii) there are funds legally available for the payment of dividends, or (iii) such dividends are declared by our board of directors.

 

 

If full dividends are not paid on the Series A preferred stock for a quarterly dividend period, we will not be permitted to pay dividends on our common stock (100% of which is owned directly or indirectly by Wells Fargo and its affiliates) or any other class or series of capital stock that ranks junior to the Series A preferred stock for any subsequent quarterly dividend period until we have paid the required amount of such accumulated dividends, as well as any other accumulated but unpaid dividends (including dividends accrued on any unpaid

 

 

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dividends), plus accrued interest, if any, on the aggregate amount payable from the last dividend payment date to the date of payment, with respect to any other prior quarterly dividend periods, in full.

 

  Additionally, our ability to pay dividends on any class or series of capital stock that ranks junior to the Series A preferred stock, except with the consent or affirmative vote of the holders of at least two-thirds of the Series A preferred stock, voting as a separate class, is subject to the limitations described below under “Voting Rights.”

 

Ranking

With respect to the payment of dividends and liquidation preference, the Series A preferred stock ranks equal to our outstanding $667 thousand aggregate liquidation preference Series B preferred stock (as of September 30, 2014) and senior to our common stock. However, the Series B preferred stock does not have a right to elect additional directors in the circumstances described below under “Voting Rights.” Additional preferred stock ranking senior to the Series A preferred stock, which we refer to as “senior stock,” may not be issued without the approval of holders of at least two-thirds of the Series A preferred stock and any other series that ranks on parity with the Series A preferred stock (including the Series B preferred stock), each voting as a separate class.

 

  When dividends are not paid in full on, or a sum sufficient for such full payment is not set apart for, the Series A preferred stock and any parity stock, or in the event of our liquidation, dissolution and winding up, and we do not have funds legally available to pay the full liquidation value of the Series A preferred stock and any parity stock, any funds that are legally available to pay such amounts will be declared or paid, as applicable, pro rata to the Series A preferred stock and any outstanding parity stock.

 

 

We may, from time to time, issue additional shares of capital stock ranking junior to, or on parity with, the Series A preferred stock (which we refer to as “junior stock” and “parity stock,” respectively) as to dividends and/or on liquidation, dissolution and winding-up of WFREIC; provided that, with respect to the issuance of additional parity stock, (A) after giving effect to such issuance, our aggregate pro forma funds from operations (“FFO”) (that is, net income (computed in accordance with U.S. generally accepted accounting principles (“GAAP”)), excluding gains or losses from sales of property) for the aggregate four fiscal quarters beginning with the fiscal quarter in which such parity stock is proposed to be issued equals or exceeds 150% of the amount that would be required to pay full annual dividends on all Series A preferred stock then outstanding, any parity stock then outstanding and any such additional parity stock that we propose to issue (the “Pro Forma FFO Test”) (calculated assuming that such proposed shares are issued and that, if outstanding or proposed new shares bear dividends based on a floating rate, the applicable dividend rate will not change during such four fiscal quarters from the rate in effect on the applicable date of determination), and (B) after giving

 

 

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effect to such issuance, the pro forma unpaid principal balance of our total unpledged, performing assets will equal or exceed three times the sum of the aggregate liquidation preference of the Series A preferred stock then outstanding, any parity stock then outstanding and any such additional parity stock that we propose to issue (the “Pro Forma Unpaid Principal Balance Test”). See “Description of the Series A Preferred Stock – Ranking.”

 

  The issuance of parity stock also requires the approval of a majority of our independent directors. See “Description of the Series A Preferred Stock – Independent Director Approval.”

 

Liquidation Preference

The liquidation preference for each Series A preferred share is $25, plus an amount equal to the sum of (i) any authorized, declared but unpaid dividends and (ii) any accumulated but unpaid dividends (including, in each case, dividends accrued on any unpaid dividends), plus accrued interest, if any, on the aggregate amount payable from the last dividend payment date to the date of the liquidation payment, before any distribution of assets is made to holders of junior stock and subject to the rights of the holders of any class or series of capital stock ranking senior to the Series A preferred stock as to rights upon liquidation and subject to the rights of general creditors.

 

Redemption

The Series A preferred stock is not redeemable prior to December 11, 2019, except upon the occurrence of a Tax Event, a Regulatory Event or an Investment Company Act Event (each, as defined below). On and after December 11, 2019, the Series A preferred stock may be redeemed for cash at our option, in whole or in part, at any time and from time to time, at a redemption price of $25 per share, plus an amount equal to the sum of (i) any authorized, declared but unpaid dividends and (ii) any accumulated but unpaid dividends (including, in each case, dividends accrued on any unpaid dividends), plus accrued interest, if any, on the aggregate amount payable from the last dividend payment date to the date of redemption. Within 90 days of the occurrence of a Tax Event, a Regulatory Event or an Investment Company Act Event, we will have the right prior to December 11, 2019, to provide notice of our intent to redeem, and subsequently redeem the Series A preferred stock in whole, but not in part, at a redemption price of $25 per share, plus an amount equal to the sum of (i) any authorized, declared but unpaid dividends and (ii) any accumulated but unpaid dividends (including, in each case, dividends accrued on any unpaid dividends), plus accrued interest, if any, on the aggregate amount payable from the last dividend payment date to the date of redemption. The Series A preferred stock is not subject to any sinking fund or mandatory redemption and is not convertible into any of our other capital stock. See “Description of the Series A Preferred Stock – Redemption.”

 

Voting Rights

Holders of the Series A preferred stock are not entitled to voting rights other than those required by applicable Delaware law, the rules of the NYSE and as set forth in our amended and restated certificate of

 

 

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incorporation. Without the consent of holders of two-thirds of the outstanding Series A preferred stock, voting as a separate class, we will not:

 

   

amend, alter or repeal our amended and restated certificate of incorporation in a manner that materially and adversely affects the existing terms of the Series A preferred stock;

 

   

issue any senior stock;

 

   

issue any additional common stock to any person, other than to Wells Fargo, the Bank, WPFC or any other entity that is an affiliate of Wells Fargo;

 

   

incur indebtedness for borrowed money, including any guarantees of indebtedness (which does not include any pledges of our assets on behalf of the Bank or one of our other affiliates as described below under “Pledge of Assets on Behalf of the Bank”), at any time; provided that we may incur indebtedness in an aggregate amount not exceeding 20% of our stockholders’ equity, as determined in accordance with GAAP;

 

   

pay dividends on our common stock or other junior stock unless our FFO for the four full prior fiscal quarters equals or exceeds 150% of the amount that would be required to pay full annual dividends on the Series A preferred stock, as well as any other parity stock then outstanding, except as may be necessary to maintain our status as a REIT;

 

   

make any payment of interest or principal with respect to our indebtedness to the Bank or any of our other affiliates unless our FFO for the four full prior fiscal quarters equals or exceeds 150% of the amount that would be required to pay full annual dividends on the Series A preferred stock, as well as any other parity stock then outstanding, except as may be necessary to maintain our status as a REIT;

 

   

fail to make investments of the proceeds of our assets in other interest-earning assets such that our FFO over any period of four fiscal quarters will be anticipated to equal or exceed 150% of the amount that would be required to pay full annual dividends on the Series A preferred stock, as well as any other parity stock then outstanding, except as may be necessary to maintain our status as a REIT; or

 

   

effect our consolidation, conversion, or merger with or into, or a share exchange with, another entity, except that we may consolidate or merge with or into, or enter into a share exchange with, another entity if:

 

   

such entity is an affiliate of Wells Fargo;

 

 

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such entity is not regulated as an investment company and is a REIT for U.S. federal income tax purposes;

 

   

such other entity expressly assumes all of our obligations and commitments;

 

   

to the extent we are not the surviving entity of such a transaction, the outstanding shares of the Series A preferred stock are exchanged for or converted into securities of the surviving entity having preferences, limitations, and relative voting and other rights substantially identical to those of the Series A preferred stock;

 

   

any such consolidation, conversion, or merger or share exchange is tax-free to holders of the Series A preferred stock;

 

   

after giving effect to such merger, consolidation, or share exchange, no breach, or event that, with the giving of notice or passage of time or both, could become a breach by us of obligations under our amended and restated certificate of incorporation, will have occurred and be continuing; and

 

   

we have received written notice from each of the rating agencies then rating the Series A preferred stock, if any, and delivered a copy of such written notice to the transfer agent, confirming that such merger, consolidation, or share exchange will not result in a reduction of the rating assigned by any of such rating agencies to the Series A preferred stock or the preferred interests of any surviving corporation, trust or entity, issued in replacement of the Series A preferred stock.

 

  Holders of the Series A preferred stock, voting together as a single and separate class with the holders of any parity stock with similar voting rights, will also have the right to elect two directors in addition to the directors then in office if we fail to pay, or declare and set aside for payment, dividends on the Series A preferred stock for six quarterly dividend periods. The term of such additional directors will terminate when we pay for three consecutive quarterly dividend periods and pay or declare and set aside for payment for the fourth consecutive quarterly dividend period full dividends, and have paid all dividends in arrears, on the Series A preferred stock or, if earlier, upon the redemption of all Series A preferred stock.

 

Assets and Investments

We acquire, hold and manage interests in predominantly domestic mortgage assets and other authorized investments. As of September 30, 2014, we had total assets of $12.8 billion, the substantial majority of which consisted of participation interests in consumer and commercial loans, as described in further detail below under “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers,” “Management’s Discussion and Analysis of Financial

 

 

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Condition and Results of Operations – Risk Management – Credit Risk Management” and “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy.”

 

  Substantially all of our assets, including interests in real estate loans, have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers.” The Bank originated the loans, purchased them from another financial institution or acquired them as part of the acquisition of other financial institutions.

 

  Substantially all of our loans currently are serviced by the Bank pursuant to the terms of loan participation and servicing and assignment agreements. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers.”

 

Pledge of Assets on Behalf of the Bank

We may pledge our loan assets in an aggregate amount not exceeding 80% of our total assets at any time as collateral on behalf of the Bank for the Bank’s access to secured borrowing facilities through Federal Home Loan Banks and Federal Reserve Banks; provided that, after giving effect to any and all such pledges of loan assets, the unpaid principal balance of our total unpledged, performing assets (which, for the avoidance of doubt, shall not be pledged in respect of any other indebtedness we incur or otherwise) will equal or exceed three times the sum of the aggregate liquidation preference of the Series A preferred stock then outstanding plus any other parity stock then outstanding. We do not currently have a pledge agreement with the Bank in place, but may do so in the future. But see “Risk Factors – Risks Relating to the Terms of the Series A Preferred Stock – Because we may, without the approval of the holders of the Series A preferred stock, pledge up to 80% of our total assets to secure certain borrowings by the Bank and incur indebtedness of up to 20% of our stockholders’ equity, it is possible that upon liquidation the pledgees of our assets, together with the lenders of that indebtedness, would have claims superior to those of the holders of Series A preferred stock on substantially all of our assets.”

In exchange for the pledge of our loan assets, the Bank will pay us a fee. Such fee initially will be in an amount we believe represents an arrangement that is not inconsistent with market terms. Such fee may be renegotiated by us and the Bank from time to time. Any material amendment to the terms of agreements related to the pledge of our loan assets on behalf of the Bank, including with respect to fees, will require the approval of a majority of our independent directors. The Bank currently pledges assets to the Federal Home Loan Bank of Des Moines and the discount window of the Federal Reserve Bank of San Francisco. See “Business – Pledge of Assets on Behalf of the Bank.”

 

 

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Listing

We have applied to have the Series A preferred stock listed on the NYSE under the symbol “WFE Pr A”.

 

Use of Proceeds

We intend to use the net proceeds from this offering for general corporate purposes, including the acquisition of qualifying REIT assets in the ordinary course of our business, either by acquiring qualifying REIT assets in fourth quarter 2014 or reducing any outstanding balance on our line of credit used to fund acquisitions of qualifying REIT assets made during 2014 and using the additional borrowing capacity thereunder to acquire additional qualifying REIT assets in the future. Based on our expectation of the timing of this offering, we anticipate the net proceeds will be used to reduce the outstanding balance on our line of credit.

 

Tax Consequences

As long as we qualify as a REIT, corporate holders of the Series A preferred stock will not be entitled to a dividends-received deduction for any income recognized from the Series A preferred stock.

 

  Further, we expect that distributions paid on the Series A preferred stock will not qualify for taxation of dividends at preferential capital gains rates.

 

  See “Federal Income Tax Considerations.”

 

Settlement

We expect that delivery of the Series A preferred stock will be made to investors through the facilities of The Depository Trust Company on or about December 11, 2014.

 

ERISA Considerations

If you are a fiduciary of a pension, profit-sharing or other employee benefit plan subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), or Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”), you should consider the requirements of ERISA and the Code in the context of the plan’s particular circumstances and ensure the availability of an applicable exemption before authorizing an investment in the Series A preferred stock. See “ERISA Considerations.”

 

Regulatory Capital Considerations

The Series A preferred stock will not qualify as regulatory capital of the Bank or Wells Fargo under the risk based capital guidelines of the Office of the Comptroller of the Currency (the “OCC”) applicable to national banking organizations or the risk-based capital guidelines of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) applicable to bank holding companies.

 

 

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RISK FACTORS

An investment in our Series A preferred stock involves a high degree of risk. You should carefully consider the following risk factors, together with all the information contained in this prospectus, including our historical financial statements and the notes thereto, before making an investment decision to purchase our Series A preferred stock. The occurrence of any of the following risks could materially and adversely affect our business and could cause you to lose all or a significant part of your investment in our Series A preferred stock. Some statements in this prospectus, including statements in the following risk factors, constitute forward-looking statements. See the section entitled “Forward-Looking Statements.”

Risks Relating to the Terms of the Series A Preferred Stock

 

 

You are not entitled to receive dividends unless authorized and declared by our board of directors.

Our board of directors may determine that it would be in our best interests to pay less than the full amount of the stated dividends on the Series A preferred stock or no dividends for any quarterly dividend period even though funds are available. Factors that would generally be considered by our board of directors in making this determination are the amount of our distributable funds, our financial condition and capital needs, the impact of current and pending legislation and regulations, economic conditions, tax considerations and our continued qualification as a REIT for U.S. federal income tax purposes. If we fail to pay, or fail to declare and set aside for payment, dividends on the Series A preferred stock for six quarterly dividend periods, the holders of the Series A preferred stock, voting together as a single and separate class with the holders of our other capital stock ranking on parity with our Series A preferred stock having similar voting rights, will have the right to elect two directors in addition to those already on the board of directors.

Regulatory restrictions on the Bank, as well as Wells Fargo, may limit our ability to pay dividends on the Series A preferred stock.

Because we are an indirect subsidiary of the Bank, banking regulatory authorities, including the OCC, have the right to examine us and our activities, and, under certain circumstances, to impose restrictions on the Bank or us that could impact our ability to conduct business pursuant to our business plan and that could adversely affect our financial condition and results of operations. If the OCC, which is the Bank’s primary federal regulator, determines that the Bank’s relationship with us is an unsafe and unsound banking practice, then the OCC will have the authority to restrict our ability to transfer assets, to make distributions to our stockholders (including dividends to the holders of Series A preferred stock) or to redeem the Series A preferred stock. Such banking regulatory authorities may also require the Bank to sever its relationship with or divest its direct and indirect ownership of us or to liquidate us.

Payments or distributions on the Series A preferred stock are subject to certain regulatory limitations. Among other limitations, regulatory capital guidelines limit the total dividend payments made by a consolidated banking entity to the sum of earnings for the current year and prior two years less dividends paid during the same periods. Any dividends paid in excess of this amount can only be made with the approval of the Bank’s regulator.

In addition, the payment of a dividend on the Series A preferred stock would be prohibited under the OCC’s prompt corrective action regulations if the Bank becomes or would become “undercapitalized” for purposes of such regulations, which is currently defined as having a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a core capital,

 

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or Tier 1 leverage ratio of less than 4.0%. As of September 30, 2014, the Bank was “well-capitalized” under applicable regulatory capital adequacy guidelines. As of that date, the Bank’s total risk-based capital ratio was 12.88%, its Tier 1 risk-based capital ratio was 10.69%, its common equity Tier 1 risk-based capital ratio was 10.69% and its Tier 1 leverage ratio was 8.33%.

In October 2013, the Federal Reserve and the OCC published in the Federal Register final capital rules that substantially amend the existing capital rules for bank holding companies and banks. These new rules reflect, in part, certain standards adopted by the Basel Committee on Banking Supervision in December 2010 (commonly referred to as “Basel III”) as well as requirements contemplated by the Dodd-Frank Act. The prompt corrective action rules, which apply to the Bank, were modified to include a common equity Tier 1 risk-based ratio and a supplementary leverage ratio and to increase certain other capital requirements for the various thresholds. Under the new rules, which are effective January 1, 2015 for the Bank, the Bank would become “undercapitalized” for purposes of such regulations, if it had a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 6.0%, a common equity Tier 1 risk-based capital ratio of less than 4.5% or a Tier 1 leverage ratio of less than 4.0%, or, effective January 1, 2018, a supplementary leverage ratio of less than 3.0%.

Finally, Wells Fargo and its subsidiaries, including WFREIC, are subject to broad prudential supervision by the Federal Reserve, which may result in a limitation on or the elimination of our ability to pay dividends on the Series A preferred stock, including, for example, in the event that the OCC had not otherwise restricted the payment of such dividends as described above and the Federal Reserve determines that such payment would constitute an unsafe and unsound practice. To the extent the payment of dividends on the Series A preferred stock were restricted or eliminated by the OCC or the Federal Reserve in such a manner, such dividends would nevertheless continue to accumulate. See “Description of Series A Preferred Stock – Dividends.”

The holders of the Series A preferred stock have limited voting rights.

Except as specified in our amended and restated certificate of incorporation, the holders of the Series A preferred stock are not entitled to voting rights. Wells Fargo indirectly owns 100% of our common stock and therefore has effective control over voting. We are prohibited by our amended and restated certificate of incorporation from materially and adversely altering the terms of the Series A preferred stock without the consent or vote of holders of at least two-thirds of the then outstanding Series A preferred stock, voting as a separate class. For descriptions of the matters on which the holders of the Series A preferred stock have a right to vote, see “Description of the Series A Preferred Stock — Voting Rights.”

We may liquidate, dissolve or wind up at any time without your approval or consent.

Our amended and restated certificate of incorporation provides that, subject to the terms of the capital stock we have outstanding at the time, we may liquidate, dissolve or wind up upon the affirmative vote of a majority of our independent directors. However, since the holders of the Series A preferred stock do not have voting rights as a separate class with respect to these matters, WPFC, which is currently the holder of all of our common stock and substantially all of our Series B preferred stock, has control over our liquidation, dissolution or winding up. Although WPFC has no present intention to cause such an event to occur, it may in the future cause us to liquidate, dissolve or wind up at any time or for any reason. If such an event were to occur, you may not be able to invest your liquidation proceeds in securities with a dividend yield comparable to that of the Series A preferred stock.

Holders of the Series A preferred stock have no right to require redemption; however, we may redeem the Series A preferred stock upon certain events, and at any time after December 11, 2019.

Within 90 days of the occurrence of a Tax Event, a Regulatory Event or an Investment Company Act Event, even if such event occurs prior to December 11, 2019, we will have the right to provide notice of

 

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Risks Relating to the Terms of the Series A Preferred Stock (continued)

 

our intent to reedem, and subsequently redeem the Series A preferred stock in whole or in part. The occurrence of such Tax Event, Regulatory Event or Investment Company Act Event will not, however, give a stockholder any right to request that the Series A preferred stock be redeemed. Tax Event, Regulatory Event and Investment Company Act Event are defined as follows:

 

 

A Tax Event means our determination, based on our receipt of an opinion of counsel, rendered by a law firm experienced in such matters, in form and substance satisfactory to us, which states that there is a significant risk that dividends paid or to be paid by us with respect to our capital stock are not or will not be fully deductible by us for U.S. federal income tax purposes or that we are or will be subject to additional taxes, duties, or other governmental charges, determined by reference to the effect on the tax liability of any consolidated, combined, unitary or similar tax group of which we are a part, in an amount we reasonably determine to be significant as a result of:

 

   

any amendment to, clarification of, or change in, the laws, treaties, or related regulations of the United States or any of its political subdivisions or their taxing authorities affecting taxation; or

 

   

any judicial decision, official administrative pronouncement, published or private ruling, technical advice memorandum, Chief Counsel Advice, as such term is defined in the Code, regulatory procedure, notice, or official announcement, which we refer to collectively as “Administrative Actions”;

which amendment, clarification, or change, or such official pronouncement or decision, is announced, on or after the original date of issuance of the Series A preferred stock.

 

 

A Regulatory Event means our reasonable determination, as evidenced by a certificate of one of our senior executive officers, that the Series A preferred stock remaining outstanding would (x) not be consistent with any applicable law or regulation or (y) have a material adverse effect on either us or any of Wells Fargo or the Bank (or any of their respective successors), in each case, as a result of a change in law or regulation or a written change in interpretation or application of law or regulation, by any legislative body, court, governmental agency, or regulatory authority occurring on or after the original date of issuance of the Series A preferred stock, such change in law being reflected in an opinion of counsel, in form and substance satisfactory to us.

 

 

An Investment Company Act Event means our determination, based on our receipt of an opinion of counsel, rendered by a law firm experienced in such matters, in form and substance satisfactory to us, which states that there is a significant risk that we are or will be considered an “investment company” that is required to be registered under the Investment Company Act, as a result of the occurrence of a change in law or regulation or a written change in interpretation or application of law or regulation, by any legislative body, court, governmental agency, or regulatory authority.

See “Risk Factors – Risks Associated with Our Business - Our no longer qualifying for an exclusion from the definition of an investment company under the Investment Company Act could have a material adverse effect on us.”

While the Series A preferred stock may be redeemed at our option under certain circumstances described herein, investors in the Series A preferred stock will have no right to reclaim their initial investment from us and the Series A preferred stock may never be redeemed. If investors in Series A preferred stock choose to sell their shares of Series A preferred stock in order to reclaim all or part of their initial investment in the absence of any redemption, those investors may not be able to sell their securities in the secondary market, or if such a sale occurs the sale price may not be at or above the initial price at which such shares were purchased.

 

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If we redeem the Series A preferred stock, you may not be able to invest your redemption proceeds in securities with a dividend yield comparable to that of the Series A preferred stock. See “Description of the Series A Preferred Stock – Redemption.”

The Series A preferred stock will rank subordinate to claims of our creditors and on parity with our outstanding Series B preferred stock and any other capital stock on parity with the Series A preferred stock that we may issue in the future.

The Series A preferred stock will rank subordinate to all claims of our creditors and, with respect to assets pledged on behalf of the Bank, subordinate to claims on such assets pledged on behalf of the Bank. The Series A preferred stock will rank on parity with our outstanding $667 thousand of aggregate liquidation preference Series B preferred stock (as of September 30, 2014) with respect to dividend rights and upon our liquidation, dissolution and winding up. In addition, our board of directors has the power to create and issue additional stock that will rank on parity with the Series A preferred stock without the consent of the holders of the Series A preferred stock so long as we satisfy the Pro Forma FFO Test and the Pro Forma Unpaid Principal Balance Test and such issuance is approved by a majority of our independent directors. Accordingly, if

 

 

we do not have funds legally available to pay full dividends on the Series A preferred stock and any other parity stock that we may issue; or

 

 

in the event of our liquidation, dissolution and winding up, we do not have funds legally available to pay the full liquidation value of the Series A preferred stock and any other parity stock,

any funds that are legally available to pay such amounts will be paid pro rata to the Series A preferred stock and any other outstanding parity stock. See “Description of the Series A Preferred Stock – Ranking.”

Because we may, without the approval of the holders of the Series A preferred stock, pledge up to 80% of our total assets to secure certain borrowings by the Bank and incur indebtedness of up to 20% of our stockholders’ equity, it is possible that upon liquidation the pledgees of our assets, together with the lenders of that indebtedness, would have claims superior to those of the holders of Series A preferred stock on substantially all of our assets.

We will have the right to pledge our loan assets in an aggregate amount not exceeding 80% of our total assets at any time as collateral on behalf of the Bank for the Bank’s access to secured borrowing facilities through the Federal Home Loan Banks and Federal Reserve Banks. In addition, without the consent of holders of the Series A preferred stock, we have the ability to incur indebtedness at any time in an aggregate amount not exceeding 20% of our stockholders’ equity (determined in accordance with GAAP). As of September 30, 2014, our stockholders’ equity of $12.1 billion was equal to 94% of our total assets of $12.8 billion. GAAP does not require that pledges of assets used to secure the Bank’s borrowing obligations be treated as liabilities. Accordingly, it is possible that upon liquidation the pledgees of our assets, together with the lenders of indebtedness we are permitted to incur, would have claims superior to those of the holders of Series A preferred stock on substantially all of our assets, in which case those claims would prevent holders of the Series A preferred stock from obtaining any recovery upon our liquidation.

 

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Risks Relating to the Terms of the Series A Preferred Stock (continued)

 

The level of our assets relative to the aggregate liquidation preference of the Series A preferred stock could decline over time because of, among other things, dividends paid by us on our common stock, or other junior stock, if any such junior stock is issued at a future date.

Subject to satisfying an FFO test (see “Description of the Series A Preferred Stock – Voting Rights”), if we have paid full dividends on the Series A preferred stock as described below under “Description of the Series A Preferred Stock – Dividends,” we are not prohibited from paying dividends, whether in cash or in kind, that could cause the level of our assets relative to the aggregate liquidation preference of the Series A preferred stock to decline. Additionally, we have the power to create and issue parity stock without the consent of the holders of the Series A preferred stock so long as we satisfy the Pro Forma FFO Test and the Pro Forma Unpaid Principal Balance Test and the issuance has been approved by a majority of our independent directors. See “Description of the Series A Preferred Stock – Ranking” and “– Independent Director Approval.”

As various loans prepay or repay principal and distributions, subject to the limitations referenced above, we may choose to apply such amounts to pay dividends or return capital on our common stock. Additionally, subject to the limitations referenced above, we could distribute a portion of our assets as a return of capital on our common stock. We have no current intention to declare a return of capital, and Wells Fargo and the Bank have no current intention to cause or permit us to declare a return of capital. Nevertheless, dividends paid by us on our common stock could result in a reduction in our assets that could have the consequence of us not having funds available to pay full dividends on the Series A preferred stock in future periods or loss to you of some or all of the amount of your investment should we be liquidated.

There has been no public market for the Series A preferred stock prior to this offering and an active trading market may never develop or be sustained following this offering.

Prior to this offering, there has been no public market for our Series A preferred stock, and an active trading market may not develop or be sustained. The initial public offering price of shares of our Series A preferred stock will be determined by agreement among us and the underwriters, but our Series A preferred stock may trade below the initial public offering price following the completion of this offering. See “Underwriting.” The market value of our Series A preferred stock could be substantially affected by general market conditions, including the extent to which a secondary market develops for our Series A preferred stock following the completion of this offering, the extent of institutional investor interest in us, the general reputation of REITs and the attractiveness of their equity securities in comparison to other equity securities (including securities issued by other real estate-based companies), our financial performance and general stock and bond market conditions.

Stock markets, including the NYSE (on which we intend to list shares of our Series A preferred stock), have from time to time experienced significant price and volume fluctuations. As a result, the market price of shares of our Series A preferred stock may be similarly volatile, and investors in shares of our Series A preferred stock may from time to time experience a decrease in the value of their shares, including decreases unrelated to our operating performance or prospects. The price of shares of our Series A preferred stock could be subject to wide fluctuations in response to a number of factors, including those listed in this “Risk Factors” section of this prospectus and others such as:

 

 

our operating performance and the performance of other similar companies;

 

 

actual or anticipated differences in our quarterly operating results;

 

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changes in our revenues or earnings estimates or recommendations by securities analysts;

 

 

publication of research reports about us, the residential mortgage loan, commercial loan or industrial loan sectors or the real estate industry;

 

 

the level and volatility of capital markets, interest rates, currency values and other market indices that affect the value of our assets and liabilities;

 

 

increases in market interest rates or other changes in monetary policy, which may lead investors to demand higher distribution yields for shares of our Series A preferred stock;

 

 

the availability and cost of both credit and capital, and our ability to obtain financing;

 

 

increased competition in the residential mortgage loan, commercial real estate or industrial financing business;

 

 

strategic decisions by us and our affiliates or our competitors, such as acquisitions, divestments, spin-offs, joint ventures, strategic investments or changes in business strategy, and the ability to execute on them;

 

 

the impact of current, pending and future legislation, regulation and legal actions applicable to us, the Bank, Wells Fargo or our industry;

 

 

speculation in the press or investment community;

 

 

actions by institutional stockholders;

 

 

security issuances by us, or resales by our stockholders, or the perception that such issuances or resales may occur;

 

 

changes in accounting standards, rules and interpretations or actual, potential or perceived accounting problems;

 

 

failure to qualify as a REIT;

 

 

cyber-attacks, terrorist acts, natural or man-made disasters or threatened or actual armed conflicts; and

 

 

economic conditions that affect the general economy, housing prices, the job market, consumer confidence and spending habits, including our borrowers’ prepayment and repayment of our loans (particularly in states where we have significant exposure), including factors unrelated to our performance.

The market price of shares of our Series A preferred stock may fluctuate or decline significantly in the future and holders of shares of our Series A preferred stock may not be able to sell their shares when desired on favorable terms, or at all. From time to time in the past, securities class action litigation has been instituted against companies following periods of extreme volatility in their stock price. This type of litigation could result in substantial costs and divert our management’s attention and resources.

The Series A preferred stock solely represents an interest in us and is not the obligation of, or guaranteed by, any other entity.

The Series A preferred stock does not constitute an obligation or equity security of Wells Fargo, the Bank or any other entity, nor is our obligation with respect to the Series A preferred stock guaranteed

 

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Risks Relating to the Terms of the Series A Preferred Stock (continued)

 

by any other entity. In particular, none of Wells Fargo, the Bank or any other entity guarantees that we will declare or pay any dividends nor are they obligated to provide additional capital or other support to us to enable us to pay dividends in the event our assets and results of operations are insufficient for such purpose.

The shares of Series A preferred stock are not deposits or accounts and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency. Neither the Bank nor Wells Fargo is prohibited, pursuant to the terms of the Series A preferred stock, from paying dividends at any time, even if we have not paid dividends on the Series A preferred stock.

Risks Associated with Our Business

 

 

We are effectively controlled by Wells Fargo and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.

Both of our executive officers are also executive officers of Wells Fargo and are executive officers and directors of the Bank. One of these executive officers is also a director of the Company. After this offering, Wells Fargo, the Bank and WPFC will continue to directly and indirectly control a substantial majority of our outstanding voting shares and, in effect, have the right to elect all of our directors, including our independent directors, except under limited circumstances if we fail to pay dividends.

Wells Fargo and the Bank may have interests that differ from our interests. Wells Fargo may have investment goals and strategies that differ from those of the holders of the Series A preferred stock. Furthermore, the Bank currently is responsible for the administration of our day-to-day activities pursuant to the terms of loan participation and servicing and assignment agreements. Consequently, conflicts of interest between us, on the one hand, and Wells Fargo, WPFC and/or the Bank, on the other hand, may arise. Because Wells Fargo’s interests may differ from those of the holders of the Series A preferred stock, actions Wells Fargo takes or omits to take with respect to us may not be as favorable to the holders of the Series A preferred stock as they are to Wells Fargo.

As a consolidated subsidiary of Wells Fargo, we are subject to Wells Fargo’s enterprise risk management framework, including enterprise-level management committees that have been established to inform the risk management framework and provide governance and advice regarding management functions, and we are subject to key elements of Wells Fargo’s enterprise risk management culture. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Wells Fargo’s Risk Management Framework and Culture.”

We depend on the officers and employees of Wells Fargo and the Bank for the selection, structuring and monitoring of our loan portfolio, and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.

Wells Fargo and the Bank are involved in virtually every aspect of our management and operations. We are dependent on the diligence and skill of the officers and employees of the Bank for the selection, structuring and monitoring of our loan portfolio and our other authorized investments and business opportunities.

Because of the nature of our relationship with the Bank and its affiliates, it is likely that conflicts of interest will arise with respect to certain transactions, including, without limitation, our acquisition of loans from, or disposition of loans to, the Bank, foreclosure on defaulted loans and the modification of loan participation and servicing and assignment agreements.

 

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Conflicts of interest among us and the Bank or its affiliates may also arise in connection with making decisions that bear upon the credit arrangements that the Bank or its affiliates may have with a borrower under a loan. Conflicts also could arise in connection with other actions taken by us or the Bank or its affiliates. In addition, conflicts could arise between the Bank or its affiliates and us in connection with modifications to consumer loans, including under modifications made pursuant to the Bank’s proprietary programs and pursuant to the U.S. Treasury’s Making Home Affordable programs and the Home Affordable Modification Program, for first lien loans and Second Lien Mortgage Program for junior lien loans.

It is our intention that any agreements and transactions between us and the Bank or its affiliates, including, without limitation, any loan participation and servicing and assignment agreements, be fair to all parties and consistent with market terms for such types of transactions. The terms of any such agreement or transaction may, however, differ from terms that could have been obtained from unaffiliated third parties.

We depend on the officers and employees of Wells Fargo and the Bank for administrative services and the servicing of the loans, and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.

The loans in our portfolio are predominantly serviced by the Bank pursuant to the terms of loan participation and servicing and assignment agreements. In some instances, the Bank has delegated servicing responsibility for certain of our loans to third parties that are not affiliated with us or the Bank or its affiliates. We pay the Bank monthly loan servicing fees for its services under the terms of the loan participation and servicing and assignment agreements. See Note 6 (Transactions With Related Parties) to the Audited Financial Statements in this prospectus. The loan participation and servicing and assignment agreements require the Bank to service the loans in our portfolio in a manner substantially the same as for similar work performed by the Bank for transactions on its own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions and submits and pursues insurance claims. The Bank also provides accounting and reporting services required by us for our loans. We also may direct the Bank to dispose of any loans that are classified as nonperforming, placed in a nonperforming status or renegotiated due to the financial deterioration of the borrower. We generally may not sell, transfer, encumber, assign, pledge or hypothecate the loans without the prior written consent of the Bank. The Bank is required to pay all expenses related to the performance of its duties under the loan participation and servicing and assignment agreements, including any payment to its affiliates or third parties for servicing the loans. In accordance with the terms of the loan participation and servicing and assignment agreements in place, we have the authority to decide whether to foreclose on collateral that secures a loan in the event of a default. Upon sale or other disposition of foreclosure property, the Bank will remit to us the proceeds less the cost of holding and selling the foreclosure property. In the event it is determined that it would be uneconomical to foreclose on the related property, the entire outstanding principal balance of the real estate 1-4 family mortgage loan may be charged off. In addition, we may separately agree with the Bank to sell a defaulted loan back to the Bank at its estimated fair value. We anticipate that the Bank will continue to act as servicer of any additional loans that we acquire from the Bank. We anticipate that any such servicing arrangement that we enter into in the future with the Bank will contain fees and other terms that most likely will differ from, but be substantially equivalent to, those that would be contained in servicing arrangements entered into with unaffiliated third parties. To the extent we acquire loans from unaffiliated third parties, we anticipate that such loans may be serviced by entities other than the Bank. It is our policy that any servicing arrangements with unaffiliated third parties will be consistent with standard industry practices.

In addition, our loan participation and servicing and assignment agreements include obligations of the Bank to hold us harmless from any claims, causes of action, suits, damages and costs and expenses

 

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Risks Associated with Our Business (continued)

 

(including reasonable attorneys’ fees) arising from any unlawful act or omission occurring intentionally or unintentionally in connection with the loan products, loan applications, closings, dispositions and servicing arising under or with respect to any of the loans in our portfolio. In the event the Bank is unable or otherwise prevented from holding us harmless under such covenants, we could suffer a loss as a result of the Bank not fulfilling its servicing obligations under the agreements.

Our loan participation and servicing and assignment agreements may be amended from time to time at our discretion and, in certain circumstances, subject to the approval of a majority of our independent directors, without a vote of our stockholders, including holders of the Series A preferred stock.

Competition may impede our ability to acquire additional loans or other authorized assets, which could materially and adversely affect our results of operations and cash flow.

In order to qualify as a REIT, we can only be a passive investor in real estate loans and certain other qualifying investments. We anticipate that we will hold loans in addition to those in the current portfolio and that a majority, if not all, of these loans will be obtained from the Bank.

The Bank competes with mortgage conduit programs, investment banking firms, savings and loan associations, banks, savings banks, finance companies, mortgage bankers and insurance companies in acquiring and originating loans. To the extent we acquire loans directly from unaffiliated third parties in the future, we will face competition similar to that which the Bank faces in acquiring such loans.

Legislative and regulatory changes and proposals may restrict or limit our ability to engage in our current businesses or in businesses that we desire to enter into.

In light of recent conditions in the U.S. and global financial markets and the U.S. and global economy, legislators, the presidential administration and regulators have continued their increased focus on regulation of the financial services industry. In July 2010, the Dodd-Frank Act was enacted, in part, to impose significant investment restrictions and capital requirements on banking entities and other organizations that are significant to the U.S. financial markets. For instance, under the Dodd-Frank Act, in December 2013, federal banking regulators issued regulations implementing the “Volcker Rule,” which imposes significant restrictions on the proprietary trading and covered fund activities of certain banking entities. The Dodd-Frank Act also seeks to reform the asset-backed securitization market (including the mortgage-backed securities market) and imposes significant regulatory restrictions on the origination of residential mortgage loans. Final asset-backed securitization rules were issued in October 2014 and are expected to become effective, with respect to residential mortgage backed securities, in October 2015 and, with respect to other asset backed securities, in October 2016. The Dodd-Frank Act also created a new regulator, the CFPB, which now oversees many of the laws that regulate the mortgage industry, including among others the Real Estate Settlement Procedures Act and the Truth in Lending Act (“TILA”).

In 2013, the CFPB issued the final ability to repay and qualified mortgage rules that generally became effective in January 2014. The ability to repay and qualified mortgage rules implement the Dodd-Frank Act requirement that creditors originating residential mortgage loans make a reasonable and good faith determination that each applicant has a reasonable ability to repay. Although we do not currently originate loans, we cannot predict the long-term impact of these final rules on our ability or desire to acquire certain types of loans or loans to certain borrowers or on our financial results.

Proposals that further increase regulation of the financial services industry have been and are expected to continue to be introduced in Congress, in state legislatures and before various regulatory

 

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agencies that supervise our operations. Not all regulations authorized or required under the Dodd-Frank Act have been proposed or finalized by federal regulators. Further legislative changes and additional regulations may change our operating environment in substantial and unpredictable ways. We cannot predict whether future legislative proposals will be enacted and, if enacted, the effect that they, or any implementing regulations, would have on our business, results of operations or financial condition. The same uncertainty exists with respect to regulations authorized or required under the Dodd-Frank Act that have not yet been proposed or finalized.

We continue to evaluate the potential impact of legislative and regulatory proposals. Any future legislation or regulations, if adopted, could impose restrictions on or otherwise limit our ability to continue our business as currently operated, increase our cost of doing business or impose liquidity or capital burdens that would negatively affect our financial position or results of operations.

Our financial results and condition may be adversely affected by difficult business and economic and other conditions, particularly if housing prices decline, unemployment worsens or general economic conditions deteriorate.

Our financial performance is affected by general business and economic conditions in the United States and abroad, and a worsening of current business and economic conditions could adversely affect our business, results of operations and financial condition. If housing prices decline, unemployment worsens or general economic conditions deteriorate, we would expect to incur higher net charge-offs and provision expense from increases in our allowance for credit losses.

In addition, the regulatory environment, natural disasters or other external factors can influence recognition of credit losses in the portfolio and our allowance for credit losses. These economic and other conditions may adversely affect not only consumer loan performance but also commercial loan performance, especially for borrowers that rely on the health of industries or properties that may experience deteriorating economic conditions.

We have no control over changes in interest rates and such changes could negatively impact our financial condition, results of operations and ability to pay dividends.

Our income consists primarily of interest payments on our loans. As of September 30, 2014, 71% of loans, as measured by the aggregate outstanding principal amount, bore interest at fixed rates and the remainder bore interest at adjustable rates. Fixed rate loans increase our interest rate risk because rates on these loans do not adjust with changes in interest rates and prepayment of these loans generally increases in low interest rate environments, which could have the effect of reducing our overall yield. Adjustable-rate loans decrease the risks to a lender associated with changes in interest rates but involve other risks. For adjustable rate loans, as interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, and this increased payment increases the potential for default. At the same time, the fair value and therefore marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on the fixed rate loans in our portfolio as the borrowers refinance their loans at lower interest rates. Under these circumstances, we may find it more difficult to acquire additional loans with rates sufficient to support the payment of the dividends on the Series A preferred stock. A declining interest rate environment could adversely affect our ability to pay full, or even partial, dividends on the Series A preferred stock.

Loans are subject to economic and other conditions that could negatively affect the value of the collateral securing such loans and/or the results of our operations.

The value of the collateral underlying our loans and/or the results of our operations could be affected by various economic and other conditions, such as:

 

 

changes in interest rates;

 

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Risks Associated with Our Business (continued)

 

 

local and other economic conditions affecting real estate and other collateral values;

 

 

the continued financial stability of a borrower and the borrower’s ability to make loan principal and interest payments, which may be adversely affected by job loss, recession, divorce, illness or personal bankruptcy;

 

 

the ability of tenants to make lease payments and the creditworthiness of tenants;

 

 

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, rent on the property and on other comparable properties located in the same region, the attractiveness of properties to tenants, and the ability of the owner to pay leasing commissions, provide adequate maintenance and insurance, pay tenant improvement costs and make other tenant concessions;

 

 

historical and anticipated level of vacancies;

 

 

the availability of credit to refinance loans at or prior to maturity;

 

 

increased operating costs, including energy costs, real estate taxes, and costs of compliance with environmental controls and regulations;

 

 

sudden or unexpected changes in economic conditions, including changes that might result from terrorist attacks and the United States’ response to such attacks; and

 

 

potential or existing environmental risks and the occurrence of natural disasters that cause damage to our collateral.

Adverse conditions in states in which we have a higher concentration of loans could negatively impact our operations.

As of September 30, 2014, 46% of loans, as measured by the aggregate outstanding principal amount, were located in California, Florida, New Jersey, Pennsylvania and North Carolina. In the event of adverse economic conditions in states in which we have a higher concentration of loans, including California, Florida, New Jersey, Pennsylvania and North Carolina, we would likely experience higher rates of loss and delinquency on our loan portfolio than if the underlying loans were more geographically diversified. Additionally, our loans may be subject to a greater risk of default than other comparable loans in the event of adverse economic, political or business developments or natural hazards that may affect states in which we have a higher concentration of loans. Adverse conditions may affect the ability of property owners or commercial borrowers in those states to make payments of principal and interest on the underlying loans. In the event of any adverse development or natural disaster, our ability to pay dividends on the Series A preferred stock could be adversely affected.

Our commercial loans subject us to risks that are not present in our consumer loan portfolio, including the fact that some commercial loans are unsecured.

As of September 30, 2014, 20% of our assets, as measured by aggregate outstanding principal amount, consisted of commercial loans, which includes CSRE loans and C&I loans. Commercial loans generally tend to have shorter maturities than real estate 1-4 family mortgage loans and may not be fully

 

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amortizing, meaning that they may have a significant principal balance or “balloon” payment due on maturity. Commercial real estate properties tend to be unique and are more difficult to value than single-family residential real estate properties. Foreclosures of defaulted commercial loans generally are subject to a number of complicating factors, including environmental considerations, which are not generally present in foreclosures of real estate 1-4 family mortgage loans. See “– We could incur losses as a result of environmental liabilities of properties underlying our assets through foreclosure action.” Additionally, there is no requirement regarding the percentage that must be leased of any property securing a commercial loan at the time we acquire the loan nor are commercial loans required to have third-party guarantees.

As of September 30, 2014, less than 5%, as measured by aggregate outstanding principal amount, of our commercial loans are unsecured. Such unsecured loans are more likely than loans secured by real estate or personal property collateral to result in a loss upon a default.

We have not obtained a third-party valuation of any of our assets acquired from affiliated parties. Therefore, there can be no assurance that the terms by which we acquired such assets did not differ from the terms that could have been obtained from unaffiliated parties.

It is our intention that any agreements and transactions between us and the Bank or its affiliates, including, without limitation, any loan participation and servicing and assignment agreements, be fair to all parties and consistent with market terms for such types of transactions. We have adopted policies with a view to ensuring that all financial dealings between the Bank and us will be fair to both parties and consistent with market terms. However, there has not been a third-party valuation of any of our assets acquired from affiliated parties. In addition, it is not anticipated that third-party valuations will be obtained in connection with future acquisitions or dispositions of assets even in circumstances where an affiliate of ours is transferring the assets to us, or purchasing the assets from us. Accordingly, we cannot assure you that the purchase price we paid for our assets was equal to that which would have been paid to an unaffiliated party. Nor can we assure you that the consideration to be paid by us to, or received by us from, the Bank, any of our affiliates or third parties in connection with future acquisitions or dispositions of assets will be equal to that which would have been paid to or received from an unaffiliated party.

We may not be able to acquire loans at the same volumes or with the same yields as we have historically acquired.

As of September 30, 2014, substantially all of our assets, including interests in real estate loans, have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview – Asset Contributions.” The Bank originates and underwrites, or purchases and re-underwrites, loans. Our ability to acquire interests in loans in the future will depend on the Bank’s ability to continue to originate or purchase such loans. Originating and purchasing real estate loans is highly competitive and subject to extensive regulation. As a result, the Bank may not be able to originate or purchase loans at the same volumes or with the same yields as it has historically originated or purchased. This may interfere with our ability to maintain the requisite level of real estate assets to maintain our qualification as a REIT. In addition, although we have policies relating to the minimum credit quality (as measured by FICO score and LTV/CLTV) of loans that we may acquire, the relative quality of our portfolio could decline substantially in the future even though we continue to meet our existing thresholds (which are, in any event, subject to change). If volumes of loans purchased decline or the

 

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Risks Associated with Our Business (continued)

 

yields on these loans decline from existing levels, it could negatively affect our financial condition or results of operations.

Holding mortgage loans as participation interests instead of holding whole loans poses certain additional risks to us.

As of September 30, 2014, substantially all of our assets, including interests in real estate loans, have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview – Asset Contributions.” The substantial majority of these loans were originated or purchased by the Bank, and the Bank remains the lender of record under the related mortgage notes and other mortgage documents. As the holder of participation interests in loans, substantially all of which are serviced by the Bank, we are dependent on the servicing and efforts of the Bank. We do not have a direct contractual relationship with borrowers under the loan participation and servicing and assignment agreements. However, in accordance with the terms of the loan participation and servicing and assignment agreements in place, we have the authority to decide whether to foreclose on collateral that secures a loan and certain other rights. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Investment Company Act of 1940.” In addition, we generally may not sell, transfer, encumber, assign, pledge or hypothecate our participation interests in loans without the prior written consent of the Bank.

Furthermore, if the Bank became subject to a receivership proceeding or failed to repay a deposit made by a borrower on a mortgage loan in which we have a participation interest, such borrower may be entitled to set off their obligation to pay principal or interest on such mortgage loan against the Bank’s obligation to repay the deposit of the borrower.

We may invest in assets that involve new risks and need not maintain our current asset coverage.

Although our loan portfolio consists primarily of consumer and commercial loans, to the extent we acquire additional assets in the future, we are not required to limit our investments to assets of the type that will constitute our loan portfolio upon the consummation of this offering. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy.” Other real estate assets may involve different risks not described in this prospectus. Nevertheless, we will not invest in assets that are not real estate assets (which includes consumer loans, CSRE loans, mortgage-backed securities that are eligible to be held by REITs, cash, cash equivalents, including receivables and government securities, and other real estate assets) if such investments would cause us to no longer qualify as a REIT for U.S. federal income tax purposes. Moreover, while our policies will call for maintaining specified levels of FFO coverage as to expected dividend distributions and for maintaining specified levels of unpledged, performing assets, we are not required to maintain current levels of asset coverage.

 

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The origination of consumer loans, including those we currently own, is heavily regulated, and real or alleged violations of statutes or regulations applicable to the origination of our consumer loans could have an adverse effect on our financial condition and results of operations and our ability to pay dividends on the Series A preferred stock.

The origination of consumer loans, such as the real estate 1-4 family mortgage loans currently owned by us, and other mortgage loans that we may own in the future, is governed by a variety of federal and state laws and regulations, including TILA and various anti-fraud and consumer protection statutes. The laws and regulations of the various jurisdictions in which companies in the financial services industry conduct their mortgage lending business are complex, frequently changing and, in some cases, in direct conflict with each other. We believe that our consumer loans were originated in compliance with the applicable laws and regulations in all material respects. However, a borrower or borrowers may allege that the origination of their loan did not comply with applicable laws or regulations in one or more respects. Borrowers may assert such violations as an affirmative defense to payment or to the exercise by us (through our loan servicer) of our remedies, including foreclosure proceedings or in an action seeking statutory and other damages in connection with such violations. We and the Bank could become involved in litigation in connection with any such dispute, including class action lawsuits. Pursuant to our loan participation and servicing and assignment agreements (see “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers”), the Bank is obligated to hold us harmless from any claims, causes of action, suits, damages and costs and expenses (including reasonable attorneys’ fees) arising from any unlawful act or omission occurring intentionally or unintentionally in connection with the loan products, loan applications, closings, dispositions and servicing arising under or with respect to any of the loans. However, in the event the Bank was unable or otherwise prevented from holding us harmless under such agreements, and if we and the Bank are not successful in demonstrating that the loans in dispute were originated in accordance with applicable statutes and regulations, we and the Bank could become subject to monetary damages and other civil penalties, including possible rescission of the affected loans, and could incur substantial litigation costs over a period of time that could be protracted. The risk that borrowers will allege a defense to payment of their loans, including that the origination of the loan did not comply in some respect with laws or regulations, is likely to increase if general economic conditions in the United States deteriorate and if delinquencies and foreclosures increase.

Loans secured by second or more junior liens might not have adequate security.

The consumer loans that are secured by second or more junior liens may not afford security comparable to that provided by first lien mortgage loans, particularly in the case of real estate 1-4 family junior lien mortgage loans that have a high combined loan to value ratio, because foreclosure may not be economical. The proceeds from any foreclosure, insurance or condemnation proceedings will be available to satisfy the outstanding balance of the junior lien only to the extent that the liens of the senior mortgages have been satisfied in full, including any related foreclosure costs. In accordance with the terms of the loan participation and servicing and assignment agreements in place, we have the authority to decide whether to foreclose on collateral that secures a loan in the event of a default. In the event it is determined that it would be uneconomical to foreclose on the related property, the entire outstanding principal balance of the real estate 1-4 family mortgage loan may be charged off. In addition, we may separately agree with the Bank to sell a defaulted loan back to the Bank at its estimated fair value. There can be no guarantee that the market value of the collateral realized through the foreclosure process or the value of the loan sold back to the Bank would equal the carrying value of the loan for purposes of our financial statements. In these circumstances, including with respect to charge-off, any related losses with respect to such loans would be borne by us and could affect our ability to pay dividends on the Series A preferred stock.

 

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Risks Associated with Our Business (continued)

 

The rate of default of real estate 1-4 family junior lien mortgage loans may be greater than that of loans secured by senior mortgages on comparable properties. If real estate markets generally experience an overall decline in value, this could diminish the value of our interest as a junior mortgagee.

For real estate 1-4 family junior lien mortgage loans, the underwriting standards and procedures applicable to such loans, as well as the repayment prospects of those loans, may be more dependent on the creditworthiness of the borrower and less dependent on the adequacy of the mortgaged property as collateral.

We do not have insurance to cover our exposure to borrower defaults and bankruptcies and special hazard losses that are not covered by standard insurance.

Generally, neither we nor the Bank obtain credit enhancements such as borrower bankruptcy insurance or obtain special hazard insurance for our loans, other than standard hazard insurance typically required by the Bank, which relates only to individual loans. Without third-party insurance, we are subject to risks of borrower defaults and bankruptcies and special hazard losses, such as losses occurring from floods, that are not covered by standard hazard insurance.

We could incur losses as a result of environmental liabilities of properties underlying our assets through foreclosure action.

We may be forced to foreclose on an underlying loan where the borrower has defaulted on its obligation to repay the loan. We may also be subject to environmental liabilities with respect to foreclosed property, particularly industrial and warehouse properties, which are generally subject to relatively greater environmental risks, and to the corresponding burdens and costs of compliance with environmental laws and regulations, than non-commercial properties. The discovery of these liabilities and any associated costs for removal of hazardous substances, wastes, contaminants or pollutants could exceed the value of the real property and could have a material adverse effect on the fair value of such loan and therefore we may not recover any or all of our investment in the underlying loan. Although the Bank has exercised and will continue to exercise due diligence to discover potential environmental liabilities prior to our acquisition of any participation in loans secured by such property, hazardous substances or wastes, contaminants, pollutants or their sources may be discovered on properties during our ownership of the loans. To the extent that we acquire any loans secured by such real property directly from unaffiliated third parties, we intend to exercise due diligence to discover any such potential environmental liabilities prior to our acquisition of such loan. Nevertheless we may be unable to recoup any of the costs from any third party and we could incur full recourse liability for the entire cost of any removal and clean-up on a property.

Delays in liquidating defaulted loans could occur that could cause our business to suffer.

Substantial delays could be encountered in connection with the liquidation of the collateral securing defaulted loans, with corresponding delays in our receipt of related proceeds. An action to foreclose on a mortgaged property or repossess and sell other collateral securing a loan is regulated by state statutes and rules. Any such action is subject to many of the delays and expenses of lawsuits, which may impede our ability to foreclose on or sell the collateral or to obtain proceeds sufficient to repay all amounts due on the related loan.

 

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Unexpected rates of loan prepayments may cause us to violate the Investment Company Act or cause a decrease in our net income.

We generally reinvest the cash from loan pay-downs and prepayments in acquiring new loans. If we are unable to acquire new loans, determine not to acquire loans, or if actual prepayment rates exceed the expected rates, excess cash may accumulate on our balance sheet. If we have cash on our balance sheet greater than permitted pursuant to the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act, we may, absent other relief, no longer qualify for the exclusion under the Investment Company Act.

Our no longer qualifying for an exclusion from the definition of an investment company under the Investment Company Act could have a material adverse effect on us.

Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities, which for these purposes includes loans and participation interests therein of the types owned by us. Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis.

We believe that we qualify, and intend to conduct our operations so as to continue to qualify, for the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C) excludes from the definition of an investment company entities that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” As reflected in a series of no-action letters, the SEC staff’s position on Section 3(c)(5)(C) generally requires that in order to qualify for this exclusion, an issuer must maintain

 

 

at least 55% of the value of its assets in Qualifying Interests,

 

 

at least an additional 25% of its assets in other permitted real estate-type interests (reduced by any amount the issuer held in excess of the 55% minimum requirement for Qualifying Interests), and

 

 

no more than 20% of its assets in other than Qualifying Interests and real estate-type assets,

and also that the interests in real estate meet other criteria described in such no-action letters. Mortgage loans that were fully and exclusively secured by real property are typically qualifying for these purposes. In addition, participation interests in such loans meeting certain criteria described in such no-action letters are generally qualifying real estate assets for purposes of the Section 3(c)(5)(C) exclusion. See “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Investment Company Act of 1940.” We believe that our participation interests in mortgage loans satisfy these criteria and that we otherwise qualify for the exclusion provided by Section 3(c)(5)(C) of the Investment Company Act.

Under the Investment Company Act, a non-exempt entity that is an investment company is required to register with the SEC and is subject to extensive, restrictive and potentially adverse regulation relating to, among other things, operating methods, management, capital structure, dividends and transactions with affiliates. In August 2011, the SEC issued a concept release which indicated that the SEC is reviewing whether issuers who own certain mortgage related investments that

 

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Risks Associated with Our Business (continued)

 

rely on the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act should continue to be allowed to rely on such exclusion. The concept release and the public comments thereto have not yet resulted in SEC rulemaking or interpretive guidance and we cannot predict what form any such rulemaking or interpretive guidance may take. We cannot provide you with any assurance that the outcome of the SEC’s review will not require us to register under the Investment Company Act. If a change in the laws or the interpretations of those laws were to occur, we could be required to either change the manner in which we conduct our operations to avoid being required to register as an investment company or register as an investment company, either of which could have a material adverse effect on us and the price of the Series A preferred stock, and could give us the right and/or cause us to redeem the Series A preferred stock, as applicable. See “Description of the Series A Preferred Stock – Redemption” and “– Risks Relating to the Terms of the Series A Preferred Stock – Holders of the Series A preferred stock have no right to require redemption; however, we may redeem the Series A preferred stock upon certain events, and at any time after December 11, 2019.”

Further, in order to ensure that we at all times continue to qualify for the Section 3(c)(5)(C) exclusion, we may be required at times to adopt less efficient methods of financing certain of our assets than would otherwise be the case and may be precluded from acquiring certain types of assets whose yield is somewhat higher than the yield on assets that could be acquired in a manner consistent with the exclusion. The net effect of these factors may at times reduce our net interest income.

Finally, if we were an unregistered investment company, there would be a risk that we would be subject to monetary penalties and injunctive relief in an action brought by the SEC, that we would be unable to enforce contracts with third parties and that third parties could seek to obtain rescission of transactions undertaken during the period we were determined to be an unregistered investment company.

Our framework for managing risks may not be effective in mitigating risk and loss to us.

Our risk management framework seeks to mitigate risk and loss to us. We have established processes and procedures intended to identify, measure, monitor, report and analyze the types of risk to which we are subject, including credit risk, interest rate risk and liquidity risk, among others. However, as with any risk management framework, there are inherent limitations to our risk management strategies as there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. In certain instances, we rely on models to measure, monitor and predict risks, such as credit risks; however, there is no assurance that these models will appropriately capture all relevant risks or accurately predict future events or exposures. The recent financial and credit crisis and resulting regulatory reform highlighted both the importance and some of the limitations of managing unanticipated risks, and the federal banking regulators remain focused on ensuring that financial institutions build and maintain robust risk management policies. If our risk management framework proves ineffective, we could suffer unexpected losses that could have a material adverse effect on our results of operations or financial condition. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management” for additional information about our risk management framework.

Changes in accounting policies or accounting standards, and changes in how accounting standards are interpreted or applied, could materially affect how we report our financial results and condition.

Our accounting policies are fundamental to determining and understanding our financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of

 

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our assets or liabilities and financial results. Further, our policies related to the allowance for credit losses are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. For a description of these policies, refer to the “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policy” section in this prospectus.

From time to time the Financial Accounting Standards Board (“FASB”) and the SEC change the financial accounting and reporting standards that govern the preparation of our external financial statements. In addition, accounting standard setters and those who interpret the accounting standards (such as FASB, the SEC, banking regulators and our outside auditors) may change or even reverse their previous interpretations or positions on how these standards should be applied.

Because we are a consolidated subsidiary of the Bank, we may be subject to regulatory guidance and other pronouncements issued from time to time by the OCC and other banking regulators. Changes in financial accounting and reporting standards and changes in current interpretations may be beyond our control, can be hard to predict and could materially affect how we report our financial results and condition. We may be required to apply retroactively a new standard, a revised standard or an existing standard in a different manner than previously applied. In all cases, this retroactive application may potentially result in us having to restate prior period financial statements in amounts that may be material.

Our financial statements are based in part on assumptions and estimates which, if wrong, could cause unexpected losses in the future.

Pursuant to GAAP, we are required to use certain assumptions and estimates in preparing our financial statements, including in determining credit loss reserves, among other items. Our policies related to the allowance for credit losses are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. For a description of these policies, refer to the “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policy” section in this prospectus. If assumptions or estimates underlying our financial statements are incorrect, we may experience material losses.

As an “emerging growth company” under the JOBS Act we are eligible to take advantage of certain exemptions from various reporting requirements.

We are an “emerging growth company,” as defined in the JOBS Act, and we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies.” If we do take advantage of any of these exemptions, we do not know if some investors will find our Series A preferred stock less attractive as a result. The result may be a less active trading market for our Series A preferred stock and our share price may be more volatile.

In addition, Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended (the “Securities Act”), for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we are choosing to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging

 

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Risks Associated with Our Business (continued)

 

growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

We could remain an “emerging growth company” for up to five years after our initial public offering of common stock, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period. The Series A preferred stock is an equity interest in the Company and does not constitute indebtedness.

We may pledge up to 80% of our assets as collateral on behalf of the Bank for the Bank’s access to secured borrowing facilities through Federal Home Loan Banks and Federal Reserve Banks, which subjects us to the Bank’s default risk.

The Bank may access secured borrowing facilities through Federal Home Loan Banks and through the discount window of Federal Reserve Banks. The Bank is a member of the Federal Home Loan Bank of Des Moines and the Federal Reserve Bank of San Francisco, and as a subsidiary of the Bank, we may pledge assets, including our loans, on behalf of the Bank for the Bank’s access to these secured borrowing facilities. The Bank uses funds borrowed from the Federal Home Loan Bank of Des Moines to finance housing and economic development in local communities and funds borrowed from the discount window of the Federal Reserve Bank of San Francisco for short term, generally overnight, funding. We may pledge up to 80% of our assets on behalf of the Bank; provided that, after giving effect to any and all such pledges of assets, the unpaid principal balance of our total unpledged, performing assets (which, for the avoidance of doubt, shall not be pledged in respect of any other indebtedness we incur or otherwise) will equal or exceed three times the sum of the aggregate liquidation preference of the Series A preferred stock then outstanding plus any other parity stock then outstanding. Those unpledged assets, however, may be of a lower credit quality than the remainder of our loan portfolio, even if they are classified as performing assets. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Credit Risk Management” and Note 2 (Loans and Allowance for Credit Losses) to the Financial Statements for additional information on the overall credit quality of our mortgage loan portfolio. In exchange for the pledge of our assets, the Bank will pay us a fee. Such fee initially will be in an amount we believe represents an arrangement that is not inconsistent with market terms. Such fee may be renegotiated by us and the Bank from time to time. Although we currently believe that this arrangement is not inconsistent with market terms, we cannot assure you that this is and/or will be the case in the future to the extent such fees are renegotiated. Any material amendment to the terms of agreements related to the pledge of our assets on behalf of the Bank, including with respect to fees, will require the approval of a majority of our independent directors. See also “– We are effectively controlled by Wells Fargo and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest,” and “– We depend on the officers and employees of Wells Fargo and the Bank for administrative services and the servicing of the loans, and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.” Moreover, this fee may not adequately compensate us for the risks associated with the pledge of our loan assets. A Federal Home Loan Bank has priority over other creditors with respect to assets pledged to it. In the event the Bank defaults on a Federal Home Loan Bank advance, the Federal Home Loan Bank will own the pledged assets, and we will lose these assets. In the event the Bank defaults on a discount window advance, the Federal Reserve Bank may take possession of the pledged assets, and we may lose the assets. Although the Bank is obligated to reimburse us for these losses, it is likely that the Bank would be in receivership when such a default occurs. In that case, these

 

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losses would be borne by us, which could affect our ability to pay dividends on the Series A preferred stock. Any unpledged assets that we continue to own may decline in value and may be insufficient to pay the redemption price or satisfy the liquidation preference of the Series A preferred stock. See “Business – Pledge of Assets on Behalf of the Bank.”

In addition, if the Bank loses access to Federal Home Loan Bank funding, the Bank may be required to find other sources of funding and may be unable to originate new loans. This may limit our ability to acquire additional loans from the Bank.

Risks Related to Our REIT Status

 

 

We may suffer adverse tax consequences if we fail to qualify as a REIT.

No assurance can be given that we will be able to continue to operate in 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 limited judicial and administrative interpretations and involves the determination of various factual matters and circumstances not entirely within our control. New legislation or new regulations, administrative interpretations or court decisions could significantly change the tax laws in the future with respect to qualification as a REIT or the U.S. federal income tax consequences of such qualification in a way that would materially and adversely affect our ability to operate.

If we were to fail to qualify as a REIT, the dividends on preferred stock would not be deductible for U.S. federal income tax purposes. In that event, we could face a tax liability that could consequently result in a reduction in our net income after taxes, which could also adversely affect our ability to pay dividends to common and preferred stockholders. Although we intend to operate in a manner designed to qualify as a REIT, future economic, market, legal, tax or other considerations may cause us to determine that it is in our best interests and the best interests of holders of common and preferred stock to revoke the REIT election. As long as any Series A preferred stock is outstanding, any such determination to revoke the REIT election by us may not be made without the approval of a majority of our independent directors.

Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends.

The maximum tax rate applicable to qualified dividend income payable to certain non-corporate U.S. stockholders has been reduced by legislation to an effective 23.8%. Dividends payable by REITs, however, generally are not eligible for the reduced rates. Although this legislation does not adversely affect the taxation of REITs or dividends payable by REITs, the more favorable rates applicable to regular corporate qualified dividends could cause certain non-corporate investors to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including our Series A preferred stock.

 

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Use of Proceeds

We estimate the proceeds we will receive from this offering will be approximately $233,574,125, or approximately $267,471,625 if the underwriters exercise in full their option to purchase additional shares of the Series A preferred stock, net of underwriting discounts and before expenses, based on the initial public offering price of $25.00 per share.

We intend to use the net proceeds from this offering for general corporate purposes, including the acquisition of qualifying REIT assets in the ordinary course of our business, either by acquiring qualifying REIT assets in fourth quarter 2014 or reducing any outstanding balance on our line of credit used to fund acquisitions of qualifying REIT assets made during 2014 and using the additional borrowing capacity thereunder to acquire additional qualifying REIT assets in the future. Based on our expectation of the timing of this offering, we anticipate the net proceeds will be used to reduce the outstanding balance on our line of credit.

Our revolving line of credit enables us to borrow $1.2 billion from the Bank as a short-term liquidity source. The outstanding balance on the line of credit at September 30, 2014 was $734.0 million. The line of credit bears a rate of interest equal to the average federal funds rate plus 12.5 basis points (0.125%).

 

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Capitalization

The following table sets forth our capitalization as of September 30, 2014.

 

 

 
     September 30, 2014  
  

 

 

 
(in thousands)    Historical     As Adjusted
for this
Offering
 

 

 

Long-term debt

   $                            –   

Stockholders’ equity

    

Preferred stock:

    

Series A preferred stock, $0.01 par value per share, $240 million liquidation preference, cumulative, 9,600,000 shares authorized, issued and outstanding

            96   

Outstanding Series B preferred stock, $0.01 par value per share, $1 million liquidation preference, cumulative, 1,000 shares authorized, 667 issued and outstanding

              

 

 

Total Preferred Stock

            96   

 

 

Common stock, $0.01 par value, 1,000 shares authorized, issued and outstanding

    

Additional paid-in capital

     12,285,060       12,516,769  

Retained earnings (deficit)

     (190,543 )     (190,543 )

 

 

Total stockholders’ equity

     12,094,517        12,326,322   

 

 

Total capitalization

   $     12,094,517        12,326,322   

 

 

 

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Selected Financial Data

The following selected financial data for the nine-month periods ended September 30, 2014 and 2013 are derived from our unaudited financial statements and the following selected financial data for the three years ended December 31, 2013 are derived from our audited financial statements. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus and our financial statements, related notes and other financial information beginning on page F-1 of this prospectus.

In November 2013, WPFC contributed $7.1 billion of consumer and commercial loans in the form of an assignment of their participation interests from the Bank, $18.0 million of accrued interest and $2.4 million of foreclosed assets to us. The contribution of assets was an equity transaction between entities under common control; therefore, the assets were recorded at their WPFC book value, including the allowance for credit losses of $197.1 million and unamortized premiums and discounts on loans.

Selected Financial Data

 

 

 
     Nine months ended
September 30,
    Year ended December 31,  
  

 

 

   

 

 

 
($ in thousands, except per share data)    2014      2013     2013      2012      2011  

 

 

Income statement data

             

Net interest income

   $     520,711         170,455        297,425         203,422         240,385   

Noninterest income

     541         111        225         491         728   

 

 

Revenue

     521,252         170,566        297,650         203,913         241,113   

Provision for credit losses

     4,380         13,505        18,235         45,376         35,615   

Noninterest expense

     33,943         13,375        21,985         15,445         16,119   

Net income

     482,929         143,686        257,430         143,092         189,379   

Diluted earnings per common share

     748,660         222,702        399,028         221,760         293,522   

Dividends declared per common share

     689,922         248,062        496,124         288,372         361,240   

 

 

Other Supplemental Data (unaudited)

             

Ratio of earnings to fixed charges and preferred dividends (1)

     448.12           204.14         1,724.31         3,322.44   

 

 
                  September 30,
2014
     December 31,  
          

 

 

 
($ in thousands)                    2013      2012  

 

 

Balance sheet data

             

Loans, net of unearned income

          12,923,416         13,120,341         4,112,498   

Allowance for loan losses

          194,039         243,752         65,340   

Total assets

          12,834,479         12,966,194         4,114,993   

Total liabilities

          739,962         909,563         452,371   

Total stockholders’ equity

          12,094,517         12,056,631         3,662,622   

 

 

 

(1) This ratio is included herein in compliance with SEC regulations. The calculation of this ratio is included as an exhibit to the registration statement that this prospectus forms a part.

 

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Business

General

 

 

We are a Delaware corporation incorporated on August 29, 1996 and have operated as a REIT for U.S. federal income tax purposes since our formation. We are a direct subsidiary of WPFC and an indirect subsidiary of Wells Fargo and the Bank. Our organizational structure at September 30, 2014 was:

 

LOGO

Our principal business is to acquire, hold and manage predominantly domestic mortgage assets and other authorized investments. As of September 30, 2014 and December 31, 2013, we had $12.8 billion and $13.0 billion of assets, $0.7 billion and $0.9 billion of liabilities and $12.1 billion and $12.1 billion of stockholders’ equity, respectively. Our assets consisted of the following as of September 30, 2014:

 

 

$8.5 billion, or 66%, of our assets were real estate 1-4 family first mortgage loans;

 

 

$1.8 billion, or 14%, of our assets were real estate 1-4 family junior lien mortgage loans; and

 

 

$2.5 billion, or 20%, of our assets were CSRE loans.

 

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General (continued)

 

In addition, as of September 30, 2014, less than 1% of our assets consisted of C&I loans and less than 1% consisted of other assets.

The weighted average yield earned on total interest-earning assets for the nine months ended September 30, 2014 was 5.48%.

Although we have the authority to acquire interests in real estate loans and other authorized investments from unaffiliated third parties, as of September 30, 2014, substantially all of our interests in mortgages and other assets have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements. See “– General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers.” The Bank originated the loans, purchased them from another financial institution or acquired them as part of the acquisition of other financial institutions. We may also acquire from time to time real estate loans or other assets from unaffiliated third parties. In addition, we may acquire from time to time mortgage-backed securities and a limited amount of additional non-mortgage related securities from the Bank.

In November 2013, WPFC contributed loans and other assets to us totaling approximately $7.1 billion in the form of an assignment of their participation interests from the Bank. The contribution of assets was an equity transaction between entities under common control; therefore, the assets were recorded at their WPFC book value, including allowance for credit losses and unamortized premiums and discounts on loans. WPFC also contributed $1.5 billion of cash during 2013. We did not issue additional shares of common stock to WPFC in respect of this contribution; accordingly, the contributions were recorded as an increase in additional paid-in capital. See Note 1 (Summary of Significant Accounting Policies) to the Audited Financial Statements for additional information.

Substantially all of the loans in our portfolio currently are serviced by the Bank pursuant to the terms of loan participation and servicing and assignment agreements. The Bank has delegated servicing responsibility for certain loans to third parties, which are not affiliated with us or the Bank.

General Description of Mortgage Assets and Other Authorized Investments; Investment Policy

 

 

General

We do not have lending operations. Instead, we expect to acquire our loans principally from the Bank. See “— Assets in General; Participation Interests and Transfers” and “— Conflicts of Interest and Related Management Policies and Programs — Asset Acquisition and Disposition Policies” for more details.

Authorized Investments

As a REIT, the Code requires us to invest at least 75% of the total value of our assets in real estate assets, which includes residential mortgage loans and commercial mortgage loans, including participation interests in residential or commercial mortgage loans, mortgage-backed securities eligible to be held by REITs, cash, cash equivalents, including receivables and government securities, and other real estate assets. We refer to these types of assets as “REIT Qualified Assets.” The Code also requires that not more than 25% of the value of a REIT’s assets constitute securities issued by taxable REIT subsidiaries and that the value of any one issuer’s securities, other than those securities included in the 75% test, may not exceed 5% of the value of the total assets of the REIT. In addition, under the Code,

 

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the REIT may not own more than 10% of the voting securities or more than 10% of the value of the outstanding securities of any one issuer, other than those securities included in the 75% test, the securities of wholly-owned qualified REIT subsidiaries or taxable REIT subsidiaries. We make investments and operate our business in such a manner consistent with the requirements of the Code to qualify as a REIT. However, future economic, market, legal, tax or other considerations may cause our board of directors, subject to approval by a majority of our independent directors, to determine that it is in our best interest and the best interest of our shareholders to revoke our REIT status. The Code prohibits us from electing REIT status for the four taxable years following the year of such revocation. For the tax year ended December 31, 2014, we expect to be taxed as a REIT.

Under the Code, as of December 31, 2013, approximately 99% of our assets were REIT Qualified Assets and approximately 1% were commercial loans and other assets that are not REIT Qualified Assets. We do not hold any securities nor do we intend to hold securities in any one issuer that exceed 5% of our total assets or more than 10% of the voting securities of any one issuer.

REITs generally are subject to tax at the maximum corporate rate on income from foreclosure property less deductible expenses directly connected with the production of that income. Income from foreclosure property includes gain from the sale of foreclosure property and income from operating foreclosure property, but income that would be qualifying income for purposes of the 75% gross income test is not treated as income from foreclosure property. Qualifying income for purposes of the 75% gross income test includes, generally, rental income and gain from the sale of property not held as inventory or for sale in the ordinary course of a trade or business. In accordance with the terms of the loan participation and servicing and assignment agreements in place, we have the authority to decide whether to foreclose on collateral that secures a loan in the event of a default. Upon sale or other disposition of foreclosure property, the Bank will remit to us the proceeds less the cost of holding and selling the foreclosure property. In the event it is determined that it would be uneconomical to foreclose on the related property, the entire outstanding principal balance of the real estate 1-4 family mortgage loan may be charged off. In addition, we may separately agree with the Bank to sell a defaulted loan back to the Bank at its estimated fair value.

Additionally, we intend to operate in a manner that will not subject us to regulation under the Investment Company Act. Therefore, we do not intend to:

 

 

invest in the securities of other issuers for the purpose of exercising control over such issuers;

 

 

underwrite securities of other issuers;

 

 

actively trade in loans or other investments;

 

 

offer securities in exchange for property; or

 

 

make loans to third parties, including our officers, directors or other affiliates.

Investment Company Act of 1940

Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities, which for these purposes includes loans and participation interests therein of the types owned by us. Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis.

 

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General Description of Mortgage Assets and Other Authorized Investments; Investment Policy (continued)

 

We believe that we qualify, and intend to conduct our operations so as to continue to qualify, for the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C) excludes from the definition of an investment company entities that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” As reflected in a series of no-action letters, the SEC staff’s position on Section 3(c)(5)(C) generally requires that in order to qualify for this exclusion, an issuer must maintain

 

   

at least 55% of the value of its assets in Qualifying Interests,

 

   

at least an additional 25% of its assets in other permitted real estate-type interests (reduced by any amount the issuer held in excess of the 55% minimum requirement for Qualifying Interests), and

 

   

no more than 20% of its assets in other than Qualifying Interests and real estate-type assets,

and also that the interests in real estate meet other criteria described in such no-action letters. Mortgage loans that were fully and exclusively secured by real property are typically qualifying for these purposes. In addition, participation interests in such loans (see “– Assets in General; Participation Interests and Transfers”) where the holder of the participation interests (i) has the right to receive its proportionate share of the interest and the principal payments made on the mortgage loan by the borrower, and the holder’s returns on the participation interests are based on such payments; (ii) invests in the participation interest only after performing the same type of due diligence and credit underwriting procedures that it would perform if it were underwriting the underlying mortgage loan; (iii) has approval rights in connection with any material decisions pertaining to the administration and servicing of the loan and with respect to material modifications to the loan agreements; and (iv) in the event that the loan becomes non-performing, has effective control over the remedies relating to the enforcement of the mortgage loan, including ultimate control of the foreclosure process, by having the right to (a) appoint the special servicer to manage the resolution of the loan; (b) advise, direct or approve the actions of the special servicer; (c) terminate the special servicer at any time with or without cause; (d) cure the default so that the mortgage loan is no longer non-performing; and (e) purchase any senior participation interest in the underlying mortgage loan at par value plus accrued interest such that the holder would then own the entire mortgage loan, are generally qualifying real estate assets for purposes of the Section 3(c)(5)(C) exclusion. We believe that our participation interests in mortgage loans satisfy these criteria, to the extent such criteria are applicable to the participation interests owned by us, and that we otherwise qualify for the exclusion provided by Section 3(c)(5)(C) of the Investment Company Act.

In August 2011, the SEC issued a concept release which indicated that the SEC is reviewing whether issuers who own certain mortgage related investments that rely on the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act should continue to be allowed to rely on such exclusion. The concept release and the public comments thereto have not yet resulted in SEC rulemaking or interpretative guidance and we cannot predict what form any such rulemaking or interpretive guidance may take. We cannot provide you with any assurance that the outcome of the SEC’s review will not require us to register under the Investment Company Act. If a change in the laws or the interpretations of those laws were to occur, we could be required to either change the manner in which we conduct our operations to avoid being required to register as an investment company or register as an investment company. We have the right to redeem the Series A preferred stock within 90 days of the occurrence of an Investment Company Act Event. See “Risk Factors – Risks Relating to the Terms of the Series A Preferred Stock – Holders of the Series A

 

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preferred stock have no right to require redemption; however, we may redeem the Series A preferred stock upon certain events, and at any time after December 11, 2019.”

The provisions of the Investment Company Act therefore may limit the assets that we may acquire. We have established a policy of limiting authorized investments that are not Qualifying Interests or other permitted real estate-type assets to no more than 20% of the value of our total assets to comply with these provisions.

Generally, the Code designation for REIT Qualified Assets is less stringent than the Investment Company Act designation for Qualifying Interests or other permitted real estate-type assets, due to the ability under the Code to treat cash and cash equivalents as REIT Qualified Assets and a lower required ratio of REIT Qualified Assets to total assets.

Because we are not deemed to be an investment company in accordance with the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act, Wells Fargo’s and the Bank’s ownership interests in us are therefore not prohibited by the provisions of Section 619 of the Dodd-Frank Act, the so-called “Volcker Rule,” and the rules and regulations jointly promulgated thereunder.

Assets in General; Participation Interests and Transfers

We generally have acquired, or accepted as capital contributions, participation interests in loans both secured and not secured by real estate along with other assets. We anticipate that we will acquire, or receive as capital contributions, loans or other assets from the Bank pursuant to loan participation and servicing and assignment agreements among the Bank, certain of its subsidiaries and us.

As of September 30, 2014, and December 31, 2013, we had $12.8 billion and $13.0 billion in assets, respectively, consisting substantially of real estate loan participation interests. Substantially all of our interests in mortgages and other assets have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements. The Bank originated the loans, purchased them from other financial institutions or acquired them as part of the acquisition of other financial institutions. Substantially all of our loans are serviced by the Bank.

In general, the Bank initially transfers participation interests in loans to a subsidiary of the Bank that does not have a direct or indirect ownership interest in us, which then transfers such participation interests to WFREIC. We may transfer such participation interests to such a subsidiary, which may ultimately transfer such interests to the Bank.

Pursuant to the terms of the relevant participation and servicing and assignment agreements, we generally may not sell, transfer, encumber, assign, pledge or hypothecate our participation interests in loans without the prior written consent of the Bank.

We also have the authority to acquire interests in loans and other assets directly from unaffiliated third parties, although we have not done so to date. In addition, we may acquire from time to time mortgage-backed securities and a limited amount of additional non-mortgage related securities from the Bank.

Consumer Loans

Our consumer loan portfolio consists of real estate 1-4 family first mortgage loans and real estate 1-4 family junior lien mortgage loans. We refer to residential mortgage loans primarily made for personal, family or household use and evidenced by a promissory note secured by a mortgage or deed of trust or other similar security instrument creating a first lien on 1-4 family real estate property as “real estate

 

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General Description of Mortgage Assets and Other Authorized Investments; Investment Policy (continued)

 

1-4 family first mortgage loans” and those creating a lien junior to a first lien on 1-4 family real estate property as “real estate 1-4 family junior lien mortgage loans” and collectively as “real estate 1-4 family mortgage loans” or “consumer loans.”

REAL ESTATE 1-4 FAMILY MORTGAGE LOANS. We have acquired both conforming and non-conforming real estate 1-4 family mortgage loans from the Bank. Conforming real estate 1-4 family mortgage 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 the Federal National Mortgage Association (“FNMA”). Non-conforming real estate 1-4 family mortgage loans are real estate 1-4 family mortgage loans that do not qualify in one or more respects for purchase by FHLMC or FNMA under their standard programs. The Bank sells substantially all conforming loans to FNMA or FHLMC; accordingly, we acquire primarily non-conforming loans from the Bank. Therefore, at September 30, 2014, 94% of the carrying value of our real estate 1-4 family mortgage loans was non-conforming and 6% was conforming. A majority of the non-conforming real estate 1-4 family mortgage loans acquired by us to date are non-conforming because they have original principal balances that exceeded the program requirements, the original terms are shorter than the minimum requirements at the time of origination, the original balances are less than the minimum program requirements, 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. For additional details relating to the credit quality of our portfolios, see Note 2 (Loans and Allowance for Credit Losses) to the Financial Statements.

The properties underlying real estate 1-4 family mortgage loans consist of single-family detached units, individual condominium units, 2-4 family dwelling units and townhouses.

Our portfolio of real estate 1-4 family mortgage loans consists of both adjustable and fixed rate mortgage loans.

See also “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Credit Risk Management – Real Estate 1-4 Family Mortgage Loans.”

REAL ESTATE 1-4 FAMILY JUNIOR LIEN MORTGAGE LOANS. We own real estate 1-4 family junior lien mortgage loans. These loans are secured by a junior lien mortgage that primarily is on the borrower’s residence and typically are made for reasons such as home improvements, acquisition of furniture and fixtures, purchases of automobiles and debt consolidation. Generally, junior liens are repaid on an amortization basis. As of September 30, 2014, substantially all of our real estate 1-4 family junior lien mortgage loans bear interest at fixed rates.

See also “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Credit Risk Management – Real Estate 1-4 Family Junior Lien Mortgage Loans.”

Commercial Loans

Our commercial loan portfolio consists of C&I loans and CSRE loans. C&I loans are loans for commercial, financial or industrial purposes, whether secured or unsecured, single-payment or installment. Unsecured loans are more likely than secured loans to result in a loss upon default. CSRE loans are loans secured by a mortgage or deed of trust on a multi-family residential or commercial real estate property or real estate construction loans secured by real property.

As of September 30, 2014, the majority of the loans in our C&I loan portfolio, as measured by the outstanding principal amount, were unsecured and the remainder were secured by short-term assets, such as accounts receivable, inventory and securities, or long-lived assets, such as equipment and other

 

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business assets. Generally, the collateral securing this portfolio represents a secondary source of repayment. Unsecured loans are more likely than secured loans to result in a loss upon default.

Our CSRE portfolio consists of both mortgage loans and construction loans and these loans are primarily secured by real estate.

Our commercial loan portfolio consists of both adjustable and fixed rate loans. As of September 30, 2014, substantially all of our commercial loans bear interest at adjustable rates.

See also “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Credit Risk Management – Commercial and Industrial Loans” and “– Commercial Secured by Real Estate.”

Dividend Policy

 

 

We expect to distribute annually an aggregate amount of dividends with respect to our outstanding capital stock equal to approximately 100% of our REIT taxable income for U.S. federal income tax purposes, which excludes capital gains. REIT taxable income means the taxable income of a REIT, which generally is computed in the same fashion as the taxable income of any corporation, except that (a) certain deductions are not available, such as the deduction for dividends received, (b) it may deduct dividends paid (or deemed paid) during the taxable year, (c) net capital gains and losses are excluded, and (d) certain other adjustments are made. Such dividend distributions may in some periods exceed net income determined under GAAP due to differences in income and expense recognition for REIT taxable income determination purposes. In order to remain qualified as a REIT, we are required to distribute annually at least 90% of our REIT taxable income to our stockholders.

Dividends will be authorized and declared at the discretion of our board of directors. Factors that would generally be considered by our board of directors in making this determination are our distributable funds, financial condition and capital needs, the impact of current and pending legislation and regulations, Delaware corporation law, economic conditions, tax considerations and our continued qualification as a REIT. Although there can be no assurance, we currently expect that both our cash available for distribution and our REIT taxable income will be in excess of the amounts needed to pay dividends on all of our outstanding series of preferred stock, even in the event of a significant drop in interest rate levels or increase in allowance for loan losses because:

 

 

substantially all of our real estate loans and other qualified investments are interest-bearing;

 

 

while from time to time we may incur indebtedness, we will not incur an aggregate amount that exceeds 20% of our stockholders’ equity;

 

 

we expect that our interest-earning assets will continue to exceed the liquidation preference of our preferred stock; and

 

 

we anticipate that, in addition to cash flows from operations, additional cash will be available from principal payments on the loans we hold.

Accordingly, we expect that we will, after paying the dividends on all of our preferred stock, pay dividends to holders of shares of our common stock in an amount sufficient to comply with applicable requirements regarding qualification as a REIT. There are, however, certain limitations that restrict our ability to pay dividends on our common stock that are more fully described in this prospectus under the heading “Description of Other WFREIC Capital Stock – Preferred Stock.”

Under certain circumstances, including any determination that the Bank’s relationship to us results in an unsafe and unsound banking practice, the OCC will have the authority to issue an order that restricts our ability to make dividend payments to our stockholders, including holders of the

 

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Dividend Policy (continued)

 

Series A preferred stock. National banking laws and other banking regulations limit the total dividend payments made by a consolidated banking entity to be the sum of earnings for the current year and prior two years less dividends paid during the same periods. Any dividends paid in excess of this amount can only be made with the approval of the Bank’s regulator. Finally, Wells Fargo and its subsidiaries, including WFREIC, are subject to broad prudential supervision by the Federal Reserve, which may result in a limitation on or the elimination of our ability to pay dividends on the Series A preferred stock, including, for example, in the event that the OCC had not otherwise restricted the payment of such dividends as described above and the Federal Reserve determines that such payment would constitute an unsafe and unsound practice. To the extent the payment of dividends on the Series A preferred stock were restricted or eliminated by the OCC or the Federal Reserve in such a manner, such dividends would nevertheless continue to accumulate. See “Description of Series A Preferred Stock – Dividends.”

Conflicts of Interest and Related Management Policies and Programs

 

 

General

In administering our loan portfolio (see “– Assets in General; Participation Interests and Transfers”) and other authorized investments pursuant to the loan participation and servicing and assignment agreements, the Bank has a high degree of autonomy. We have, however, adopted certain practices to guide our administration with respect to the acquisition and disposition of assets, use of leverage, credit risk management, and certain other activities. The loan participation and servicing and assignment agreements may be amended, at the discretion of our board of directors and, in certain circumstances subject to the approval of a majority of our independent directors (see “Description of the Series A Preferred Stock – Independent Director Approval”), from time to time without a vote of our stockholders, including holders of the Series A preferred stock. A majority of the members of our board of directors are considered independent from us and the Bank.

Asset Acquisition and Disposition Policies

Management determines the timing of loan acquisitions by considering available cash and borrowing capacity on our Bank line of credit in conjunction with requirements to maintain our REIT status. Once the decision is made to acquire loans, management works with the respective business lines within the Bank to identify loans to be acquired. These loans are evaluated against credit criteria approved by our board of directors that consumer and commercial loans must meet to be eligible for us to acquire. The criteria approved for participation interests in consumer loans include:

 

 

loans must be performing, meaning they are current;

 

 

the borrower has made at least 3 payments;

 

 

the borrower’s FICO score is above established thresholds;

 

 

the loans must have LTV/CLTV below established thresholds;

 

 

loans must be unencumbered; and

 

 

loans must be secured by real property such that they are REIT Qualified Assets.

 

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The criteria approved for participation interests in commercial loans include:

 

 

loans must be performing, meaning they are current;

 

loans must be designated as Pass under the Bank’s borrower and collateral quality ratings; and

 

 

loans must be secured by real property such that they are REIT Qualified Assets.

The above criteria may be amended from time to time at the discretion of our board of directors.

In addition, the board of directors has limited our acquisitions so that non-Qualifying Interests and other permitted real estate-type assets for purposes of the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act will be no greater than 20% of the total value of our total assets. See “ – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Investment Company Act of 1940.” We do not have specific policies with respect to the percentage of consumer and commercial loans we hold.

Following this offering, we will monitor and administer our asset portfolio by investing the proceeds of our assets in other interest earning assets such that our FFO over any period of four fiscal quarters will equal or exceed 150% of the amount that would be required to pay full annual dividends on the Series A preferred stock, as well as any parity stock, except as may be necessary to maintain our status as a REIT. See “Description of Series A Preferred Stock – Voting Rights.”

However, from time to time, we may accept as capital contributions loans that are in nonaccrual status. For example, as part of the November 2013 asset contribution from WPFC, we accepted $304.3 million of loans in nonaccrual status.

We may from time to time acquire whole loans or participation interests in loans directly from unaffiliated third parties. To date, we have not done so. It is our intention that any whole loans or participation interests acquired directly from unaffiliated third parties will meet the same general criteria as the loans or participation interests we acquire from the Bank. See “– General Description of Mortgage Assets and Other Authorized Investments; Investment Policy.”

In the past, we have acquired or accepted as capital contributions whole loans and participation interests in loans both secured and not secured by real property along with other assets. We anticipate that we will acquire, or receive as capital contributions, interests in additional real estate secured loans from the Bank. We may use any proceeds received in connection with the repayment or disposition of loans in our portfolio to acquire additional loans. Although we are not precluded from acquiring additional types of whole loans, loan participation interests or other assets, we anticipate that additional loans acquired by us will be of the types described above under the heading “– General Description of Mortgage Assets and Other Authorized Investments; Investment Policy.”

We may from time to time acquire a limited amount of other authorized investments. Although we do not intend to acquire any mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans that are secured by real estate 1-4 family mortgage loans or commercial real estate properties located throughout the U.S., we are not restricted from doing so. We do not intend to acquire any interest-only or principal-only mortgage-backed securities. As of September 30, 2014, we did not hold any mortgage-backed securities.

We do not have a direct contractual relationship with borrowers under the loan participation and servicing and assignment agreements. As the holder of participation interests in loans, substantially all of which currently are serviced by the Bank, the Company is dependent on the servicing and efforts of the Bank. See “– Servicing.”

 

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Conflicts of Interest and Related Management Policies and Programs (continued)

 

In accordance with the terms of the loan participation and servicing and assignment agreements in place, we have the authority to decide whether to foreclose on collateral that secures a loan in the event of a default. Upon sale or other disposition of foreclosure property, the Bank will remit to us the proceeds less the cost of holding and selling the foreclosure property. In the event it is determined that it would be uneconomical to foreclose on the related property, the entire outstanding principal balance of the real estate 1-4 family mortgage loan may be charged off. In addition, we may separately agree with the Bank to sell a defaulted loan back to the Bank at its estimated fair value.

Credit Risk Management Policies

For a description of our credit risk management policies, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management.”

Conflict of Interest Policies

Because of the nature of our relationship with the Bank and its affiliates, it is likely that conflicts of interest will arise with respect to certain transactions, including, without limitation, our acquisition of loans from, or disposition of loans to, the Bank, foreclosure on defaulted loans and the modification of loan participation and servicing and assignment agreements. It is our policy that the terms of any financial transactions with the Bank will be consistent with those available from third parties in the lending industry.

Conflicts of interest among us and the Bank or its affiliates may also arise in connection with making decisions that bear upon the credit arrangements that the Bank or its affiliates may have with a borrower under a loan. Conflicts also could arise in connection with actions taken by us or the Bank or its affiliates. In addition, conflicts could arise between the Bank or its affiliates and us in connection with modifications to consumer loans, including under modifications made pursuant to the Bank’s proprietary programs and pursuant to the U.S. Treasury’s Making Home Affordable (“MHA”) programs and the Home Affordable Modification Program (“HAMP”), for first lien loans and Second Lien Mortgage Program (“2MP”) for junior lien loans.

It is our intention that any agreements and transactions between us and the Bank or its affiliates, including, without limitation, any loan participation and servicing and assignment agreements, be fair to all parties and consistent with market terms for such types of transactions. Our board of directors is comprised of a majority of independent directors, and the requirement in our amended and restated certificate of incorporation that certain of our actions be approved by a majority of our independent directors is intended to ensure fair dealings among us and the Bank or its affiliates. There can be no assurance, however, that any such agreement or transaction will not differ from terms that could have been obtained from unaffiliated third parties. See Note 6 (Transactions With Related Parties) to the Audited Financial Statements in this prospectus for more details.

There are no provisions in our amended and restated certificate of incorporation limiting any of our officers, directors, stockholders, or affiliates from having any direct or indirect pecuniary interest in any asset to be acquired or disposed of by us or in any transaction in which we have an interest or from engaging in acquiring, holding, and managing our assets or from engaging for their own account in business activities of the type conducted by us. As described in this prospectus, it is expected that the Bank will have direct interests in transactions with us, including, without limitation, the sale of assets to us; however, except as borrowers under consumer loans, none of our officers or directors and no non-affiliate holders of our Series B preferred stock will have any interests in such mortgage assets.

 

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Other Policies

We may, under certain circumstances, purchase the Series A preferred stock and other shares of capital stock in the open market or otherwise. We have no present intention of repurchasing any of our shares of capital stock, and any such action would be taken only in conformity with applicable federal and state laws and regulations and the requirements for qualifying as a REIT.

We currently make investments and operate our business in a manner consistent with the requirements of the Code to qualify as a REIT. However, future economic, market, legal, tax, or other considerations may cause our board of directors, subject to approval by a majority of our independent directors, to determine that it is in our best interest and the best interest of our shareholders to revoke our REIT status. The Code prohibits us from electing REIT status for the four taxable years following the year of such revocation.

Servicing

 

 

Substantially all the loans in our portfolio currently are serviced by the Bank pursuant to the terms of loan participation and servicing and assignment agreements. See “– General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Assets in General; Participation Interests and Transfers.” The Bank has delegated servicing responsibility for certain consumer loans to third parties that are not affiliated with us or the Bank or its affiliates.

We pay the Bank monthly loan servicing fees for its services under the terms of the loan participation and servicing and assignment agreements. The amount and terms of the fee are determined by mutual agreement of the Bank and us from time to time during the terms of the loan participation and servicing and assignment agreements. See Note 6 (Transactions With Related Parties) to the Audited Financial Statements for more details.

Depending on the loan type, the monthly servicing fee charges are based in part on (a) outstanding principal balances, (b) a flat fee per month or (c) a total loan commitment amount. We paid the Bank total servicing fees of $23.7 million for the nine months ended September 30, 2014 and $13.7 million, $11.4 million and $12.6 million for the years ended December 31, 2013, 2012 and 2011, respectively.

The loan participation and servicing and assignment agreements require the Bank to service the loans in our portfolio in a manner substantially the same as for similar work performed by the Bank for transactions on its own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions, and submits and pursues insurance claims. The Bank also provides accounting and reporting services required by us for our participation interests and loans. We also may direct the Bank to dispose of any loans that are classified as nonperforming, placed in a nonperforming status or 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 loan participation and servicing and assignment agreements, including any payment to its affiliates or third parties for servicing the loans.

In accordance with the terms of the loan participation and servicing and assignment agreements in place, we have the authority to decide whether to foreclose on collateral that secures a loan in the event of a default as well as certain other rights (see “Business – General Description of Mortgage Assets and Other Authorized Investments; Investment Policy – Investment Company Act of 1940”). Upon sale or other disposition of foreclosure property, the Bank will remit to us the proceeds less the cost of holding and selling the foreclosure property. In the event it is determined that it would be uneconomical to foreclose on the related property, the entire outstanding principal balance of the real estate 1-4 family mortgage loan may be charged off. In addition, we may separately agree with the Bank to sell a defaulted loan back to the Bank at its estimated fair value.

 

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Servicing (continued)

 

We anticipate that the Bank will continue to act as servicer of any additional loans that we acquire from the Bank. We anticipate that any such servicing arrangement that we enter into in the future with the Bank will contain fees and other terms that most likely will differ from, but be substantially equivalent to, those that would be contained in servicing arrangements entered into with unaffiliated third parties. To the extent we acquire loans or participation interests from unaffiliated third parties, we anticipate that such loans or participation interests may be serviced by entities other than the Bank. It is our policy that any servicing arrangements with unaffiliated third parties will be consistent with standard industry practices.

Pledge of Assets on Behalf of the Bank

 

 

The Bank may access secured borrowing facilities through the Federal Home Loan Banks and through the discount window of the Federal Reserve Banks. The Bank is currently a member of the Federal Home Loan Bank of Des Moines and the Federal Reserve Bank of San Francisco. Federal Home Loan Banks are cooperatives that lending institutions use to finance housing and economic development in local communities. Federal Home Loan Banks make loans, or advances, to their members on the security of mortgages and other eligible collateral pledged by the borrowing member. The discount window of the Federal Reserve Banks generally provides access to short-term, usually overnight, borrowing.

We may pledge our loans in an aggregate amount not exceeding 80% of our total assets at any time as collateral on behalf of the Bank for the Bank’s access to these secured borrowing facilities through the Federal Home Loan Banks or the discount window of Federal Reserve Banks; provided that, after giving effect to any and all such pledges of assets, the unpaid principal balance of our total unpledged, performing assets (which, for the avoidance of doubt, shall not be pledged in respect of any other indebtedness we incur or otherwise) will equal or exceed three times the sum of the aggregate liquidation preference of the Series A preferred stock then outstanding plus any other parity stock then outstanding. Performing assets are assets other than nonaccrual loans and foreclosed assets. We do not currently have a pledge agreement with the Bank in place, but may do so in the future.

A Federal Home Loan Bank has priority over other creditors with respect to assets pledged to it. In the event the Bank defaults on an advance from a Federal Home Loan Bank, the Federal Home Loan Bank will own the pledged assets, and we will lose these assets. In the event the Bank defaults on a discount window advance, the Federal Reserve Bank may take possession of the pledged assets, and we may lose the assets. Although the Bank is obligated to reimburse us for these losses, it is likely that the Bank will be in receivership when such a default occurs. In that case, these losses would be borne by us, which could affect our ability to pay dividends on the Series A preferred stock. Any unpledged assets that we continue to own may decline in value and may be insufficient to pay the redemption price or satisfy the liquidation preference of the Series A preferred stock.

In exchange for the pledge of our loan assets, the Bank will pay us a fee. Such fee initially will be in an amount which we believe represents an arrangement that is not inconsistent with market terms. Such fee may be renegotiated by us and the Bank from time to time. Although we currently believe that this arrangement is not inconsistent with market terms, we cannot assure you that this is or will be the case in the future to the extent such fees are renegotiated. Any material amendment to the terms of agreements related to the pledge of our loan assets on behalf of the Bank, including with respect to fees, will require the approval of a majority of our independent directors. See also “Risk Factors – Risks Associated with Our Business – We are effectively controlled by Wells Fargo and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest” and “Risk Factors – Risks

 

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Associated with Our Business – We depend on the officers and employees of Wells Fargo and the Bank for administrative services and the servicing of the loans, and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.”

Competition

 

 

In order to qualify as a REIT under the Code, we can only be a passive investor in real estate loans and certain other assets. Thus, we do not originate loans. We anticipate that we will continue to hold interests in mortgage and other loans in addition to those in the current portfolio and that a majority of all of these loans will be obtained from the Bank. The Bank competes with mortgage conduit programs, investment banking firms, savings and loan associations, banks, savings banks, finance companies, mortgage bankers or insurance companies in acquiring and originating loans. To the extent we acquire additional whole loans or participation interests directly from unaffiliated third parties in the future, we will face competition similar to that which the Bank faces in acquiring such loans or participation interests.

Regulatory Considerations

 

 

In light of recent conditions in the U.S. and global financial markets and the U.S. and global economy, legislators, the presidential administration and regulators have continued their increased focus on regulation of the financial services industry. Proposals that further increase regulation of the financial services industry have been and are expected to continue to be introduced in the U.S. Congress, in state legislatures and before various regulatory agencies that supervise our operations. In addition, not all regulations authorized or required under the Dodd-Frank Act have been proposed or finalized by federal regulators. Further legislative changes and additional regulations may change our operating environment in substantial and unpredictable ways. We cannot predict whether future legislative proposals will be enacted and, if enacted, the effect that they, or any implementing regulations, would have on our business, results of operations or financial condition. The same uncertainty exists with respect to regulations authorized or required under the Dodd-Frank Act but that have not yet been proposed or finalized.

As a REIT, we are subject to regulation under the Code. The Code requires us to invest at least 75% of the total value of our assets in REIT Qualified Assets. In addition, we intend to operate in a manner that will not subject us to regulation under the Investment Company Act. See “– General Description of Mortgage Assets and Other Authorized Investments; Investment Policy” for more detailed descriptions of the requirements of the Code applicable to us and the requirements we have to follow in order not to be subject to regulation under the Investment Company Act.

Under certain circumstances, including any determination that the Bank’s relationship to us results in unsafe and unsound banking practices, the OCC has the authority to restrict our ability to make dividend payments to our stockholders. See “– Dividend Policy” for a more detailed description of such restrictions. As of September 30, 2014, the Bank was considered “well-capitalized” under risk-based capital guidelines issued by federal banking regulators. The Series A preferred stock will not qualify as regulatory capital of the Bank or Wells Fargo under the risk-based capital guidelines of the OCC applicable to national banking organizations or the risk-based capital guidelines of the Federal Reserve applicable to bank holding companies. The Bank is also regulated by the Federal Deposit Insurance Corporation, the CFPB, the Federal Reserve and the Federal Reserve Bank of San Francisco.

Legal Proceedings

 

 

We are not currently involved in nor, to our knowledge, currently threatened with any material litigation with respect to the assets included in our portfolio, other than routine litigation arising in the

 

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Legal Proceedings (continued)

 

ordinary course of business. Based on information currently available, advice of counsel, available insurance coverage and established reserves, we believe that the eventual outcome of the actions with respect to the assets included in our portfolio will not, in the aggregate, have a material adverse effect on our financial position or results of operations. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, may be material to our results of operations for any particular period.

Employees

 

 

We have two executive officers. Our current executive officers are also executive officers of Wells Fargo. Our non-executive officers are also officers or employees of Wells Fargo and/or certain of its affiliates, including the Bank. We do not anticipate that we will require any additional employees because employees of the Bank are servicing the loans under the participation and servicing and assignment agreements. We maintain corporate records and audited financial statements that are separate from those of the Bank. Except as borrowers under real estate 1-4 family mortgage loans, none of our officers, employees or directors will have any direct or indirect pecuniary interest in any mortgage asset to be acquired or disposed of by us or in any transaction in which we have an interest or will engage in acquiring, holding and managing mortgage assets. However, as of September 30, 2014, 15 current employees of Wells Fargo or its affiliates, each own one share of our outstanding Series B preferred stock.

 

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis of financial condition and results of operations should be read in conjunction with annual and interim financial statements.

Overview

 

 

Wells Fargo Real Estate Investment Corporation (formerly Wachovia Real Estate Investment Corp.) is engaged in acquiring, holding and managing predominantly domestic mortgage assets and other authorized investments that generate net income for distribution to our shareholders. We are classified as a REIT for federal income tax purposes.

We are a direct subsidiary of WPFC and an indirect subsidiary of Wells Fargo and the Bank.

As of September 30, 2014, and December 31, 2013, we had $12.8 billion and $13.0 billion in assets, respectively, consisting substantially of real estate loan participation interests (“loans”). Substantially all of our interests in mortgages and other assets have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements among the Bank, certain of its subsidiaries and us. See “Business — General Description of Mortgage Assets and Other Authorized Investments; Investment Policy — Assets in General; Participation Interests and Transfers” and “ – Asset Contributions.” The Bank originated the loans, purchased them from other financial institutions or acquired them as part of the acquisition of other financial institutions. Substantially all of our loans are serviced by the Bank.

REIT Tax Status

For the tax year ended December 31, 2013, we complied with the relevant provisions of the Code to be taxed as a REIT. These provisions for qualifying as a REIT for federal income tax purposes are complex, involving many requirements, including, among others, distributing at least 90% of our REIT taxable income to shareholders and satisfying certain asset, income and stock ownership tests. To the extent we meet those provisions, we will not be subject to federal income tax on net income. We believe that we continue to satisfy each of these requirements and therefore continue to qualify as a REIT. We continue to monitor each of these complex tests.

In the event we do not continue to qualify as a REIT, earnings and cash provided by operating activities available for distribution to shareholders would be reduced by the amount of any applicable income tax obligation. Given the level of earning assets, we currently expect there would be sufficient earnings and ample cash to pay preferred dividends. The preferred dividends we pay as a REIT are ordinary investment income not eligible for the dividends-received deduction for corporate shareholders or for the favorable qualified dividend tax rate applicable to non-corporate taxpayers. If we were not a REIT, preferred dividends we pay generally would qualify for the dividends-received deduction for corporate shareholders and the favorable qualified dividend tax rate applicable to non-corporate taxpayers.

Financial Performance

We earned $482.9 million in the first nine months of 2014, or $748,660 per common share, compared with $143.7 million in the first nine months of 2013, or $222,702 per common share. The 2014 increase was predominantly attributable to increased interest income resulting from a larger average interest-earning asset base, as well as an increase in yield. We earned $257.4 million in 2013, or $399,028 per common share, compared with $143.1 million in 2012, or $221,760 per common share, and $189.4 million in 2011, or $293,522 per common share. The 2013 increase in net income was primarily attributable to increased interest income resulting from a larger average interest-earning asset base, as well as a lower provision for credit losses. The 2012 decrease in net income was primarily attributable to a decline in interest income and a higher provision for credit losses.

 

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Overview (continued)

 

Asset Contributions

In November 2013, WPFC contributed $7.1 billion of consumer and commercial loans in the form of an assignment of their participation interests from the Bank, $18.0 million of accrued interest and $2.4 million of foreclosed assets to the Company. The contribution of assets was an equity transaction between entities under common control; therefore, the assets were recorded at their WPFC book value, including the allowance for credit losses of $197.1 million and unamortized premiums and discounts on loans. WPFC also contributed $1.5 billion of cash during 2013. We did not issue additional common stock to WPFC; accordingly, the contributions were recorded as an increase in additional paid-in capital. See Note 1 (Summary of Significant Accounting Policies) to the Audited Financial Statements for additional information.

The weighted average Fair Isaac Corporation (“FICO”) score and loan-to-value (“LTV”) ratio for real estate 1-4 family first mortgage loans included within the November 2013 contribution was 712 and 62%, respectively, compared with 752 and 60%, respectively, for the existing WFREIC portfolio. The weighted average FICO score and combined LTV for the contributed real estate 1-4 family junior lien mortgage portfolio was 706 and 85%, respectively, compared with 702 and 88%, respectively, for the existing WFREIC portfolio. The percentage of contributed commercial loan risk ratings, based on recorded investment, designated as Pass under the Bank’s borrower and collateral quality ratings was 97%, compared with 84% for the existing WFREIC commercial portfolio.

Loans

Total loans were $12.9 billion at September 30, 2014, compared with $13.1 billion at December 31, 2013 and $4.1 billion at December 31, 2012. In the first nine months of 2014, we reinvested loan pay-downs by acquiring $1.8 billion of consumer loans from the Bank. The decrease at September 30, 2014, was due to loan pay-downs and pay-offs exceeding the loan acquisition amount. Most of the 2013 increase related to the $7.1 billion contribution of loans from WPFC in November 2013. The loans were recorded by us at the carrying amount of WPFC, including the associated allowance for credit losses of $197.1 million. The 2013 increase in loans was also due to cash contributions of $1.5 billion to us from WPFC that, in combination with draws on our line of credit, were used to acquire $3.9 billion of loans from the Bank. In 2012, we reinvested loan pay-downs by acquiring $2.0 billion of consumer loans from the Bank. Net loans represented approximately 99% of assets at both September 30, 2014 and December 31, 2013, and 98% at December 31, 2012. Loan pay-downs and pay-offs represented 20.1% and 42.9% of average loan balances during the first nine months of 2014 and 2013, respectively. The higher loan pay-down and pay-off percentages in 2013 were a result of the low interest rate environment. Loan pay-downs and pay-offs represented 34.9% and 31.6% of average loan balances during 2013 and 2012, respectively.

Purchased credit-impaired (“PCI”) loans represented less than 1 percent of total loans at September 30, 2014, December 31, 2013 and December 31, 2012. See Note 1 (Summary of Significant Accounting Policies) to the Audited Financial Statements for additional information.

Credit quality, as measured by net charge-off rates, nonaccruals and delinquencies, continued to improve overall in the first nine months of 2014 and full year 2013, reflecting the benefit of an improving economy and improving housing market. Net charge-offs of $50.9 million were 0.54% of average loans (annualized) in the first nine months of 2014, compared with $19.1 million, or 0.58%, in the first nine months of 2013. Net charge-offs of $34.6 million were 0.62% of average loans in 2013, compared with $46.9 million, or 1.43%, in 2012 and $46.0 million, or 1.26%, in 2011.

Nonaccrual loans were $336.7 million at September 30, 2014 compared with $423.3 million at December 31, 2013 and $107.5 million at December 31, 2012. The decrease in 2014 was due in part to improving economic conditions as well as the Bank’s proactive credit risk management activities. Of

 

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the increase in nonaccrual loans at December 31, 2013, $304.3 million were nonaccrual loans when contributed from WPFC in November 2013. Loans 90 days or more past due and still accruing, excluding PCI loans, were $19.9 million at September 30, 2014, compared with $18.2 million at December 31, 2013 and $4.4 million at December 31, 2012. Of the loans 90 days or more past due and still accruing at December 31, 2013, $11.9 million related to loans contributed from WPFC in 2013.

Reflecting overall continued improvement in delinquency and related loss estimates due to strong underlying credit performance and improving home prices, our provision for credit losses was $4.4 million in the first nine months of 2014 compared with $13.5 million in the first nine months of 2013. The provision for credit losses was $18.2 million in 2013, compared with $45.4 million in 2012 and $35.6 million in 2011. The provisions for the first nine months of 2014 and full years 2013, 2012 and 2011 were $46.5 million, $16.4 million, $1.5 million and $10.4 million less than net loan charge-offs, respectively.

Capital Distributions

Dividends declared to holders of our $667 thousand of aggregate liquidation preference Series B preferred securities totaled $43 thousand in the first nine months of 2014 and 2013. Dividends declared to holders of our preferred securities totaled $57 thousand in 2013, 2012 and 2011. The outstanding shares of the Series B preferred securities are held by WPFC, Wells Fargo, current or former employees of Well Fargo, and other third-party investors.

Dividends declared to holders of our common stock totaled $445.0 million and $160.0 million in the first nine months of 2014 and 2013, respectively. Dividends declared to holders of our common stock totaled $320.0 million and $186.0 million in 2013 and 2012, respectively. Distributions made to holders of our common stock totaled $1.1 billion in 2011, which included $233.0 million in dividends declared and $850.0 million of special capital distributions.

Earnings Performance

 

 

Net Income

For the first nine months of 2014, net income was $482.9 million, compared with $143.7 million for the same period a year ago. The 2014 increase in net income was predominantly attributable to increased interest income resulting from a larger average interest-earning asset base, as well as an increase in yield. We earned net income of $257.4 million, $143.1 million and $189.4 million in 2013, 2012 and 2011, respectively. The 2013 increase in net income was primarily attributable to increased interest income resulting from a larger average interest-earning asset base, as well as a lower provision for credit losses. The 2012 decrease in net income was primarily attributable to a decline in interest income and a higher provision for credit losses.

Net Interest Income

Net interest income is the sum of interest earned on loans and cash and cash equivalents less the interest paid on our Bank line of credit. The net interest margin is the average yield on interest-earning assets minus the average interest paid for funding. Net interest income was $520.7 million in the first nine months of 2014 compared with $170.5 million for the same period a year ago. The increase in 2014 was primarily due to an increase in the average balance of interest-earning assets, as well as an increase in yield. Net interest income was $297.4 million in 2013, compared with $203.4 million in 2012 and $240.4 million in 2011. The increase in 2013 was primarily due to an increase in the average balance of interest-earning assets, partially offset by a decrease in yield. The decrease in 2012 was due to decreases in the average balances of interest-earning assets as well as a decrease in yield.

 

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Earnings Performance (continued)

 

Interest-earning assets primarily consist of loans. Average loan balances were $12.7 billion in the first nine months of 2014 compared with $4.4 billion a year ago. The increase in average loan balances was primarily due to the $7.1 billion loan contribution in November 2013. Average loan balances were $5.6 billion in 2013, compared with $3.3 billion in 2012 and $3.7 billion in 2011. The 2013 increase was primarily due to the $7.1 billion loan contribution in November 2013 as well as $3.9 billion in loan acquisitions during 2013. The 2012 decrease in average loans was caused by a combination of loan pay-downs, net loan charge-offs and loan sales outpacing loan acquisitions. To the extent we reinvest loan pay-downs or make loan acquisitions, we anticipate that we will acquire consumer and commercial loans and other REIT-eligible assets.

The average yield on total interest-earning assets was 5.48% in the first nine months of 2014 compared with 5.06% for the same period a year ago. The increase in average yield was primarily due to higher yielding loans contributed in November 2013 compared with the existing portfolio. Interest income included net discount accretion of $45.4 million in the first nine months of 2014 compared with a net premium amortization of $1.0 million for the first nine months of 2013. The discount accretion in the first nine months of 2014 compared with premium amortization a year ago was primarily driven by net acquisition discounts included with the loan contribution. The average yield on total interest-earning assets was 5.25% in 2013, compared with 5.39% in 2012 and 6.01% in 2011. The decreases in average yield in 2013 and 2012 were due to reinvestment of pay-downs and pay-offs into lower yielding assets. Additionally, the decreases were partially caused by declines in discount accretion on acquired loans. Interest income included net discount accretion of $10.2 million in 2013, compared with $23.5 million in 2012 and $43.1 million in 2011. The decrease in discount accretion was primarily driven by a decrease in loan pay-downs and pay-offs on those loans acquired with a discount.

Notwithstanding the 2013 loan contribution, we expect downward pressure on our average yield on total interest-earning assets as we reinvest proceeds from loan payments in the low interest rate environment. We also expect to recognize less discount accretion as a percentage of interest income due to the passage of time from when the loans acquired at a higher discount were acquired compared with our recent loan acquisitions that generally have lower discounts. The Company has the ability to increase interest income over time by reinvesting loan payments in real estate 1-4 family mortgage loans, commercial loans and other REIT-eligible assets; however, interest income in any one period can be affected by a variety of factors, including mix and size of the earning asset portfolio. See the Interest Rate Risk section under “Risk Management” for more information on interest rates and interest income.

The Company has a $1.2 billion line of credit with the Bank. At September 30, 2014, the outstanding balance under our Bank line of credit was $734.0 million, compared with $901.4 million at December 31, 2013 and $451.4 million at December 31, 2012. During 2014, 2013, and 2012, we borrowed on our line of credit in order to fund loan acquisitions. Interest expense related to borrowings on the line of credit was $1.0 million for the first nine months of 2014 compared with $698 thousand for the same period a year ago. Interest expense related to borrowings on the line of credit was $1.2 million in 2013, compared with $26 thousand in 2012. Average borrowings were $364.6 million in the first nine months of 2014, compared with $245.4 million for the same period a year ago. Average borrowings were $318.2 million for 2013, compared with $6.9 million for 2012. The weighted average interest rate for all periods was 0.38%. We did not borrow on our line of credit with the Bank in 2011; accordingly, we did not incur interest expense.

Table 1 presents the components of interest-earning assets and interest-bearing liabilities and related average yields to provide an analysis of changes that influenced net interest income. The dollar amount of changes in interest income related to our interest-earning assets and liabilities for the years ended December 31, 2013 and 2012 are presented in Table 2.

 

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Table 1: Net Interest Income

 

 
     Nine months ended September 30,  
                   2014                   2013  
  

 

 

   

 

 

 
(in thousands)    Average
balance
     Interest
income/
expense
     Yields/
rates
    Average
balance
     Interest
income/
expense
     Yields/
rates
 

 

 

Earning assets

                

Commercial loans

   $ 2,775,035        52,273        2.52   $ 275,337        5,532        2.69

Real estate 1-4 family mortgage loans

     9,908,904        469,433        6.33        4,114,193        165,383        5.37   

Interest-bearing deposits in banks and other interest-earning assets

     21,991        42        0.25        125,273        238        0.25   

 

      

 

 

    

Total interest-earning assets

   $     12,705,930        521,748        5.48   $     4,514,803        171,153        5.06

 

 

Funding sources

                

Line of credit with Bank

   $ 364,606        1,037        0.38   $ 245,428        698        0.38

 

      

 

 

    

Total interest-bearing liabilities

   $ 364,606        1,037        0.38      $ 245,428        698        0.38   

 

 

Net interest margin and net interest income

      $     520,711        5.47      $     170,455        5.04

 

 

 

 

 
     Year ended December 31,  
                   2013                   2012  
  

 

 

   

 

 

 
(in thousands)    Average
balance
     Interest
income/
expense
     Yields/
rates
    Average
balance
     Interest
income/
expense
     Yields/
rates
 

 

 

Earning assets

                

Commercial loans

   $ 581,607        15,193        2.61   $ 449,424        10,318        2.30

Real estate 1-4 family mortgage loans

     5,017,931        283,205        5.64       2,836,831        192,062        6.77  

Interest-bearing deposits in banks and other interest-earning assets

     93,697        237        0.25       486,161        1,069        0.22  

 

      

 

 

    

Total interest-earning assets

   $       5,693,235        298,635        5.25   $     3,772,416        203,449        5.39

 

 

Funding sources

                

Line of credit with Bank

   $ 318,215        1,210        0.38   $ 6,853        26        0.38

 

      

 

 

    

Total interest-bearing liabilities

   $ 318,215        1,210        0.38     $ 6,853        26        0.38  

 

 

Net interest margin and net interest income on a tax-equivalent basis (1)

      $     297,425        5.22      $     203,423        5.39

 

 

 

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Earnings Performance (continued)

 

 

 
     Year ended December 31, 2011  

 

 

Earning assets

                 

Commercial loans

            $ 578,688        12,813        2.21

Real estate 1-4 family mortgage loans

              3,071,792        227,398        7.40  

Interest-bearing deposits in banks and other interest-earning assets

              348,154        176        0.05  

 

    

Total interest-earning assets

            $     3,998,634        240,387        6.01

 

 

Funding sources

                 

Line of credit with Bank

            $              

 

    

Total interest-bearing liabilities

            $                

 

 

Net interest margin and net interest income on a tax-equivalent basis (1)

               $     240,387        6.01

 

 

 

(1) Tax-equivalent basis was only applicable to 2012 and 2011.

Table 2: Analysis of Changes in Interest Income

 

 

 
     Year ended December 31,  
  

 

 

 
     2013 over 2012     2012 over 2011  
  

 

 

   

 

 

 
    

Interest

income

variance

    Variance
attributable to
   

Interest

income

variance

    Variance
attributable to
 
(in thousands)      Rate     Volume       Rate     Volume  

 

 

Commercial loans

   $ 4,875       1,631       3,244       (2,494     421       (2,915

Real estate 1-4 family mortgage loans

     91,143       (44,240     135,383       (35,336     (18,686     (16,650

Interest-bearing deposits in banks and other interest-earning assets

     (832     96       (928     892       706       186  

 

 

Total interest-earning assets

   $     95,186       (42,513     137,699       (36,938     (17,559     (19,379

 

 

Line of credit with Bank

   $ 1,184             1,184       26             26  

 

 

Total interest-bearing liabilities

   $ 1,184             1,184       26             26  

 

 

Provision for Credit Losses

The provision for credit losses was $4.4 million in the first nine months of 2014 compared with $13.5 million for the same period a year ago. The provision for credit losses was $18.2 million in 2013, compared with $45.4 million in 2012 and $35.6 million in 2011. The lower level of provision in the first nine months of 2014 and full year 2013 primarily reflected continued credit improvement, particularly in consumer loans primarily as a result of continued improvement in the housing market. The higher level of provision in 2012 primarily reflected a slower rate of delinquency improvement than in 2011, as well as an increase in net charge-offs. Please refer to the “– Balance Sheet Analysis” and” Risk Management – Credit Risk Management – Allowance for Credit Losses” sections for additional information on the allowance for credit losses.

 

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Noninterest Expense

Noninterest expense was $33.9 million in the first nine months of 2014 compared with $13.4 million for the same period a year ago. Noninterest expense in 2013 was $22.0 million, compared with $15.4 million in 2012 and $16.1 million in 2011. Noninterest expense primarily consists of loan servicing costs, management fees, and foreclosed assets expense.

Loan servicing costs were $23.8 million in the first nine months of 2014 compared with $8.7 million for the same period a year ago. The increase in these costs reflected an increase in the average loan portfolio balances. Loan servicing costs were $13.7 million, $11.4 million and $12.6 million in 2013, 2012 and 2011, respectively. The 2013 increase in these costs reflected an increase in the average loan portfolio balances while the 2012 decrease in servicing costs resulted from a decrease in average loan portfolio balances. These costs are driven by the size and mix of our loan portfolio.

Management fees represent reimbursements made to the Bank for general overhead expenses, including allocations of technology support and a combination of finance and accounting, risk management and other general overhead expenses incurred on our behalf. Management fees are calculated based on Wells Fargo’s total monthly allocable costs multiplied by a formula. The formula is based on our proportion of Wells Fargo’s consolidated: (1) full-time equivalent employees, (2) total average assets and (3) total revenue. Management fees were $2.3 million in the first nine months of 2014 compared with $1.3 million for the same period a year ago. The increase in management fees related to an increase in allocated expenses, mainly technology and related support costs. Management fees were $2.0 million in 2013, compared with $2.1 million in 2012 and $1.5 million in 2011. While the 2013 expense was consistent with the prior year, the 2012 increase in management fees related to an increase in technology system and support expenses.

Foreclosed assets expense was $7.3 million in the first nine months of 2014 compared with $3.2 million for the same period a year ago. Foreclosed assets expense was $5.9 million in 2013, $1.6 million in 2012 and $1.7 million in 2011. The increase in the first nine months of 2014 and full year 2013 was due to higher costs of maintaining our foreclosed assets as well as a higher volume of foreclosure activity due to the November 2013 asset contribution. Substantially all of our foreclosed assets consist of residential 1-4 family real estate assets.

Balance Sheet Analysis

 

 

Total Assets

Our assets predominantly consist of commercial and consumer loans, although we have the authority to hold assets other than loans. Total assets were $12.8 billion at September 30, 2014, $13.0 billion at December 31, 2013 and $4.1 billion at December 31, 2012.

Loans

Loans, net of unearned income were $12.9 billion at September 30, 2014, $13.1 billion at December 31, 2013 and $4.1 billion at December 31, 2012. In the first nine months of 2014, we acquired $1.8 billion of consumer loans from the Bank at their estimated fair value. The increase in 2013 primarily reflected the $7.1 billion loan contribution and loan acquisitions partially offset by pay-downs, charge-offs and loan sales across the entire portfolio. In 2013, we acquired $2.9 billion of consumer loans and $1.0 billion of commercial loans from the Bank at their estimated fair value. In 2012, we acquired $2.0 billion of consumer loans from the Bank at their estimated fair value. At September 30, 2014, December 31, 2013 and December 31, 2012, consumer loans represented 80%, 78% and 93% of loans, respectively, and commercial loans represented the balance of our loan portfolio.

 

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Balance Sheet Analysis (continued)

 

Allowance for Loan Losses

The allowance for loan losses decreased $49.8 million to $194.0 million at September 30, 2014, from $243.8 million at December 31, 2013, primarily due to the continued improved portfolio performance of the residential real estate portfolio as a result of the continued improvement in the housing market. The allowance for loan losses increased $178.5 million to $243.8 million at December 31, 2013, from $65.3 million at December 31, 2012. The 2013 increase was primarily due to $196.8 million of allowance transferred to us as part of the loan contribution because the loan contribution was accounted for as an equity transaction between entities under common control.

At September 30, 2014, the allowance for loan losses included $171.9 million for consumer loans and $22.1 million for commercial loans. At December 31, 2013, the allowance for loan losses included $218.1 million for consumer loans and $25.7 million for commercial loans. The total allowance reflects management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. See the “– Risk Management – Credit Risk Management – Allowance for Credit Losses” section for a description of how management estimates the allowance for loan losses and the allowance for unfunded credit commitments.

Accounts Receivable – Affiliates, Net

The accounts payable and receivable from affiliates result from intercompany transactions in the normal course of business related to net loan pay-downs, interest receipts, servicing costs, management fees and other transactions with the Bank or its affiliates.

Line of Credit with Bank

We draw upon our line of credit to finance loan acquisitions. At September 30, 2014, December 31, 2013 and December 31, 2012, we had a $1.2 billion line of credit with the Bank, of which $734.0 million, $901.4 million and $451.4 million, respectively, was outstanding.

Retained Earnings (Deficit)

We expect to distribute annually an aggregate amount of dividends with respect to outstanding capital stock equal to approximately 100 percent of our REIT taxable income for federal income tax purposes before dividends paid deduction. Because our net income determined under GAAP may vary from the determination of REIT taxable income, periodic distributions may exceed our GAAP net income.

The retained deficit included within our balance sheet results from cumulative distributions that have exceeded GAAP net income, primarily due to the impact on REIT taxable income of purchase accounting adjustments attributable to the Company from the 2008 acquisition of Wachovia Corporation by Wells Fargo. The remaining purchase accounting adjustments at December 31, 2013 are not expected to cause a significant variance between GAAP net income and REIT taxable income in future years.

The following table summarizes differences between taxable income before dividends paid deduction reported on our income tax returns and net income as reported in our statement of income.

 

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Table 3: Taxable income before dividends paid deduction

 

 
     December 31,  
  

 

 

 
(in thousands)    2013     2012     2011  

 

 

Net income

   $ 257,430       143,092       189,379  

Tax adjustments:

      

Purchase accounting

     57,629       38,948       47,744  

Allowance for credit losses

     (20,306     (3,076     (11,775

Other

     1,292       732       (142

 

 

REIT taxable income

   $ 296,045       179,696       225,206  

 

 

Dividends

   $     320,057       186,057       233,057  

 

 

Risk Management

 

 

Our board of directors has overall responsibility for overseeing the Company’s risk management structure. This oversight is accomplished through the audit committee of the board of directors and a management-level committee that reviews the allowance for credit losses and is supplemented by certain elements of Wells Fargo’s risk management framework.

Allowance Governance Committee

The Company’s Allowance Governance Committee (the “Committee”) reviews the process and supporting analytics for the allowance for loan losses and the allowance for unfunded credit commitments to help ensure the allowance for credit losses (“ACL”) is maintained at an appropriate level for the Company in conformity with GAAP and regulatory guidelines. The Committee meets its responsibilities principally through its review of the process and supporting analytics employed to establish the allowance. The Committee participates in scheduled meetings during which information is presented, as appropriate, on the following items relating to the ACL:

 

 

Review of the current loss estimates, including the factors and methodologies employed in estimating such amounts;

 

 

Recent reviews, audits, and exams of ACL adequacy, effectiveness, related internal controls and governance process; and

 

 

Recent accounting, regulatory and industry developments affecting the allowance process.

Wells Fargo’s Risk Management Framework and Culture

As a consolidated subsidiary of Wells Fargo, we are subject to Wells Fargo’s enterprise risk management framework, including enterprise-level management committees that have been established to inform the risk management framework and provide governance and advice regarding management functions. While these committees may not separately consider issues at the Company level, the assets of the Company are inherently subject to the oversight of these committees because those assets are consolidated on the Wells Fargo balance sheet. These Wells Fargo committees include:

 

 

The Operating Committee, which meets weekly to, among other things, discuss strategic, operational and risk issues at the Wells Fargo enterprise level.

 

 

The Enterprise Risk Management Committee, which meets regularly during the year and reviews significant and emerging risk topics and high-risk business initiatives, particularly those that may result in additional regulatory or reputational risk.

 

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Risk Management (continued)

 

 

The Asset and Liability Committee, which is responsible for enterprise-wide oversight of Wells Fargo’s balance sheet, interest rate exposure, market risks, liquidity, and capital. The committee provides guidance and recommendations to Wells Fargo’s management and board of directors related to risk management for these areas.

 

 

The Market Risk Committee, which provides oversight of Wells Fargo’s market risk exposures to ensure significant market risks throughout the enterprise are identified, measured and monitored in accordance with the stated risk appetite.

 

 

The Operational Risk Management Committee, which provides a forum for senior risk managers to focus on enterprise-wide compliance and operational risk issues, and provides leadership and direction in evaluating management of operational risks, establishing priorities, and fostering collaboration and coordination of risk management activities across the enterprise.

 

 

The Corporate Allowance for Credit Losses Approval Governance Committee, which reviews the process and supporting analytics for allowance for loan and lease losses and the allowance for unfunded credit commitments to help ensure the Wells Fargo ACL is maintained at an appropriate level in conformity with GAAP and regulatory guidelines.

Management of the Company are members of each of the listed committees.

The Company is also subject to key elements of Wells Fargo’s enterprise risk management culture, which include the following:

 

 

Wells Fargo strongly believes in managing risk as close to the source as possible. Wells Fargo manages risk through three lines of defense, and the first line of defense is the team members in each line of business who are responsible for identifying, assessing, monitoring, managing, mitigating, and owning the risks in their businesses. All of Wells Fargo’s team members have accountability for risk management. Accordingly, those team members acting on behalf of the Company serve as the Company’s first line of defense such as in the case of the Company’s management and Allowance Governance Committee described above.

 

 

Wells Fargo recognizes the importance of strong oversight. Wells Fargo’s Corporate Risk group, led by its Chief Risk Officer who reports to the Risk Committee of Wells Fargo’s board of directors, as well as other corporate functions such as the Law Department, Corporate Controllers, and the Human Resources Department, serve as the second line of defense and provide company-wide leadership, oversight, an enterprise view, and appropriate challenge to help ensure effective and consistent understanding and management of all risks by each line of business. Wells Fargo Audit Services, led by Wells Fargo’s Chief Auditor who reports to the Audit and Examination Committee of Wells Fargo’s board of directors, serves as the third line of defense and through its audit, assurance, and advisory work evaluates and helps improve the effectiveness of the governance, risk management, and control processes across the enterprise. The Company is subject to the oversight by these enterprise level lines of defense both at the Company level and via consolidation into Wells Fargo’s financial statements. In addition, Wells Fargo’s Chief Risk Officer is the Chief Executive Officer and a director of the Company, and senior management of Wells Fargo Audit Services regularly reports to the Company’s Audit Committee.

Further discussion and specific examples of reporting, measurement and monitoring techniques we use in each risk area are included within the subsequent sub-sections of the Risk Management section.

 

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Credit Risk Management

Loans represent the largest component of assets on our balance sheet and their related credit risk is a significant risk we manage. We define credit risk as the risk of loss associated with a borrower or counterparty default (failure to meet obligations in accordance with agreed upon terms).

The table below represents loans by segment and class of financing receivable and the weighted average maturity for those loans calculated using contractual maturity dates.

Table 4: Total Loans Outstanding by Portfolio Segment and Class of Financing Receivable and Weighted Average Maturity

 

 
     Loans outstanding      Weighted average maturity in
years
 
(in thousands)    Sept. 30,
2014
     Dec. 31,
2013
     Dec. 31,
2012
     Sept. 30,
2014
     Dec. 31,
2013
     Dec. 31,
2012
 

 

 

Commercial:

                 

Commercial and industrial

   $ 54,497         80,053         47,272         1.4         1.6         0.7   

Secured by real estate

     2,514,235         2,859,662         246,344         3.1         3.4         3.4   

 

          

Total commercial

     2,568,732         2,939,715         293,616         3.1         3.3         3.0   

 

          

Consumer:

                 

Real estate 1-4 family first mortgage

     8,522,910         8,029,146         3,361,857         22.2         20.9         22.0   

Real estate 1-4 family junior lien mortgage

     1,831,774         2,151,480         457,025         16.7         16.9         17.6   

 

          

Total consumer

     10,354,684         10,180,626         3,818,882         21.2         20.1         21.4   

 

          

Total loans

   $ 12,923,416         13,120,341         4,112,498         17.6         16.3               20.1   

 

 

The discussion that follows provides analysis of the risk elements of our various loan portfolios and our credit risk management and measurement practices. See Note 2 (Loans and Allowance for Credit Losses) to Financial Statements for more analysis and credit metric information.

In order to maintain REIT status, the composition of the loans is highly concentrated in real estate.

We continually evaluate and modify our credit policies. Measuring and monitoring our credit risk is an ongoing process that tracks delinquencies, collateral values, FICO scores, economic trends by geographic areas, loan-level risk grading for certain portfolios (typically commercial) and other indications of credit risk. Our credit risk monitoring process is designed to enable early identification of developing risk and to support our determination of an appropriate allowance for credit losses.

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

Table 5: Loan Portfolio by Geography

 

 
     September 30, 2014  
(in thousands)    Commercial      Real estate
1-4 family
first
mortgage
     Real estate
1-4 family
junior lien
mortgage
     Total      % of
total
loans
 

 

 

California

   $ 822,648         679,450         24,054         1,526,152         12

Florida

     183,729         871,384         242,865         1,297,978         10   

New Jersey

     120,802         645,724         360,587         1,127,113         9   

Pennsylvania

     16,497         770,772         278,913         1,066,182         8   

North Carolina

     169,060         649,610         134,161         952,831         7   

All other states

     1,255,996         4,905,970         791,194         6,953,160         54   

 

 

Total loans

   $ 2,568,732         8,522,910         1,831,774         12,923,416             100

 

 

 

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Risk Management (continued)

 

COMMERCIAL AND INDUSTRIAL LOANS (“C&I”). Table 6 summarizes C&I loans by industry. We believe the C&I loan portfolio is appropriately underwritten and diversified. Our credit risk management process for this portfolio primarily focuses on a customer’s ability to repay the loan through their cash flows. The majority of loans in our C&I portfolio are unsecured at September 30, 2014, with the remainder secured by short-term assets, such as accounts receivable, inventory and securities, as well as long-lived assets, such as equipment and other business assets. Generally, the collateral securing this portfolio represents a secondary source of repayment.

Table 6: Commercial and Industrial Loans by Industry

 

 
     September 30, 2014  
(in thousands)    Total      % of
total
C&I loans
 

 

 

Public administration

   $ 14,517        27

Real estate lessor

     12,157         22   

Entertainment

     11,108         21   

Food and beverage

     10,508         19   

Leasing

     5,499         10   

Healthcare

     572         1   

Other

     136           

 

 

Total loans

   $ 54,497                     100

 

 

COMMERCIAL SECURED BY REAL ESTATE (“CSRE”). The CSRE portfolio consists of both mortgage loans and construction loans where loans are primarily secured by real estate. Table 7 summarizes CSRE loans by state and property type. To identify and manage newly emerging problem CSRE loans, we employ a high level of monitoring and regular customer interaction to understand and manage the risks associated with these loans, including regular loan reviews and appraisal updates. We consider the creditworthiness of the customers and collateral valuations when selecting CSRE loans for acquisition. In future periods, we expect to consider acquisitions of CSRE loans in addition to other REIT qualifying assets such as real estate 1-4 family mortgage loans.

 

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Table 7: CSRE Loans by State and Property Type

 

 
     September 30, 2014  
(in thousands)    CSRE loans      % of
total
CSRE loans
 

 

 

By state:

     

California

   $ 822,644         33

North Carolina

     168,931         7   

Florida

     158,717         6   

Georgia

     143,395         6   

Illinois

     140,002         5   

All other states

     1,080,546         43   

 

 

Total loans

   $ 2,514,235         100

 

 

By property type:

     

Office buildings

   $ 787,443         31

Shopping centers

     486,818         19   

Warehouses

     421,977         17   

Retail establishments (restaurants, stores)

     254,134         10   

5+ multifamily residences

     231,882         9   

Manufacturing plants

     118,777         5   

Research and development

     41,510         2   

Motels/hotels

     39,358         2   

Institutional

     38,892         1   

Real estate collateral pool – multi-family

     28,996         1   

Religious institutions

     16,685         1   

Other

     47,763         2   

 

 

Total loans

   $ 2,514,235                         100

 

 

REAL ESTATE 1-4 FAMILY MORTGAGE LOANS. The concentrations of real estate 1-4 family mortgage loans by state and the related combined loan-to-value (“CLTV”) ratio are presented in Table 8. Our underwriting and periodic review of loans collateralized by residential real property includes appraisals or estimates from automated valuation models (“AVMs”) to support property values. AVMs are computer-based tools used to estimate the market value of homes. AVMs are a lower-cost alternative to appraisals and support valuations of large numbers of properties in a short period of time using market comparable and price trends for local market areas. The primary risk associated with the use of AVMs is that the value of an individual property may vary significantly from the average for the market area. We have processes to periodically validate AVMs and specific risk management guidelines addressing the circumstances when AVMs may be used. AVMs are generally used in underwriting to support property values on loan originations only where the loan amount is under $250,000. We generally require property visitation appraisals by a qualified independent appraiser for larger residential property loans.

We continue to modify real estate 1-4 family mortgage loans to assist homeowners and other borrowers experiencing financial difficulties. Loans are underwritten at the time of the modification in accordance with underwriting guidelines established for governmental and proprietary loan modification programs. As a participant in the U.S. Treasury’s MHA programs, we are focused on helping customers stay in their homes. The MHA programs create a standardization of modification terms including incentives paid to borrowers, servicers, and investors. MHA includes the Home Affordable Modification Program (“HAMP”) for first lien loans and the Second Lien Modification Program 2MP for junior lien loans. Under both our proprietary programs and the MHA programs, we may provide concessions such as interest rate reductions, forbearance of principal, and in some cases, principal forgiveness. These programs generally include trial payment periods of three to four months, and after successful completion and compliance with terms during this period, the loan is permanently modified. Once the loan enters a trial period or permanent modification, it is accounted for as a troubled debt restructuring (“TDR”).

 

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Risk Management (continued)

 

We also monitor changes in real estate values and underlying economic or market conditions for all geographic areas of our real estate 1-4 family mortgage loan portfolio as part of our credit risk management process.

We monitor the credit performance of our junior lien mortgage portfolio for trends and factors that influence the frequency and severity of loss. In third quarter 2012 we aligned our nonaccrual and troubled debt reclassification policies in accordance with OCC guidance, which requires consumer loans discharged in bankruptcy to be written down to net realizable collateral value and classified as nonaccrual TDRs, regardless of their delinquency status.

Table 8: Real Estate 1-4 Family Mortgage Loans by State and CLTV

 

 
     September 30, 2014  
(in thousands)    Real estate
1-4 family
mortgage
     Current
CLTV
ratio (1)
 

 

 

Florida

   $ 1,114,249                    64

Pennsylvania

     1,049,685        63   

New Jersey

     1,006,311        68   

Virginia

     814,156        64   

North Carolina

     783,771        63   

All other states

     5,586,512        62   

 

 

Total loans

   $ 10,354,684        63   

 

 

 

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

REAL ESTATE 1-4 FAMILY JUNIOR LIEN MORTGAGE LOANS. Our junior lien portfolio includes real estate 1-4 family junior lien mortgage loans secured by real estate. Predominantly all of our junior lien loans are amortizing payment loans with fixed interest rates and repayment periods between 5 to 30 years. Junior lien loans with balloon payments at the end of the repayment term represent less than 1% of our junior lien loans. We frequently monitor the credit performance of our junior lien mortgage portfolio for trends and factors that influence the frequency and severity of loss.

Table 9 summarizes delinquency and loss rates by state for our junior lien portfolio, which reflected the largest portion of our credit losses.

Table 9: Real Estate 1-4 Family Junior Lien Portfolio (1)

 

 
    Outstanding balance     % of loans
two payments
or more past due
    Loss rate
(annualized)
Quarter ended
 
(in thousands)   Sept. 30,
2014
    Dec. 31,
2013
    Sept. 30,
2014
    Dec. 31,
2013
    Sept. 30,
2014
    Jun. 30
2014
    Mar. 31,
2014
    Dec. 31,
2013
    Sept. 30,
2013
 

 

 

New Jersey

  $ 359,280        415,592        6.03     5.64        2.00        2.41        3.61       3.32       1.96  

Pennsylvania

    277,620        328,218        4.60        4.19        1.40        2.22        2.10       2.24       2.70  

Florida

    242,470        282,151        3.20        4.30        2.13        2.31        2.75       4.50       6.13  

Virginia

    184,472        214,645        3.19        3.39        1.26        2.72        1.70       1.06       2.01  

Georgia

    144,662        170,216        3.22        3.13        2.09        1.76        3.06       5.20       3.44  

Other

    616,528        732,499        4.35        3.79        0.99        1.37        2.18       3.23       0.45  

 

               

Total

  $ 1,825,032        2,143,321        4.36        4.19        1.52        1.99        2.54       3.19       2.24  

 

               

 

 

 

(1) Consists of real estate 1-4 family junior lien mortgages, excluding PCI loans of $6,742 thousand at September 30, 2014 and $8,159 thousand at December 31, 2013.

 

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NONPERFORMING ASSETS (NONACCRUAL LOANS AND FORECLOSED ASSETS). Table 10 summarizes nonperforming assets (“NPAs”) for the last five quarters and Table 11 for each of the last three years. We generally place loans on nonaccrual status when:

 

 

the full and timely collection of interest or principal becomes uncertain (generally based on an assessment of the borrower’s financial condition and the adequacy of collateral, if any);

 

 

they are 90 days (120 days with respect to real estate 1-4 family first and junior lien mortgages) past due for interest or principal, unless both well-secured and in the process of collection;

 

 

part of the principal balance has been charged off (including loans discharged in bankruptcy);

 

 

for junior lien mortgages, we have evidence that the related first lien mortgage may be 120 days past due or in the process of foreclosure regardless of the junior lien delinquency status; or

 

 

performing consumer loans are discharged in bankruptcy, regardless of their delinquency status.

Note 1 (Summary of Significant Accounting Policies) to the Audited Financial Statements describes our accounting policy for nonaccrual and impaired loans.

Table 10: Nonperforming Assets (Nonaccrual Loans and Foreclosed Assets)

 

 
(in thousands)    Sept. 30,
2014
    June 30,
2014
     Mar. 31,
2014
     Dec. 31,
2013
    Sept. 30,
2013
 

 

 

Nonaccrual loans:

            

Commercial:

            

Commercial and industrial

   $                            

Secured by real estate

     4,883        5,070         8,451        8,802        371   

 

 

Total commercial

     4,883        5,070         8,451        8,802        371   

 

 

Consumer:

            

Real estate 1-4 family first mortgage

     247,088        256,319         270,740        310,069            76,828   

Real estate 1-4 family junior lien mortgage

     84,724        87,348         93,556        104,423        21,371   

 

 

Total consumer

     331,812        343,667         364,296        414,492        98,199   

 

 

Total nonaccrual loans (1)

     336,695        348,737         372,747        423,294        98,570   

 

 

Foreclosed assets (2)

     3,860        5,404         3,967        5,142        416   

 

 

Total nonperforming assets

   $ 340,555        354,141         376,714        428,436        98,986   

 

 

As a percentage of total loans

     2.64     2.78         3.00        3.27        1.78   

 

 

 

(1) Beginning December 31, 2013 includes nonaccrual loans contributed from WPFC. See Table 12.
(2) Beginning December 31, 2013 reflects the impact of assets contributed from WPFC, which included $2.4 million of foreclosed assets.

 

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Risk Management (continued)

 

Table 11: Nonperforming Assets (Nonaccrual Loans and Foreclosed Assets)

 

 
     December 31,  
(in thousands)    2013     2012      2011  

 

 

Nonaccrual loans:

       

Commercial:

       

Commercial and industrial

   $                 

Secured by real estate

     8,802       822        2,543  

 

 

Total commercial

     8,802       822        2,543  

 

 

Consumer:

       

Real estate 1-4 family first mortgage

     310,069       81,154        53,384  

Real estate 1-4 family junior lien mortgage

     104,423       25,541        20,070  

 

 

Total consumer (1)

     414,492       106,695        73,454  

 

 

Total nonaccrual loans (2)

     423,294       107,517        75,997  

 

 

Foreclosed assets (3)

     5,142       1,820        1,067  

 

 

Total nonperforming assets

   $ 428,436       109,337        77,064  

 

 

As a percentage of total loans

     3.27     2.66        2.39  

 

 

 

(1) December 31, 2012 includes the impact of the implementation of the Interagency and OCC Guidance issued in 2012.
(2) December 31, 2013 includes nonaccrual loans contributed by WPFC. See Table 12.
(3) December 31, 2013 reflects the impact of assets contributed from WPFC, which included $2.4 million of foreclosed assets.

Total NPAs were $340.6 million (2.64% of total loans) at September 30, 2014, and included $336.7 million of nonaccrual loans and $3.9 million of foreclosed assets. Total NPAs were $428.4 million (3.27% of total loans) at December 31, 2013, and included $423.3 million of nonaccrual loans and $5.1 million of foreclosed assets. The decrease in 2014 was due in part to improving economic conditions and the Bank’s proactive credit risk management activities. Nonaccrual loans increased $315.8 million in 2013, including $304.3 million nonaccrual loans contributed from WPFC.

Typically, changes to nonaccrual loans period-over-period represent inflows for loans that are placed on nonaccrual status in accordance with our policy, offset by reductions for loans that are paid down, or charged off while on nonaccrual status, or sold, transferred to foreclosed properties, or are no longer classified as nonaccrual as a result of continued performance and an improvement in the borrower’s financial condition and loan repayment capabilities. Table 12 provides an analysis of the changes in nonaccrual loans.

If interest due on all nonaccrual loans (including loans that were, but are no longer on nonaccrual status at year end) had been accrued under the original terms, approximately $8.4 million of interest would have been recorded as income on these loans, compared with $6.2 million actually recorded as interest income in 2013. In 2012, $1.3 million of interest income was recorded on nonaccrual loans while $5.9 million would have been recorded under their terms.

 

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Table 12: Analysis of Changes in Nonaccrual Loans

 

 

 
     Quarter ended              
  

 

 

     
     Sept. 30,     June 30,     Mar. 31,     Dec. 31,     Sept. 30,     Year ended Dec. 31,  
  

 

 

   

 

 

 
(in thousands)    2014     2014    

2014

    2013     2013     2013     2012  

 

 

Commercial nonaccrual loans

              

Balance, beginning of period

   $ 5,070        8,451        8,802        371        707        822        2,543   

Inflows (1)

     365               69        8,498        169        8,741        689   

Outflows

     (552     (3,381     (420     (67     (505     (761     (2,410

 

 

Balance, end of period

     4,883        5,070        8,451        8,802        371        8,802        822   

 

 

Consumer nonaccrual loans

              

Balance, beginning of period

     343,667        364,296        414,492        98,199        103,161        106,695        73,454   

Inflows (1)

     53,926        60,315        67,003        361,597        15,668        417,170        120,951   

Outflows:

              

Returned to accruing

     (31,689     (36,757     (60,396     (18,356     (8,924     (46,626     (37,894

Foreclosures

     (3,082     (4,941     (2,782     (1,282     (422     (2,802     (4,723

Charge-offs

     (12,124     (14,287     (18,871     (14,793     (3,432     (28,868     (28,049

Payment, sales and other

     (18,886     (24,959     (35,150     (10,873     (7,852     (31,077     (17,044

 

 

Total outflows

     (65,781     (80,944     (117,199     (45,304     (20,630     (109,373     (87,710

 

 

Balance, end of period

     331,812        343,667        364,296        414,492        98,199        414,492        106,695   

 

 

Total nonaccrual loans

   $     336,695        348,737        372,747        423,294        98,570        423,294        107,517   

 

 

 

(1) Quarter ended December 31, 2013 inflows included $8.2 million of commercial and $296.1 million of consumer nonaccrual loans contributed from WPFC.

TROUBLED DEBT RESTRUCTURINGS. Recorded investment of loans modified in TDRs is provided in Tables 13 and 14. The allowance for loan losses for TDRs was $115.1 million, $136.2 million and $19.2 million at September 30, 2014, December 31, 2013 and December 31, 2012, respectively. See Note 2 (Loans and Allowance for Credit Losses) to our Financial Statements for more information. Those loans discharged in bankruptcy and reported as TDRs have been written down to net realizable collateral value.

In those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. We sometimes delay the timing on the repayment of a portion of principal (principal forbearance) and charge off the amount of forbearance if that amount is not considered fully collectible.

Our nonaccrual policies are generally the same for all loan types when a restructuring is involved. We re-underwrite loans at the time of restructuring to determine whether there is sufficient evidence of sustained repayment capacity based on the borrower’s documented income, debt to income ratios, and other factors. Loans lacking sufficient evidence of sustained repayment capacity at the time of modification are charged down to the fair value of the collateral, if applicable. For an accruing loan that has been modified, if the borrower has demonstrated performance under the previous terms and the underwriting process shows the capacity to continue to perform under the restructured terms, the loan will generally remain in accruing status. Otherwise, the loan will be placed in nonaccrual status until the borrower demonstrates a sustained period of performance, generally six consecutive months of payments, or equivalent, inclusive of consecutive payments made prior to modification. Loans will also be placed on nonaccrual status, and a corresponding charge-off is recorded to the loan balance, when we believe that principal and interest contractually due under the modified agreement will not be collectible.

 

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Risk Management (continued)

 

Table 15 provides an analysis of the changes in TDRs. Loans that may be modified more than once are reported as TDR inflows only in the period they are first modified.

Table 13: Troubled Debt Restructurings

 

 

 
(in thousands)    Sept. 30,
2014
     June 30,
2014
     Mar. 31,
2014
     Dec. 31,
2013
     Sept. 30,
2013
 

 

 

Commercial TDRs:

              

Commercial and industrial

   $                               

Secured by real estate

     2,880        3,252        3,109        2,777         

 

 

Total commercial TDRs

     2,880        3,252        3,109        2,777         

 

 

Consumer TDRs:

              

Real estate 1-4 family first mortgage

     387,667        388,765        393,503        390,309        96,787  

Real estate 1-4 family junior lien mortgage

     123,234        123,273        124,389        127,680        24,771  

Trial modifications

     20,494        17,131        16,658        19,953        7,551  

 

 

Total consumer TDRs

     531,395        529,169        534,550        537,942        129,109  

 

 

Total TDRs (1)

   $ 534,275        532,421        537,659        540,719        129,109  

 

 

TDRs on nonaccrual status

   $ 179,633        184,538        196,884        230,230        55,732  

TDRs on accrual status

     354,642        347,883        340,775        310,489        73,377  

 

 

Total TDRs

   $     534,275        532,421        537,659        540,719        129,109  

 

 

 

(1) Beginning December 31, 2013 includes TDRs contributed by WPFC. See Table 15.

Table 14: Troubled Debt Restructurings

 

 

 
     December 31,  
  

 

 

 
(in thousands)    2013      2012      2011  

 

 

Commercial TDRs:

        

Commercial and industrial

   $                

Secured by real estate

     2,777               1,440  

 

 

Total commercial TDRs

     2,777               1,440  

 

 

Consumer TDRs:

        

Real estate 1-4 family first mortgage

     390,309        81,794        43,220  

Real estate 1-4 family junior lien mortgage

     127,680        23,492        21,039  

Trial modifications

     19,953        4,788        3,338  

 

 

Total consumer TDRs (1)

     537,942        110,074        67,597  

 

 

Total TDRs (2)

   $ 540,719        110,074        69,037  

 

 

TDRs on nonaccrual status

   $ 230,230        50,435        19,541  

TDRs on accrual status

     310,489        59,639        49,496  

 

 

Total TDRs

   $     540,719        110,074        69,037  

 

 

 

(1) Reflects the impact of the prospective adoption of the OCC guidance issued in 2012.
(2) December 31, 2013 included TDRs contributed by WPFC. See Table 15.

 

 

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Table 15: Analysis of Changes in TDRs

 

 

 
     Quarter ended              
  

 

 

     
    

Sept. 30,

2014

   

June 30,

2014

   

Mar. 31

2014

   

Dec. 31

2013

   

Sept. 30,

2013

    Year ended Dec. 31,  
            

 

 

 
(in thousands)              2013     2012  

 

 

Commercial TDRs:

              

Balance, beginning of quarter

   $ 3,252        3,109        2,777                             1,440   

Inflows (1)

            289        382        5,693               5,693        146   

Outflows (2)

     (372     (146 )     (50 )     (2,916 )            (2,916 )     (1,586

 

 

Balance, end of quarter

     2,880        3,252        3,109        2,777               2,777          

 

 

Consumer TDRs:

              

Balance, beginning of quarter

     529,169       534,550        537,942        129,109        124,895        110,074        67,597   

Inflows (1)

     15,427       15,552        21,907        402,210        7,993        431,132        58,408   

Outflows:

              

Charge-offs

     (4,223     (2,839 )     (8,410 )     (2,694 )     (814 )     (7,531 )     (9,656

Foreclosures

     (1,653     (1,448 )     (484 )     (583 )            (1,279 )     (52

Payments, sales and other (2)

     (10,688     (17,120 )     (13,110 )     (2,502 )     (3,179 )     (9,619 )     (7,673

Net change in trial modifications (3)

     3,363       474        (3,295 )     12,402        214        15,165        1,450   

 

 

Total outflows

     (13,201     (20,933 )     (25,299 )     6,623        (3,779 )     (3,264 )     (15,931

 

 

Balance, end of quarter

     531,395       529,169        534,550        537,942        129,109        537,942        110,074   

 

 

Total TDRs

   $     534,275       532,421        537,659        540,719        129,109        540,719        110,074   

 

 

 

(1) Quarter ended December 31, 2013 inflows included $388.0 million of commercial and consumer TDRs contributed from WPFC.
(2) Other outflows include normal amortization/accretion of loan basis adjustments. No loans were removed from TDR classification in the quarters ended September 30, June 30 and March 31, 2014 and December 31 and September 30, 2013 as a result of being refinanced or restructured as new loans.
(3) Net change in trial modifications includes: inflows of new TDRs entering the trial payment period, net of outflows for modifications that either (i) successfully perform and enter into a permanent modification, or (ii) did not successfully perform according to the terms of the trial period plan and are subsequently charged-off, foreclosed upon or otherwise resolved. Our experience is that most of the mortgages that enter a trial payment period program are successful in completing the program requirements.

LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING. Certain loans 90 days or more past due as to interest or principal are still accruing, because they are (1) well-secured and in the process of collection or (2) real estate 1-4 family mortgage loans exempt under regulatory rules from being classified as nonaccrual until later delinquency, usually 120 days past due. PCI loans of $5.2 million, $7.0 million, $1.2 million and $1.5 million at September 30, 2014 and December 31, 2013, 2012 and 2011, respectively, are excluded from this disclosure even though they are 90 days or more contractually past due. These PCI loans are considered to be accruing because they continue to earn interest from accretable yield, independent of performance in accordance with their contractual terms.

Loans 90 days or more past due and still accruing at September 30, 2014 were relatively flat from December 31, 2013. Loans 90 days or more past due and still accruing at December 31, 2013 were up $13.8 million from December 31, 2012. At December 31, 2013, $11.9 million of loans 90 days or more past due and still accruing related to loans contributed from WPFC. Table 16 reflects non-PCI loans 90 days or more past due and still accruing.

 

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Table 16: Loans 90 Days or More Past Due and Still Accruing

 

 

 
(in thousands)    Sept. 30
2014
     Jun. 30,
2014
     Mar. 31,
2014
     Dec. 31,
2013
     Sept. 30,
2013
 

 

 

Commercial:

              

Commercial and industrial

   $                                

Secured by real estate

                                    

 

 

Total commercial

                                    

 

 

Consumer:

              

Real estate 1-4 family first mortgage

     15,701         9,237         10,893        13,120        5,365  

Real estate 1-4 family junior lien mortgage

     4,232         4,001         2,666        5,062        918  

 

 

Total consumer

     19,933         13,238         13,559        18,182        6,283  

 

 

Total (1)

   $ 19,933        13,238         13,559        18,182        6,283  

 

 

 

(1) Beginning December 31, 2013, includes loans 90 days or more past due and still accruing that were contributed from WPFC.

 

 

 
     December 31,  
(in thousands)    2013      2012      2011  

 

 

Commercial:

        

Commercial and industrial

   $                   

Secured by real estate

                     1,455  

 

 

Total commercial

                     1,455  

 

 

Consumer:

        

Real estate 1-4 family first mortgage

     13,120        3,252        5,235  

Real estate 1-4 family junior lien mortgage

     5,062        1,141        1,880  

 

 

Total consumer

     18,182        4,393        7,115  

 

 

Total (1)

   $     18,182        4,393        8,570  

 

 

 

(1) December 31, 2013 balance included $11.9 million of loans 90 days or more past due and still accruing that were contributed from WPFC.

NET CHARGE-OFFS. Table 17 presents net charge-offs for the first nine months of 2014 and 2013, and the full years of 2013, 2012 and 2011. Substantially all net losses were in consumer real estate.

Table 17: Net Charge-offs

 

 

 
    Nine months ended September 30,     Year ended December 31,  
          2014           2013           2013           2012 (2)           2011  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
($ in thousands)   Net loan
charge-
offs
    % of
avg.
loans (1)
    Net loan
charge-
offs
   

% of

avg.
loans (1)

   

Net loan

charge-

offs

(recoveries)

    % of
avg.
loans
    Net loan
charge-
offs
    % of
avg.
loans
    Net loan
charge-
offs
    % of
avg.
loans
 

 

 

Total commercial

  $ 508        0.02 %   $ 2        0.00 %   $ (191 )     (0.03 )%   $ 255        0.06 %   $ 202        0.03 %

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Consumer:

                   

Real estate 1-4 family first mortgage

    20,295        0.34        9,462        0.34        15,310        0.35        18,894        0.81        19,452        0.78   

Real estate
1-4 family junior lien mortgage

    30,112        2.03        9,599        3.09        19,507        3.13        27,713        5.45        26,365        4.51   

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Total consumer (2)

    50,407        0.68        19,061        0.62        34,817        0.69        46,607        1.64        45,817        1.49   

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Total

  $     50,915        0.54 %   $ 19,063        0.58 %   $ 34,626        0.62   $ 46,862        1.43 %   $ 46,019        1.26 %

 

 

 

(1) Net charge-offs as a percentage of average loans are annualized.
(2) The year ended December 31, 2012 reflects the impact of the OCC guidance issued in third quarter 2012.

 

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ALLOWANCE FOR CREDIT LOSSES. The allowance for credit losses, which consists of the allowance for loan losses and the allowance for unfunded credit commitments, is management’s estimate of credit losses inherent in the loan portfolio and unfunded credit commitments at the balance sheet date.

We apply a disciplined process and methodology to establish our allowance for credit losses each quarter. This process takes into consideration many factors, including historical and forecasted loss trends, loan-level credit quality ratings and loan grade-specific characteristics. The process involves subjective and complex judgments. In addition, we review a variety of credit metrics and trends. These credit metrics and trends, however, do not solely determine the amount of the allowance as we use several analytical tools. Our estimation approach for the commercial portfolio reflects the estimated probability of default in accordance with the borrower’s financial strength, and the severity of loss in the event of default, considering the quality of any underlying collateral. Probability of default and severity at the time of default are statistically derived through historical observations of defaults and losses after default within each credit risk rating. Our estimation approach for the consumer portfolio uses forecasted losses that represent our best estimate of inherent loss based on historical experience, quantitative and other mathematical techniques over the loss emergence period.

The ratio of the allowance for credit losses to total nonaccrual loans may fluctuate significantly from period to period due to such factors as the mix of loan types in the portfolio, the amount of nonaccrual loans that have been written down to current collateral value, borrower credit strength, foreclosure process timeframes and the value and marketability of collateral.

Total provision for credit losses was $4.4 million for the nine months ended September 30, 2014, compared with $13.5 million for the same period a year ago. The provision for the first nine months of 2014 was $46.5 million less than net charge-offs. The provision for the first nine months of 2013 was $5.6 million less than net charge-offs. Total provision for credit losses was $18.2 million in 2013, $45.4 million in 2012 and $35.6 million in 2011. The 2013 provision was less than net charge-offs by $16.4 million. The 2012 and 2011 provision was $1.5 million and $10.4 million less than net charge-offs, respectively. The lower level of provision in the first nine months of 2014 and full year 2013 primarily reflected continued credit improvement, particularly in consumer loans primarily as a result of continued improvement in the housing market. The higher level of provision in 2012 primarily reflected a slower rate of delinquency improvement than in 2011, as well as an increase in net charge-offs.

In determining the appropriate allowance attributable to our consumer loan portfolios, our process considers the associated credit characteristics, including re-defaults of modified loans and projected loss severity for loan modifications that occur or are probable to occur. In addition, our process incorporates the estimated allowance associated with high-risk portfolios defined in Interagency Guidance relating to junior lien mortgages.

Changes in the allowance reflect changes in statistically derived loss estimates, historical loss experience, current trends in borrower risk and/or general economic activity on portfolio performance, and management’s estimate for imprecision and uncertainty.

At September 30, 2014, the allowance for credit losses totaled $194.8 million. At December 31, 2013, the allowance for credit losses totaled $244.3 million, compared with $65.5 million at December 31, 2012. The increase in 2013 was primarily due to $197.1 million of allowance being transferred to the Company as part of the November 2013 WPFC loan contribution. We believe the allowance for credit losses at September 30, 2014 was appropriate to cover credit losses inherent in the loan portfolio, including unfunded credit commitments, at that date. The allowance for credit losses is subject to change and reflects existing factors as of the date of determination, including economic or market conditions and ongoing internal and external examinations processes. Due to the sensitivity of

 

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Risk Management (continued)

 

the allowance for credit losses to changes in the economic and business environment, it is possible that we will incur incremental credit losses not anticipated as of the balance sheet date. Our process for determining the allowance for credit losses is discussed in the “Critical Accounting Policy” section and Note 1 (Summary of Significant Accounting Policies), and the detail of the changes in the allowance for credit losses by portfolio segment (including charge-offs and recoveries by loan class) is in Note 2 (Loans and Allowance for Credit Losses) to our Financial Statements.

Table 18 presents an analysis of the allowance for credit losses.

Table 18: Allowance for Credit Losses

 

 

 
(in thousands)    Sep. 30,
2014
    June 30,
2014
     Mar. 31,
2014
     Dec. 31,
2013
     Sep. 30,
2013
 

 

 

Components:

          

Allowance for loan losses

   $     194,039        211,809        212,115        243,752        58,479  

Allowance for unfunded credit commitments

     809        726        774        517        151  

 

 

Allowance for credit losses (1)

   $     194,848        212,535        212,889        244,269        58,630  

 

 

Allowance for loan losses as a percentage of total loans

     1.50     1.66        1.69        1.86        1.05  

Allowance for loan losses as a percentage of annualized net charge-offs (2)

     370.17        367.78        224.05        394.78        325.89  

Allowance for credit losses as a percentage of total loans

     1.51        1.67        1.70        1.86        1.06  

Allowance for credit losses as a percentage of total nonaccrual loans

     57.87        60.94        57.11        57.71        59.48  

 

 

 

 

 
(in thousands)    2013     2012      2011  

 

 

Components:

    

Allowance for loan losses

   $     243,752       65,340        68,394  

Allowance for unfunded credit commitments

     517       119        141  

 

 

Allowance for credit losses (1)

   $ 244,269       65,459        68,535  

 

 

Allowance for loan losses as a percentage of total loans

     1.86     1.59        2.12  

Allowance for loan losses as a percentage of net charge-offs (2)

     703.96       139.43        148.62  

Allowance for credit losses as a percentage of total loans

     1.86       1.59        2.12  

Allowance for credit losses as a percentage of total nonaccrual loans

     57.71       60.88        90.18  

 

 

 

(1) December 31, 2013 included $197.1 million related to the loan contribution from WPFC.
(2) The 2013 allowance for loan losses reflects allowance transferred in the November 2013 loan contribution from WPFC while 2013 net charge-offs do not include activity that occurred prior to the loan contribution.

Asset/Liability Management

Asset/liability management involves the evaluation, monitoring and management of interest rate risk and liquidity and funding.

INTEREST RATE RISK. Interest rate risk is the sensitivity of earnings to changes in interest rates. Approximately 29% of our loan portfolio consisted of variable rate loans at September 30, 2014, compared with 32% at December 31, 2013. In a declining rate environment, we may experience a reduction in interest income on our loan portfolio and a corresponding decrease in funds available to be distributed to our shareholders. The reduction in interest income may result from downward adjustment of the indices upon which the interest rates on loans are based and from prepayments of loans with fixed interest rates, resulting in reinvestment of the proceeds in lower yielding assets.

 

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To manage interest rate risk, we monitor loan pay-down rates, portfolio composition, and the rate sensitivity of loans acquired. Our loan acquisition process attempts to balance desirable yields with the quality of loans acquired.

At September 30, 2014, approximately 71% of our loans had fixed interest rates, compared with 68% at December 31, 2013. Such loans increase our interest rate risk. Our methods for evaluating interest rate risk include an analysis of interest-rate sensitivity “gap,” which is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. A gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. Our interest rate-sensitive liabilities are generally limited to our line of credit with the Bank.

During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to adversely affect net interest income. Because different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market rates or conditions, changes in interest rates may affect net interest income positively or negatively even if an institution is perfectly matched in each maturity category.

At September 30, 2014, 29% of our assets had variable interest rates, compared with 32% at December 31, 2013, and could be expected to reprice with changes in interest rates. At September 30, 2014, our liabilities were 6% of our assets, compared with 7% at December 31, 2013. Stockholders’ equity was 94% of our assets at September 30, 2014, compared with 93% at December 31, 2013. This positive gap between our assets and liabilities indicates that an increase in interest rates would result in an increase in net interest income and a decrease in interest rates would result in a decrease in net interest income.

Our rate-sensitive assets and liabilities at December 31, 2013 are presented in Table 19. At December 31, 2013 we held no assets that immediately reprice. The allowance for loan losses is not included in loans. At December 31, 2013, the fair value of the loan portfolio was $13.7 billion with fixed rate loans of approximately $9.4 billion and variable rate loans of approximately $4.3 billion.

Table 19: Rate-sensitive Assets and Liabilities

 

 

 
     December 31, 2013  
(In thousands)    Within
one year
     One to
three years
     Three to
five years
     Over
five years
     Total  

 

 

Rate-sensitive assets

              

Interest-bearing deposits in banks

   $                                  

Loans and loan participations

              

Fixed rate

     48,727         282,667         214,919         8,346,287         8,892,600  

Variable rate

     557,450         1,013,266         551,304         2,105,721         4,227,741  

 

 

Total rate-sensitive assets

   $     606,177         1,295,933         766,223         10,452,008         13,120,341  

 

 

Line of credit with Bank

     901,350                                901,350  

 

 

Total rate-sensitive liabilities

   $ 901,350                                901,350  

 

 

LIQUIDITY AND FUNDING. The objective of effective liquidity management is to ensure that we can meet customer loan requests and other cash commitments efficiently under both normal operating conditions and under unpredictable circumstances of industry or market stress. To achieve this objective, Wells Fargo’s Corporate Asset/Liability Management Committee establishes and monitors liquidity guidelines that require sufficient asset-based liquidity to cover potential funding requirements and to avoid over-dependence on volatile, less reliable funding markets.

 

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Risk Management (continued)

 

Proceeds received from pay-downs of loans are typically sufficient to fund existing lending commitments and loan acquisitions. Depending upon the timing of the loan acquisitions, we may draw on our $1.2 billion revolving line of credit we have with the Bank as a short-term liquidity source. At September 30, 2014, there was $734.0 million outstanding on our Bank line of credit, compared with $901.4 million at December 31, 2013. The rate of interest on the line of credit is equal to the average federal funds rate plus 12.5 basis points.

Our primary liquidity needs are to pay operating expenses, fund our lending commitments, acquire loans to replace existing loans that mature or repay, and pay dividends. Primarily due to the impact on REIT taxable income of purchase accounting adjustments attributable to the Company from the 2008 acquisition of Wachovia Corporation by Wells Fargo, dividend distributions to shareholders in 2011 through 2013, based on REIT taxable income, exceeded net cash provided by operating activities (generally interest income). The excess dividend distributions were funded by using cash provided by investing (generally principal payments received on our loans) and financing activities (generally draws on our Bank line of credit). As the remaining purchase accounting adjustments at December 31, 2013 are not expected to cause a significant variance between GAAP net income and REIT taxable income in future years, operating expenses and dividends are expected to be funded through cash generated by operations or paid-in capital. Funding commitments and the acquisition of loans are intended to be funded with the proceeds obtained from repayment of principal balances by individual borrowers and our line of credit with the Bank. In the first nine months of 2014, we acquired $1.8 billion of loans from the Bank, compared with $2.9 billion in the first nine months of 2013. In 2013, we acquired $3.9 billion of loans from the Bank. If in future periods we do not reinvest loan pay-downs at sufficient levels, management may request our board of directors to consider a return of capital to the holders of our common stock. Annually, we expect to distribute an aggregate amount of outstanding capital stock dividends equal to approximately 100% of our REIT taxable income for federal tax purposes. Such distributions may exceed net income determined under GAAP.

To the extent that we determine that additional funding is required, we could issue additional common or preferred stock, or raise funds through debt financings, limited retention of cash flows or a combination of these methods. Any cash flow retention must be consistent with the provisions of the Investment Company Act and the Code, which requires 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. We do not have and do not anticipate having any material capital expenditures in the foreseeable future, and we believe our existing sources of liquidity are sufficient to meet our funding needs.

As of September 30, 2014 and December 31, 2013, our liabilities consisted of the line of credit with the Bank and other liabilities. Our amended and restated certificate of incorporation does not contain any limitation on the amount or percentage of debt, funded or otherwise, we may incur; however, as part of issuing our Series A preferred stock, we have a covenant in which we agree not to incur indebtedness for borrowed money, including any guarantees of indebtedness (which does not include any pledges of our assets on behalf of the Bank or our other affiliates as described above under “Business – Pledge of Assets on Behalf of the Bank”), without the consent of the holders of two-thirds of the Series A preferred stock, voting as a separate class, provided that, we may incur indebtedness in an aggregate amount not exceeding 20% of our stockholders’ equity.

 

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Critical Accounting Policy

 

 

Our significant accounting policies (see Note 1 (Summary of Significant Accounting Policies) to the Audited Financial Statements) are fundamental to understanding our results of operations and financial condition because they require that we use estimates and assumptions that may affect the value of our assets or liabilities and financial results. We have identified the accounting policy covering allowance for credit losses as particularly sensitive in terms of judgments and the extent to which estimates are used. Management and the board of directors have reviewed and approved this critical accounting policy.

Allowance for Credit Losses

As a subsidiary of Wells Fargo, our loans are subject to the same analysis of the appropriateness of the ACL as applied to loans maintained in Wells Fargo’s other subsidiaries, including the Bank.

The allowance for credit losses, which consists of the allowance for loan losses and the allowance for unfunded credit commitments, is management’s estimate of credit losses inherent in the loan portfolio, including unfunded credit commitments, at the balance sheet date. We develop and document our allowance methodology at the portfolio segment level. Our loan portfolio consists of a commercial loan portfolio segment and a consumer loan portfolio segment.

We employ a disciplined process and methodology to establish our allowance for credit losses. The total allowance for credit losses considers both impaired and unimpaired loans. While our methodology attributes portions of the allowance to specific portfolio segments, the entire allowance for credit losses is available to absorb credit losses inherent in the total loan portfolio and unfunded credit commitments. No single statistic or measurement determines the appropriateness of the allowance for credit losses.

COMMERCIAL PORTFOLIO SEGMENT. The allowance for credit losses for unimpaired commercial loans is estimated through the application of loss factors to loans based on credit risk ratings for each loan. In addition, the allowance for unfunded credit commitments, including letters of credit, is estimated by applying these loss factors to loan equivalent exposures. The loss factors reflect the estimated default probability and quality of the underlying collateral. The loss factors used are statistically derived through the observation of historical losses incurred for loans within each credit risk rating over a relevant specified period of time. We apply our judgment to adjust or supplement these loss factors and estimates to reflect other risks that may be identified from current conditions and developments in selected portfolios. These risk ratings are subject to review by an internal team of credit specialists.

The allowance also includes an amount for estimated credit losses on impaired loans such as nonaccrual loans and loans that have been modified in a TDR, whether on accrual or nonaccrual status.

CONSUMER PORTFOLIO SEGMENT. Loans are pooled generally by product type with similar risk characteristics. Losses are estimated using forecasted losses to represent our best estimate of inherent loss based on historical experience, quantitative and other mathematical techniques over the loss emergence period. Each business group exercises significant judgment in the determination of the credit loss estimation model that fits the credit risk characteristics of its portfolio. We use both internally developed and vendor supplied models in this process. We often use roll rate or net flow models for near-term loss projections, and vintage-based models, behavior score models, and time series or statistical trend models for longer-term projections. Management must use judgment in establishing additional input metrics for the modeling processes, considering further stratification into

 

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Critical Accounting Policy (continued)

 

sub-product and other predictive characteristics. In addition, we establish an allowance for consumer loans modified in a TDR, whether on accrual or nonaccrual status.

The models used to determine the allowance are validated by a model validation group of Wells Fargo operating in accordance with Company policies.

OTHER ACL MATTERS. The allowance for credit losses for both portfolio segments includes an amount for imprecision or uncertainty that may change from period to period. This amount represents management’s judgment of risks inherent in the processes and assumptions used in establishing the allowance. This imprecision considers economic environmental factors, modeling assumptions and performance, process risk, and other subjective factors, including industry trends and risk assessments for commitments made by Wells Fargo and the Bank to regulatory and government agencies regarding settlements of mortgage foreclosure-related matters.

Impaired loans, which predominantly include nonaccrual commercial loans and any loans that have been modified in a TDR, have an estimated allowance calculated as the difference, if any, between the impaired value of the loan and the recorded investment in the loan. The impaired value of the loan is generally calculated as the present value of expected future cash flows from principal and interest which incorporates expected lifetime losses, discounted at the loan’s effective interest rate. The development of these expectations requires significant management review and judgment. When collateral is the sole source of repayment for an impaired loan, rather than the borrower’s income or other sources of repayment, we charge down to net realizable value, which may reduce or eliminate the need for an allowance. The allowance for an unimpaired loan is based solely on principal losses without consideration for timing of those losses. The allowance for an impaired loan that was modified in a TDR may be lower than the previously established allowance for that loan due to benefits received through modification, such as lower probability of default and/or severity of loss, and the impact of prior charge-offs or charge-offs at the time of the modification that may reduce or eliminate the need for an allowance.

SENSITIVITY TO CHANGES. Changes in the allowance for credit losses and, therefore, in the related provision for credit losses can materially affect net income. In applying the review and judgment required to determine the allowance for credit losses, management considers changes in economic conditions, customer behavior, and collateral value, among other influences. From time to time, economic factors or business decisions, such as the addition or liquidation of a loan product or business unit, may affect the loan portfolio, causing management to provide or release amounts from the allowance for credit losses.

The allowance for credit losses for commercial loans, including unfunded credit commitments (individually risk weighted), is sensitive to credit risk ratings assigned to each credit exposure. Commercial loan risk ratings are evaluated based on each situation by experienced senior credit officers and are subject to periodic review by an internal team of credit specialists.

The allowance for credit losses for consumer loans (statistically modeled) is sensitive to economic assumptions and delinquency trends. Forecasted losses are modeled using a range of economic scenarios.

Assuming a one risk rating downgrade throughout our commercial portfolio segment and a downside economic scenario (reflecting worsening unemployment and lower Home Price Index (“HPI”)) for modeled losses on our consumer portfolio segment could imply an additional allowance requirement of approximately $44.5 million at December 31, 2013.

 

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Assuming a one risk rating upgrade throughout our commercial portfolio segment and an upside economic scenario (reflecting improving unemployment and higher HPI) for modeled losses on our consumer portfolio segment could imply a reduced allowance requirement of approximately $15.0 million at December 31, 2013.

The sensitivity analyses provided are hypothetical scenarios and are not considered probable. They do not represent management’s view of inherent losses in the portfolio as of the balance sheet date. Because significant judgment is used, it is possible that others performing similar analyses could reach different conclusions.

See “Risk Management – Credit Risk Management” section, Note 1 (Summary of Significant Accounting Policies) and Note 2 (Loans and Allowance for Credit Losses) to our Financial Statements for further discussion of the allowance for credit losses.

Current Accounting Developments

 

 

The following accounting pronouncement has been issued by the FASB but is not yet effective:

 

 

Accounting Standards Update (ASU or Update) 2014-14 – Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Classification of Certain Government-Guaranteed Mortgage Loans Upon Foreclosure;

ASU 2014-14 requires government-guaranteed mortgage loans to be classified as other receivables upon foreclosure if the following criteria are met: (1) the loan has a government guarantee that is inseparable from the loan before foreclosure, (2) the creditor has the intent to convey the real estate property to the guarantor, plans to make a claim on the guarantee, and has the ability to recover under the claim, and (3) any claim amount determined based on the fair value of the underlying real estate is fixed at the time of foreclosure. The Update also requires the creditor to measure the other receivable based on the loan balance expected to be recovered from the guarantor. These changes are effective for us in first quarter 2015 with early adoption permitted. The guidance can be applied either prospectively or through modified retrospective transition, with a cumulative-effect adjustment to the separate other receivable as of the beginning of the annual adoption period. This Update will not have a material impact on our financial statements.

 

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Management

Executive Officers

 

 

We currently have two executive officers. Our executive officers are also executive officers of Wells Fargo and are executive officers and directors of the Bank. The names of our executive officers, their ages, their positions with Wells Fargo, and their business experience during the past five years, are as follows:

Michael J. Loughlin (age 58) has been our President and Chief Executive Officer since March 2014 and a Director since July 2014. Mr. Loughlin has served as Senior Executive Vice President and Chief Risk Officer of Wells Fargo since July 2011. See “– Directors” for Mr. Loughlin’s business experience.

John R. Shrewsberry (age 49) has been our Senior Executive Vice President and Chief Financial Officer since May 2014. Mr. Shrewsberry has served as Senior Executive Vice President and Chief Financial Officer of Wells Fargo since May 2014. From 2006 to May 2014, Mr. Shrewsberry was head of Wells Fargo Securities. Mr. Shrewsberry has over 20 years of experience in banking and investing.

None of our executive officers owns any shares of our capital stock.

Directors

 

 

We currently have four directors. One of our directors, Michael J. Loughlin, is an executive officer of both Wells Fargo and WFREIC. The names of our directors, their ages, and their business experience during the past five years, are as follows:

George L. Ball (age 55) has been Chief Financial Officer and Executive Vice President of Parsons Corporation, Pasadena, California, an international engineering, construction, technical, and management services firm, since May 2008. Previously, he was Senior Vice President, Financial Systems and Control, of Parsons Corporation from March 2007 to May 2008 and Vice President, Finance, of Parsons Development Company from October 2004 to February 2008. His experience in a variety of finance positions allows him to bring a broad understanding of financial matters to the board of directors, including expertise in accounting, internal controls, financial reporting, and risk management. Mr. Ball has served as a director of the Company since July 2014 and is a member of the Audit Committee. He is also a director of NCI Building Systems, Inc.

Gary K. Bettin (age 60) has served as Managing Director of Crosh Consulting, LLC, Mooresville, North Carolina, a financial services consulting firm, since 2010. He also served as Senior Vice President and Head of Mortgage Loan Servicing of American Security Mortgage Corporation, Charlotte, North Carolina, a mortgage banking company, from 2013 to August 2014 and as Chief Executive Officer of Quatrro Mortgage Solutions, Inc., Charlotte, North Carolina, a mortgage outsourcing business, from 2006 to 2010. Mr. Bettin retired from Bank of America, a financial services company, in 2006 after serving in a variety of senior executive roles in customer service and mortgage loan servicing. He brings more than 30 years of mortgage and consumer banking industry experience to the board of directors, having held senior executive roles in loan origination and fulfillment, customer service, servicing, technology and finance. Mr. Bettin has served as a director of the Company since July 2014 and is chair of the Audit Committee.

Michael J. Loughlin (age 58) has served as President and Chief Executive Officer of the Company since March 2014 and as a director since July 2014. He has been Senior Executive Vice President and Chief Risk Officer of Wells Fargo since July 2011. Previously, he served as Executive Vice President and

 

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Chief Risk Officer from November 2010 to July 2011, and Executive Vice President and Chief Credit and Risk Officer from April 2006 to November 2010. As Chief Risk Officer of Wells Fargo, Mr. Loughlin provides oversight for, among other things, Wells Fargo’s risk management activities, including credit risk, operational risk, and market risk. Mr. Loughlin brings significant financial institution, risk management, credit risk, mortgage lending, and real estate lending expertise to the board of directors.

John F. Luikart (age 65) has been president of Bethany Advisors LLC, San Francisco, California, a privately-owned consulting business, since February 2007. He has also served on the Board of Directors of the Federal Home Loan Bank of San Francisco, a cooperative wholesale bank since 2007 and currently serves as the Chairman. Mr. Luikart is also currently a trustee of four asbestos trusts, having begun his work in this area in 2004. Previously, he was Chairman of Wedbush Securities Inc., Los Angeles, California, an investment firm, from 2006 to 2010; President and Chief Operating Officer of Tucker Anthony Sutro, a brokerage and investment firm, from 2001 to 2002; and Chairman and Chief Executive Officer of Sutro & Co., a brokerage and investment firm, from 1996 to 2002. With his long career in the financial services industry, Mr. Luikart brings significant leadership and executive management experience to the board of directors, including extensive governance and strategic knowledge, as well as financial and investment expertise. Mr. Luikart has served as a director of the Company since July 2014 and is a member of the Audit Committee.

Messrs. Ball, Bettin and Luikart are our independent directors, as discussed below under “– Independent Directors.”

Each of our directors will serve until their successors are duly elected and qualified. We have no current intention to further alter the number of directors comprising our board of directors after the sale of the Series A preferred stock in this offering.

None of our directors owns any shares of our capital stock.

If we fail to pay, or declare and set aside for payment, dividends on the Series A preferred stock and any parity stock for six quarterly dividend periods, the number of our directors will be increased by two and holders of the Series A preferred stock, voting together as a class with the holders of any parity stock with the same voting rights, will have the right to elect such additional directors.

Independent Directors

 

 

We currently have three directors who are considered “independent” for purposes of Rule 10A-3 of the Exchange Act. In accordance with this rule, our independent directors may not accept any consulting, advisory or other compensatory fee from the issuer other than certain fixed compensation under a retirement or deferred compensation plan for prior service with us, or be an “affiliated person” of us. An affiliated person means a person that directly or indirectly controls, is controlled by or is under common control with the company, which generally means an executive officer or a beneficial owner of more than 10% of any class of voting securities of the company. See also “Description of the Series A Preferred Stock – Independent Director Approval.”

Audit Committee

 

 

We have an audit committee consisting of our three independent directors. The board of directors has determined, in its business judgment, that each member of the Audit Committee qualifies as an “audit committee financial expert” as defined by SEC regulations.

 

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Audit Committee (continued)

 

The Audit Committee’s purpose is to assist the board of directors in fulfilling its responsibilities to oversee our policies and management activities related to:

 

 

accounting and financial reporting, internal controls, auditing, operational risk and legal and regulatory compliance;

 

 

the integrity of our financial statements and the adequacy and reliability of disclosures to stockholders;

 

 

the qualifications and independence of the outside auditors and the performance of internal and outside auditors; and

 

 

overseeing reputation risk related to the Audit Committee’s responsibilities.

To those ends, the Audit Committee:

 

 

taking into consideration our status as a subsidiary of Wells Fargo, selects, evaluates, and where appropriate, replaces the outside auditors, and approves all audit engagement fees and terms and all non-audit engagements of the outside auditors;

 

 

reviews the financial statements, which are prepared by management and audited by the independent outside auditors;

 

 

reviews reports prepared by management on our internal controls; and

 

 

discusses with our independent outside auditors the audit process.

Compensation Committee

 

 

We do not have a compensation committee of the board of directors because we do not currently compensate our officers. Our officers, however, receive compensation from Wells Fargo in connection with their duties as employees of Wells Fargo, including serving as officers of WFREIC.

Limitations on Liability of Directors and Officers

 

 

Section 145 of the Delaware General Corporation Law (the “DGCL”) provides that a corporation will indemnify directors and officers as well as other employees and individuals against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with any threatened, pending or completed actions, suits or proceedings in which such person is made a party by reason of such person being or having been a director, officer, employee or agent of the corporation, subject to certain limitations. The statute provides that it is not exclusive of other rights to which those seeking indemnification may be entitled under any by-law, agreement, vote of stockholders or disinterested directors or otherwise.

Section 102 (b)(7) of the DGCL permits a corporation to provide in its certificate of incorporation that a director of the corporation shall not be personally liable to the corporation or its shareholders for monetary damages for breach of fiduciary duty as a director, except for liability:

 

 

for any breach of the director’s duty of loyalty to the corporation or its shareholders;

 

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for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;

 

 

for payments of unlawful dividends or unlawful stock purchases or redemptions; or

 

 

for any transaction from which the director derived an improper personal benefit.

Our amended and restated certificate of incorporation provides for the elimination of personal liability of each of our directors, and for the indemnification of our directors and officers, to the extent permitted by the DGCL.

We maintain directors and officers liability insurance. In general, the policy insures:

 

 

our directors and officers against loss by reason of any of their wrongful acts; and

 

 

against loss arising from claims against the directors and officers by reason of their wrongful acts, all subject to the terms and conditions contained in the policy.

Exclusive Forum

 

 

Our Amended and Restated Bylaws provide that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware (or, if no state court located within the State of Delaware has jurisdiction, the federal district court for the District of Delaware) shall be the exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any director or officer or other employee to us or our stockholders, (iii) any action asserting a claim pursuant to the DGCL or (iv) any action asserting a claim governed by the internal affairs doctrine.

 

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Executive Compensation

Executive Compensation

 

 

Currently, we do not directly pay or award any compensation in any form to our executive officers. In 2014, our executive officers, John Shrewsberry and Michael J. Loughlin, were employed and compensated by Wells Fargo in connection with their duties, including serving as officers of WFREIC. We have no current plans to directly compensate our executive officers.

Director Compensation

 

 

In 2013 and until July 3, 2014, all of our directors were employees of the Bank. These directors did not, and will not in the future, receive compensation from us for their services as our directors.

Such employees, however, receive compensation from Wells Fargo in connection with their duties as employees of Wells Fargo.

For services rendered as our directors, directors who are not employees of us or Wells Fargo will be paid an annual cash retainer of $75,000. In addition, directors are reimbursed for travel and lodging costs to attend meetings of directors. Our board of directors has the authority to set reasonable and appropriate compensation for the directors who are not employees of us or Wells Fargo. Directors who are not employees of us or Wells Fargo were first elected on July 3, 2014.

Employment Contracts

 

 

None.

Compensation Committee Interlocks and Insider Participation; Compensation Committee Report

 

 

We do not have a compensation committee. None of our executive officers or employees is currently compensated by us.

 

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Certain Relationships and Related Party Transactions

One of our directors is also an executive officer of Wells Fargo. Our executive officers are also executive officers of Wells Fargo and are executive officers and directors of the Bank. In addition, some of our directors and executive officers are customers of Wells Fargo’s affiliated financial and lending institutions and have transactions with such affiliates in the ordinary course of business. Transactions with directors and executive officers have been on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the time for comparable transactions with third parties and do not involve more than the normal risk of collectability or present other unfavorable features. We may hold a participation interest in some of these loans.

We are subject to certain income and expense allocations from affiliated parties for various services received. In addition, we enter into transactions with affiliated parties in the normal course of business. The nature of the transactions with affiliated parties is discussed below. Further information, including amounts involved, is presented in Note 6 (Transactions With Related Parties) of our Audited Financial Statements.

We acquire and sell loans from and to the Bank. The loan acquisitions and sales are transacted at fair value resulting in acquisition discounts and premiums. We sell foreclosed assets back to the Bank from time to time at estimated fair value with no gain or loss recognized upon the transfer of such assets (as the assets are written down to the fair value of the underlying collateral before being sold). The net acquisition discount accretion is reported within interest income. Gains or losses on sales of loans are included within noninterest income. In 2013, all of our loan acquisitions and sales were with the Bank. In 2013, we acquired $2.9 billion of consumer loans and $1.0 billion of commercial loans from the Bank at their estimated fair value. In November 2013, WPFC contributed $7.1 billion of consumer and commercial loans in the form of an assignment of their participation interests from the Bank.

We may pledge our loan assets in an aggregate amount not exceeding 80% of our total assets at any time as collateral on behalf of the Bank for the Bank’s access to secured borrowing facilities through the Federal Home Loan Bank of Des Moines or the discount window of the Federal Reserve Bank of San Francisco. In exchange for the pledge of our loan assets, the Bank will pay us a fee. Such fee initially will be in an amount we believe represents an arrangement that is not inconsistent with market terms. Such fee may be rene