10-Q 1 wfe-20180930x10q.htm 10-Q Document
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018

Commission file number 1-36768
Wells Fargo Real Estate Investment Corporation
(Exact name of registrant as specified in its charter)
Delaware
 
56-1986428   
(State of incorporation)
 
(I.R.S. Employer Identification No.)    
90 South 7th Street
Minneapolis, Minnesota 55402
(Address of principal executive offices)
(Zip Code)

(855) 825-1437
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ
 
No o

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
Yes þ
 
No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company' in Rule 12b-2 of the Exchange Act.
 
 
Large accelerated filer    o
 
Accelerated filer  o
 
 
 
 
 
 
 
Non-accelerated filer    þ
 
Smaller reporting company  o
 
 
 
 
Emerging growth company  o
 
          
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o
 
No þ

 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of October 29, 2018, there were 34,058,028 shares of the registrant’s common stock outstanding.

 


FORM 10-Q
CROSS-REFERENCE INDEX
 
PART I
Financial Information
 
 
 
 
Item 1.
Financial Statements
Page
  
  
  
  
  
Notes to Financial Statements
 
  
1

—

  
2

—

  
3

—

  
4

—

  
5

—

 
 
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Financial Review)
 
  
  
  
  
  
  
  
  
  
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
PART II
Other Information
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.
 
 
 
 
 
 
 
 
 
 
 
 






1


PART I - FINANCIAL INFORMATION
FINANCIAL REVIEW
Summary Financial Data
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
% Change
 
 
 
 
 
 
 
  
Quarter ended
 
 
September 30, 2018 from
 
 
Nine months ended
 
 
 
($ in thousands, except per share data)
Sep 30,
2018

 
Jun 30,
2018

 
Sep 30,
2017

 
Jun 30,
2018

 
Sep 30,
2017

 
Sep 30,
2018

 
Sep 30,
2017

 
% Change

For the period
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
$
301,123

 
307,303

 
326,540

 
(2
)%
 
(8
)
 
$
927,458

 
903,737

 
3
 %
Net income applicable to common stock
296,726

 
302,906

 
322,143

 
(2
)
 
(8
)
 
914,267

 
890,546

 
3

Diluted earnings per common share
8.71

 
8.89

 
9.46

 
(2
)
 
(8
)
 
26.84

 
26.15

 
3

Profitability ratios
 
 
 
 
 
 


 


 
 
 
 
 


Return on average assets
3.59
%
 
3.57

 
3.87

 
1

 
(7
)
 
3.60
 %
 
3.62

 
(1
)
Return on average stockholders’ equity
3.68

 
3.79

 
3.99

 
(3
)
 
(8
)
 
3.82

 
3.73

 
2

Average stockholders’ equity to average assets
97.42

 
94.28

 
96.78

 
3

 
1

 
94.35

 
97.28

 
(3
)
Common dividend payout ratio (1)
96.10

 
97.41

 
99.37

 
(1
)
 
(3
)
 
98.99

 
100.50

 
(2
)
Dividend coverage ratio (2)
7,064

 
7,208

 
6,837

 
(2
)
 
3

 
7,064

 
6,837

 
3

Total revenue
$
330,025

 
333,504

 
345,155

 
(1
)
 
(4
)
 
$
1,007,049

 
1,004,061

 
—

Average loans
33,024,229

 
34,234,880

 
33,243,173

 
(4
)
 
(1
)
 
34,186,792

 
31,802,058

 
7

Average assets
33,288,067

 
34,499,277

 
33,516,352

 
(4
)
 
(1
)
 
34,443,845

 
33,338,443

 
3

Net interest margin
3.99
%
 
3.90

 
3.96

 
2

 
1

 
3.90
 %
 
3.87

 
1

Net loan charge-offs (recoveries)
$
(119
)
 
(786
)
 
1,156

 
(85
)
 
NM

 
$
(1,411
)
 
5,331

 
NM

As a percentage of average total loans (annualized)
—
%
 
(0.01
)
 
0.01

 
(100
)
 
(100
)
 
(0.01
)%
 
0.02

 
NM

At period end
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
$
32,510,311

 
33,599,587

 
32,697,065

 
(3
)
 
(1
)
 
$
32,510,311

 
32,697,065

 
(1
)
Allowance for loan losses
104,556

 
112,381

 
129,116

 
(7
)
 
(19
)
 
104,556

 
129,116

 
(19
)
As a percentage of total loans
0.32
%
 
0.33

 
0.39

 
(3
)
 
(18
)
 
0.32
 %
 
0.39

 
(18
)
Assets
$
32,589,234

 
33,747,152

 
32,738,812

 
(3
)
 
—

 
$
32,589,234

 
32,738,812

 
—

Total stockholders’ equity
32,399,530

 
32,387,804

 
32,389,730

 
—

 
—

 
32,399,530

 
32,389,730

 
—

Total nonaccrual loans and foreclosed assets
182,513

 
190,136

 
200,896

 
(4
)
 
(9
)
 
182,513

 
200,896

 
(9
)
As a percentage of total loans
0.56
%
 
0.57

 
0.61

 
(2
)
 
(8
)
 
0.56
 %
 
0.61

 
(8
)
Loans 90 days or more past due and still accruing (3)
$
6,118

 
2,641

 
6,174

 
132

 
(1
)
 
$
6,118

 
6,174

 
(1
)
NM - Not meaningful
(1)
Dividends declared per common share as a percentage of earnings per common share.
(2)
The dividend coverage ratio is considered a non-GAAP financial measure. Management believes the dividend coverage ratio is a useful financial measure because the certificate of designation for the Series A preferred stock limits, among other matters, our ability to pay dividends on our common stock or make any payment of interest or principal on our line of credit with Wells Fargo Bank, National Association, if the dividend coverage ratio for the four prior fiscal quarters is less than 150%. The dividend coverage ratio is expressed as a percentage and calculated by dividing the four prior fiscal quarters' GAAP net income, excluding gains (or losses) from sales of property (consistent with the National Association of Real Estate Investment Trusts definition of “funds from operations”), by the amount that would be required to pay annual dividends on the Series A and Series B preferred stock.
(3)
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.



2

This Quarterly Report, including the Financial Review and the Financial Statements and related Notes, contains forward-looking statements, which may include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not unduly rely on forward-looking statements. Actual results may differ materially from our forecasts and expectations due to several factors. Factors that could cause our results to differ materially from our forward looking statements are described in this Report, including in the “Forward-Looking Statements” section, and the “Risk Factors” section in our Annual Report on Form 10-K for the year ended December 31, 2017 ( 2017 Form 10-K).

When we refer to “WFREIC,” the “Company,” “we,” “our,” and “us” in this Report, we mean Wells Fargo Real Estate Investment Corporation, and where relevant, Wells Fargo Bank, National Association, acting on our behalf; the “Bank” refers to Wells Fargo Bank, National Association; and “Wells Fargo” refers to Wells Fargo & Company.

Financial Review
OVERVIEW

The Company is engaged in acquiring, holding and managing domestic mortgage assets and other authorized investments that generate net income for distribution to our shareholders. We are classified as a real estate investment trust (REIT) for federal income tax purposes and are an indirect subsidiary of Wells Fargo and the Bank.
As of September 30, 2018, we had $32.6 billion in assets, consisting substantially of real estate loan participation interests (loans). Our interests in mortgage 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. 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, 2017, we complied with the relevant provisions of the Internal Revenue Code of 1986, as amended (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 continue to monitor each of these complex tests. We believe that we continue to satisfy each of these requirements and therefore continue to qualify as a REIT.
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 and common 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, however non-corporate shareholders may be able to deduct 20% of the preferred and common dividends as a deduction for qualified business income under the Tax Cuts and Jobs Act. If we were not a REIT, preferred and common 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 net income and net income applicable to common stock of $301.1 million and $296.7 million, respectively, in third quarter 2018, or $8.71 diluted earnings per common share, compared with $326.5 million and $322.1 million, respectively, in third quarter 2017, or $9.46 diluted earnings per common share. For the first nine months of 2018, net income and net income applicable to common stock were $927.5 million and $914.3 million, respectively, or $26.84 diluted earnings per common share, compared with $903.7 million and $890.5 million, respectively, for the same period a year ago, or $26.15 diluted earnings per common share. The decrease in net income in the third quarter of 2018 was due to lower pledge fees, a lower reversal of provision for credit losses and an increase in noninterest expense. The increase in net income for the first nine months of 2018 was attributable to an increase in net interest income and reversal of provision for credit losses, partially offset by a decrease in pledge fees and an increase in noninterest expense.

Loans
Total loans were $32.5 billion at September 30, 2018, compared with $35.9 billion at December 31, 2017. Net loans represented 99% of assets at both September 30, 2018 and December 31, 2017.
Credit quality, as measured by net charge-offs, nonaccrual loans and delinquencies, remained strong during third quarter 2018. Net recoveries were $119 thousand and $1.4 million in the third quarter and first nine months of 2018, compared with net charge-offs of $1.2 million and $5.3 million in the third quarter and first nine months of 2017. These results reflect the benefit of continued improvement in the housing market driving favorable performance in our residential real estate portfolio. Nonaccrual loans were $179.9 million at September 30, 2018, compared with $197.4 million at December 31, 2017. Loans 90 days or more past due and still accruing were $6.1 million at September 30, 2018, compared with $12.9 million at December 31, 2017. Delinquencies remain a small percentage of our loan balances.

3

Reversal of provision for credit losses was $6.8 million and $22.9 million in the third quarter and first nine months of 2018, compared with reversal of provision for credit losses of $11.5 million and provision for credit losses of $14.7 million for the same periods in 2017. The reversal of provision was lower in the third quarter of 2018 compared with a year ago due to a decrease in allowance release as continued portfolio improvement stabilizes. The reversal of provision in the first nine months of 2018 compared to the provision a year ago reflected continued improvement in the housing market driving favorable performance in our residential real estate portfolio. Future allowance levels will be based on a variety of factors, including loan portfolio composition, size and performance, and the general economic environment, including housing market conditions.
Capital Distributions
Dividends declared to holders of our Series A preferred stock totaled $4.4 million and $13.1 million in the third quarter and first nine months, respectively, of both 2018 and 2017. Dividends declared to holders of our Series B preferred stock totaled $14 thousand and $42 thousand in the third quarter and first nine months, respectively, of both 2018 and 2017.
Dividends declared to the holders of our common stock totaled $285.0 million and $905.0 million for the third quarter and first nine months of 2018, respectively, compared with $320.0 million and $895.0 million for the same periods in 2017.


4

Earnings Performance

Net Income
We earned net income of $301.1 million and $326.5 million in third quarter 2018 and 2017, respectively. For the first nine months of 2018, net income was $927.5 million, compared with $903.7 million for the same period a year ago. The decrease in net income in the third quarter of 2018 was due to lower pledge fee income, a lower reversal of provision for credit losses, and an increase in noninterest expense. The increase in net income for the first nine months of 2018 was attributable to an increase in net interest income and reversal of provision for credit losses, partially offset by a decrease in pledge fees and an increase in noninterest expense.

Net Interest Income
Net interest income is the interest earned on loans and cash and cash equivalents less the interest paid on our Bank line of credit. Net interest income was $329.9 million and $1.0 billion in the third quarter and first nine months of 2018, respectively, compared with $329.6 million and $959.8 million for the same periods a year ago. Third quarter 2018 reflected an increase in commercial loan yield, offset by a decrease in real estate 1-4 family mortgage loan yield compared with a year ago. The increase in net interest income in the first nine months of 2018 was attributable to an increase in interest income resulting from a higher average loan balance and higher yield, partially offset by an increase in interest expense.
Net interest margin is the average yield on interest-earning assets minus the average interest paid for funding. Interest-earning assets predominantly consist of loans. Net interest margin was 3.99% and 3.90% in the third quarter and first nine months of 2018, respectively, compared with 3.96% and 3.87% for the same periods a year ago. Interest income in the third quarter and first nine months of 2018 included net accretion of adjustments on loans of $5.0 million and $14.3 million, respectively, compared with $4.1 million and $10.4 million a year ago. Loan paydowns and payoffs annualized represented 12.9% of average loan balances for both the third quarter and first nine months of 2018, respectively, compared with 13.3% and 13.4% during the same periods a year ago.

 
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 “Risk Management - Asset/Liability Management - Interest Rate Risk” section in this Report for more information on interest rates and interest income.
The Company has a $5.0 billion line of credit with the Bank. Average borrowings for third quarter 2018 and 2017 were $757.5 million and $968.3 million, respectively, at weighted average interest rates of 2.41% and 1.30%, respectively. Average borrowings for the first nine months of 2018 and 2017 were $1.9 billion and $352.0 million, respectively, at weighted average interest rates of 2.16% and 1.30%, respectively. Effective October 2017, the rate of interest on the line of credit was changed from the average federal funds rate plus 12.5 basis points (0.125%) to the three-month London Interbank Offered Rate (LIBOR) plus 4.4 basis points (0.044%).
Table 1 presents the components of interest-earning assets and interest-bearing liabilities and related average yields to provide an analysis of year-over-year changes that influenced net interest income.



5

Table 1: Interest Income
 
Quarter ended September 30,
 
 
 
 
 
 
2018

 
 
 
 
 
2017

(in thousands)
Average
balance

 
Interest
income/expense

 
Yields/rates

 
Average
balance

 
Interest
income/expense

 
Yields/rates

Earning assets
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
2,763,794

 
29,401

 
4.22
%
 
$
3,554,112

 
30,397

 
3.39
%
Real estate 1-4 family mortgage loans
30,260,435

 
305,072

 
4.03

 
29,689,061

 
302,349

 
4.07

Interest-bearing deposits
2,243

 
12

 
2.07

 
474

 
2

 
1.17

Total interest-earning assets
$
33,026,472

 
334,485

 
4.04

 
$
33,243,647

 
332,748

 
4.00

Funding sources
 
 
 
 
 
 
 
 
 
 
 
Line of credit with Bank
$
757,455

 
4,604

 
2.41

 
$
968,313

 
3,173

 
1.30

Total interest-bearing liabilities
$
757,455

 
4,604

 
2.41

 
$
968,313

 
3,173

 
1.30

Net interest margin and net interest income
 
 
$
329,881

 
3.99
%
 
 
 
$
329,575

 
3.96
%
 
Nine months ended September 30,
 
 
 
 
 
 
2018

 
 
 
 
 
2017

(in thousands)
Average
balance

 
Interest
income/expense

 
Yields/rates

 
Average
balance

 
Interest
income/expense

 
Yields/rates

Earning assets
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
3,008,863

 
90,250

 
4.01
%
 
$
3,717,154

 
85,726

 
3.08
%
Real estate 1-4 family mortgage loans
31,177,929

 
941,094

 
4.03

 
28,084,905

 
869,005

 
4.13

Interest-bearing deposits

756

 
12

 
2.07

 
1,313,619

 
8,498

 
0.86

Total interest-earning assets
$
34,187,548

 
1,031,356

 
4.02

 
$
33,115,678

 
963,229

 
3.88

Funding sources
 
 
 
 
 
 
 
 
 
 
 
Line of credit with Bank
$
1,907,366

 
30,866

 
2.16

 
$
352,017

 
3,423

 
1.30

Total interest-bearing liabilities
$
1,907,366

 
30,866

 
2.16

 
$
352,017

 
3,423

 
1.30

Net interest margin and net interest income
 
 
$
1,000,490

 
3.90
%
 
 
 
$
959,806

 
3.87
%


Provision for Credit Losses
Reversal of provision for credit losses was $6.8 million and $22.9 million in the third quarter and first nine months of 2018, respectively, compared with reversal of provision for credit losses of $11.5 million and provision for credit losses of $14.7 million for the same periods a year ago. The reversal of provision was lower in the third quarter of 2018 compared with a year ago due to a decrease in allowance release as continued portfolio improvement stabilizes. The reversal of provision in the first nine months of 2018 compared to the provision a year ago reflected continued improvement in the housing market driving favorable performance in our residential real estate portfolio. See the “Balance Sheet Analysis” and "Risk Management – Allowance for Credit Losses” sections in this Report for additional information on the allowance for credit losses.


6

Noninterest Income
Noninterest income was $144 thousand and $6.6 million in the third quarter and first nine months of 2018, respectively, compared with $15.6 million and $44.3 million for the same periods a year ago. The decrease in the third quarter and first nine months of 2018 was attributable to a decrease in pledge fees, a result of having no loans pledged during second and third quarter 2018.
The certificate of designation for the Series A preferred stock limits our ability to pledge our loans to 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 or the discount window of Federal Reserve Banks. However, the Bank's borrowings will differ from loan balances pledged. In exchange for the pledge of our loan assets, the Bank pays us a fee that is consistent with market terms. We did not earn pledge fees in third quarter 2018. Pledge fees were $6.0 million in the first nine months of 2018. Pledge fees were $15.9 million and $44.3 million in the third quarter and first nine months of 2017, respectively.
See Note 5 (Transactions With Related Parties) to Financial Statements in this Report for more details.


 
Noninterest Expense
Noninterest expense was $35.7 million and $102.5 million in the third quarter and first nine months of 2018, respectively, compared with $30.2 million and $85.7 million for the same periods a year ago. Noninterest expense predominantly consists of loan servicing costs, management fees, and foreclosed assets expense.
The loans in our portfolio are predominantly serviced by the Bank pursuant to the terms of participation and servicing and assignment agreements. In limited instances, the Bank has delegated servicing responsibility to third parties that are not affiliated with us or the Bank. 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. Loan servicing costs were $20.6 million for both the third quarter of 2018 and 2017. Loan servicing costs were $63.8 million in the first nine months of 2018, respectively, compared with $58.6 million for the same period a year ago. The increase in the first nine months of 2018 was attributable to a higher average loan balance.
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 include direct and indirect expense allocations. Indirect expenses are allocated based on ratios that use our proportion of expense activity drivers. The expense activity drivers and ratios may change from time to time. Management fees were $11.0 million and $29.0 million in the third quarter and first nine months of 2018, compared with $6.4 million and $19.2 million for the same periods a year ago.
Foreclosed assets expense was $4.0 million and $9.2 million in the third quarter and first nine months of 2018, respectively, compared with $2.7 million and $7.1 million for the same periods a year ago. Substantially all of our foreclosed assets consist of residential 1-4 family real estate assets.
See Note 5 (Transactions With Related Parties) to Financial Statements in this Report for more details.


7

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 $32.6 billion at September 30, 2018, and $35.9 billion at December 31, 2017.
Loans
Loans were $32.5 billion at September 30, 2018, and $35.9 billion at December 31, 2017. We did not acquire loans in the third quarter and first nine months of 2018. We did not acquire loans in the third quarter of 2017. In the first nine months of 2017, we acquired $4.7 billion of consumer loans from the Bank at their estimated fair value. At September 30, 2018 and December 31, 2017, consumer loans represented 92% and 91% of loans, respectively, and commercial loans represented the remaining balance of our loan portfolio.
Allowance for Loan Losses
The allowance for loan losses, which decreased $24.8 million to $104.6 million at September 30, 2018, from $129.4 million at December 31, 2017, reflected continued improvement in the housing market driving favorable performance in our residential real estate portfolio.
At September 30, 2018, the allowance for loan losses included $82.5 million for consumer loans and $22.1 million for commercial loans; however, the entire allowance is available to absorb credit losses inherent in the total loan portfolio. 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 in this Report for a description of how management estimates the allowance for loan losses and the allowance for unfunded credit commitments.

 
Accounts Receivable—Affiliates, Net
Accounts receivable from or payable to the Bank or its affiliates result from intercompany transactions in the normal course of business related to loan paydowns and payoffs, interest receipts, servicing costs, management fees and other transactions with the Bank or its affiliates.

Line of Credit with Bank
We draw upon our $5.0 billion line of credit with the Bank to finance loan acquisitions. At September 30, 2018 and December 31, 2017, we had $182.2 million and $3.6 billion outstanding, respectively.

Retained Earnings (Deficit)
We expect to distribute annually an aggregate amount of dividends with respect to outstanding capital stock equal to approximately 100% 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, due to recognition differences for items such as loan losses and purchase accounting adjustments, 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, predominantly due to the impact on REIT taxable income of purchase accounting adjustments attributable to the Company during the years 2009 through 2013, from the 2008 acquisition of Wachovia Corporation by Wells Fargo.
For further information on the differences between taxable income before dividends paid deduction reported on our income tax returns and net income as reported in our statement of income, see the “Balance Sheet Analysis” section in our 2017 Form 10-K.
    

        


8

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. For more information about how we manage these risks, see the “Risk Management” section in our 2017 Form 10-K. The discussion that follows provides an update regarding these risks.
 
Credit Risk Management Our assets consist predominantly of loans, and their related credit risk is among the most significant risks we manage. We define credit risk as the risk to earnings associated with a borrower or counterparty default (failure to meet obligations in accordance with agreed upon terms).
Table 2 represents loans by segment and class of financing receivable and the weighted average maturity for those loans calculated using contractual maturity dates.
Table 2: Total Loans Outstanding by Portfolio Segment and Class of Financing Receivable and Weighted Average Contractual Maturity
 
Loans outstanding
 
 
Weighted average maturity in years
 
(in thousands)
Sep 30, 2018

 
Dec 31, 2017

 
Sep 30, 2018

 
Dec 31, 2017

Total commercial
$
2,639,772

 
3,325,939

 
3.1

 
3.2

Consumer:
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
29,162,590

 
31,683,651

 
24.5

 
25.1

Real estate 1-4 family junior lien mortgage
707,949

 
855,586

 
15.1

 
15.4

Total consumer
29,870,539

 
32,539,237

 
24.2

 
24.8

Total loans
$
32,510,311

 
35,865,176

 
22.5

 
22.8

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 in this Report for more analysis and credit metric information.
In order to maintain our REIT status, the composition of our loan portfolio is highly concentrated in real estate.
 
We continually evaluate our credit policies and modify as necessary. 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.




9

LOAN PORTFOLIO BY GEOGRAPHY Table 3 is a summary of the geographical distribution of our loan portfolio for the top five states by loans outstanding.

Table 3: Loan Portfolio by Geography
 
September 30, 2018
 
(in thousands)
Commercial

 
Real estate
1-4 family
first
mortgage

 
Real estate
1-4 family
junior lien
mortgage

 
Total

 
% of
total
loans

California
$
1,241,468

 
8,183,514

 
7,810

 
9,432,792

 
29
%
New York
9,332

 
3,079,324

 
44,425

 
3,133,081

 
10

Washington
133,048

 
2,004,212

 
937

 
2,138,197

 
7

Virginia
50,844

 
1,706,072

 
72,453

 
1,829,369

 
6

Texas
71,030

 
1,165,982

 
8,720

 
1,245,732

 
4

All other states
1,134,050

 
13,023,486

 
573,604

 
14,731,140

 
44

Total loans
$
2,639,772

 
29,162,590

 
707,949

 
32,510,311

 
100
%

COMMERCIAL AND INDUSTRIAL LOANS (C&I) C&I loans were less than 1% of total loans at September 30, 2018. Our credit risk management process for this portfolio focuses on a
 
customer's ability to repay the loan through their cash flows. All of the loans in our C&I portfolio were unsecured at September 30, 2018.



10

COMMERCIAL SECURED BY REAL ESTATE (CSRE) The CSRE portfolio consists of both mortgage loans and construction loans, where loans are secured by real estate. Table 4 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. 

Table 4: CSRE Loans by State and Property Type
 
September 30, 2018
 
(in thousands)
Total
CSRE loans

 
% of
total
CSRE loans

By state:
 
 
 
California
$
1,241,468

 
47
%
Florida
201,411

 
8

Utah
155,733

 
6

Oregon
145,900

 
6

Washington
133,048

 
5

All other states
738,519

 
28

Total loans
$
2,616,079

 
100
%
By property type:
 
 
 
Office buildings
$
639,648

 
24
%
Shopping centers
516,226

 
20

Warehouses
394,413

 
15

Retail establishments (restaurants, stores)
332,973

 
13

5 + multifamily residences
332,918

 
13

Mini-storage
110,369

 
4

Commercial/industrial (non-residential)
91,625

 
4

Manufacturing plants
63,847

 
2

Motels/hotels
59,075

 
2

Research and development
45,106

 
2

Other
29,879

 
1

Total loans
$
2,616,079

 
100
%


11

REAL ESTATE 1-4 FAMILY MORTGAGE LOANS The concentrations of real estate 1-4 family mortgage loans by state and the related loan-to-value (LTV) ratio for real estate 1-4 family first mortgage and combined loan-to-value (CLTV) ratio for real estate 1-4 family junior lien mortgage loans are presented in combination in Table 5. CLTV means the ratio of the total loan balance of first and junior mortgages to property collateral value. We monitor changes in real estate values and underlying economic or market conditions for all geographic areas of our real estate 1-4 family mortgage portfolio as part of our credit risk management process. Our underwriting and periodic review of loans secured by residential real estate collateral includes appraisals or estimates from automated valuation models (AVMs) to support property values. Additional information about AVMs and our policy for their use can be
 
found in Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report and the “Risk Management - Credit Risk Management - Real Estate 1-4 Family Mortgage Loans” section in our 2017 Form 10-K.
We modify real estate 1-4 family mortgage loans to assist homeowners and other borrowers experiencing financial difficulties. For more information on our modification programs, see the “Risk Management – Credit Risk Management – Real Estate 1-4 Family Mortgage Loans” section in our 2017 Form 10-K.
The credit performance associated with our real estate 1-4 family mortgage portfolio remained strong in third quarter 2018, as measured through net charge-offs, nonaccrual loans and delinquencies.

Table 5: Real Estate 1-4 Family Mortgage Loans LTV/CLTV by State
 
September 30, 2018
 
(in thousands)
Real estate
1-4 family
mortgage

 
Current
LTV\CLTV
ratio (1)

California
$
8,191,324

 
44
%
New York
3,123,749

 
58

Washington
2,005,149

 
49

Virginia
1,778,525

 
61

Texas
1,174,702

 
56

All other states
13,597,090

 
59

Total loans
$
29,870,539

 
54

(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 FIRST MORTGAGE LOANS Net charge-offs (recoveries) (annualized) as a percentage of average loans improved to (0.02)% in both the third quarter and first nine months of 2018, compared with less than 0.01% and 0.01% for the same periods a year ago. Nonaccrual loans were
 
$142.0 million at September 30, 2018, compared with $150.4 million at December 31, 2017.
Table 6 summarizes delinquency and loss rates by state for our real estate 1-4 family first mortgage portfolio.
Table 6: Real Estate 1-4 Family First Mortgage Portfolio Performance
 
Outstanding balance
 
 
% of loans
30 days
or more past due
 
Loss (recovery) rate (annualized) quarter ended
 
(in thousands)
Sep 30,
2018

 
Dec 31,
2017

 
Sep 30,
2018

 
Dec 31,
2017
 
Sep 30,
2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

California
$
8,183,327

 
8,852,383

 
0.11
%
 
0.15
 
—

 
—

 
—

 
—

 
—

New York
3,078,782

 
3,268,458

 
0.57

 
0.45
 
0.06

 
0.02

 
—

 
0.02

 
0.01

Washington
2,004,212

 
2,149,416

 
0.11

 
0.03
 
(0.01
)
 
—

 
(0.01
)
 
—

 
(0.01
)
Virginia
1,705,190

 
1,818,445

 
0.40

 
0.51
 
(0.02
)
 
(0.02
)
 
(0.02
)
 
0.01

 
0.02

Texas
1,165,947

 
1,289,611

 
0.17

 
0.44
 
(0.01
)
 
—

 
0.02

 
(0.01
)
 
0.01

All other states
13,017,527

 
14,296,320

 
0.86

 
0.90
 
(0.04
)
 
(0.05
)
 
(0.03
)
 
0.01

 
—

Total
29,154,985

 
31,674,633

 
0.51

 
0.54
 
(0.02
)
 
(0.02
)
 
(0.01
)
 
0.01

 
—

PCI
7,605

 
9,018

 
 
 
 
 
 
 
 
 
 
 
 
 
 
  Total first mortgages
$
29,162,590

 
31,683,651

 
 
 
 
 
 
 
 
 
 
 
 
 
 



12

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. Net charge-offs (annualized) as a percentage of average loans were 0.58% and 0.41% in the third quarter and first nine months of 2018 compared with 0.40% and 0.33% for the same periods a year ago. Nonaccrual loans were $35.9 million at September 30, 2018, compared with $44.7 million at December 31, 2017.
Table 7 summarizes delinquency and loss rates by state for our junior lien portfolio.
Table 7: Real Estate 1-4 Family Junior Lien Portfolio Performance
 
Outstanding balance
 
 
% of loans
30 days
or more past due
 
Loss (recovery) rate (annualized) quarter ended
 
(in thousands)
Sep 30,
2018

 
Dec 31,
2017

 
Sep 30,
2018

 
Dec 31,
2017
 
Sep 30,
2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

New Jersey
$
155,073

 
183,405

 
3.66
%
 
5.42
 
1.43

 
2.31

 
0.73

 
(0.18
)
 
1.06

Pennsylvania
111,007

 
133,313

 
4.65

 
5.29
 
0.92

 
0.43

 
(0.67
)
 
0.21

 
0.86

Florida
92,171

 
112,437

 
3.37

 
2.65
 
(0.14
)
 
(0.08
)
 
(1.31
)
 
(0.51
)
 
(0.56
)
Virginia
72,453

 
88,017

 
2.85

 
5.22
 
0.41

 
(1.30
)
 
2.59

 
(0.86
)
 
1.26

Georgia
48,804

 
60,259

 
2.16

 
2.70
 
0.16

 
(0.07
)
 
(0.78
)
 
(1.41
)
 
(1.96
)
All other states
228,441

 
278,155

 
5.19

 
4.73
 
0.27

 
(0.14
)
 
0.63

 
(0.55
)
 
0.38

Total
707,949

 
855,586

 
4.08

 
4.60
 
0.58

 
0.37

 
0.29

 
(0.44
)
 
0.40

PCI
—

 
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total junior lien mortgages
$
707,949

 
855,586

 
 
 
 
 
 
 
 
 
 
 
 
 
 


13

NONPERFORMING ASSETS (NONACCRUAL LOANS AND FORECLOSED ASSETS) Table 8 summarizes nonperforming assets (NPAs) for each of the last five quarters. 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 120 days with respect to real estate 1-4 family first and junior lien mortgages (90 days with respect to commercial) 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;
•
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
•
consumer real estate loans receive notification of bankruptcy, regardless of their delinquency status. 
Table 8: Nonperforming Assets (Nonaccrual Loans and Foreclosed Assets)
(in thousands)
Sep 30,
2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

Nonaccrual loans:
 
 
 
 
 
 
 
 
 
Total commercial
$
2,016


2,506


2,519


2,306


3,325

Consumer:
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
141,953

 
147,574

 
152,510

 
150,381

 
152,861

Real estate 1-4 family junior lien mortgage
35,948

 
37,553

 
42,161

 
44,703

 
42,237

Total consumer
177,901


185,127


194,671


195,084


195,098

Total nonaccrual loans (1)
179,917


187,633


197,190


197,390


198,423

Foreclosed assets
2,596

 
2,503

 
2,259

 
2,377

 
2,473

Total nonperforming assets
$
182,513


190,136


199,449


199,767


200,896

As a percentage of total loans
0.56
%
 
0.57

 
0.57

 
0.56

 
0.61

(1)
Excludes PCI loans because they continue to earn interest income from accretable yield, independent of performance in accordance with their contractual terms.

Total NPAs were $182.5 million (0.56% of total loans) at September 30, 2018, and included $179.9 million of nonaccrual loans. Total NPAs were $199.8 million (0.56% of total loans) at December 31, 2017, and included $197.4 million of nonaccrual loans.
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, charged off while on nonaccrual status, 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 9 provides an analysis of the changes in nonaccrual loans.
Table 9: Analysis of Changes in Nonaccrual Loans
 
Quarter ended
 
(in thousands)
Sep 30,
2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

Commercial:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
$
2,506

 
2,519

 
2,306

 
3,325

 
3,144

Inflows
—

 
241

 
252

 
140

 
214

Outflows
(490
)
 
(254
)
 
(39
)
 
(1,159
)
 
(33
)
 Balance, end of period
2,016


2,506


2,519


2,306


3,325

Consumer:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
185,127

 
194,671

 
195,084

 
195,098

 
200,470

Inflows
19,111

 
23,551

 
32,155

 
36,586

 
31,201

Outflows:
 
 
 
 
 
 
 
 
 
Returned to accruing
(12,164
)
 
(14,291
)
 
(15,190
)
 
(18,388
)
 
(17,063
)
Foreclosures
(3,278
)
 
(2,326
)
 
(4,899
)
 
(2,596
)
 
(2,286
)
Charge-offs
(2,538
)
 
(2,277
)
 
(3,396
)
 
(4,680
)
 
(3,508
)
Payment, sales and other
(8,357
)
 
(14,201
)
 
(9,083
)
 
(10,936
)
 
(13,716
)
Total outflows
(26,337
)

(33,095
)

(32,568
)

(36,600
)

(36,573
)
 Balance, end of period
177,901


185,127


194,671


195,084


195,098

Total nonaccrual loans (excluding PCI)
$
179,917


187,633


197,190


197,390


198,423





14

TROUBLED DEBT RESTRUCTURINGS (TDRs) The recorded investment of loans modified in TDRs is provided in Table 10. The allowance for loan losses for TDRs was $45.9 million and $56.8 million at September 30, 2018 and December 31, 2017, respectively. See Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report 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. When we delay the timing on the repayment of a portion of principal (principal forbearance), we charge off the amount of forbearance if that amount is not considered fully collectible.    
 
For more information on our nonaccrual policies when a restructuring is involved, see the “Risk Management – Credit Risk Management – Troubled Debt Restructurings (TDRs)” section of our 2017 Form 10-K.
Table 11 provides an analysis of the changes in TDRs. Loans modified more than once are reported as TDR inflows only in the period they are first modified. Other than resolutions such as foreclosures, we may remove loans from TDR classification, but only if they have been refinanced or restructured at market terms and qualify as a new loan.
Table 10: Troubled Debt Restructurings (TDRs)
(in thousands)
Sep 30,
2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

Total commercial TDRs
$
2,509

 
3,124

 
3,152

 
2,992

 
3,035

Consumer:
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
289,563

 
294,171

 
305,212

 
309,678

 
316,831

Real estate 1-4 family junior lien mortgage
78,802

 
81,578

 
86,659

 
89,560

 
91,534

Trial modifications
5,044

 
5,980

 
5,557

 
7,498

 
8,799

Total consumer TDRs
373,409

 
381,729

 
397,428

 
406,736

 
417,164

Total TDRs
$
375,918

 
384,853

 
400,580

 
409,728

 
420,199

 TDRs on nonaccrual status
$
113,893

 
115,672

 
118,659

 
116,885

 
119,122

 TDRs on accrual status
262,025

 
269,181

 
281,921

 
292,843

 
301,077

Total TDRs
$
375,918

 
384,853

 
400,580

 
409,728

 
420,199

Table 11: Analysis of Changes in TDRs
 
Quarter ended
 
(in thousands)
Sep 30,
2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

Commercial:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
$
3,124

 
3,152

 
2,992

 
3,035

 
3,078

Inflows (1)
350

 
—

 
203

 
—

 
—

Outflows (2)
(965
)
 
(28
)
 
(43
)
 
(43
)
 
(43
)
Balance, end of period
2,509

 
3,124

 
3,152

 
2,992

 
3,035

Consumer:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
381,729

 
397,428

 
406,736

 
417,164

 
429,390

Inflows (1)
5,872

 
6,476

 
7,520

 
6,187

 
5,539

Outflows:
 
 
 
 
 
 
 
 
 
Charge-offs
(249
)
 
(388
)
 
(380
)
 
(269
)
 
(995
)
Foreclosures
(1,298
)
 
(2,734
)
 
(825
)
 
(640
)
 
(657
)
Payments, sales and other (2)
(11,710
)
 
(19,476
)
 
(13,682
)
 
(14,405
)
 
(14,747
)
Net change in trial modifications (3)
(935
)
 
423

 
(1,941
)
 
(1,301
)
 
(1,366
)
Balance, end of period
373,409

 
381,729

 
397,428

 
406,736

 
417,164

Total TDRs
$
375,918

 
384,853

 
400,580

 
409,728

 
420,199

(1)
Inflows include loans that modify, even if they resolve, within the period as well as advances on loans that modified in a prior period.
(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, 2018, and December 31 and September 30, 2017, as a result of being refinanced or restructured at market terms and qualifying 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.


15

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.
 
Loans 90 days or more past due and still accruing were less than 1% of loans at both September 30, 2018 and December 31, 2017.
Table 12 reflects non-PCI loans 90 days or more past due and still accruing.
Table 12: Loans 90 Days or More Past Due and Still Accruing (1)
(in thousands)
Sep 30, 2018

 
Jun 30, 2018

 
Mar 31, 2018

 
Dec 31, 2017

 
Sep 30, 2017

Total commercial
$
—

 
—

 
2,854

 
990

 
991

Consumer:
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
4,640

 
2,321

 
3,999

 
9,001

 
3,685

Real estate 1-4 family junior lien mortgage
1,478

 
320

 
1,419

 
2,914

 
1,498

Total consumer
6,118


2,641


5,418


11,915


5,183

Total past due (excluding PCI)
$
6,118


2,641


8,272


12,905


6,174

(1)
PCI loans of $422 thousand, $504 thousand, $529 thousand, $699 thousand and $853 thousand at September 30, June 30 and March 31,2018, and December 31 and September 30, 2017, 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.



16

NET CHARGE-OFFS Table 13 presents net charge-offs for third quarter 2018 and the previous four quarters. Substantially all net charge-offs (recoveries) were in consumer real estate. Net charge-offs were in a net recovery position of $119 thousand in
 
third quarter 2018, compared with net charge-offs of $1.2 million in third quarter 2017, respectively.
Table 13: Net Charge-offs (Recoveries)
 
 
 
 
 
Quarter ended
 
 
Sep 30, 2018
 
 
Jun 30, 2018
 
 
Mar 31, 2018
 
 
Dec 31, 2017
 
 
Sep 30, 2017
 
(in thousands)
Net loan
charge-
offs

 
% of avg. loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

Total commercial
$
(12
)
 
—
 %
 
$
(13
)
 
—
 %
 
$
(15
)
 
—
 %
 
$
(396
)
 
(0.05
)%
 
$
(59
)
 
(0.01
)%
Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
(1,171
)
 
(0.02
)
 
(1,505
)
 
(0.02
)
 
(1,092
)
 
(0.01
)
 
(1,417
)
 
(0.02
)
 
276

 
—

Real estate 1-4 family junior lien mortgage
1,064

 
0.58

 
732

 
0.37

 
601

 
0.29

 
(978
)
 
(0.44
)
 
939

 
0.40

Total consumer
(107
)
 
—

 
(773
)
 
(0.01
)
 
(491
)
 
(0.01
)
 
(2,395
)
 
(0.03
)
 
1,215

 
0.02

Total
$
(119
)
 
—
 %
 
$
(786
)
 
(0.01
)%
 
$
(506
)
 
(0.01
)%
 
$
(2,791
)
 
(0.03
)%
 
$
1,156

 
0.01
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Quarterly net charge-offs (recoveries) as a percentage of average loans are annualized.
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, excluding loans carried at fair value. 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 Financial Statements in this Report.
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.
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, borrower credit strength and the value and marketability of collateral. Substantially all of our nonaccrual loans were real estate 1-4 family first and junior lien mortgage loans at September 30, 2018.
The allowance for loan losses which decreased $24.8 million to $104.6 million at September 30, 2018, from $129.4 million at December 31, 2017, reflected continued improvement in the housing market driving favorable performance in our residential real estate portfolio.
We believe the allowance for credit losses of $106.2 million at September 30, 2018, 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 examination processes. Due to the sensitivity of 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. Future allowance levels will be based on a variety of factors, including loan growth, portfolio performance and general economic conditions. 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) to Financial Statements in this Report and in our 2017 Form 10-K.
Table 14 presents an analysis of the allowance for credit losses.

17

Table 14: Allocation of the Allowance for Credit Losses (ACL)
 
Quarter ended
 
 
Sep 30, 2018
 
 
Jun 30, 2018
 
 
Mar 31, 2018
 
 
Dec 31, 2017
 
 
Sep 30, 2017
 
(in thousands)
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

Total commercial
$
23,722

 
8
%
 
$
25,856

 
9
%
 
$
27,020

 
9
%
 
$
28,085

 
9
%
 
$
26,577

 
11
%
Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
59,026

 
90

 
61,702

 
89

 
67,780

 
89

 
71,341

 
88

 
72,941

 
86

Real estate 1-4 family junior lien mortgage
23,454

 
2

 
26,178

 
2

 
29,266

 
2

 
31,235

 
3

 
30,905

 
3

Total consumer
82,480

 
92

 
87,880

 
91

 
97,046

 
91

 
102,576

 
91

 
103,846

 
89

Total
$
106,202

 
100
%
 
$
113,736

 
100
%
 
$
124,066

 
100
%
 
$
130,661

 
100
%
 
$
130,423

 
100
%
 
 
 
 
 
 
 
 
 
 
 
Quarter ended
 
(in thousands)
Sep 30, 2018

 
Jun 30,
2018

 
Mar 31,
2018

 
Dec 31,
2017

 
Sep 30,
2017

Components:
 
 
 
 
 
 
 
 
 
Allowance for loan losses
$
104,556

 
112,381

 
122,863

 
129,360

 
129,116

Allowance for unfunded credit commitments
1,646

 
1,355

 
1,203

 
1,301

 
1,307

Allowance for credit losses
$
106,202

 
113,736

 
124,066

 
130,661

 
130,423

Allowance for loan losses as a percentage of total loans
0.32
%
 
0.33

 
0.35

 
0.36

 
0.39

Allowance for loan losses as a percentage of annualized net charge-offs
NM

 
NM

 
NM

 
NM

 
NM

Allowance for credit losses as a percentage of total loans
0.33

 
0.34

 
0.36

 
0.36

 
0.40

Allowance for credit losses as a percentage of total nonaccrual loans
59.03

 
60.62

 
62.92

 
66.19

 
65.73

NM – Not meaningful


18

Asset/Liability Management
Asset/liability management involves the evaluation, monitoring and management of interest rate risk, market risk and liquidity and funding.
INTEREST RATE RISK Interest rate risk is the sensitivity of earnings to changes in interest rates. At September 30, 2018, 12% of our loans had variable interest rates. 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. To manage interest rate risk, we monitor loan paydown 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, 2018, approximately 88% of our loans had fixed interest rates. 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, 2018, 12% of our assets had variable interest rates, and could be expected to reprice with changes in interest rates. At September 30, 2018, our liabilities were 1% of our assets. 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.

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.
 
Proceeds received from paydowns of loans are typically sufficient to fund existing lending commitments. Depending upon the timing of the loan acquisitions, we may draw on our $5.0 billion revolving line of credit we have with the Bank as a short-term liquidity source. At September 30, 2018 there was $182.2 million outstanding on our Bank line of credit. The rate of interest is three-month LIBOR plus 4.4 basis points (0.044%).
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. The retained deficit included within our balance sheet results from cumulative distributions that have exceeded GAAP net income, predominantly due to the impact on REIT taxable income of purchase accounting adjustments attributable to the Company during the years 2009 through 2013, from the 2008 acquisition of Wachovia Corporation by Wells Fargo. 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 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.
On September 8, 2016, Wells Fargo reached agreements with the Consumer Financial Protection Bureau (CFPB), the Office of the Comptroller of the Currency (OCC), and the Office of the Los Angeles City Attorney, regarding allegations that some of its retail customers received products and services they did not request. On February 2, 2018, Wells Fargo entered into a consent order with the Board of Governors of the Federal Reserve System (FRB) related to governance oversight and compliance and operational risk management that imposes an asset cap on Wells Fargo until plans to enhance governance oversight and compliance and operational risk management are approved and implemented to the satisfaction of the FRB. On April 20, 2018 Wells Fargo reached agreement on consent orders issued by the CFPB and OCC to resolve matters regarding the compliance risk management program and past practices involving certain automobile collateral protection insurance policies and certain mortgage interest rate lock extensions. On August 1, 2018, Wells Fargo announced an agreement with the U.S. Department of Justice regarding the resolution of claims related to certain 2005-2007 residential mortgage-backed securities activities. Negative publicity or public opinion resulting from the settlements, consent orders, and related matters and other instances where the Bank’s customers may have experienced financial harm as well as from the resolution of other regulatory matters, litigation, or legal actions by Wells Fargo and the Bank may increase the risk of reputational harm to the business of Wells Fargo and the Bank, including the Bank’s ability to originate loans at the same volumes as we have historically acquired. If in future periods we do not reinvest loan paydowns 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.

19

To the extent that we determine that additional funding is necessary or advisable, we could issue additional common or preferred stock, subject to Board of Directors approval, raise funds through debt financings, or a combination of these methods. Retention of operating cash flows does not represent a significant source of funding because 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.
The certificate of designation for the Series A preferred stock contains 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), 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.


20

Critical Accounting Policy
 
Our significant accounting policies (see Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2017 Form 10-K) 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 critical because it requires 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.
Management and the audit committee of the board of directors have reviewed and approved this critical accounting policy. This policy is described in the "Critical Accounting Policy" section in our 2017 Form 10-K.

Current Accounting Developments

Table 15 provides accounting pronouncements applicable to us that have been issued by the FASB but are not yet effective.
 

Table 15: Current Accounting Developments - Issued Standards
Standard
Description
Effective date and financial statement impact
Accounting Standards Update (ASU or Update)
ASU 2018-13 – Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement

The Update provides for guidance to eliminate and modify current fair value disclosures, as well as add new fair value disclosures.
The guidance is effective in first quarter 2020. The eliminated, modified and new fair value disclosures can all be adopted individually. Subject to completion of our assessment, we are not expecting this Update to have a material impact on our financial statements.
ASU 2016-13 – Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
The Update changes the accounting for credit losses on loans by requiring a current expected credit loss (CECL) approach to determine the allowance for credit losses. CECL requires loss estimates for the remaining estimated life of the financial asset using historical experience, current conditions, and reasonable and supportable forecasts. Also, the Update eliminates the existing guidance for purchased credit-impaired (PCI) loans, but requires an allowance for purchased financial assets with more than insignificant deterioration since origination.
The guidance is effective in first quarter 2020 with a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. While early adoption is permitted beginning in first quarter 2019, we do not expect to elect that option. We are evaluating the impact of the Update on our financial statements, including the development and implementation of models to estimate losses. We expect the Update will result in an increase in the allowance for credit losses given the change to estimated losses over the contractual life adjusted for expected prepayments with an expected material impact from longer duration portfolios. The amount of the increase will be impacted by the portfolio composition and quality at the adoption date as well as economic conditions and forecasts at that time.

21

Forward-Looking Statements

This Report 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 paydowns; 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, 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 the following, without limitation:
•
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 (including the impact of the Tax Cuts & Jobs Act);
•
losses related to natural disasters, including from damage or loss to our collateral for loans in our consumer and commercial loan portfolios and from the impact on the ability of our borrowers to repay their loans;
•
the effect of the interest rate environment or changes in interest rates on our net interest income;
•
the level and volatility of the 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;
•
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, including negative effects from the Bank's retail banking sales practices matter and other instances where the Bank’s customers may have experienced financial harm and negative effects from the resolution of regulatory matters, litigation, or other legal actions by 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;
•
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 the 2017 Form 10-K.

In addition to the above 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 Report 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 publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.

Risk Factors
An investment in Wells Fargo Real Estate Investment Corporation involves risk, including the possibility that the value of the investment could fall substantially and that dividends or other distributions on the investment could be reduced or eliminated. For a discussion of risk factors that could adversely affect our financial results and condition and the value of, and return on, an investment in WFREIC, refer to the “Risk Factors” section in our 2017 Form 10-K.

22

Controls and Procedures

Disclosure Controls and Procedures
The Company's management evaluated the effectiveness, as of September 30, 2018, of our disclosure controls and procedures. The Company's chief executive officer and chief financial officer participated in the evaluation. Based on this evaluation, the chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2018.
Internal Control Over Financial Reporting
Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (GAAP) and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the Company;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. No change occurred during third quarter 2018 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.



23

Financial Statements
Wells Fargo Real Estate Investment Corporation
 
 
 
 
 
 
 
Statement of Income (Unaudited)
 
Quarter ended September 30,
 
 
Nine months ended September 30,
 
(in thousands, except per share amounts)
2018

 
2017

 
2018

 
2017

Interest income
$
334,485

 
332,748

 
1,031,356

 
963,229

Interest expense
4,604

 
3,173

 
30,866

 
3,423

Net interest income
329,881

 
329,575

 
1,000,490

 
959,806

Provision (reversal of provision) for credit losses
(6,824
)
 
(11,537
)
 
(22,890
)
 
14,664

Net interest income after provision for credit losses
336,705

 
341,112

 
1,023,380

 
945,142

Noninterest income
 
 
 
 
 
 
 
Pledge fees
—

 
15,864

 
6,037

 
44,338

Other
144

 
(284
)
 
522

 
(83
)
Total noninterest income
144

 
15,580

 
6,559

 
44,255

Noninterest expense
 
 
 
 
 
 
 
Loan servicing costs
20,561

 
20,614

 
63,843

 
58,602

Management fees
10,977

 
6,384

 
28,987

 
19,155

Foreclosed assets
3,993

 
2,713

 
9,167

 
7,124

Other
195

 
441

 
484

 
779

Total noninterest expense
35,726

 
30,152

 
102,481

 
85,660

Net income
301,123

 
326,540

 
927,458

 
903,737

Comprehensive income
301,123

 
326,540

 
927,458

 
903,737

Dividends on preferred stock
4,397

 
4,397

 
13,191

 
13,191

Net income applicable to common stock
$
296,726

 
322,143

 
914,267

 
890,546

Per common share information
 
 
 
 
 
 
 
Earnings per common share
$
8.71

 
9.46

 
26.84

 
26.15

Diluted earnings per common share
8.71

 
9.46

 
26.84

 
26.15

Average common shares outstanding
34,058

 
34,058

 
34,058

 
34,058

Diluted average common shares outstanding
34,058

 
34,058

 
34,058

 
34,058

The accompanying notes are an integral part of these statements.

 

24


Wells Fargo Real Estate Investment Corporation
Balance Sheet
(in thousands, except shares)
Sep 30,
2018

 
Dec 31,
2017

Assets
(Unaudited)

 
 
Cash and cash equivalents
$
—

 
—

Loans
32,510,311

 
35,865,176

Allowance for loan losses
(104,556
)
 
(129,360
)
Net loans
32,405,755

 
35,735,816

Accounts receivable - affiliates, net
94,146

 
113,755

Other assets
89,333

 
96,028

Total assets
$
32,589,234

 
35,945,599

Liabilities
 
 
 
Line of credit with Bank
$
182,207

 
3,551,426

Other liabilities
7,497

 
3,910

Total liabilities
189,704

 
3,555,336

Stockholders’ Equity
 
 
 
Preferred stock
110

 
110

Common stock – $0.01 par value, authorized 100,000,000 shares; issued and outstanding 34,058,028 shares
341

 
341

Additional paid-in capital
32,550,660

 
32,550,660

Retained earnings (deficit)
(151,581
)
 
(160,848
)
Total stockholders’ equity
32,399,530

 
32,390,263

Total liabilities and stockholders’ equity
$
32,589,234

 
35,945,599

The accompanying notes are an integral part of these statements.


25


Wells Fargo Real Estate Investment Corporation
Statement of Changes in Stockholders’ Equity (Unaudited)
Quarter ended September 30,
 
(in thousands, except per share data)
Preferred
stock

 
Common
stock

 
Additional
paid-in
capital

 
Retained
earnings
(deficit)

 
Total
stockholders’
equity

Balance, June 30, 2018
$
110

 
341

 
32,550,660

 
(163,307
)
 
32,387,804

Net income
—

 
—

 
—

 
301,123

 
301,123

Cash dividends
 
 
 
 
 
 
 
 
 
   Series A preferred stock at $0.40 per share
—

 
—

 
—

 
(4,383
)
 
(4,383
)
   Series B preferred stock at $21.25 per share
—

 
—

 
—

 
(14
)
 
(14
)
   Common stock at $8.37 per share
—

 
—

 
—

 
(285,000
)
 
(285,000
)
Balance, September 30, 2018
$
110

 
341

 
32,550,660

 
(151,581
)
 
32,399,530

Balance, June 30, 2017
$
110

 
341

 
32,550,660

 
(163,524
)
 
32,387,587

Net income
—

 
—

 
—

 
326,540

 
326,540

Cash dividends
 
 
 
 
 
 
 
 
 
   Series A preferred stock at $0.40 per share
—

 
—

 
—

 
(4,383
)
 
(4,383
)
   Series B preferred stock at $21.25 per share
—

 
—

 
—

 
(14
)
 
(14
)
   Common stock at $9.40 per share
—

 
—

 
—

 
(320,000
)
 
(320,000
)
Balance, September 30, 2017
$
110

 
341

 
32,550,660

 
(161,381
)
 
32,389,730

 
 
 
 
 
 
 
 
 
 
Nine months ended September 30,
 
(in thousands, except per share data)
Preferred
stock

 
Common
stock

 
Additional
paid-in
capital

 
Retained
earnings
(deficit)

 
Total
stockholders’
equity

Balance, December 31, 2017
$
110

 
341

 
32,550,660

 
(160,848
)
 
32,390,263

Net income
—

 
—

 
—

 
927,458

 
927,458

Cash dividends
 
 
 
 
 
 
 
 

   Series A preferred stock at $1.20 per share
—

 
—

 
—

 
(13,149
)
 
(13,149
)
   Series B preferred stock at $63.75 per share
—

 
—

 
—

 
(42
)
 
(42
)
   Common stock at $26.57 per share
—

 
—

 
—

 
(905,000
)
 
(905,000
)
Balance, September 30, 2018
$
110


341


32,550,660


(151,581
)

32,399,530

Balance, December 31, 2016
$
110

 
341

 
32,550,660

 
(156,927
)
 
32,394,184

Net income
—

 
—

 
—

 
903,737

 
903,737

Cash dividends
 
 
 
 
 
 
 
 
 
   Series A preferred stock at $1.20 per share
—

 
—

 
—

 
(13,149
)
 
(13,149
)
   Series B preferred stock at $63.75 per share
—

 
—

 
—

 
(42
)
 
(42
)
   Common stock at $26.28 per share
—

 
—

 
—

 
(895,000
)
 
(895,000
)
Balance, September 30, 2017
$
110

 
341

 
32,550,660

 
(161,381
)
 
32,389,730

The accompanying notes are an integral part of these statements.


26


Wells Fargo Real Estate Investment Corporation
Statement of Cash Flows (Unaudited)
 
Nine months ended September 30,
 
(in thousands)
2018

 
2017

Cash flows from operating activities:
 
 
 
Net income
$
927,458

 
903,737

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Net accretion of adjustments on loans
(14,275
)
 
(10,392
)
Provision (reversal of provision) for credit losses
(22,890
)
 
14,664

Other operating activities, net
30,581

 
(162
)
Net cash provided by operating activities
920,874

 
907,847

Cash flows from investing activities:
 
 
 
Increase (decrease) in cash realized from
 
 
 
Loans:
 
 
 
Acquisitions
—

 
(4,707,964
)
Proceeds from payments and sales
3,362,139

 
3,391,498

 Net cash provided (used) by investing activities
3,362,139

 
(1,316,466
)
Cash flows from financing activities:
 
 
 
Increase (decrease) in cash realized from
 
 
 
Draws on line of credit with Bank
844,478

 
1,885,152

Repayments of line of credit with Bank
(4,213,697
)
 
(1,544,088
)
Cash dividends paid
(913,794
)
 
(903,794
)
 Net cash used by financing activities
(4,283,013
)
 
(562,730
)
Net change in cash and cash equivalents
—

 
(971,349
)
Cash and cash equivalents at beginning of period
—

 
971,349

Cash and cash equivalents at end of period
$
—

 
—

Supplemental cash flow disclosures:
 
 
 
Change in noncash items:
 
 
 
Transfers from loans to foreclosed assets
$
10,448

 
9,124

Preferred dividends payable
4,397

 
4,397

Cash paid for interest
32,036

 
2,981

The accompanying notes are an integral part of these statements.

 

27

Note 1: Summary of Significant Accounting Policies
 
Wells Fargo Real Estate Investment Corporation (the Company, we, our or us) is an indirect subsidiary of both Wells Fargo & Company (Wells Fargo) and Wells Fargo Bank, National Association (the Bank). The Company, a Delaware corporation, has operated as a real estate investment trust (REIT) since its formation in 1996.
The accounting and reporting policies of the Company are in accordance with U.S. generally accepted accounting principles (GAAP). For discussion of our significant accounting policies, see Note 1 (Summary of Significant Accounting Policies) in our Annual Report on Form 10-K for the year ended December 31, 2017 (2017 Form 10-K). There were no material changes to these policies in third quarter 2018. The preparation of the financial statements in accordance with GAAP requires management to make estimates based on assumptions about future economic and market conditions that affect the reported amounts of assets and liabilities at the date of the financial statements and income and expenses during the reporting period and the related disclosures. Although our estimates contemplate current conditions and how we expect them to change in the future, it is reasonably possible that actual future conditions could be significantly different than anticipated in those estimates, which could materially affect our results of operations and financial condition. Management has made significant estimates related to the allowance for credit losses (Note 2 (Loans and Allowance for Credit Losses)). Actual results could differ from those estimates.
These unaudited interim financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim financial statements do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with our 2017 Form 10-K.

 
Accounting Standards Adopted in 2018
In first quarter 2018, we adopted the following new accounting guidance:
•
Accounting Standards Update (ASU or Update) 2016-15 – Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.
•
ASU 2014-09 – Revenue from Contracts With Customers (Topic 606) and subsequent related Updates.
•
ASU 2016-01 – Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities

ASU 2016-15 addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice for reporting in the Statement of Cash Flows. The Update is effective for us in first quarter 2018 with retrospective application. We do not have any of the activities included in the ASU and there is no impact on our financial statements.

ASU 2014-09 modifies the guidance used to recognize revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other guidance. Our revenue is from net interest income on financial assets and pledge fees, which are both excluded from the scope of the guidance. Accordingly, there is no impact on our financial statements.

ASU 2016-01 changes the accounting for certain equity securities to record at fair value with unrealized gains or losses reflected in earnings, as well as improve the disclosures of equity securities and the fair value of financial instruments. We do not have equity securities. Accordingly, the impact to our financial statements is limited to our disclosure of the fair value of financial instruments. The valuation methodologies for estimating the fair value of financial instruments that are recorded at amortized cost, including loans, has been changed to conform with an exit price notion.

Subsequent Events
We have evaluated the effects of events that have occurred subsequent to September 30, 2018. There were no material subsequent events requiring adjustment to the financial statements or disclosure in the Notes to Financial Statements.

28

Note 2: Loans and Allowance for Credit Losses

The Company acquires loans originated or purchased by the Bank. In order to maintain our status as a REIT, the composition of the loans is highly concentrated in real estate. Underlying loans are concentrated primarily in California, New York, Washington, Virginia and Texas. These markets include approximately 56% of our total loan balance at September 30, 2018.
 
The following table presents total loans outstanding by portfolio segment and class of financing receivable. Total reductions and additions for unamortized premiums, discounts and other adjustments were less than 1% of outstanding balances at September 30, 2018 and December 31, 2017.
(in thousands)
Sep 30,
2018

 
Dec 31,
2017

Total commercial
$
2,639,772

 
3,325,939

Consumer:
 
 
 
Real estate 1-4 family first mortgage
29,162,590

 
31,683,651

Real estate 1-4 family junior lien mortgage
707,949

 
855,586

Total consumer
29,870,539

 
32,539,237

Total loans
$
32,510,311

 
35,865,176

 
The following table summarizes the proceeds paid or received from the Bank for acquisitions and sales of loans, respectively.
 
2018
 
 
2017
 
(in thousands)
Commercial

 
Consumer

 
Total

 
Commercial

 
Consumer

 
Total

Quarter ended September 30,
 
 
 
 
 
 
 
 
 
 
 
Loan acquisitions
$
—

 
—

 
—

 
—

 
—

 
—

Loan sales
(20,677
)
 
—

 
(20,677
)
 
—

 
(43,641
)
 
(43,641
)
Nine months ended September 30,
 
 
 
 
 
 
 
 
 
 
 
Loan acquisitions
$
—

 
—

 
—

 
—

 
4,707,964

 
4,707,964

Loan sales
(20,677
)
 
(5,775
)
 
(26,452
)
 
—

 
(100,670
)
 
(100,670
)
 
Commitments to Lend
The contract or notional amount of commercial loan commitments to extend credit was $567.6 million at September 30, 2018 and $507.8 million at December 31, 2017.

Pledged Loans
See Note 5 (Transactions With Related Parties) for additional details on our agreement with the Bank to pledge loans.




29

Allowance for Credit Losses
The following table presents the allowance for credit losses, which consists of the allowance for loan losses and the allowance for unfunded credit commitments.
 

 
Quarter ended September 30,
 
 
Nine months ended September 30,
 
(in thousands)
2018

 
2017

 
2018

 
2017

Balance, beginning of period
$
113,736

 
144,447

 
$
130,661

 
125,029

Provision (reversal of provision) for credit losses
(6,824
)
 
(11,537
)
 
(22,890
)
 
14,664

Interest income on certain impaired loans (1)
(829
)
 
(1,331
)
 
(2,980
)
 
(3,939
)
Loan charge-offs:
 
 
 
 
 
 
 
Total commercial
—

 
—

 
—

 
(11
)
Consumer:
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
(1,461
)
 
(2,320
)
 
(4,215
)
 
(8,120
)
Real estate 1-4 family junior lien mortgage
(2,576
)
 
(3,299
)
 
(7,567
)
 
(11,266
)
Total consumer
(4,037
)
 
(5,619
)
 
(11,782
)
 
(19,386
)
Total loan charge-offs
(4,037
)
 
(5,619
)
 
(11,782
)
 
(19,397
)
Loan recoveries:
 
 
 
 
 
 
 
Total commercial
12

 
59

 
40

 
88

  Consumer:
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
2,632

 
2,044

 
7,983

 
5,197

Real estate 1-4 family junior lien mortgage
1,512

 
2,360

 
5,170

 
8,781

Total consumer
4,144

 
4,404

 
13,153

 
13,978

Total loan recoveries
4,156

 
4,463

 
13,193

 
14,066

Net loan recoveries (charge-offs)
119

 
(1,156
)
 
1,411

 
(5,331
)
Balance, end of period
$
106,202

 
130,423

 
$
106,202

 
130,423

Components:
 
 
 
 
 
 
 
Allowance for loan losses
$
104,556

 
129,116

 
$
104,556

 
129,116

Allowance for unfunded credit commitments
1,646

 
1,307

 
1,646

 
1,307

Allowance for credit losses
$
106,202

 
130,423

 
$
106,202

 
130,423

Net loan (recoveries) charge-offs as a percentage of average total loans (2)
—
 %
 
0.01

 
(0.01
)%
 
0.02

Allowance for loan losses as a percentage of total loans
0.32

 
0.39

 
0.32

 
0.39

Allowance for credit losses as a percentage of total loans
0.33

 
0.40

 
0.33

 
0.40

(1)
Certain impaired loans with an allowance calculated by discounting expected cash flows using the loan’s effective interest rate over the remaining life of the loan recognize changes in allowance attributable to the passage of time as interest income.
(2)
Quarterly net charge-offs (recoveries) as a percentage of average total loans are annualized.

30


The following table summarizes the activity in the allowance for credit losses by our commercial and consumer portfolio segments.
 
 
2018
 
 
2017
 
(in thousands)
 
Commercial

 
Consumer

 
Total

 
Commercial

 
Consumer

 
Total

Quarter ended September 30,
 
 
 
 
 
 
 
 
 
 
 
 
Balance, beginning of period
 
$
25,856

 
87,880

 
113,736

 
27,375

 
117,072

 
144,447

Reversal of provision for credit losses
 
(2,146
)
 
(4,678
)
 
(6,824
)
 
(857
)
 
(10,680
)
 
(11,537
)
Interest income on certain impaired loans
 
—

 
(829
)
 
(829
)
 
—

 
(1,331
)
 
(1,331
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan charge-offs
 
—

 
(4,037
)
 
(4,037
)
 
—

 
(5,619
)
 
(5,619
)
Loan recoveries
 
12

 
4,144

 
4,156

 
59

 
4,404

 
4,463

Net loan recoveries (charge-offs)
 
12

 
107

 
119

 
59

 
(1,215
)
 
(1,156
)
Balance, end of period
 
$
23,722

 
82,480

 
106,202

 
26,577

 
103,846

 
130,423

 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30,
 
 
 
 
 
 
 
 
 
 
 
 
Balance, beginning of period
 
$
28,085

 
102,576

 
130,661

 
29,644

 
95,385

 
125,029

Provision (reversal of provision) for credit losses
 
(4,403
)
 
(18,487
)
 
(22,890
)
 
(3,144
)
 
17,808

 
14,664

Interest income on certain impaired loans
 
—

 
(2,980
)
 
(2,980
)
 
—

 
(3,939
)
 
(3,939
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan charge-offs
 
—

 
(11,782
)
 
(11,782
)
 
(11
)
 
(19,386
)
 
(19,397
)
Loan recoveries
 
40

 
13,153

 
13,193

 
88

 
13,978

 
14,066

Net loan recoveries (charge-offs)
 
40

 
1,371

 
1,411

 
77

 
(5,408
)
 
(5,331
)
Balance, end of period
 
$
23,722

 
82,480

 
106,202

 
26,577

 
103,846

 
130,423

The following table disaggregates our allowance for credit losses and recorded investment in loans by impairment methodology.
 
Allowance for credit losses
 
 
Recorded investment in loans
 
(in thousands)
Commercial

 
Consumer

 
Total

 
Commercial

 
Consumer

 
Total

September 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Collectively evaluated (1)
$
23,267

 
36,996

 
60,263

 
2,637,263

 
29,489,525

 
32,126,788

Individually evaluated (2)
455

 
45,484

 
45,939

 
2,509

 
373,409

 
375,918

Purchased credit-impaired (PCI) (3)
—

 
—

 
—

 
—

 
7,605

 
7,605

Total
$
23,722

 
82,480

 
106,202

 
2,639,772

 
29,870,539

 
32,510,311

December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Collectively evaluated (1)
$
27,192

 
46,664

 
73,856

 
3,322,947

 
32,123,483

 
35,446,430

Individually evaluated (2)
893

 
55,912

 
56,805

 
2,992

 
406,736

 
409,728

PCI (3)
—

 
—

 
—

 
—

 
9,018

 
9,018

Total
$
28,085

 
102,576

 
130,661

 
3,325,939

 
32,539,237

 
35,865,176

(1)
Represents loans collectively evaluated for impairment in accordance with Accounting Standards Codification (ASC) 450-20, Loss Contingencies (formerly FAS 5), and pursuant to amendments by ASU 2010-20 regarding allowance for non-impaired loans.
(2)
Represents loans individually evaluated for impairment in accordance with ASC 310-10, Receivables (formerly FAS 114), and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans.
(3)
Represents the allowance and related loan carrying value determined in accordance with ASC 310-30, Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality (formerly SOP 03-3) and pursuant to amendments by ASU 2010-20 regarding allowance for PCI loans.


31

Credit Quality
We monitor credit quality by evaluating various attributes and utilize such information in our evaluation of the appropriateness of the allowance for credit losses. The following sections provide the credit quality indicators we most closely monitor. The credit quality indicators are generally based on information as of our financial statement date, with the exception of updated Fair Isaac Corporation (FICO) scores and updated loan-to-value (LTV)/combined LTV (CLTV). We obtain FICO scores at loan origination and the scores are generally updated at least quarterly, except in limited circumstances, including compliance with the Fair Credit Reporting Act (FCRA). Generally, the LTV and CLTV indicators are updated in the second month of each quarter, with updates no older than June 30, 2018.
 
COMMERCIAL CREDIT QUALITY INDICATORS In addition to monitoring commercial loan concentration risk, we manage a consistent process for assessing commercial loan credit quality. Generally commercial loans are subject to individual risk assessment using our internal borrower and collateral quality ratings. Our ratings are aligned to Pass and Criticized categories. The Criticized category includes Special Mention, Substandard, and Doubtful categories which are defined by bank regulatory agencies.
The table below provides a breakdown of outstanding commercial loans by risk category.
(in thousands)
Total

September 30, 2018
 
By risk category:
 
Pass
$
2,603,918

Criticized
35,854

Total commercial loans
$
2,639,772

December 31, 2017
 
By risk category:
 
Pass
$
3,316,604

Criticized
9,335

Total commercial loans
$
3,325,939


The following table provides past due information for commercial loans, which we monitor as part of our credit risk management practices.
(in thousands)
Total

September 30, 2018
 
By delinquency status:
 
Current-29 days past due (DPD) and still accruing
$
2,635,342

30-89 DPD and still accruing
2,414

90+ DPD and still accruing
—

Nonaccrual loans
2,016

Total commercial loans
$
2,639,772

December 31, 2017
 
By delinquency status:
 
Current-29 DPD and still accruing
$
3,320,666

30-89 DPD and still accruing
1,977

90+ DPD and still accruing
990

Nonaccrual loans
2,306

Total commercial loans
$
3,325,939



32

CONSUMER CREDIT QUALITY INDICATORS We have various classes of consumer loans that present unique risks. Loan delinquency, FICO credit scores and LTV/CLTV for loan types are common credit quality indicators that we monitor and utilize in our evaluation of the appropriateness of the allowance for credit losses for the consumer portfolio segment.
 
Many of our loss estimation techniques used for the allowance for credit losses rely on delinquency-based models; therefore, delinquency is an important indicator of credit quality and the establishment of our allowance for credit losses. The following table provides the outstanding balances of our consumer portfolio by delinquency status.
(in thousands)
Real estate
1-4 family
first
mortgage

 
Real estate
1-4 family
junior lien
mortgage

 
Total

September 30, 2018
 
 
 
 
 
By delinquency status:
 
 
 
 
 
Current-29 DPD
$
29,032,668

 
681,616

 
29,714,284

30-59 DPD
53,618

 
11,754

 
65,372

60-89 DPD
15,784

 
3,600

 
19,384

90-119 DPD
8,061

 
3,541

 
11,602

120-179 DPD
6,684

 
1,686

 
8,370

180+ DPD
50,537

 
8,752

 
59,289

Remaining PCI accounting adjustments
(4,762
)
 
(3,000
)
 
(7,762
)
Total consumer loans
$
29,162,590

 
707,949

 
29,870,539

December 31, 2017
 
 
 
 
 
By delinquency status:
 
 
 
 
 
Current-29 DPD
$
31,529,774

 
819,000

 
32,348,774

30-59 DPD
63,591

 
13,663

 
77,254

60-89 DPD
20,770

 
6,245

 
27,015

90-119 DPD
15,384

 
5,462

 
20,846

120-179 DPD
9,235

 
3,648

 
12,883

180+ DPD
50,323

 
10,917

 
61,240

Remaining PCI accounting adjustments
(5,426
)
 
(3,349
)
 
(8,775
)
Total consumer loans
$
31,683,651

 
855,586

 
32,539,237


33

The following table provides a breakdown of our consumer portfolio by FICO. FICO is not available for certain loan types and may not be obtained if we deem it unnecessary due to strong collateral and other borrower attributes.
(in thousands)
Real estate
1-4 family
first
mortgage

 
Real estate
1-4 family
junior lien
mortgage

 
Total

September 30, 2018
 
 
 
 
 
By FICO:
 
 
 
 
 
< 600
$
151,476

 
55,092

 
206,568

600-639
117,253

 
40,768

 
158,021

640-679
280,241

 
66,260

 
346,501

680-719
853,587

 
123,089

 
976,676

720-759
2,166,566

 
136,381

 
2,302,947

760-799
5,146,191

 
107,141

 
5,253,332

800+
20,258,310

 
157,503

 
20,415,813

No FICO available
193,728

 
24,715

 
218,443

Remaining PCI accounting adjustments
(4,762
)
 
(3,000
)
 
(7,762
)
Total consumer loans
$
29,162,590

 
707,949

 
29,870,539

December 31, 2017
 
 
 
 
 
By FICO:
 
 
 
 
 
< 600
$
179,829

 
74,644

 
254,473

600-639
138,782

 
50,676

 
189,458

640-679
307,999

 
88,948

 
396,947

680-719
988,162

 
150,180

 
1,138,342

720-759
2,556,013

 
159,309

 
2,715,322

760-799
5,957,929

 
126,785

 
6,084,714

800+
21,359,614

 
191,851

 
21,551,465

No FICO available
200,749

 
16,542

 
217,291

Remaining PCI accounting adjustments
(5,426
)
 
(3,349
)
 
(8,775
)
Total consumer loans
$
31,683,651

 
855,586

 
32,539,237


34

LTV refers to the ratio comparing the loan’s unpaid principal balance to the property’s collateral value. CLTV refers to the combination of first mortgage and junior lien mortgage ratios. LTVs and CLTVs are updated quarterly using a cascade approach which first uses values provided by automated valuation models (AVMs) for the property. If an AVM is not available, then the value is estimated using the original appraised value adjusted by the change in Home Price Index (HPI) for the property location. If an HPI is not available, the original appraised value is used. The HPI value is normally the only method considered for high value properties, generally with an original value of $1 million or more, as the AVM values have proven less accurate for these properties.
 
The following table shows the most updated LTV and CLTV distribution of the real estate 1-4 family first and junior lien mortgage loan portfolios. We consider the trends in residential real estate markets as we monitor credit risk and establish our allowance for credit losses. In the event of a default, any loss should be limited to the portion of the loan amount in excess of the net realizable value of the underlying real estate collateral value. Certain loans do not have an LTV or CLTV due to industry data availability and portfolios acquired from or serviced by other institutions.
(in thousands)
Real estate
1-4 family
first
mortgage
by LTV

 
Real estate
1-4 family
junior lien
mortgage by
CLTV

 
Total

September 30, 2018
 
 
 
 
 
By LTV/CLTV:
 
 
 
 
 
0-60%
$
18,707,298

 
274,136

 
18,981,434

60.01-80%
9,516,050

 
211,385

 
9,727,435

80.01-100%
791,866

 
148,587

 
940,453

100.01-120% (1)
97,787

 
53,297

 
151,084

> 120% (1)
40,549

 
22,470

 
63,019

No LTV/CLTV available
13,802

 
1,074

 
14,876

Remaining PCI accounting adjustments
(4,762
)
 
(3,000
)
 
(7,762
)
Total consumer loans
$
29,162,590

 
707,949

 
29,870,539

December 31, 2017
 
 
 
By LTV/CLTV:
 
 
 
 
 
0-60%
$
17,500,078

 
307,358

 
17,807,436

60.01-80%
12,827,337

 
240,888

 
13,068,225

80.01-100%
1,153,304

 
196,456

 
1,349,760

100.01-120% (1)
129,637

 
80,636

 
210,273

> 120% (1)
64,239

 
32,224

 
96,463

No LTV/CLTV available
14,482

 
1,373

 
15,855

Remaining PCI accounting adjustments
(5,426
)
 
(3,349
)
 
(8,775
)
Total consumer loans
$
31,683,651

 
855,586

 
32,539,237

(1)
Reflects total loan balances with LTV/CLTV amounts in excess of 100%. In the event of default, the loss content would generally be limited to only the amount in excess of 100% LTV/CLTV.



35

NONACCRUAL LOANS The following table provides loans on nonaccrual status. PCI loans are excluded from this table due to the existence of the accretable yield, independent of performance in accordance with their contractual terms.
(in thousands)
Sep 30,
2018

 
Dec 31,
2017

Total commercial
$
2,016

 
2,306

Consumer:

 
 
Real estate 1-4 family first mortgage
141,953

 
150,381

Real estate 1-4 family junior lien mortgage
35,948

 
44,703

Total consumer
177,901

 
195,084

Total nonaccrual loans (excluding PCI)
$
179,917

 
197,390


LOANS IN PROCESS OF FORECLOSURE Our recorded investment in consumer mortgage loans collateralized by residential real estate property that are in process of foreclosure was $47.0 million and $41.7 million at September 30, 2018 and December 31, 2017, and none of these loans are government insured/guaranteed. We commence the foreclosure process on consumer real estate loans when a borrower becomes 120 days delinquent in accordance with the Bureau of Consumer Financial Protection (formerly known as the Consumer Finance Protection Bureau) Guidelines. Foreclosure procedures and timelines vary depending on whether the property address resides in a judicial or non-judicial state. Judicial states require the foreclosure to be processed through the state’s courts while non-judicial states are processed without court intervention. Foreclosure timelines vary according to state law.

 
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 $422 thousand at September 30, 2018, and $699 thousand at December 31, 2017, 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.
The following table shows non-PCI loans 90 days or more past due and still accruing.
(in thousands)
Sep 30, 2018

 
Dec 31, 2017

Total commercial
$
—

 
990

Consumer:
 
 
 
Real estate 1-4 family first mortgage
4,640

 
9,001

Real estate 1-4 family junior lien mortgage
1,478

 
2,914

Total consumer
6,118

 
11,915

Total past due (excluding PCI)
$
6,118

 
12,905




36

Impaired Loans The table below summarizes key information for impaired loans. Our impaired loans include substantially all loans on nonaccrual status in the commercial portfolio segment and loans modified in a TDR, whether on accrual or nonaccrual status. These impaired loans generally have estimated losses which are included in the allowance for credit losses. We have impaired loans with no allowance for credit losses when loss content has been previously recognized through charge-offs and
 
we do not anticipate additional charge-offs or losses, or certain loans are currently performing in accordance with their terms and for which no loss has been estimated. Impaired loans exclude PCI loans. The table below includes trial modifications that totaled $5.0 million at September 30, 2018 and $7.5 million at December 31, 2017.
 
 
 
Recorded investment
 
 
 
(in thousands)
Unpaid
principal
balance

 
Impaired
loans

 
Impaired loans
with related
allowance for
credit losses

 
Related
allowance for
credit losses

September 30, 2018
 
 
 
 
 
 
 
Total commercial
$
2,961

 
2,509

 
2,509

 
455

Consumer:
 
 

 

 
 
Real estate 1-4 family first mortgage
349,244

 
293,338

 
188,155

 
30,766

Real estate 1-4 family junior lien mortgage
89,336

 
80,071

 
61,738

 
14,718

Total consumer
438,580

 
373,409

 
249,893

 
45,484

Total impaired loans (excluding PCI)
$
441,541

 
375,918

 
252,402

 
45,939

December 31, 2017
 
 
 
 
 
 
 
Total commercial
$
3,714

 
2,992

 
2,992

 
893

Consumer:
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
377,877

 
315,529

 
215,109

 
37,090

Real estate 1-4 family junior lien mortgage
100,228

 
91,207

 
73,261

 
18,822

Total consumer
478,105

 
406,736

 
288,370

 
55,912

Total impaired loans (excluding PCI)
$
481,819

 
409,728

 
291,362

 
56,805


37

The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans by portfolio segment and class.
 
Quarter ended September 30,
 
 
Nine months ended September 30,
 
 
2018
 
 
2017
 
 
2018
 
 
2017
 
(in thousands)
Average
recorded
investment

 
Recognized
interest
income

 
Average
recorded
investment

 
Recognized
interest
income

 
Average
recorded
investment

 
Recognized
interest
income

 
Average
recorded
investment

 
Recognized
interest
income

Total commercial
$
2,903

 
16

 
4,030

 
10

 
2,996

 
43

 
3,791

 
33

Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
295,471

 
4,660

 
329,054

 
5,174

 
304,118

 
14,414

 
338,040

 
15,927

Real estate 1-4 family junior lien mortgage
81,597

 
1,632

 
94,054

 
2,037

 
85,549

 
5,316

 
97,054

 
6,236

Total consumer
377,068

 
6,292

 
423,108

 
7,211

 
389,667

 
19,730

 
435,094

 
22,163

Total impaired loans
$
379,971

 
6,308

 
427,138

 
7,221

 
392,663

 
19,773

 
438,885

 
22,196

Interest income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash basis of accounting
 
 
$
1,911

 
 
 
1,947

 
 
 
5,818

 
 
 
6,262

Other (1)
 
 
4,397

 
 
 
5,274

 
 
 
13,955

 
 
 
15,934

Total interest income
 
 
$
6,308

 
 
 
7,221

 
 
 
19,773

 
 
 
22,196

(1)
Includes interest recognized on accruing TDRs, interest recognized related to certain impaired loans which have an allowance calculated using discounting, and amortization of purchase accounting adjustments related to certain impaired loans.

Troubled Debt Restructuring (TDRs) When, for economic or legal reasons related to a borrower’s financial difficulties, we grant a concession for other than an insignificant period of time to a borrower that we would not otherwise consider, the related loan is classified as a TDR, the balance of which totaled $375.9 million and $409.7 million at September 30, 2018 and December 31, 2017, respectively. We do not consider loan resolutions, such as foreclosure or short sale, to be a TDR.
We may require some consumer borrowers experiencing financial difficulty to make trial payments generally for a period of three to four months, according to the terms of a planned permanent modification, to determine if they can perform according to those terms. These arrangements represent trial modifications, which we classify and account for as TDRs. While loans are in trial payment programs, their original terms are not considered modified and they continue to advance through delinquency status and accrue interest according to their original terms.
The following table summarizes our TDR modifications for the periods presented by primary modification type and includes the financial effects of these modifications. For those loans that modify more than once, the table reflects each modification that occurred during the period. Loans that both modify and pay off within the period, as well as changes in recorded investment during the period for loans modified in prior periods, are not included in the table.

38

 
Primary modification type (1)
 
 
Financial effects of modifications
 
(in thousands)
Principal (2)

 
Interest
rate
reduction

 
Other
concessions (3)

 
Total

 
Charge-
offs (4)

 
Weighted
average
interest
rate
reduction

 
Recorded
investment
related to
interest rate
reduction (5)

Quarter ended September 30, 2018
 
 
 
 
 
 
 
 
 
 
 
 
Total commercial
$
—

 
549

 
—

 
549

 
—

 
3.11
%
 
$
549

Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
2,006

 
799

 
3,442

 
6,247

 
—

 
2.77

 
2,262

Real estate 1-4 family junior lien mortgage
27

 
603

 
1,030

 
1,660

 
39

 
2.53

 
603

Trial modifications (6)
—

 
—

 
(774
)
 
(774
)
 
—

 
—

 
—

Total consumer
2,033

 
1,402

 
3,698

 
7,133

 
39

 
2.72

 
2,865

Total
$
2,033

 
1,951

 
3,698

 
7,682

 
39

 
2.78
%
 
$
3,414

Quarter ended September 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
Total commercial
$
—

 
—

 
—

 
—

 
—

 
—
%
 
$
—

Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
2,055

 
386

 
2,719

 
5,160

 
29

 
3.36

 
2,078

Real estate 1-4 family junior lien mortgage
33

 
841

 
1,889

 
2,763

 
363

 
3.60

 
842

Trial modifications (6)
—

 
—

 
(952
)
 
(952
)
 
—

 
—

 
—

Total consumer
2,088

 
1,227

 
3,656

 
6,971

 
392

 
3.43

 
2,920

Total
$
2,088

 
1,227

 
3,656

 
6,971

 
392

 
3.43
%
 
$
2,920


39

 
Primary modification type (1)
 
 
Financial effects of modifications
 
(in thousands)
Principal (2)

 
Interest
rate
reduction

 
Other
concessions (3)

 
Total

 
Charge-
offs (4)

 
Weighted
average
interest
rate
reduction

 
Recorded
investment
related to
interest rate
reduction (5)

Nine months ended September 30, 2018
 
 
 
 
 
 
 
 
 
 
 
 
 
Total commercial
$
—

 
549

 
2,067

 
2,616

 
—

 
3.11
%
 
$
549

Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
5,414

 
971

 
14,571

 
20,956

 
156

 
2.59

 
4,749

Real estate 1-4 family junior lien mortgage
71

 
940

 
4,725

 
5,736

 
51

 
2.58

 
940

Trial modifications (6)
—

 
—

 
(1,766
)
 
(1,766
)
 
—

 
—

 
—

Total consumer
5,485

 
1,911

 
17,530

 
24,926

 
207

 
2.59

 
5,689

Total
$
5,485

 
2,460

 
19,597

 
27,542

 
207

 
2.63
%
 
$
6,238

Nine months ended September 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
Total commercial
$
—

 
—

 
—

 
—

 
—

 
—
%
 
$
—

Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
8,499

 
5,481

 
7,875

 
21,855

 
557

 
3.43

 
10,767

Real estate 1-4 family junior lien mortgage
1,122

 
2,604

 
3,468

 
7,194

 
679

 
4.29

 
3,088

Trial modifications (6)
—

 
—

 
(274
)
 
(274
)
 
—

 
—

 
—

Total consumer
9,621

 
8,085

 
11,069

 
28,775

 
1,236

 
3.63

 
13,855

Total
$
9,621

 
8,085

 
11,069

 
28,775

 
1,236

 
3.63
%
 
$
13,855

(1)
Amounts represent the recorded investment in loans after recognizing the effects of the TDR, if any. TDRs may have multiple types of concessions, but are presented only once in the first modification type based on the order presented in the table above. The reported amounts include loans remodified of $2.6 million and $2.4 million for the quarters ended September 30, 2018 and 2017, and $9.4 million and $7.4 million for the first nine months of 2018 and 2017, respectively.
(2)
Principal modifications include principal forgiveness at the time of the modification, contingent principal forgiveness granted over the life of the loan based on borrower performance, and principal that has been legally separated and deferred to the end of the loan, with a zero percent contractual interest rate.
(3)
Other concessions include loans discharged in bankruptcy, loan renewals, term extensions and other interest and noninterest adjustments, but exclude modifications that also forgive principal and/or reduce the interest rate.
(4)
Charge-offs include write-downs of the investment in the loan in the period it is contractually modified. The amount of charge-off will differ from the modification terms if the loan has been charged down prior to the modification based on our policies. In addition, there may be cases where we have a charge-off/down with no legal principal modification. Modifications resulted in legally forgiving principal (actual, contingent or deferred) of $166 thousand and $135 thousand for the quarters ended September 30, 2018 and 2017, and $484 thousand and $753 thousand for the first nine months of 2018 and 2017, respectively.
(5)
Reflects the effect of reduced interest rates on loans with an interest rate concession as one of their concession types, which includes loans reported as a principal primary modification type that also have an interest rate concession.
(6)
Trial modifications are granted a delay in payments due under the original terms during the trial payment period. However, these loans continue to advance through delinquency status and accrue interest according to their original terms. Any subsequent permanent modification generally includes interest rate related concessions; however, the exact concession type and resulting financial effect are usually not known until the loan is permanently modified. Trial modifications for the period are presented net of previously reported trial modifications that became permanent in the current period.

The table below summarizes permanent modification TDRs that have defaulted in the current period within 12 months of their permanent modification date. We report these defaulted
 
TDRs based on a payment default definition of 90 days past due for the commercial portfolio segment and 60 days past due for the consumer portfolio segment.
 
Recorded investment of defaults
 
 
Quarter ended September 30,
 
 
Nine months ended September 30,
 
(in thousands)
2018

 
2017

 
2018

 
2017

Total commercial
$
—

 
—

 
1,855

 
—

Consumer:
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
337

 
1,187

 
1,454

 
2,257

Real estate 1-4 family junior lien mortgage
44

 
60

 
269

 
623

Total consumer
381

 
1,247

 
1,723

 
2,880

Total
$
381

 
1,247

 
3,578

 
2,880



40

Note 3: Fair Values of Assets and Liabilities
 
We use fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. We did not elect the fair value option for any financial instruments as permitted in FASB ASC 825, Financial Instruments, which allows companies to elect to carry certain financial instruments at fair value with corresponding changes in fair value reported in the results of operations. As of September 30, 2018 and December 31, 2017, assets measured at fair value on a nonrecurring basis were less than 1% of total assets. See Note 1 (Summary of Significant Accounting Policies) in our 2017 Form 10-K for additional information about our fair value measurement policies and methods.

Disclosures about Fair Value of Financial Instruments The table below is a summary of fair value estimates by level for financial instruments. In connection with the adoption of ASU 2016-01 in first quarter 2018, the valuation
 
methodologies for estimating the fair value of financial instruments that are recorded at amortized cost, including loans, has been changed, where necessary, to conform with an exit price notion. Under an exit price notion, fair value estimates are based upon the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the balance sheet date. For certain loans the estimated fair values prior to adoption of ASU 2016-01 followed an entrance price notion that based fair values on recent prices offered to customers for loans with similar characteristics. The carrying amounts in the following table are recorded in the balance sheet under the indicated captions.
We have not included assets and liabilities that are not financial instruments in our disclosure, such as other assets and other liabilities. The total of the fair value calculations presented does not represent, and should not be construed to represent, the underlying value of the Company.
 
 
 
Carrying
amount

 
Estimated fair value
 
(in thousands)
Level 1

 
Level 2

 
Level 3

 
Total

September 30, 2018
 
 
 
 
 
 
 
 
 
Financial assets
 
 
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
—

 
—

 
—

 
—

 
—

Loans, net (2)
32,405,755

 
—

 
—

 
31,864,200

 
31,864,200

 
 
 
 
 
 
 
 
 
 
Financial liabilities
 
 
 
 
 
 
 
 
 
Line of credit with Bank (1)
182,207

 
—

 
—

 
182,207

 
182,207

December 31, 2017
 
 
 
 
 
 
 
 
 
Financial assets
 
 
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
—

 
—

 
—

 
—

 
—

Loans, net (2)
35,735,816

 
—

 
—

 
36,407,260

 
36,407,260

 
 
 
 
 
 
 
 
 
 
Financial liabilities
 
 
 
 
 
 
 
 
 
Line of credit with Bank (1)
3,551,426

 
—

 
—

 
3,551,426

 
3,551,426

(1)
Amounts consist of financial instruments in which carrying value approximates fair value.
(2)
Carrying amount is net of allowance for loan losses.



41

Note 4: Common and Preferred Stock

The following table provides details of our authorized common and preferred stock.
 
 
 
 
 
September 30, 2018 and December 31, 2017
 
 
Liquidation
preference per
share

 
Shares
authorized

 
Shares
issued and
outstanding

 
Par value
per share

 
Carrying
value

Preferred stock:
 
 
 
 
 
 
 
 
 
Series A
 
 
 
 
 
 
 
 
 
6.375%, Cumulative, Perpetual Series A Preferred Stock
$
25

 
11,000,000

 
11,000,000

 
$
0.01

 
110,000

Series B
 
 
 
 
 
 
 
 
 
$85 Annual Dividend Per Share, Cumulative, Perpetual Series B Preferred Stock
1,000

 
1,000

 
667

 
0.01

 
7

Common stock
 
 
100,000,000

 
34,058,028

 
0.01

 
340,580

Total
 
 
111,001,000

 
45,058,695

 
 
 
$
450,587


In the event that the Company is liquidated or dissolved, the holders of the Series A and Series B preferred stock will be entitled to a liquidation preference for each security plus any authorized, declared and unpaid dividends that will be paid prior to any payments to common stockholders. With respect to the payment of dividends and liquidation preference, the Series A preferred stock ranks on parity with Series B preferred stock and senior to the Company’s common stock. The Company may issue additional shares of common stock to affiliates of Wells Fargo without further action by the Series A or Series B stockholders. Additional information related to Series A and B preferred stock, including the ability of the Company to redeem each series, is included in Note 5 (Common and Preferred Stock) to Financial Statements in our 2017 Form 10-K.
 
The certificate of designation for the Series A preferred stock limits our ability to pay dividends on our common stock or make any payment of interest or principal on our line of credit with the Bank if the dividend coverage ratio for the four prior fiscal quarters is less than 150%. The dividend coverage ratio, expressed as a percentage, is calculated by dividing the four prior fiscal quarters’ funds from operations, defined as GAAP net income excluding gains or losses from sales of property, by the amount that would be required to pay annual dividends on the Series A and Series B preferred stock. At September 30, 2018, the dividend coverage ratio was 7,064%.


42

Note 5: Transactions With Related Parties

The Company engages in various transactions and agreements with affiliated parties in the ordinary course of business. Due to the common ownership of the Company and the affiliated parties by Wells Fargo, these transactions and agreements may reflect circumstances and considerations that could differ from
 
those conducted with unaffiliated parties. The principal items related to transactions with affiliated parties included in the accompanying statement of income and balance sheet are described in the table and narrative below.
 
Quarter ended September 30,
 
 
Nine months ended September 30,
 
(in thousands)
2018

 
2017

 
2018

 
2017

Income statement data
 
 
 
 
 
 
 
Interest income:
 
 
 
 
 
 
 
Net accretion of adjustments on loans
$
4,956

 
4,130

 
14,275

 
10,392

Interest on deposits
12

 
2

 
12

 
8,498

Total interest income
4,968

 
4,132

 
14,287

 
18,890

Pledge fees
—

 
15,864

 
6,037

 
44,338

Interest expense
4,604

 
3,173

 
30,866

 
3,423

Loan servicing costs
20,561

 
20,614

 
63,843

 
58,602

Management fees
10,977

 
6,384

 
28,987

 
19,155

(in thousands)
Sep 30,
2018

 
Dec 31,
2017

Balance sheet related data
 
 
 
Cash and cash equivalents
$
—

 
—

Loan acquisitions (year-to-date)
—

 
9,162,579

Loan sales (book value) (year-to-date)
(26,523
)
 
(121,210
)
Pledged loans (carrying value) (1)
—

 
24,323,830

Foreclosed asset sales (year-to-date)
(10,229
)
 
(11,495
)
Line of credit with Bank
182,207

 
3,551,426

Accounts receivable - affiliates, net
94,146

 
113,755

(1)
There were no pledged loans at September 30, 2018. The fair value of pledged loans was approximately $24.8 billion at December 31, 2017.

Loans We acquire and sell loans to and from the Bank. The acquisitions and sales are transacted at fair value resulting in acquisition discounts and premiums or gains and losses on sales. The net acquisition discount accretion or premium amortization is reported within interest income. Gains or losses on sales of loans are included within noninterest income.
The certificate of designation for the Series A preferred stock limits our ability to pledge loans to 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 or the discount window of Federal Reserve Banks. However, the Bank's borrowings will differ from loan balances pledged. In exchange for the pledge of our loan assets, the Bank pays us a fee that is consistent with market terms. At September 30, 2018 and September 30, 2017, the fee was equal to an annual rate of 15 basis points (0.15%) and 34 basis points (0.34%), respectively, as applied to the unpaid principal balance of pledged loans on a monthly basis. Such fee may be renegotiated by us and the Bank from time to time.

Loan Servicing Costs The loans in our portfolio are predominantly serviced by the Bank pursuant to the terms of participation and servicing and assignment agreements. In some instances, the Bank has delegated servicing responsibility to third parties that are not affiliated with us or the Bank. 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.

Management Fees We pay the Bank a management fee to reimburse 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 include direct and indirect expense allocations. Indirect expenses are allocated based on ratios that use our proportion of expense activity drivers. The expense activity drivers and ratios may change from time to time.

Deposits Interest income earned on deposits is included in interest income. Our cash management process includes applying operating cash flows to reduce any outstanding balance on our line of credit with the Bank. Operating cash flows are settled through our affiliate accounts receivable/payable process. Upon settlement cash received is either applied to reduce our line of credit outstanding or retained as a deposit with the Bank.

Foreclosed Assets We sell foreclosed assets back to the Bank from time to time at estimated fair value.


43

Line of Credit We have a revolving line of credit with the Bank, pursuant to which we can borrow up to $5.0 billion at a rate of interest equal to the three-month London Interbank Offered Rate plus 4.4 basis points (0.044%).

Accounts Receivable – Affiliates, Net Accounts receivable from or payable to the Bank or its affiliates result from intercompany transactions which include net loan paydowns, interest receipts, and other transactions, including those transactions noted herein, which have not yet settled.

44

PART II - OTHER INFORMATION

Item 1.    Legal Proceedings

WFREIC is not currently involved in nor, to our knowledge, currently threatened with any material litigation. From time to time we may become involved in routine litigation arising in the ordinary course of business. We do not believe that the eventual outcome of any such routine litigation will, in the aggregate, have a material adverse effect on our financial statements. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, could be material to our financial statements for any particular period.

Item 1A.    Risk Factors

Information in response to this item can be found under the “Risk Factors” section in this Report which information is incorporated by reference into this item.

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

Information required by this Item 2 pursuant to Item 703 of Regulation S-K regarding issuer repurchases of equity securities is not applicable since we do not have a program providing for the repurchase of our securities.


45

Item 6.    Exhibits

A list of exhibits to this Form 10-Q is set forth below and is incorporated herein by reference.

Exhibit
No.
 
Description
 
Location
 
 
 
 
 
 
 
Incorporated by reference to Exhibit (3)(a) to WFREIC’s Annual Report on Form 10-K for the year ended December 31, 2014.
 
 
 
 
 
 
 
Incorporated by reference to Exhibit 3.3 to WFREIC’s Registration Statement on Form S-11 No. 333-198948 filed November 18, 2014.
 
 
 
 
 
 
 
Filed herewith.
 
 
 
 
 
 
 
Filed herewith.
 
 
 
 
 
 
 
Filed herewith.
 
 
 
 
 
 
 
Filed herewith.
 
 
 
 
 
(101.Ins)
 
XBRL Instance Document
 
Filed herewith.
 
 
 
 
 
(101.Sch)
 
XBRL Taxonomy Extension Schema Document
 
Filed herewith.
 
 
 
 
 
(101.Cal)
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
Filed herewith.
 
 
 
 
 
(101.Lab)
 
XBRL Taxonomy Extension Label Linkbase Document
 
Filed herewith.
 
 
 
 
 
(101.Pre)
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
Filed herewith.
 
 
 
 
 
(101.Def)
 
XBRL Taxonomy Extension Definitions Linkbase Document
 
Filed herewith.

46

SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

Wells Fargo Real Estate Investment Corporation
 
 
 
By:
 
/s/ RICHARD D. LEVY
 
 
Richard D. Levy
Executive Vice President and Controller
(Principal Accounting Officer)
Dated: November 5, 2018


47