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EX-21 - LIST OF SUBSIDIARIES - WACHOVIA PREFERRED FUNDING CORPdex21.htm
EX-24 - POWER OF ATTORNEY - WACHOVIA PREFERRED FUNDING CORPdex24.htm
EX-32.(B) - CERTIFICATION OF CFO PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT - WACHOVIA PREFERRED FUNDING CORPdex32b.htm
EX-99.(B) - SELECTED UNAUDITED FINANCIAL INFORMATION FOR WACHOVIA BANK - WACHOVIA PREFERRED FUNDING CORPdex99b.htm
EX-99.(A) - SELECTED WELLS FARGO & CO. AND SUBS AND WACH CORP AND SUBS. SUPP CONS FIN INFOR. - WACHOVIA PREFERRED FUNDING CORPdex99a.htm
EX-32.(A) - CERTIFICATION OF CEO PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT - WACHOVIA PREFERRED FUNDING CORPdex32a.htm
EX-31.(A) - CERTIFICATION OF CEO PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT - WACHOVIA PREFERRED FUNDING CORPdex31a.htm
EX-12.(A) - COMPUTATIONS OF CONS. RATIOS OF EARNINGS TO FIXED CHARGES - WACHOVIA PREFERRED FUNDING CORPdex12a.htm
EX-12.(B) - COMP. OF CON. RATIOS OF EARNINGS TO FIXED CHARGES AND PREF STOCK DIVIDENDS - WACHOVIA PREFERRED FUNDING CORPdex12b.htm
EX-31.(B) - CERTIFICATION OF CFO PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT - WACHOVIA PREFERRED FUNDING CORPdex31b.htm
Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES

EXCHANGE ACT OF 1934 (THE “EXCHANGE ACT”)

 

For the Fiscal year ended December 31, 2009

 

Commission file number 1-31557

 

 

 

Wachovia Preferred Funding Corp.

(Exact name of registrant as specified in its charter)

 

Delaware   56-1986430
(State of incorporation)   (I.R.S. Employer Identification No.)

 

1620 EAST ROSEVILLE PARKWAY

ROSEVILLE, CA 95661

(Address of principal executive offices)

(Zip Code)

 

(916) 787-9090

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Exchange Act:

 

TITLE OF EACH CLASS

 

NAME OF EXCHANGE ON WHICH REGISTERED

7.25% Non-cumulative Exchangeable Perpetual Series A Preferred Securities  

New York Stock Exchange, Inc.

(the “NYSE”)

 

Securities registered pursuant to Section 12(g) of the Exchange Act:

 

TITLE OF EACH CLASS

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  ¨  No  x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  ¨  No  x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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  x  No  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  ¨  No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

 

Large accelerated

filer  ¨

  Accelerated filer  ¨  

Non-accelerated filer  x

(Do not check if a smaller reporting company.)

 

Smaller reporting

company  ¨

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the last business day of the registrant’s completed second fiscal quarter: None (as of June 30, 2009, none of Wachovia Preferred Funding Corp.’s voting or nonvoting common equity was held by non-affiliates).

 

 

As of January 31, 2010, there were 99,999,900 shares of the registrant’s common stock outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE IN FORM 10-K

 

Incorporated Documents

 

Where Incorporated in Form 10-K

Certain portions of Wachovia Preferred Funding Corp.’s Proxy Statement for the Annual Meeting of Stockholders to be held May 10, 2010.   Part III-Items 10, 11, 12, 13 and 14.

 

Item 15.1 of Wells Fargo & Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009 (excluding the list of exhibits incorporated therein by reference).

 

 

 


Table of Contents

PART I

 

Forward Looking Statements

 

Wachovia Preferred Funding Corp. (“Wachovia Funding”) may from time to time make written or oral forward-looking statements, including statements contained in Wachovia Funding’s filings with the Securities and Exchange Commission (“SEC”) (including this Annual Report on Form 10-K and the Exhibits hereto and thereto), in its reports to stockholders and in other Wachovia Funding communications, which are made in good faith by Wachovia Funding pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

 

These forward-looking statements include, among others, statements with respect to Wachovia Funding’s beliefs, plans, objectives, goals, guidelines, expectations, financial condition, results of operations, future performance and business of Wachovia Funding, including without limitation, (i) statements regarding certain of Wachovia Funding’s goals and expectations with respect to earnings, earnings per share, revenue, expenses and the growth rate in such items, as well as other measures of economic performance, including statements relating to estimates of credit quality trends, and (ii) statements preceded by, followed by or that include the words “may”, “could”, “should”, “would”, “believe”, “anticipate”, “estimate”, “expect”, “intend”, “plan”, “projects”, “outlook” or similar expressions. These forward-looking statements involve certain risks and uncertainties that are subject to change based on various factors (many of which are beyond Wachovia Funding’s control). The following factors, among others, could cause Wachovia Funding’s financial performance to differ materially from that expressed in such forward-looking statements:

 

  Ÿ  

legislative proposals to allow mortgage cram-downs in bankruptcy or require other loan modifications;

 

  Ÿ  

the extent of our success in our loan modification efforts;

 

  Ÿ  

the adequacy of our allowance for loan losses, especially if credit markets, housing prices and unemployment do not stabilize or improve, and the effects on our financial results and condition of increases in loan charge-offs, the allowance for loan losses and related provision expense;

 

  Ÿ  

the strength of the United States economy in general and the strength of the local economies in which Wachovia Funding owns mortgage assets and other authorized investments may be different than expected resulting in, among other things, a deterioration in credit quality of such mortgage assets and other authorized investments, including the resultant effect on Wachovia Funding’s portfolio of such mortgage assets and other authorized investments and reductions in the income generated by such assets;

 

  Ÿ  

the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;

 

  Ÿ  

inflation, interest rate, market and monetary fluctuations;

 

  Ÿ  

the impact of changes in financial services laws and regulations (including laws concerning banking, securities and insurance);

 

  Ÿ  

changes in economic conditions which could negatively affect the value of the collateral securing our mortgage assets;

 

  Ÿ  

unanticipated losses due to environmental liabilities of properties underlying our mortgage assets through foreclosure actions;

 

  Ÿ  

unanticipated regulatory or judicial proceedings or rulings;

 

  Ÿ  

the impact of changes in accounting principles;

 

  Ÿ  

the impact of changes in tax laws, especially tax laws pertaining to real estate investment trusts;

 

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  Ÿ  

adverse changes in financial performance and/or condition of the borrowers on loans underlying Wachovia Funding’s mortgage assets which could impact repayment of such borrowers’ outstanding loans;

 

  Ÿ  

the impact on Wachovia Funding’s businesses, as well as on the risks set forth above, of various domestic or international military or terrorist activities or conflicts; and

 

  Ÿ  

Wachovia Funding’s success at managing the risks involved in the foregoing.

 

Wachovia Funding cautions that the foregoing list of important factors is not exclusive. Wachovia Funding does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Wachovia Funding.

 

“Wachovia Funding”, “we”, “our” and “us” refer to Wachovia Preferred Funding Corp. “Wachovia Preferred Holding” refers to Wachovia Preferred Funding Holding Corp., the “Bank” refers to Wachovia Bank, National Association, “Wachovia” refers to Wachovia Corporation, a North Carolina corporation, “Wells Fargo” refers to Wells Fargo & Company, and “WFBNA” refers to Wells Fargo Bank, National Association.

 

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Item 1.    Business.

 

General

 

Wachovia Preferred Funding Corp. (“Wachovia Funding”) is a Delaware corporation, formed in July 2002, and the survivor of a merger with First Union Real Estate Asset Company of Connecticut, which was formed in 1996. As of December 31, 2009, Wachovia Funding is a direct subsidiary of Wachovia Preferred Funding Holding Corp. (“Wachovia Preferred Holding”) and an indirect subsidiary of both Wells Fargo & Company, a Delaware corporation (“Wells Fargo”) and Wachovia Bank, National Association (the “Bank”). Wachovia Preferred Holding owns 99.85% of our common stock and Wells Fargo owns the remaining 0.15%. The Bank owns 99.95% of the common stock of Wachovia Preferred Holding and Wells Fargo owns the remaining 0.05%. Wachovia Preferred Holding owns 88.17% of our Series D preferred securities, while the remaining 11.83% is owned by 108 employees of Wells Fargo or its affiliates. All of these entities are subsidiaries of Wells Fargo. On March 20, 2010, the Bank merged into Wells Fargo Bank, National Association (“WFBNA”) with WFBNA as the surviving entity.

 

On December 31, 2008, Wells Fargo acquired Wachovia Corporation, a North Carolina corporation (“Wachovia”) by a merger of Wachovia with and into Wells Fargo. As a result of this acquisition, each outstanding share of Wachovia common stock was converted into 0.1991 shares of Wells Fargo common stock and each share of Wachovia preferred stock outstanding or reserved for issuance was converted into a share of Wells Fargo preferred stock with substantially identical terms. The acquisition did not directly affect the outstanding shares of capital stock of Wachovia Funding. However, the Wachovia Funding Series A preferred securities are now conditionally exchangeable for shares of Wells Fargo preferred stock instead of Wachovia preferred stock. Following the acquisition, all subsidiaries of Wachovia became subsidiaries of Wells Fargo. On January 2, 2009, Wells Fargo created a new legal entity, Wachovia Corporation, a Delaware corporation (“New Wachovia”), to which it contributed all former subsidiaries of Wachovia. In November 2009, in a corporate reorganization, New Wachovia was merged into Wells Fargo.

 

One of our subsidiaries, Wachovia Real Estate Investment Corp. (“WREIC”), was formed as a Delaware corporation in 1996 and has operated as a real estate investment trust (a “REIT”) since its formation. Of the 645 shares of WREIC common stock outstanding, we own 644 shares or 99.84% and the remaining 1 share is owned by Wells Fargo. Of the 667 shares of WREIC preferred stock outstanding, we own 533.3 shares or 79.96%, 127 shares or 19.04% are owned by employees of Wells Fargo or its affiliates and 6.7 shares or 1.00% are owned by Wells Fargo.

 

Our other subsidiary, Wachovia Preferred Realty, LLC (“WPR”), was formed as a Delaware limited liability company in October 2002. Under the REIT Modernization Act, which became effective on January 1, 2001, a REIT is permitted to own “taxable REIT subsidiaries” which are subject to taxation similar to corporations that do not qualify as REITs or for other special tax rules. We own 98.20% of the outstanding membership interests in WPR and the remaining 1.80% is owned by the Bank. Our majority ownership of WPR provides us with additional flexibility by allowing us to hold assets that earn non-qualifying REIT income while maintaining our REIT status.

 

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Our legal and organizational structure as of December 31, 2009 is:

 

LOGO

 

(1) The Bank merged with and into WFBNA on March 20, 2010.

 

Our principal business objective is to acquire, hold and manage domestic mortgage assets, and other authorized investments that will generate net income for distribution to our shareholders.

 

Although we have the authority to acquire interests in an unlimited number of mortgage and other assets from unaffiliated third parties, as of December 31, 2009, substantially all of our interests in mortgage and other assets that we have acquired have been acquired from the Bank or an affiliate pursuant to loan participation agreements between the Bank or its affiliate and us. The Bank either originated the mortgage assets, purchased them from other financial institutions or acquired them as part of the acquisition of other financial institutions. We may also acquire from time to time mortgage-backed securities and a limited amount of additional non-mortgage related securities from the Bank and its affiliates. We may also acquire from time to time mortgage assets or other assets from unaffiliated third parties. Following the acquisition of Wachovia by Wells Fargo, we may also acquire such assets from WFBNA and its affiliates. Following the merger of the Bank into WFBNA on March 20, 2010, we expect to acquire substantially all of our interests in mortgage and other assets from WFBNA or an affiliate.

 

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

 

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

 

The Internal Revenue Code of 1986, as amended, (the “Code”) requires us to invest at least 75% of the total value of our assets in real estate assets, which includes residential mortgage loans and commercial mortgage loans, including participation interests in residential or commercial mortgage loans, mortgage- backed securities eligible to be held by REITs, cash, cash equivalents, including receivables and government securities, and other real estate assets. We refer to these types of assets as “REIT Qualified Assets.” The Code permits us to invest up to 25% of the value of a REIT’s total assets in non-real-estate-related securities as defined in the Investment Company Act of 1940, as amended (the “Investment Company Act”). However, we have established a policy of limiting authorized investments that are not Qualifying Interests to no more than 20% of the value of our total assets to comply with the Investment Company Act. Under the Investment Company Act, the term “security” is defined broadly to include, among other things, any note, stock, treasury stock, debenture, evidence of indebtedness, or certificate of interest or participation in any profit sharing agreement or a group or index of securities. The Code also requires that not more than 20% of the value of a REIT’s assets constitute securities issued by taxable REIT subsidiaries and that the value of any one issuer’s securities, other than those securities included in the 75% test, may not exceed 5% of the value of the total assets of the REIT. In addition, under the Code, the REIT may not own more than 10% of the voting securities or more than 10% of the value of the outstanding securities of any one issuer, other than those securities included in the 75% test, the securities of wholly-owned qualified REIT subsidiaries or taxable REIT subsidiaries. Generally, the Code designation for REIT Qualified Assets is less stringent than the Investment Company Act designation for Qualifying Interests, due to the ability under the Code to treat cash and cash equivalents as REIT Qualified Assets and a lower required ratio of REIT Qualified Assets to total assets. For the tax year ended December 31, 2009, we expect to be taxed as a REIT, and we intend to comply with the relevant provisions of the Code to be taxed as a REIT.

 

REITs generally are subject to tax at the maximum corporate rate on income from foreclosure property less deductible expenses directly connected with the production of that income. Income from foreclosure property includes gain from the sale of foreclosure property and income from operating foreclosure property, but income that would be qualifying income for purposes of the 75% gross income test is not treated as income from foreclosure property. Qualifying income for purposes of the 75% gross income test includes, generally, rental income and gain from the sale of property not held as inventory or for sale in the ordinary course of a trade or business. In accordance with the terms of the commercial, commercial real estate and residential mortgage participation and servicing agreements, we maintain the authority to decide whether to foreclose on collateral that secures a loan. In the event we determine a foreclosure proceeding is appropriate, we may direct the Bank to prosecute the foreclosure on our behalf. Upon sale or other disposition of foreclosure property, the Bank will remit to us the proceeds less the cost of holding and selling the foreclosure property.

 

Commercial and Commercial Real Estate Loans

 

We own participation interests in commercial loans secured by non-real property such as industrial equipment, furniture and fixtures, and inventory. Participation interests acquired in commercial real estate loans are secured by real property such as office buildings, multi-family properties of five units or more, industrial, warehouse and self-storage properties, office and industrial condominiums, retail space, strip shopping centers, mixed use commercial properties, mobile home parks, nursing homes, hotels and motels, churches and farms. In addition, some of our commercial loans are unsecured. Such unsecured loans are more likely than loans secured by real estate or personal property collateral to result in a loss upon default. Commercial and commercial real estate loans also may not be fully amortizing. This means that the loans may have a significant principal balance or “balloon” payment due on maturity. Additionally, there is no requirement regarding the percentage of any commercial or commercial real estate property that must be leased at the time we acquire a participation interest in a commercial or commercial real estate loan secured by such property nor are commercial loans required to have third party guarantees.

 

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Commercial properties, particularly industrial and warehouse properties, generally are subject to relatively greater environmental risks than non-commercial properties. This gives rise to increased costs of compliance with environmental laws and regulations. We may be affected by environmental liabilities related to the underlying real property, which could exceed the value of the real property. Although the Bank has exercised and will continue to exercise due diligence to discover potential environmental liabilities prior to our acquisition of any participation in loans secured by such property, hazardous substances or wastes, contaminants, pollutants, or their sources may be discovered on properties during our ownership of the participation interests. To the extent that we acquire any participation in loans secured by such real property directly from unaffiliated third parties, we intend to exercise due diligence to discover any such potential environmental liabilities prior to our acquisition of such participation. Nevertheless there can be no assurance that we would not incur full recourse liability for the entire cost of any removal and clean up on a property, that the cost of removal and cleanup would not exceed the value of the property or that we could recoup any of the costs from any third party.

 

The credit quality of a commercial or commercial real estate loan may depend on, among other factors:

 

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the existence and structure of underlying leases;

 

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the physical condition of the property, including whether any maintenance has been deferred;

 

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the creditworthiness of tenants;

 

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the historical and anticipated level of vacancies;

 

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rents on the property and on other comparable properties located in the same region;

 

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potential or existing environmental risks;

 

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the availability of credit to refinance the loan at or prior to maturity; and

 

  Ÿ  

the local and regional economic climate in general.

 

Foreclosures of defaulted commercial or commercial real estate loans generally are subject to a number of complicating factors, including environmental considerations, which are not generally present in foreclosures of residential mortgage loans.

 

Home Equity Loans

 

We own participation interests in home equity loans secured by a first, second or third mortgage which primarily is on the borrower’s residence. These loans typically are made for reasons such as home improvements, acquisition of furniture and fixtures, purchases of automobiles and debt consolidation. Generally, junior liens are repaid on an installment basis and income is accrued based on the outstanding balance of the loan. First liens are repaid on an amortizing basis. Loans currently underlying the home equity loan participations bear interest at fixed and variable rates.

 

Residential Mortgage Loans

 

We have acquired both conforming and non-conforming residential mortgage loans from the Bank. Conforming residential mortgage loans comply with the requirements for inclusion in a loan guarantee or purchase program sponsored by either the Federal Home Loan Mortgage Corporation (“FHLMC”) or the Federal National Mortgage Association (“FNMA”). Non-conforming residential mortgage loans are residential mortgage loans that do not qualify in one or more respects for purchase by FHLMC or FNMA under their standard programs. A majority of the non-conforming residential mortgage loans acquired by us to date are non-conforming because they have original principal balances which exceeded the requirements for FHLMC or FNMA programs, the original terms are shorter than the minimum requirements for FHLMC or FNMA programs at the time of origination, the original balances are less than the minimum requirements for

 

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FHLMC or FNMA programs, or generally because they vary in certain other respects from the requirements of such programs other than the requirements relating to creditworthiness of the mortgagors.

 

Each residential mortgage loan is evidenced by a promissory note secured by a mortgage or deed of trust or other similar security instrument creating a first lien on one-to-four family residential property. Residential real estate properties underlying residential mortgage loans consist of single-family detached units, individual condominium units, two-to-four-family dwelling units and townhouses.

 

Our portfolio of residential mortgage loans currently consists of both adjustable and fixed rate mortgage loans and we may purchase additional interests in both types of residential mortgage loans in the future. Fixed rate mortgage loans currently consist of the following fixed rate product types:

 

Fixed Rate Mortgage Loans:    A mortgage loan that bears interest at a fixed rate for the term of the loan. Such loans generally mature in 15, 20, 25 or 30 years.

 

Government Fixed Rate Loans:    A fixed rate mortgage loan originated under a specific governmental agency program; for example, the Federal Housing Authority or the Veterans Administration. Such loans generally mature in 15 or 30 years and may be guaranteed by a government agency.

 

Balloon Mortgage Loans:    A fixed rate mortgage loan having original or modified terms to maturity for a specified period, which is typically 5, 7, 10 or 15 years, at which time the full outstanding principal balance on the loan will be due and payable. Such loans provide for level monthly payments of principal and interest based on a longer amortization schedule, generally 30 years. Some of these loans may have a conditional refinancing option at the balloon maturity, which provides that, in lieu of repayment in full, the loan may be modified to a then-current market interest rate for the remaining unamortized term.

 

Adjustable rate mortgage loans, or ARMs, currently consist of the following adjustable rate product types:

 

Conventional Various Adjustable Rate Loans:    ARMs that are fixed for one of a number of various time periods which are typically between 1 and 10 years. After the initial fixed time period, the interest adjusts in 1-month, 6-month, 12-month, 3-year and 5-year intervals with caps on the initial change and each subsequent periodic change and may be subject to maximum cap on lifetime changes. Typically, the interest is based on the same Treasury security, LIBOR index rate, or prime rate of the same time period as the adjustment period of the note, and is calculated using the margin and caps stated in the note.

 

Government:    An adjustable rate loan originated under a specific government agency program. Generally, the interest rate adjusts in 12-month intervals, and is based on specific requirements for date of index and calculations.

 

Dividend Policy

 

We currently expect to distribute annually an aggregate amount of dividends with respect to our outstanding capital stock equal to approximately 100% of our REIT taxable income for federal income tax purposes, which excludes capital gains. Such dividend distributions may in some periods exceed net income determined under U.S. generally accepted accounting principles (“GAAP”) due to differences in the timing of income and expense recognition for REIT taxable income determination purposes. In order to remain qualified as a REIT, we are required to distribute annually at least 90% of our REIT taxable income to our shareholders.

 

Dividends are authorized and declared at the discretion of our board of directors. Factors that would generally be considered by our board of directors in making this determination are our distributable funds, financial condition and capital needs, the impact of current and pending legislation and regulations, Delaware corporation law, economic conditions, tax considerations and our continued qualification as a REIT. We

 

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currently expect that both our cash available for distribution and our REIT taxable income will be in excess of the amounts needed to pay dividends on all outstanding series of preferred securities, even in the event of a significant drop in interest rate levels or increase in loan loss reserves because:

 

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substantially all of our mortgage assets and other authorized investments are interest-bearing;

 

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

 

  Ÿ  

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

 

  Ÿ  

we anticipate that, in addition to cash flows from operations, additional cash will be available from principal payments on our loan portfolio.

 

Accordingly, we expect that we will, after paying the dividends on all classes of preferred securities, pay dividends to holders of shares of our common stock in an amount sufficient to comply with applicable requirements regarding qualification as a REIT.

 

Under certain circumstances, including any determination that the Bank’s relationship to us results in an unsafe and unsound banking practice, the Office of the Comptroller of the Currency (the “OCC”) has the authority to issue an order that restricts our ability to make dividend payments to our shareholders, including holders of the Series A preferred securities. Banking capital adequacy rules limit the total dividend payments made by a consolidated banking entity to be the sum of earnings for the current year and prior two years less dividends paid during the same periods. Any dividends paid in excess of this amount can only be made with the approval of the Bank’s regulator.

 

Conflicts of Interest and Related Management Policies and Programs

 

General.    In administering our loan portfolio and other authorized investments pursuant to the participation and servicing agreements, the Bank has a high degree of autonomy. The Bank has, however, adopted certain policies to guide the administration with respect to the acquisition and disposition of assets, use of capital and leverage, credit risk management, and certain other activities. These agreements with the Bank may be amended from time to time at the discretion of our board of directors and, in certain circumstances, subject to the approval of a majority of our Independent Directors, but without a vote of our shareholders, including holders of the Series A preferred securities.

 

Asset Acquisition and Disposition Policies.    It is our policy to purchase, or accept as capital contributions, loans or participation interests in loans from the Bank or its affiliates that generally are:

 

  Ÿ  

performing, meaning they are current;

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unencumbered; and

  Ÿ  

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

 

We may, however, from time to time acquire loans or participation interests in loans directly from unaffiliated third parties. It is our intention that any loans or participation interests acquired directly from unaffiliated third parties will meet the same general criteria as the loans or participation interests we acquire from the Bank or its affiliates.

 

Our policy also allows for investment in loans or assets that are not REIT Qualified Assets up to but not exceeding the statutory limitations imposed on organizations that qualify as a REIT under the Code. In the past, we have purchased or accepted as capital contributions loans and participation interests in loans both secured and not secured by real property along with other assets. We anticipate that we will acquire, or

 

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receive as capital contributions, interests in additional real estate-secured loans from the Bank or its affiliates (or WFBNA or its affiliates following the merger of the Bank into WFBNA on March 20, 2010). We may from time to time acquire loans or loan participation interests from unaffiliated third parties. We may use any proceeds received in connection with the repayment or disposition of loan participation interests in our portfolio to acquire additional loans. Although we are not precluded from purchasing additional types of loans, loan participation interests or other assets, we anticipate that participation interests in additional loans acquired by us will be of the types described above under the heading “—General Description of Mortgage Assets and Other Authorized Investments; Investment Policy.” In addition, we will not invest in assets that are not REIT Qualified Assets if such investments would cause us to violate the requirements for taxation as a REIT under the Code.

 

We may from time to time acquire a limited amount of other authorized investments. Although we currently do not intend to acquire any mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans that are secured by single-family residential, multi-family or commercial real estate properties located throughout the United States, we are not restricted from doing so. We do not intend to acquire any interest-only or principal-only mortgage-backed securities. At December 31, 2009, we did not hold any mortgage-backed securities.

 

We currently anticipate that the Bank or its affiliates (including WFBNA or its affiliates following the merger of the Bank into WFBNA on March 20, 2010) will continue to act as servicer of any additional commercial loans that we acquire through purchase or participation interests from the Bank or its affiliates. We anticipate that any such servicing arrangement that we enter into in the future with the Bank or its affiliates (or WFBNA or its affiliates) will contain fees and other terms that most likely will be substantially equivalent to but may be more favorable to us than those that would be contained in servicing arrangements entered into with unaffiliated third parties. To the extent we acquire additional loans or participation interests from unaffiliated third parties, we anticipate that such loans or participation interests may be serviced by entities other than the Bank or its affiliates. It is our policy that any servicing arrangements with unaffiliated third parties will be consistent with standard industry practices.

 

Credit Risk Management Policies.    For a description of our credit risk management policies, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management.”

 

Conflict of Interest Policies.    Because of the nature of our relationship with the Bank or its affiliates, it is likely that conflicts of interest will arise with respect to certain transactions, including, without limitation, our acquisition of participation interests in loans from, or disposition of participation interests in loans to the Bank, foreclosure on defaulted loans, management of the cash collateral related to the interest rate swaps and the modification of either the participation or servicing agreements. It is our policy that the terms of any financial dealings with the Bank will be consistent with those available from third parties in the lending industry.

 

Conflicts of interest among us and the Bank or its affiliates may also arise in connection with making decisions that bear upon the credit arrangements that the Bank or its affiliates may have with a borrower under a loan. Conflicts also could arise in connection with actions taken by us or the Bank or its affiliates. It is our intention that any agreements and transactions between us on the one hand, and the Bank or its affiliates (or WFBNA or its affiliates) on the other hand, including, without limitation, any loan participation agreements, be fair to all parties and consistent with market terms for such types of transactions. The requirement in our certificate of incorporation that certain of our actions be approved by a majority of our Independent Directors also is intended to ensure fair dealings among us and the Bank or its affiliates. There can be no assurance, however, that any such agreement or transaction will be on terms as favorable to us as could have been obtained from unaffiliated third parties.

 

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

 

  Ÿ  

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

 

  Ÿ  

underwrite securities of other issuers;

 

  Ÿ  

actively trade in loans or other investments;

 

  Ÿ  

offer securities in exchange for property; or

 

  Ÿ  

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

 

The Investment Company Act exempts entities that, directly or through majority-owned subsidiaries, are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” We refer to these interests as “Qualifying Interests.” Under current interpretations by the staff of the SEC, in order to qualify for this exemption, we, among other things, must maintain at least 55% of our assets in Qualifying Interests and also may be required to maintain an additional 25% in Qualifying Interests or other real estate-related assets. The provisions of the Investment Company Act therefore may limit the assets that we may acquire. We have established a policy of limiting authorized investments that are not Qualifying Interests to no more than 20% of the value of our total assets to comply with these provisions.

 

We currently make investments and operate our business in such a manner consistent with the requirements of the Code to qualify as a REIT. However, future economic, market, legal, tax or other considerations may cause our board of directors, subject to approval by a majority of our Independent Directors, to determine that it is in our best interest and the best interest of our shareholders to revoke our REIT status. The Code prohibits us from electing REIT status for the four taxable years following the year of such revocation. See also “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Servicing

 

The loans currently in our portfolio are serviced by the Bank or WFBNA or their affiliates pursuant to the terms of participation and servicing agreements between the Bank or WFBNA or their affiliates and us. The Bank has delegated servicing responsibility for certain of the residential mortgage loans to third parties that are not affiliated with us or the Bank or its affiliates.

 

We pay the Bank or WFBNA a monthly loan servicing fee for their services under the terms of the loan participation and servicing agreements. The amount and terms of the fee are determined by mutual agreement of the Bank or WFBNA and us from time to time during the terms of the participation and servicing agreements.

 

Included in loan servicing costs were fees paid to the Bank or WFBNA for the years ended December 31, 2009 and 2008, of $63.0 million and $64.6 million, respectively. In both years, the monthly fee with respect to the commercial loans was equal to the total committed amount of each loan multiplied by a percentage per annum. For home equity loan products, the monthly fee was equal to the outstanding principal balance of each loan multiplied by a percentage per annum. Home equity loan products have a higher servicing fee compared to other loan products. For servicing fees related to residential mortgage products the monthly fee was equal to the outstanding principal of each loan multiplied by a percentage per annum or a flat fee per month.

 

The participation and servicing agreements currently in place require the Bank or WFBNA to service the loans in our portfolio in a manner substantially the same as for similar work performed by the Bank or WFBNA for transactions on their own behalf. The Bank or its affiliates or WFBNA collect and remit principal and interest payments, maintain perfected collateral positions, and submit and pursue insurance claims. The Bank and its affiliates or WFBNA also provide accounting and reporting services required by us for our

 

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participation interests and loans. We also may direct the Bank or WFBNA to dispose of any loans that are classified as nonperforming, are placed in a nonperforming status or are renegotiated due to the financial deterioration of the borrower. The Bank or WFBNA are required to pay all expenses related to the performance of their duties under the participation and servicing agreements, including any payment to their affiliates or third parties for servicing the loans.

 

In accordance with the terms of the commercial, commercial real estate and residential loan participation and servicing agreements currently in place, we maintain the authority to decide whether to foreclose on collateral that secures a loan. In the event we determine a foreclosure proceeding is appropriate, we may direct the Bank or WFBNA to prosecute the foreclosure on our behalf. Upon sale or other disposition of foreclosure property, the Bank or WFBNA will remit to us the proceeds less the cost of holding and selling the foreclosure property.

 

To the extent we acquire additional loans or participation interests directly from unaffiliated third parties in the future, we may also enter into servicing agreements with such unaffiliated third parties.

 

Competition

 

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

 

Regulatory Considerations

 

Various legislative and regulatory proposals concerning the financial services industry are pending in Congress, the legislatures in states in which we conduct operations and before various regulatory agencies that supervise our operations. Given the uncertainty of the legislative and regulatory process, we cannot assess the impact of any such legislation or regulations on our financial condition or results of operations.

 

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

 

Under certain circumstances, including any determination that the Bank’s relationship to us results in unsafe and unsound banking practices, the OCC has the authority to restrict our ability to make dividend payments to our shareholders. See “—Dividend Policy” for a more detailed description of such restrictions.

 

Moreover, our Series A preferred securities are automatically exchangeable for depositary shares representing Series G, Class A preferred stock of Wells Fargo at the direction of the OCC if any of the following events occurs:

 

  Ÿ  

the Bank becomes undercapitalized under the OCC’s “prompt corrective action” regulations;

 

  Ÿ  

the Bank is placed into conservatorship or receivership; or

 

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  Ÿ  

the OCC, in its sole discretion, anticipates that the Bank may become “undercapitalized” in the near term or takes supervisory action that limits the payment of dividends by us and in connection therewith directs an exchange.

 

In an exchange, holders of our Series A preferred securities would receive one depositary share representing a one-sixth interest in one share of Wells Fargo Series G, Class A preferred stock for each of our Series A preferred securities. The Wells Fargo Series G, Class A preferred stock will be non-cumulative, perpetual, non-voting preferred stock of Wells Fargo ranking equally upon issuance with the most senior preferred stock of Wells Fargo then outstanding. If such an exchange occurs, holders of our Series A preferred securities would own an investment in Wells Fargo and not in us at a time when the Bank’s and, ultimately, Wells Fargo’s financial condition is deteriorating or the Bank may have been placed into conservatorship or receivership.

 

At December 31, 2009, each of the Bank and WFBNA was considered “well-capitalized” under risk-based capital guidelines issued by banking regulators.

 

For more information concerning Wells Fargo, WFBNA and the Bank, please see Part IV, Item 15.1 of Wells Fargo’s Annual Report on Form 10-K for the year ended December 31, 2009, which is incorporated by reference herein (excluding the list of exhibits incorporated therein by reference), the audited supplementary consolidating financial information filed herewith as Exhibit (99)(a), and the selected unaudited financial information of the Bank filed herewith as Exhibit (99)(b).

 

Employees

 

We have two executive officers and 9 additional non-executive officers. Our current executive officers are also executive officers of Wells Fargo. We do not anticipate that we will require any additional employees because employees of the Bank and its affiliates are servicing the loans under the participation and servicing agreements. All of our officers are also officers or employees of Wells Fargo and/or certain of its affiliates, including the Bank. We maintain corporate records and audited financial statements that are separate from those of the Bank. Except as borrowers under home equity or residential mortgage loans, none of our officers, employees or directors will have any direct or indirect pecuniary interest in any mortgage asset to be acquired or disposed of by us or in any transaction in which we have an interest or will engage in acquiring, holding and managing mortgage assets. However, 108 employees of Wells Fargo or its affiliates, including certain of the non-executive officers discussed above, own one Series D preferred security each.

 

Executive Offices

 

Our principal executive offices are located at 1620 East Roseville Parkway, Roseville, California 95661 (telephone number (916) 787-9090).

 

Available Information

 

Wachovia Funding does not maintain its own website. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are accessible on the SEC’s website, www.sec.gov.

 

Item 1A.    Risk Factors.

 

An investment in Wachovia Funding’s securities may involve risks due to the nature of the business we engage in and activities related to that business. The following are the most significant risks associated with that business:

 

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As a result of the Wells Fargo acquisition of Wachovia, we may incur losses on loans that are materially greater than reflected in the fair value adjustments.

 

Wells Fargo accounted for the Wachovia merger under the purchase method of accounting, recording the acquired assets and liabilities at fair value based on preliminary purchase accounting adjustments. Wachovia Funding also recorded its assets and liabilities at fair value as of the merger date. Under purchase accounting, we had until one year after the merger date to finalize the fair value adjustments, meaning we could adjust the preliminary fair value estimates of assets and liabilities based on new or updated information that provided a better estimate of the fair value at merger date.

 

Using the measurement provisions for purchased credit-impaired (“PCI”) loans, which are contained in the Receivables topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 310, previously referred to as “SOP 03-3” loans, we recorded at fair value all PCI loans acquired in the merger based on the present value of their expected cash flows. We estimated cash flows using internal credit, interest rate and prepayment risk models using assumptions about matters that are inherently uncertain. We may not realize the estimated cash flows or fair value of these loans. In addition, although the difference between the pre-merger carrying value of the PCI loans and their expected cash flows—the “nonaccretable difference”—is available to absorb future charge-offs, we may be required to increase our allowance for loan losses and related provision expense because of subsequent additional credit deterioration in these loans.

 

Our financial results and condition will be adversely affected if home prices continue to fall and/or unemployment continues to increase.

 

Significant declines in home prices over the last year and recent increases in unemployment have resulted in higher loan charge-offs and increases in our allowance for loan losses and related provision expense. The economic environment and related conditions will directly affect credit performance. For example, if home prices continue to fall or unemployment continues to rise we will likely incur higher than normal charge-offs and provision expense from increases in our allowance for loan losses. These conditions are adversely affecting not only consumer loan performance but also commercial loans, especially those business borrowers that rely on the health of industries that are experiencing high levels of contraction.

 

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

 

All of our officers and one of our directors are also officers of Wells Fargo or the Bank or their affiliates. Wells Fargo, the Bank and Wachovia Preferred Holding control a substantial majority of our outstanding voting shares and, in effect, have the right to elect all of our directors, including independent directors, except under limited circumstances if we fail to pay dividends.

 

The Bank may have interests that are not identical to our interests. Wells Fargo, the ultimate parent of the Bank may have investment goals and strategies that differ from those of the holders of the Series A preferred securities. Consequently, conflicts of interest between us, on one hand, and the Bank and/or Wells Fargo, on the other hand, may arise.

 

We are dependent on the officers and employees of Wells Fargo and the Bank for our business activities and our relationship with Wells Fargo and/or the Bank may create potential conflicts of interest.

 

Wells Fargo and the Bank are involved in virtually every aspect of our operations. The Bank administers our day-to-day activities under the terms of participation and servicing agreements between the Bank and us. We are dependent on the diligence and skill of the officers and employees of the Bank for the selection, structuring and monitoring of the loans in our portfolio and our other authorized investments and business opportunities. The Bank manages our cash collateral related to our interest rate swaps.

 

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Despite our belief that the terms of the loan participation and servicing agreements between the Bank and us reflect terms consistent with those negotiated on an arms-length basis, our dependency on the Bank’s officers and employees and our close relationship with the Bank may create potential conflicts of interest. Specifically, such conflicts of interest may arise because the employees of the Bank have the power to set the amount of the service fees paid to the Bank, modify the loan participation and servicing agreements, and make business decisions with respect to servicing of the underlying loans, particularly the loans that are placed on nonaccrual status or are otherwise non-performing.

 

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

 

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

 

  Ÿ  

changes in interest rates;

 

  Ÿ  

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

 

  Ÿ  

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

 

  Ÿ  

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

 

  Ÿ  

the ability of tenants to make lease payments;

 

  Ÿ  

the ability of a property to attract and retain tenants, which may be affected by conditions such as an oversupply of space or a reduction in demand for rental space in the area, the attractiveness of properties to tenants, competition from other available space, and the ability of the owner to pay leasing commissions, provide adequate maintenance and insurance, pay tenant improvement costs, and make other tenant concessions;

 

  Ÿ  

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

 

  Ÿ  

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

 

If we lose our exemption under the Investment Company Act it could have a material adverse effect on us.

 

We believe that we are not, and intend to conduct our operations so as not to become, regulated as an investment company under the Investment Company Act. Under the Investment Company Act, a non-exempt entity that is an investment company is required to register with the SEC and is subject to extensive, restrictive and potentially adverse regulation relating to, among other things, operating methods, management, capital structure, dividends and transactions with affiliates. If a change in the laws or the interpretations of those laws were to occur, we could be required to either change the manner in which we conduct our operations to avoid being required to register as an investment company or register as an investment company, either of which could have a material adverse effect on us and the price of our securities. Further, in order to ensure that we at all times continue to qualify for the exemption, we may be required at times to adopt less efficient methods of financing certain of our assets than would otherwise be the case and may be precluded from acquiring certain types of assets whose yield is somewhat higher than the yield on assets that could be purchased in a manner consistent with the exemption. The net effect of these factors may lower at times our net interest income. Finally, if we were an unregistered investment company, there would be a risk that we would be subject to monetary penalties and injunctive relief in an action brought by the SEC, that we would be unable to enforce contracts with third parties and that third parties could seek to obtain rescission of transactions undertaken during the period we were determined to be an unregistered investment company.

 

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

 

Many legislative and regulatory proposals directed at the financial services industry are being proposed or are pending in the U.S. Congress to address perceived weaknesses in the financial system and regulatory oversight thereof that may have contributed to the financial disruption over the last two years and to provide additional protection for consumers and investors. These proposals or others affecting taxation may limit our revenues in businesses, impose fees or taxes on us, and/or intensify the regulatory supervision of us and the financial services industry. These proposals, if adopted, may have a material adverse effect on our business operations, income, and/or competitive position.

 

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

 

No assurance can be given that Wachovia Funding will be able to continue to operate in a manner so as to remain qualified as a REIT. Qualification as a REIT involves the application of highly technical and complex tax law provisions for which there are limited judicial and administrative interpretations and involves the determination of various factual matters and circumstances not entirely within our control. No assurance can be given that new legislation or new regulations, administrative interpretations, or court decisions will not significantly change the tax laws in the future with respect to qualification as a REIT or the federal income tax consequences of such qualification in a way that would materially and adversely affect Wachovia Funding’s ability to operate. Any such new legislation, regulation, interpretation or decision could be the basis of a tax event that would permit us to redeem all or any preferred securities, including the Series A preferred securities. If Wachovia Funding were to fail to qualify as a REIT, the dividends on preferred securities would not be deductible for federal income tax purposes. In that event, Wachovia Funding could face a tax liability that could consequently result in a reduction in our net income after taxes, which could also adversely affect our ability to pay dividends to preferred securities holders.

 

Although Wachovia Funding currently intends to operate in a manner designed to qualify as a REIT, future economic, market, legal, tax or other considerations may cause it to determine that it is in its best interests and the best interests of holders of common and preferred securities to revoke the REIT election.

 

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

 

Our accounting policies are fundamental to determining and understanding our financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results. Further, our policies related to the allowance for credit are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. For a description of these policies, refer to “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” section in this Form 10-K.

 

From time to time FASB and the SEC change the financial accounting and reporting standards that govern the preparation of our external financial statements. In addition, accounting standard setters and those who interpret the accounting standards (such as the FASB, SEC, banking regulators and our outside auditors) may change or even reverse their previous interpretations or positions on how these standards should be applied. Changes in financial accounting and reporting standards and changes in current interpretations may be beyond our control, can be hard to predict and could materially affect how we report our financial results and condition. We may be required to apply a new or revised standard retroactively or apply an existing standard differently, also retroactively, in each case resulting in our potentially restating prior period financial statements in material amounts.

 

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Item 1B.    Unresolved Staff Comments.

 

None.

 

Item 2.    Properties.

 

Wachovia Funding does not own any properties and our primary executive offices are used primarily by affiliates of Wells Fargo. Because we do not have any of our own employees who are not also employees of Wells Fargo or the Bank, we do not need office space for such employees. All officers of Wachovia Funding are also officers of Wells Fargo or the Bank or affiliates and perform their services from office space owned or leased by Wells Fargo or the Bank, as applicable.

 

Item 3.    Legal Proceedings.

 

Wachovia Funding 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 consolidated financial position or results of operations. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, could be material to our results of operations for any particular period.

 

Item 4.    Submission of Matters to a Vote Of Security Holders.

 

Not applicable.

 

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PART II

 

Item 5.   Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

General

 

Our common stock is 99.85% owned by Wachovia Preferred Holding and 0.15% owned by Wells Fargo and is not listed on any securities exchange. Wachovia Funding’s Series A preferred securities have been listed on the NYSE since January 10, 2003.

 

Prior to the December 2002 public offering of Wachovia Funding’s Series A preferred securities, Wachovia Preferred Holding acquired (i) 30,000,000 of Wachovia Funding’s Series A preferred securities, liquidation preference $25.00 per security, (ii) 40,000,000 of Wachovia Funding’s Series B preferred securities, liquidation preference $25.00 per security, and (iii) 4,233,754 of Wachovia Funding’s Series C preferred securities, liquidation preference $1,000 per security. The Series A, Series B and Series C preferred securities were acquired by Wachovia Preferred Holding in exchange for participations in commercial and commercial real estate loans with an aggregate fair value of $6.0 billion. The issuance of Wachovia Funding’s Series A, Series B and Series C preferred securities to Wachovia Preferred Holding was made in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act. The Series A and Series B preferred securities are conditionally exchangeable, upon certain regulatory events, into preferred stock (or depositary shares representing such stock) of Wells Fargo.

 

In December 2002 and June 2003, Wachovia Preferred Holding sold 18,000,000 shares and 12,000,000 shares, respectively, of our Series A preferred securities in registered public offerings. Wachovia Funding did not receive any of the proceeds from these offerings.

 

Dividends

 

For the year ended December 31, 2009, Wachovia Funding declared and paid (i) cash dividends of $1.81 per share on its Series A preferred securities, (ii) cash dividends of $0.68 per share on its Series B preferred securities, (iii) cash dividends of $18.68 per share on its Series C preferred securities, and (iv) cash dividends of $85.00 per share on its Series D preferred securities. Wachovia Funding also paid dividends of $9.00 per share on its common stock in 2009. Please see “—Item 1. Business–Dividend Policy” for a description of our policies regarding dividends.

 

Equity Compensation Plans

 

Wachovia Funding does not have any equity compensation plans. Our two executive officers are executive officers of Wells Fargo and receive certain equity-based compensation from Wells Fargo. See “Executive Compensation” in our definitive proxy statement to be filed no later than April 30, 2010, for more information.

 

Recent Sales of Unregistered Securities

 

Not applicable.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

Not applicable.

 

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Item 6.    Selected Consolidated Financial Data.

 

On December 31, 2008, Wells Fargo acquired Wachovia and accordingly, under purchase accounting, the assets and liabilities of Wachovia and its subsidiaries, including Wachovia Funding, were recorded at their respective fair values at December 31, 2008. The more significant fair value adjustments were recorded to the loan portfolio.

 

Because the acquisition occurred on the last day of the 2008 reporting period, the income statement for 2008 was not affected by purchase accounting. Information for periods not affected by purchase accounting are labeled herein as “predecessor” and those reflecting purchase accounting are labeled “successor”.

 

As reflected on the following page, selected consolidated financial data for the five years ended December 31, 2009, is derived from our audited consolidated financial statements. This data should be read in conjunction with the consolidated financial statements, related notes and other financial information presented elsewhere in this Annual Report on Form 10-K, the audited supplementary consolidating financial information filed herewith as Exhibit (99)(a), and the selected unaudited financial information of the Bank filed herewith as Exhibit (99)(b).

 

Additionally, the table on the following page reflects five-year trend data for nonaccrual loans. We generally place loans on nonaccrual status when commercial loans become 90 days past due as to principal or interest, or where reasonable doubt exists as to collection, unless well secured and in the process of collection. Consumer real estate loans that become 120 days past due are placed on nonaccrual status. Nonaccrual loans were $207.5 million at December 31, 2009.

 

In connection with the Wells Fargo acquisition of Wachovia, the loans acquired from Wachovia and its subsidiaries where there was evidence of deterioration in credit quality since origination and where it was probable at the date of acquisition that we would not collect all contractual principal and interest are accounted for as PCI loans. These loans are generally on nonaccrual status and are initially recorded at fair value. No allowance for loan losses is carried over or initially recorded on PCI loans. Substantially all of our nonaccrual loans were subject to PCI loan accounting at December 31, 2008. After such loans have been written down to fair value, they are evaluated for accruing status based on the collectibility of the new book value (net of the purchase accounting discount). Accordingly, such loans are no longer classified as nonaccrual even though they may be contractually past due because we expect to fully collect the new carrying values of such loans (that is, the new cost basis arising out of our purchase accounting).

 

Prior to the application of PCI loan accounting at December 31, 2008, nonaccrual loans totaled $60.6 million including $10.9 million in commercial loans and $49.7 million in consumer loans.

 

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     Years Ended December 31,  

(In thousands)

   2009     2008     2007     2006     2005  
     (Successor)     (Successor)     (Predecessor)     (Predecessor)     (Predecessor)  

INCOME STATEMENT DATA (a)

          

Net interest income

   $ 1,161,542      1,166,033      1,199,298      1,157,209      801,809   

Provision for credit losses

     217,573      321,605      21,162      (9,251   1,211   

Other income (loss)

     5,250      22,502      8,682      (2,846   (7,309

Noninterest expense

     79,974      86,493      102,947      104,039      67,641   

Net income

   $ 867,650      767,276      1,067,033      1,046,154      721,522   

BALANCE SHEET DATA

          

Cash and cash equivalents

   $ 2,092,523      1,358,129      1,394,729      1,382,021      1,484,535   

Loans, net of unearned income

     16,401,604      17,481,505      16,606,273      16,795,417      16,196,661   

Allowance for loan losses (b)

     (337,431   (269,343   (93,095   (81,350   (96,115

Interest rate swaps

     976      1,273      1,589      658      411   

Total assets

     18,410,128      18,836,915      18,233,647      18,427,969      17,896,219   

Total liabilities

     74,805      250,887      389,905      596,777      100,569   

Total stockholders’ equity

   $ 18,335,323      18,586,028      17,843,742      17,831,192      17,795,650   

SELECTED OTHER INFORMATION

          

Nonaccrual loans (c)

   $ 207,540      175      36,829      19,682      20,353   

Nonaccrual loans as a % of total loans

     1.27   0.00      0.22      0.12      0.13   

Nonaccrual loans as a % of total assets

     1.13      0.00      0.20      0.11      0.11   

Allowance for loan losses as % of nonaccrual loans

     162.59      n/m      252.78      413.32      472.24   

Allowance for loan losses as % of total loans

     2.06   1.54      0.56      0.48      0.59   

 

n/m = not meaningful

 

(a) 2008 income statement data based on predecessor. Certain amounts in prior years have been reclassified to conform with the presentation in 2009.

 

(b) The allowance for loan losses for 2009 and 2008 does not include any amounts related to PCI loans.

 

(c) 2009 and 2008 exclude loans that are accounted for as PCI loans. As a result of Wells Fargo’s acquisition of Wachovia, substantially all nonaccrual loans were eliminated in purchase accounting. 2008 nonaccrual loans exclude PCI loans in conformity with the presentation for 2009.

 

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with selected consolidated financial data set forth in Item 6 and our audited consolidated financial statements and related notes included in this Form 10-K. In addition to historical information, the discussion in this Form 10-K contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated by these forward-looking statements due to factors including, but not limited to, those factors set forth under “—Risk Management” and elsewhere in this Form 10-K. See also “Forward-Looking Statements” in Part I above.

 

For the tax year ended December 31, 2009, we expect to be taxed as a real estate investment trust (a “REIT”), and we intend to comply with the relevant provisions of the Internal Revenue 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 the majority of our earnings to shareholders and satisfying certain asset, income and stock ownership tests. To the extent we meet those provisions, with the exception of the income of our taxable REIT subsidiary, WPR, we will not be subject to federal income tax on net income. We currently believe that we continue to satisfy each of these requirements and therefore continue to qualify as a REIT. We continue to monitor each of these complex tests.

 

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In the event we do not continue to qualify as a REIT, we believe there should be minimal adverse effect of that characterization to us or to our shareholders:

 

  Ÿ  

From a shareholder’s perspective, the dividends we pay as a REIT are ordinary income not eligible for the dividends received deduction for corporate shareholders or for the favorable maximum 15% rate applicable to qualified dividends received by non-corporate taxpayers. If we were not a REIT, dividends we pay generally would qualify for the dividends received deduction and the favorable tax rate applicable to non-corporate taxpayers.

 

  Ÿ  

In addition, we would no longer be eligible for the dividends paid deduction, thereby creating a tax liability for us. Wachovia agreed to make, or cause its subsidiaries to make, a capital contribution to us equal in amount to any income taxes payable by us, which obligation was assumed by Wells Fargo in the Wachovia acquisition. Therefore, we believe a failure to qualify as a REIT would not result in any net capital impact to us.

 

Critical Accounting Policies

 

Our accounting and reporting policies are in accordance with GAAP, and they conform to general practices of the financial services industry. The application of certain of these principles involves a significant amount of judgment and the use of estimates based on assumptions for which the actual results are uncertain when we make the estimation. We have identified the allowance for loan losses policy as being particularly sensitive in terms of judgments and the extent to which estimates are used.

 

Allowance for Loan Losses

 

As a subsidiary of Wells Fargo, our loans are subject to the same analysis of the adequacy of the allowance for loan losses applied to loans maintained in Wells Fargo’s subsidiaries, including the Bank.

 

The allowance for loan losses reflects management’s judgment of probable credit losses inherent in the portfolio at the balance sheet date.

 

We employ a disciplined process and methodology to establish our allowance for loan 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 loss factors. The process involves difficult, subjective, and complex judgments. In addition, we review several credit ratio trends, such as the ratio of the allowance for loan losses to nonaccrual loans and the ratio of the allowance for loan losses to net charge-offs. These trends are not determinative of the adequacy of the allowance as we use several analytical tools in determining the adequacy of the allowance.

 

To determine the total allowance for loan losses, we estimate the reserves needed for each component of the portfolio, including loans analyzed individually and loans analyzed on a pooled basis.

 

The allowance for loan losses consists primarily of amounts applicable to: (i) the consumer portfolio; and (ii) the commercial and commercial real estate (“CRE”) portfolio.

 

To determine the consumer portfolio component of the allowance, loans are pooled by portfolio and losses are modeled using historical experience, quantitative and other mathematical techniques over the loss emergence period. Each business group exercises significant judgment in the determination of the model type and/or segmentation method that fits the credit risk characteristics of its portfolio. We use both internally developed and vendor supplied models in this process. We often use roll rate net flow models as well as econometric/statistical models for loss projections. Management must use judgment in establishing additional input metrics for the modeling processes, such as portfolio segmentation by sub-product.

 

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The models we use to determine the allowance are independently validated and reviewed to ensure that their theoretical foundation, assumptions, data integrity, computational processes, reporting practices, and end-user controls are appropriate and properly documented.

 

We estimate consumer credit losses under multiple economic scenarios to establish a range of potential outcomes. Management applies judgment to develop its own view of loss probability within that range, using external and internal parameters with the objective of establishing an allowance for the losses inherent within these portfolios as of the reporting date.

 

In addition to the allowance for the pooled consumer portfolios, we develop a separate allowance for loans that are identified as impaired through a troubled debt restructuring (“TDR”). These loans are excluded from pooled loss forecasts and a separate reserve is provided under the accounting guidance for loan impairment.

 

In determining the appropriate allowance attributable to our consumer loan portfolio, the loss rates used in our analysis include the impacts of our established loan modification programs. When modifications occur or are probable to occur, our allowance considers the impact of these modifications, taking into consideration the associated credit cost, including re-defaults of modified loans and projected loss severity. The loss content associated with existing and probable loan modifications has been considered in our allowance reserving methodology.

 

We estimate the component of the allowance for loan losses for the non-impaired commercial and CRE portfolios through the application of loss factors to loans grouped by their individual credit risk rating specialists. These ratings reflect the estimated default probability and quality of underlying collateral. The loss factors used are statistically derived through the observation of losses incurred for loans within each credit risk rating over a specified period of time. As appropriate, we adjust or supplement these allowance factors and estimates to reflect other risks that may be identified from current conditions and developments in selected portfolios.

 

The commercial component of the allowance also includes an amount for the estimated impairment in nonaccrual commercial and CRE loans with a credit exposure of $5 million or greater. Commercial and CRE loans whose terms have been modified in a TDR are also individually analyzed for estimated impairment.

 

Reflected in the allowance for loan losses is an amount for imprecision or uncertainty, which represents management’s judgment of risks inherent in the processes and assumptions used in establishing the allowance. This imprecision considers economic environmental factors, modeling assumptions and performance, process risk, and other subjective factors. No single statistic or measurement determines the adequacy of the allowance for loan losses.

 

While the allowance is determined using product estimates, it is available to absorb losses in the entire loan portfolio.

 

Changes in the allowance for loan losses and the related provision expense can materially affect net income. The establishment of the allowance for loan losses relies on a consistent quarterly process that requires multiple layers of management review and judgment and responds to changes in economic conditions, customer behavior, and collateral value, among other influences. From time to time, events or economic factors may affect the loan portfolio, causing management to provide additional amounts to or release balances from the allowance for loan losses.

 

Our allowance for loan losses is sensitive to risk ratings assigned to individually rated loans and economic assumptions and delinquency trends driving statistically modeled reserves. Individual loan risk ratings are assigned based on each situation by experienced senior credit officers.

 

Assuming a one risk grade downgrade throughout our individually rated portfolio and a slow recovery (adverse) economic scenario for modeled losses would imply an additional reserve requirement of approximately $99 million.

 

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Assuming a one risk grade upgrade throughout our individually rated portfolio and a strong recovery economic scenario for modeled losses would imply a reduced reserve requirement of approximately $23 million.

 

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

 

Results of Operations

 

For purposes of this discussion, the term “loans” includes loans and loan participation interests, the term “consumer loans” includes real estate 1-4 family first mortgages and real estate 1-4 family junior lien mortgages, and the term “commercial loans” includes commercial and commercial real estate loans. The following table presents certain performance and dividend payout ratios for the years ended December 31, 2009, 2008 and 2007.

 

     Years Ended
December 31,
     2009     2008    2007
     (Successor)     (Predecessor)    (Predecessor)

Return on average assets

   4.60   4.20    5.74

Return on average stockholders’ equity

   4.67      4.29    5.95

Average stockholders’ equity to average assets

   98.40      98.07    96.38

Dividend payout ratio

   122.25   128.80    98.82

 

Although we have the authority to acquire interests in an unlimited number of loans and other assets from unaffiliated third parties, substantially all of our interests in loans we have acquired have been acquired from the Bank or an affiliate pursuant to loan participation agreements between the Bank or an affiliate and us. The remainder of our assets were acquired directly from the Bank. The Bank either originated the assets, or purchased them from other financial institutions or acquired them as part of the acquisition of other financial institutions.

 

In each of the years in the three-year period ended December 31, 2009, we purchased loans from the Bank at estimated fair value. In 2009, 2008, and 2007, Wachovia Funding paid $2.7 billion, $3.6 billion and $3.7 billion, respectively, for consumer loans.

 

On December 31, 2008, Wells Fargo acquired Wachovia and accordingly, under purchase accounting, the assets and liabilities of Wachovia and its subsidiaries were recorded at their respective fair values at December 31, 2008. The more significant fair value adjustments were recorded to the loan portfolio. Because the acquisition occurred on the last day of the 2008 reporting period, the income statement for 2008 was not affected by purchase accounting. Information for periods not affected by purchase accounting are labeled herein as “predecessor” and post-acquisition periods reflecting purchase accounting are labeled “successor”. Refer to Note 1 to Notes to Consolidated Financial Statements in this Report for further information.

 

2009 to 2008 Comparison

 

Net income available to common stockholders.    We earned net income available to common stockholders of $707.0 million and $474.0 million in 2009 and 2008, respectively. This increase was attributable to lower dividends on preferred stock (due to a decrease in the index rate in 2009), lower provision for credit losses, lower management fees and lower income tax expense. These were partially offset by lower gains on interest rate swaps and lower net interest income.

 

Interest Income.    Interest income of $1.2 billion in 2009 decreased $10.3 million, or 1%, compared with 2008. Higher average interest-earning assets were more than offset by decreases in interest rates compared with 2008. The average interest rate on total interest-earning assets was 6.20% in 2009 compared with 6.53% in 2008 which reflects the impact of a lower interest rate environment in 2009.

 

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Average consumer loans increased $1.4 billion to $14.9 billion compared with 2008 while average commercial loans decreased $643.6 million to $2.2 billion in the same period due to pay-downs. In 2009, interest income included $124.0 million from the accretion of discounts on purchased consumer loans primarily driven by an acceleration of accretion from repayment of loans during the period. All loan pay- downs were reinvested in consumer loans. We currently anticipate that we will continue to reinvest loan pay- downs primarily in consumer real-estate secured loans. Interest income on cash invested in overnight eurodollar deposits decreased $29.5 million to $1.4 million in 2009 compared with 2008, driven by significantly lower short-term interest rates from the same period one year ago. See the interest rate risk management section under “Risk Management” for more information on interest rates and interest income.

 

The average balances, interest income and rates related to interest-earning assets for the two years ended December 31, 2009, are presented below.

 

    Year Ended
December 31, 2009
    Year Ended
December 31, 2008
 

(In thousands)

  Average
Balance
  Interest
Income
  Rate     Average
Balance
  Interest
Income
  Rate  
    (Successor)   (Successor)   (Successor)     (Predecessor)   (Predecessor)   (Predecessor)  

Commercial loans

  $ 2,204,638   56,113   2.55   $ 2,848,256   130,127   4.57

Real estate 1-4 family

    14,905,900   1,104,451   7.41        13,498,319   1,011,162   7.49   

Interest-bearing deposits in banks and other earning assets

    1,641,713   1,358   0.08        1,592,639   30,892   1.94   
                       

Total interest-earning assets

  $ 18,752,251   1,161,922   6.20   $ 17,939,214   1,172,181   6.53
                               

 

We allocate the changes in net interest income to changes in either average balances or average interest rates. Because of the numerous simultaneous volume and rate changes during any period, it is not possible to precisely allocate such changes between volume and rate. For this table, changes that are not solely due to either volume or rate are allocated to these categories in proportion of the percentage changes in average volume and average interest rate. The dollar amount of change in interest income related to our interest-earning assets for the year ended December 31, 2009, is presented below.

 

     2009 Compared to 2008  
     Interest
Income

Variance
    Variance
Attributable to
 

(In thousands)

     Rate     Volume  

Earning Assets

      

Commercial loans

   $ (74,014   (51,121   (22,893

Real estate 1-4 family

     93,289      (11,579   104,868   

Interest-bearing deposits in banks and other earning assets

     (29,534   (30,030   496   
                    

Total earning assets

   $ (10,259   (92,730   82,471   
                    

 

Interest Expense.    Interest expense, which primarily relates to interest expense paid on our line of credit with the Bank, decreased to $380 thousand in 2009 compared with $6.1 million in 2008 primarily reflecting a significantly lower rate environment in 2009 compared with the same period one year ago. The line of credit with the Bank averaged $210.8 million in 2009 compared with $246.8 million in 2008. At December 31, 2009, there was no outstanding balance under the line of credit with the Bank.

 

Provision for Credit Losses.    The provision for credit losses was $217.6 million in 2009 compared with $321.6 million in 2008. The decrease in the provision for credit losses resulted from slowing our rate of building the allowance for loan losses, reflecting an improving economy, and from the accounting for purchased credit-impaired (“PCI”) loans, which offset credit deterioration in the non-impaired portfolio. Please refer to Note 1 to Notes to Consolidated Financial Statements for more information on PCI loans and the “—Balance Sheet Analysis” section for information on the allowance for loan losses.

 

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Gain on Interest Rate Swaps.    Our interest rate swaps lose value in an increasing rate environment and gain value in a declining rate environment. The gain on interest rate swaps was $4.1 million in 2009 compared with a gain of $16.1 million in 2008. The lower gain in 2009 primarily reflects a lower magnitude of interest rate decreases in 2009 compared with 2008. Included in gain on interest rate swaps was expense associated with the derivative cash collateral received of $360 thousand and $5.6 million in 2009 and 2008, respectively.

 

Loan Servicing Costs.    Loan servicing costs increased $683 thousand to $66.0 million in 2009, which reflects the impact of reinvesting pay-downs in additional purchases of consumer loans. Home equity loan products have a higher servicing fee compared to other loan products. These loans are serviced by the Bank pursuant to our participation and servicing agreements which include market-based fees. For home equity loan products, the monthly fee is equal to the outstanding principal balance of each loan multiplied by a percentage per annum. For servicing fees related to residential mortgage products the monthly fee is equal to the outstanding principal of each loan multiplied by a percentage per annum or a flat fee per month. For commercial loans, the monthly fee is equal to the total committed amount of each loan multiplied by a percentage per annum.

 

Management Fees.    Management fees were $10.2 million in 2009 compared with $18.7 million in 2008, primarily reflecting a decrease in the allocable expense base. Management fees represent reimbursements for general overhead expenses paid on our behalf. In 2009, an affiliate was assessed monthly management fees based on its relative percentage of the Bank’s total consolidated assets and noninterest expense. For 2008, monthly management fees were assessed to affiliates with over $10 million in qualifying assets. If an affiliate qualified for an allocation, the affiliate was assessed monthly management fees based on its relative percentage of the Bank’s total consolidated assets and noninterest expense.

 

Other Expense.    Other expense primarily consists of costs associated with foreclosures on residential properties.

 

Income Tax Expense.    Income tax expense, which is primarily based on the pre-tax income of WPR, our taxable REIT subsidiary, was $1.6 million in 2009 compared with $13.2 million in 2008. WPR holds our interest rate swaps as well as certain cash investments. The decrease in income tax expense for 2009 is primarily related to the decrease in income before income tax expense of WPR and a decrease in state income tax expense related to the adoption of the Wells Fargo tax settlement policy.

 

2009 to 2008 Fourth Quarter Comparison

 

Net income available to common stockholders increased to $146.6 million in fourth quarter 2009 compared with $86.6 million in fourth quarter 2008. The majority of income for both quarters was earned from interest on consumer and commercial loans. Net interest income decreased $35.5 million to $275.5 million in fourth quarter 2009 compared with fourth quarter 2008 driven primarily by lower average interest rates. The average interest rate received on total interest-earning assets was 5.91% in fourth quarter 2009 compared with 6.87% in the same quarter one year ago. Average total loans increased $111.4 million in fourth quarter 2009 compared with fourth quarter 2008. Average consumer loans increased $780.4 million to $14.5 billion compared with fourth quarter 2008 while average commercial loans decreased $669.0 million to $2.0 billion during the same time period due to pay-downs. Commercial loan pay-downs were reinvested in consumer loans. Interest income on cash invested in overnight eurodollar deposits decreased $1.7 million in fourth quarter 2009 compared with the same period last year driven primarily by lower short-term interest rates in 2009.

 

Provision for credit losses was $76.0 million in fourth quarter 2009 compared with $134.5 million in fourth quarter 2008. The lower expense in fourth quarter 2009 was driven primarily by improved expectations for the economy and related portfolio performance.

 

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Interest rate swaps were a gain of $554 thousand in fourth quarter 2009 compared with a gain of $11.5 million in fourth quarter 2008. Included in interest rate swaps was expense associated with the derivative cash collateral received of $62 thousand and $345 thousand in fourth quarter 2009 and 2008, respectively. The lower gain in fourth quarter 2009, compared to fourth quarter 2008, primarily reflects a lower magnitude of rate decreases in fourth quarter 2009 compared with the year ago quarter.

 

Loan servicing costs decreased by $796 thousand to $16.2 million in fourth quarter 2009 compared with fourth quarter 2008. Management fees of $1.6 million in fourth quarter 2009 decreased from $5.7 million in fourth quarter 2008, primarily reflecting a decrease in the allocable expense base.

 

An income tax benefit of $1.8 million was recognized in fourth quarter 2009 compared with income tax expense of $5.5 million in fourth quarter 2008. Income taxes were lower in fourth quarter 2009 as a result of adopting the Wells Fargo tax settlement policy and lower interest income on cash invested in overnight eurodollar deposits.

 

2008 to 2007 Comparison

 

Net income available to common stockholders.    We earned net income available to common stockholders of $474.0 million and $679.6 million in 2008 and 2007, respectively. The decrease was driven by higher provision for credit losses, lower net interest income and higher loan servicing costs, partially offset by lower dividends on preferred stock (due to a decrease in the index rate in 2008), higher gains on interest rate swaps, lower management fees and lower income tax expense.

 

Interest Income.    Interest income of $1.2 billion in 2008 decreased $55.7 million, or 5%, compared with 2007 driven by decreases in interest rates on interest-earning assets, primarily commercial loans and overnight eurodollar deposits, compared with the same period one year ago. The average interest rate on total interest-earning assets was 6.53% in 2008 compared with 6.73% in 2007 which reflects the impact of a lower interest rate environment in 2008. Average consumer loans increased $168.7 million to $13.5 billion compared with 2007 while average commercial loans decreased $539.9 million to $2.8 billion in the same period due to pay-downs. In the first, third and fourth quarters of 2008, proceeds from loan pay-downs were reinvested in consumer loans. We currently anticipate that we will continue to reinvest loan pay-downs primarily in consumer real-estate secured loans. Interest income on cash invested in overnight eurodollar deposits decreased $47.6 million to $30.9 million in 2008 compared with 2007 driven by lower short-term interest rates in 2008. See the interest rate risk management section under “Risk Management” for more information on interest rates and interest income.

 

The average balances, interest income and rates related to interest-earning assets for the two years ended December 31, 2008, are presented below.

 

    Year Ended
December 31, 2008
    Year Ended
December 31, 2007
 

In thousands)

  Average
Balance
  Interest
Income
  Rate     Average
Balance
  Interest
Income
  Rate  
    (Predecessor)   (Predecessor)   (Predecessor)     (Predecessor)   (Predecessor)   (Predecessor)  

Commercial loans

  $ 2,848,256   130,127   4.57   $ 3,388,175   230,393   6.80

Real estate 1-4 family

    13,498,319   1,011,162   7.49        13,329,594   919,012   6.89   

Interest-bearing deposits in banks and other earning assets

    1,592,639   30,892   1.94        1,531,125   78,511   5.13   
                       

Total interest-earning assets

  $ 17,939,214   1,172,181   6.53 %    $ 18,248,894   1,227,916   6.73
                               

 

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We allocate the changes in net interest income to changes in either average balances or average interest rates. Because of the numerous simultaneous volume and rate changes during any period, it is not possible to precisely allocate such changes between volume and rate. For this table, changes that are not solely due to either volume or rate are allocated to these categories in proportion of the percentage changes in average volume and average interest rate. The dollar amount of change in interest income related to our interest-earning assets for the year ended December 31, 2008, is presented below.

 

     2008 Compared to 2007  
     Interest
Income

Variance
    Variance
Attributable to
 

(In thousands)

     Rate     Volume  

Earning Assets

      

Commercial loans

   $ (100,266   (69,575   (30,691

Real estate 1-4 family

     92,150      80,014      12,136   

Interest-bearing deposits in banks and other earning assets

     (47,619   (49,793   2,174   
                    

Total earning assets

   $ (55,735   (39,354   (16,381
                    

 

Interest Expense.    Interest expense decreased to $6.1 million in 2008 compared with $28.6 million in 2007 reflecting a lower interest rate environment in 2008 and decreased borrowings on our line of credit with the Bank, which funded our lower volume of purchases of home equity loans in the second and third quarters of 2007 and the first, third and fourth quarters of 2008. At December 31, 2008, there was an outstanding balance of $170.0 million under the line of credit with the Bank.

 

Provision for Credit Losses.    The provision for credit losses was $321.6 million in 2008 compared with $21.2 million in 2007. The increase in the provision for credit losses was primarily driven by continued weakness in housing markets, particularly in Florida. See the allowance for loan losses section under “Balance Sheet Analysis” and “Critical Accounting Policies” for further information.

 

Interest Rate Swaps.    Our interest rate swaps lose value in an increasing rate environment and gain value in a declining rate environment. The gain on interest rate swaps was $16.1 million in 2008 compared with a gain of $7.6 million in 2007. Included in gain on interest rate swaps was expense associated with the derivative cash collateral received of $5.6 million and $16.6 million in 2008 and 2007, respectively. The increase in the gain on interest rate swaps is primarily due to a decrease in expense on cash collateral as the result of a decrease in short-term rates paid on these balances.

 

Loan Servicing Costs.    Loan servicing costs increased $3.2 million to $65.3 million in 2008 which reflects the impact of reinvesting pay-downs in home equity loan products which have a higher servicing fee related to other loan products. These loans are serviced by the Bank pursuant to our participation and servicing agreements which include market-based fees. For home equity loan products, the monthly fee is equal to the outstanding principal balance of each loan multiplied by a percentage per annum. For commercial loans, the monthly fee is equal to the total committed amount of each loan multiplied by a percentage per annum. For servicing fees related to residential mortgage products the monthly fee is equal to the outstanding principal of each loan multiplied by a percentage per annum or a flat fee per month.

 

Management Fees.    Management fees were $18.7 million in 2008 compared with $39.1 million in 2007 primarily reflecting a decreased allocable expense base. Management fees represent reimbursements for general overhead expenses paid on our behalf. In both 2008 and 2007, the management fee was charged to affiliates that have over $10.0 million in qualifying assets. If the affiliate qualifies for an allocation, the affiliate is assessed monthly management fees based on its relative percentage of total consolidated assets and noninterest expense.

 

Other Expense.    Other expense primarily consists of costs associated with foreclosures on residential properties.

 

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Income Tax Expense.    Income tax expense, which is primarily based on the pre-tax income of WPR, our taxable REIT subsidiary, was $13.2 million in 2008 compared with $16.8 million in 2007 with the decrease related to a decrease in pre-tax income. WPR holds our interest rate swaps as well as certain cash investments. The decrease in pre-tax income in WPR was due to lower interest income on cash invested in overnight eurodollar deposits compared with the prior year driven by lower short-term interest rates in 2008. Partially offsetting was the effect of higher gains on interest rate swaps in 2008 compared with the prior year.

 

Balance Sheet Analysis

 

Total Assets.    Our assets primarily consist of commercial and residential loans although we have the authority to hold assets other than loans. Total assets were $18.4 billion at December 31, 2009, compared with $18.8 billion at December 31, 2008. Loans, net of unearned income were 89% of total assets at December 31, 2009, compared to 93% at December 31, 2008.

 

Loans.    Loans, net of unearned income decreased $1.1 billion to $16.4 billion at December 31, 2009, compared with December 31, 2008, primarily reflecting pay-downs across the entire portfolio, partially offset by an increase in consumer loan reinvestments. At December 31, 2009, and 2008, consumer loans represented 88% and 86% of loans, respectively, and commercial loans represented 12% and 14%, respectively.

 

Commercial loan maturities for the years ended December 31, 2009 and 2008, is presented below.

 

     Commercial and
Commercial Real Estate
     December 31,

(In thousands)

   2009    2008
     (Successor)    (Successor)

FIXED RATE

     

1 year or less

   $ 16,389    11,536

1-5 years

     73,668    67,538

After 5 years

     55,638    86,015
           

Total fixed rate

     145,695    165,089
           

ADJUSTABLE RATE

     

1 year or less

     513,245    490,384

1-5 years

     838,721    1,194,409

After 5 years

     494,072    674,150
           

Total adjustable rate

     1,846,038    2,358,943
           

Total

   $ 1,991,733    2,524,032
           

 

Allowance for Loan Losses.    The allowance for loan losses increased $68.1 million from December 31, 2008, to $337.4 million at December 31, 2009. The December 31, 2008, allowance reflected a reduction of $55.6 million due to the accounting for PCI loans. The 2009 reserve build was primarily driven by deterioration in economic conditions that increased projected losses in our consumer loan portfolio.

 

At December 31, 2009, the allowance for loan losses included $318.9 million for consumer loans and $18.5 million for commercial loans. The total allowance reflects management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. We consider the allowance for loan losses of $337.4 million adequate to cover credit losses inherent in the loan portfolio at December 31, 2009.

 

Net charge-offs in 2009 were $149.8 million (0.88% of average loans) compared with $89.2 million (0.55%) in 2008. The increase in losses during the year was anticipated given the economic conditions in the marketplace affecting our customers. The increase was concentrated in consumer real estate. For the consumer real estate portfolios, continued property value disruption combined with rising unemployment affected loss levels. The rise in unemployment levels is also increasing the frequency of loss. Net charge-offs in the consumer loan portfolio totaled $149.6 million in 2009. Until housing prices fully stabilize, these credit losses will continue to remain elevated.

 

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Interest Rate Swaps.    Interest rate swaps, net were $1.0 million at December 31, 2009, and $1.3 million at December 31, 2008, which represents the fair value of our net position in interest rate swaps.

 

Accounts Receivable—Affiliates, Net.    Accounts receivable from affiliates, net was $166.4 million at December 31, 2009, compared with $167.0 million at December 31, 2008, as a result of intercompany transactions related to net loan paydowns, interest receipts and funding with the Bank.

 

Commitments

 

Our commercial loan relationships include unfunded loan commitments that are provided in the normal course of business. For commercial borrowers, loan commitments generally take the form of revolving credit arrangements to finance customers’ working capital requirements. These instruments are not recorded on the balance sheet until funds are advanced under the commitment. For lending commitments, the contractual amount of a commitment represents the maximum potential credit risk if the entire commitment is funded and the borrower does not perform according to the terms of the contract. Some of these commitments expire without being funded, and accordingly, total contractual amounts are not representative of our actual future credit exposure or liquidity requirements. The “—Risk Management—Credit Risk Management” section describes how we use Wells Fargo’s risk management framework to manage credit risk.

 

Loan commitments create credit risk in the event that the counterparty draws on the commitment and subsequently fails to perform under the terms of the lending agreement. This risk is incorporated into an overall evaluation of credit risk and to the extent necessary, reserves are recorded on these commitments. Uncertainties around the timing and amount of funding under these commitments may create liquidity risk. The “—Risk Management—Liquidity Risk Management” section describes the way we manage liquidity and fund these commitments, to the extent funding is required. At December 31, 2009 and 2008, unfunded commitments to extend credit were $666.7 million and $730.8 million, respectively.

 

Liquidity and Capital Resources

 

Our internal sources of liquidity are primarily cash generated from interest and principal payments on loans in our portfolio. Our primary liquidity needs are to pay operating expenses, fund our lending commitments, purchase loans as the existing loans mature or prepay, and pay dividends. We expect to distribute annually an aggregate amount of dividends with respect to our outstanding capital stock equal to approximately 100 percent of our REIT taxable income for federal income tax purposes, which primarily results from interest income on our loan portfolio. Such distributions may in some periods exceed net income determined under GAAP.

 

Proceeds received from pay-downs of loans are typically sufficient to fund existing lending commitments and loan purchases. Depending upon the timing of the loan purchases, we may draw on the line of credit we have with the Bank as a short-term liquidity source. Wachovia Funding has a $1.0 billion line of credit with the Bank, and our subsidiaries WREIC and WPR have lines of credit with the Bank of $1.0 billion and $200.0 million, respectively. Each of these lines is under a revolving demand note at a rate equal to the federal funds rate. Generally, we repay these borrowings within several months as we receive cash on loan pay-downs from our loan portfolio. At December 31, 2009, there were no borrowings outstanding on our line of credit with the Bank. Should a longer-term liquidity need arise, we could issue additional common or preferred stock, subject to any pre-approval rights of our shareholders. We do not have and do not anticipate having any material capital expenditures in the foreseeable future. We believe our existing sources of liquidity are sufficient to meet our funding needs.

 

Risk Management

 

We use Wells Fargo’s risk management framework to manage our credit, interest rate, market, operational and liquidity risks. The following discussion highlights this framework at it relates to how we manage each of these risks.

 

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Credit Risk Management

 

The credit risk management process is governed centrally, but provides for decentralized management and accountability. Our overall credit process includes comprehensive credit policies, judgmental or statistical credit underwriting, frequent and detailed risk measurement and modeling, extensive credit training programs, and a continual loan review and audit process. In addition, regulatory examiners review and perform detailed tests of our credit underwriting, loan administration and allowance processes.

 

We continually evaluate and modify our credit policies to address unacceptable levels of risk as they are identified. Accordingly, from time to time, we designate certain portfolios and loan products as non-strategic or high risk to specially monitor their loss potential.

 

A key to our credit risk management is utilizing a well controlled underwriting process, which we believe is appropriate for the needs of our customers as well as investors who purchase the loans. Our underwriting of loans collateralized by residential real property utilizes appraisals or automated valuation models (AVMs) to support property values. AVMs are computer-based tools used to estimate the market value of homes. AVMs are a lower-cost alternative to appraisals and support valuations of large numbers of properties in a short period of time. AVMs estimate property values based on processing large volumes of market data including market comparables and price trends for local market areas. The primary risk associated with the use of AVMs is that the value of an individual property may vary significantly from the average for the market area. We have processes to periodically validate AVMs and specific risk management guidelines addressing the circumstances when AVMs may be used. Generally, AVMs are only used in underwriting to support property values where the loan amount is under $250,000. For underwriting residential property loans of $250,000 or more we require property visitation appraisals by qualified independent appraisers.

 

Measuring and monitoring our credit risk is an ongoing process that tracks delinquencies, collateral values, economic trends by geographic areas, loan-level risk grading for certain portfolios (typically commercial) and other indications of risk to loss. Our credit risk monitoring process is designed to enable early identification of developing risk to loss and to support our determination of an adequate allowance for loan losses. During the current economic cycle our monitoring and resolution efforts have focused on loan portfolios exhibiting the highest levels of risk including mortgage loans supported by real estate (both consumer and commercial), junior lien and commercial portfolios.

 

Our underwriting of CRE loans is focused primarily on cash flows and creditworthiness, not solely collateral valuations. To identify and manage newly emerging problem CRE loans we employ a high level of surveillance and regular customer interaction to understand and manage the risks associated with these assets, including regular loan reviews and appraisal updates. As issues are identified, management is engaged and dedicated workout groups are in place to manage problem assets.

 

For purposes of portfolio risk management, we aggregate commercial loans according to market segmentation and standard industry codes. This portfolio has experienced less credit deterioration than our CRE portfolio. We believe this portfolio is well underwritten and is diverse in its risk with relatively even concentrations across several industries.

 

Some of our real estate 1-4 family mortgage loans, including first mortgage and home equity products, include an interest-only feature as part of the loan terms. Most of these loans are considered to be prime or near prime. We have manageable adjustable-rate mortgage (ARM) reset risk across our owned mortgage loan portfolios.

 

 

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Concentration of credit risk generally arises with respect to our loans when a significant number of underlying loans have borrowers that engage in similar business activities or activities in the same industry or geographical region. Concentration of credit risk indicates the relative sensitivity of performance to both positive and negative developments affecting a particular industry. By the nature of our status as a REIT, the composition of the loans underlying the participation interests are highly concentrated in real estate. The following table is a summary of the geographical distribution of our loan portfolio for the states with more than five percent of the total loans outstanding at December 31, 2009.

 

     December 31, 2009  

(In thousands)

   Commercial and
Commercial
Real Estate
   Real Estate
1-4 Family
First
Mortgage
   Real Estate
1-4 Family
Junior Lien
Mortgage
   Total    % of
Total
Loans
 

Florida

   $ 529,202    1,366,181    726,688    2,622,071    16

Pennsylvania

     265,808    1,282,162    896,169    2,444,139    15   

New Jersey

     284,655    991,811    1,072,175    2,348,641    14   

North Carolina

     365,005    888,388    432,254    1,685,647    10   

Virginia

     150,151    666,856    543,912    1,360,919    9   

Georgia

     86,649    492,159    432,805    1,011,613    6   

All other states

     310,263    3,445,726    1,172,585    4,928,574    30   
                            

Total loans

   $ 1,991,733    9,133,283    5,276,588    16,401,604    100
                            

 

The following table is a summary of our commercial loans by industry.

 

     December 31, 2009  

(In thousands)

   Total    % of
Total
Loans
 

Public administration

   $ 96,987    34

Finance

     45,544    16   

Real estate - other (1)

     33,815    12   

Food and beverage

     28,705    10   

Investors

     25,900    9   

Industrial equipment

     17,290    6   

Crops

     9,667    3   

Healthcare

     7,330    3   

Real estate investment trust

     6,878    2   

Other

     15,462    5   
             

Total commercial loans

   $ 287,578    100
             

 

(1) Includes lessors, building operators and real estate agents.

 

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The following table is a summary of commercial real estate loans by state and property type.

 

      December 31, 2009  

(In thousands)

   Real Estate
Mortgage
   Real Estate
Construction
   Total    % of
Total
Loans
 

By state:

           

Florida

   $ 396,877    18,577    415,454    25

North Carolina

     352,165    10,347    362,512    21   

New Jersey

     226,074    —      226,074    13   

Pennsylvania

     172,083    52,372    224,455    13   

South Carolina

     104,979    147    105,126    6   

Virginia

     95,610    3,561    99,171    6   

All other states

     269,788    1,575    271,363    16   
                       

Total loans

   $ 1,617,576    86,579    1,704,155    100
                       

By property:

           

Office buildings

   $ 411,774    1,661    413,435    24

Industrial/warehouse

     312,131    4,172    316,303    19   

Retail (excluding shopping center)

     212,383    3,482    215,865    13   

Real estate - other

     168,410    3,803    172,213    10   

Shopping center

     152,633    —      152,633    9   

Hotel/motel

     111,538    —      111,538    7   

Apartments

     91,970    12,703    104,673    6   

Institutional

     78,870    2,496    81,366    5   

Land (excluding 1-4 family)

     70,450    3,004    73,454    4   

1-4 family structure

     5,209    54,284    59,493    3   

Other

     2,208    974    3,182    —     
                       

Total loans

   $ 1,617,576    86,579    1,704,155    100
                       

 

The following table is a summary of real estate 1-4 family mortgage loans by state and loan-to-value (LTV) ratio:

 

     December 31, 2009  

(In thousands)

   Real Estate
1-4 Family
Mortgage
   Current
LTV Ratio (1)
 

Pennsylvania

   $ 2,178,331    72

Florida

     2,092,869    85   

New Jersey

     2,063,986    74   

North Carolina

     1,320,642    76   

Virginia

     1,210,768    76   

Georgia

     924,964    88   

All other states

     4,618,311    76
         

Total loans

   $ 14,409,871   
         

 

(1) Collateral values are 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.

 

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Nonaccrual loans increased to $207.5 million at December 31, 2009, from $175 thousand at December 31, 2008. The increase was primarily related to real estate 1-4 family first mortgage loans. The rate of nonaccrual loan growth has been somewhat increased by the effect of accounting for substantially all of the nonaccrual loans as PCI loans at year-end 2008. This purchase accounting resulted in reclassifying nonaccruing loans to accruing status, resulting in a reduced level of nonaccrual loans. Typically, changes to nonaccrual loans period-over-period represent inflows for loans that reach a specified past due status, offset by reductions for loans that are charged off or are no longer classified as nonaccrual because they return to accrual status. The impact of purchase accounting on nonaccrual loan data should diminish over time.

 

There were no commercial loan TDRs at December 31, 2009. Total consumer loan TDRs amounted to $110.6 million at December 31, 2009. At December 31, 2009, nonaccruing TDRs were $10.0 million. Consumer loans that enter into a TDR before they reach nonaccrual status (normally 120 days past due) remain in accrual status as long as they continue to perform according to the terms of the TDR. We strive to identify troubled loans and work with the customer to modify to more affordable terms before their loan reaches nonaccrual status. Accordingly, during 2009 most consumer loans were in accrual status at the time of TDR and therefore most of our consumer TDR loans are in accrual status at the end of the year. We establish an impairment reserve when a loan is restructured in a TDR.

 

NONACCRUAL LOANS AND OTHER NONPERFORMING ASSETS     
     December 31,

(In thousands)

   2009     2008
     (Successor)     (Successor)

NONACCRUAL LOANS (1)

    

Commercial and commercial real estate

    

Commercial

   $ 3,510      —  

Real estate mortgage

     4,869      —  

Real estate construction

     —        —  
            

Total commercial and commercial real estate

     8,379      —  
            

Consumer

    

Real estate 1-4 family first mortgage (2)

     119,666      175

Real estate 1-4 family junior lien mortgage

     79,495      —  
            

Total consumer

     199,161      175
            

Total nonaccrual loans

     207,540      175
            

OTHER NONPERFORMING ASSETS

    

Foreclosed assets

     2,282      3,604
            

Total nonaccrual loans and other nonperforming assets

   $ 209,822      3,779
            

As a percentage of total loans

     1.28   0.02
            

 

(1) Excludes loans that are accounted for as PCI loans.
(2) 2008 nonaccrual loans exclude PCI loans in conformity with the presentation for 2009.

 

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ACCRUING LOANS PAST DUE 90 DAYS OR MORE (1)

 

     December 31,

(In thousands)

   2009    2008
     (Successor)    (Successor)

COMMERCIAL AND COMMERCIAL REAL ESTATE

     

Commercial

   $ —      —  

Real estate mortgage

     9,445    —  

Real estate construction

     —      —  
           

Total commercial and commercial real estate

     9,445    —  
           

CONSUMER

     

Real estate 1-4 family first mortgage (2)

     20,681    3,146

Real estate 1-4 family junior lien mortgage

     20,406    —  

Other revolving credit and installment

     —      —  
           

Total consumer

     41,087    3,146
           

Total loans

   $ 50,532    3,146
           

 

 

(1) PCI loans are excluded from the disclosure of loans 90 days or more past due and still accruing interest. Even though certain of them are 90 days or more contractually past due, they are considered to be accruing because the interest income on these loans relates to the establishment of an accretable yield under the accounting for PCI loans and not to contractual interest payments.
(2) 2008 loans exclude PCI loans in conformity with the presentation for 2009.

 

We have increased loan modifications and restructurings to assist homeowners in the current difficult economic cycle. For consumer loans that have been modified, if the borrower has demonstrated performance under the previous terms, the loan is currently accruing and the borrower shows the capacity to continue to perform under the restructured terms, the loan will remain in accruing status. Otherwise, the loan will be placed in a nonaccrual status. Modified loans on nonaccrual status can be returned to accrual status if both of the following conditions are met: (1) we have a well-documented credit evaluation of the borrower’s financial condition and prospects for repayment of the loan must be reasonably assured and; (2) the borrower has paid timely the full amount of six consecutive contractual principal and interest payments and any amounts past due are reasonably assured of repayment within a reasonable time.

 

Interest Rate Risk Management

 

Interest rate risk is the sensitivity of earnings to changes in interest rates. Approximately 16% of our loan portfolio consisted of variable rate loans at December 31, 2009. 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.

 

At December 31, 2009, approximately 84% of the balance of our loans had fixed interest rates. Such loans tend to increase our interest rate risk. We monitor the rate sensitivity of assets acquired. 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 interest rate-sensitive assets.

 

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 affect net interest income adversely. Because different types of assets and liabilities with the same or similar

 

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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 December 31, 2009, $4.8 billion, or 26% of our assets, had variable interest rates and could be expected to reprice with changes in interest rates. At December 31, 2009, our liabilities were $74.8 million, or less than 1% of our assets, while stockholders’ equity was $18.3 billion, or greater than 99% 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.

 

Our rate-sensitive assets and liabilities at December 31, 2009, are presented below. Assets that immediately reprice are placed in the overnight column. The allowance for loan losses is not included in loans. At December 31, 2009 the fair value of the loan portfolio was $16.2 billion with fixed rate loans and loan participations of approximately $13.5 billion and variable rate loans of approximately $2.7 billion.

 

    December 31, 2009
(Successor)

(In thousands)

  Overnight   Within
One Year
  One to
Three
Years
  Three to
Five Years
  Over Five
Years
  Total

RATE-SENSITIVE ASSETS

           

Interest-bearing deposits in banks

  $ 2,092,523   —     —     —     —     2,092,523

Loans and loan participations

           

Fixed rate

    —     185,951   337,775   950,274   12,238,775   13,712,775

Variable rate

    —     518,508   517,624   369,573   1,283,124   2,688,829
                         

Total rate-sensitive assets

  $ 2,092,523   704,459   855,399   1,319,847   13,521,899   18,494,127
                         

Total rate-sensitive liabilities

  $ —     —     —     —     —     —  
                         

 

All of our derivatives are economic hedges and none are treated as accounting hedges. In addition, all our derivatives (currently consisting of interest rate swaps) are recorded at fair value in the balance sheets. When we have more than one transaction with a counterparty and there is a legally enforceable master netting agreement between the parties, the net of the gain and loss positions are recorded as an asset or a liability in our consolidated balance sheets. Realized and unrealized gains and losses are recorded as a net gain or loss on interest rate swaps in our consolidated statements of operations.

 

In 2001, the Bank contributed receive-fixed interest rate swaps with a notional amount of $4.25 billion and a fair value of $673.0 million to us in exchange for common stock. The unaffiliated counterparty to the receive-fixed interest rate swaps provided cash collateral to us. We pay interest to the counterparty on the collateral at a short-term interest rate. Shortly after the contribution of the receive-fixed interest rate swaps, we entered into pay-fixed interest rate swaps with a notional amount of $4.25 billion that serve as an economic hedge of the contributed swaps. All interest rate swaps are transacted with the same unaffiliated third party.

 

At December 31, 2009, our position in interest rate swaps was an asset of $578.8 million, a liability of $404.2 million, and a cash collateral payable of $174.6 million which is recorded as a net amount on our consolidated balance sheet at fair value.

 

At December 31, 2009, our receive-fixed interest rate swaps with a notional amount of $4.1 billion had a weighted average maturity of 2.46 years, weighted average receive rate of 7.45% and weighted average pay rate of 0.25%. Our pay-fixed interest rate swaps with a notional amount of $4.1 billion had a weighted average

 

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maturity of 2.46 years, weighted average receive rate of 0.25% and weighted average pay rate of 5.72% at December 31, 2009. Since the swaps have a weighted average maturity of 2.46 years, their value is primarily driven by changes in long-term interest rates. All the interest rate swaps have variable pay or receive rates based on three- or six-month LIBOR, and they are the pay or receive rates in effect at December 31, 2009.

 

Market Risk Management

 

Market risk is the risk of loss from adverse changes in market prices and interest rates. Market risk arises primarily from interest rate risk inherent in lending, investment in derivative financial instruments and borrowing activities.

 

Due to the difference in fixed rates in our interest rate swaps, volatility is expected given certain interest rate fluctuations. If market rates were to decrease 100 basis points or 200 basis points, we would recognize short-term net gains on our interest rate swaps of $2.6 million or $5.2 million, respectively. If market rates were to increase 100 basis points or 200 basis points, we would recognize short-term net losses on our interest rate swaps of $2.5 million or $5.0 million, respectively. These short-term fluctuations will eventually offset over the life of the interest rate swaps when held to maturity, with no change in cash flow occurring for the net positions. The changes in value of the net swap positions were calculated under the assumption there was a parallel shift in the LIBOR curve using 100 basis point and 200 basis point shifts, respectively.

 

Operational Risk Management

 

Our business is dependent on our ability to process, record and monitor a large number of complex transactions. If any of our financial, accounting, or other data processing systems fail or have other significant shortcomings, we could be materially adversely affected. Third parties with which we do business could also be sources of operational risk to us, including relating to breakdowns or failures of such parties’ own systems. Any of these occurrences could diminish our ability to operate, or result in potential liability to clients, reputational damage and regulatory intervention, any of which could materially adversely affect us.

 

If personal, confidential or proprietary information of customers or clients in our possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. Such mishandling or misuse could include, for example, if such information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees, or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.

 

We may be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, which may include, for example, computer viruses or electrical or telecommunications outages, natural disasters, disease pandemics or other damage to property or physical assets, or events arising from local or larger scale politics, including terrorist acts. Such disruptions may give rise to losses in service to customers and loss or liability to us.

 

Liquidity Risk Management

 

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.

 

Wachovia Funding’s primary liquidity needs are to pay operating expenses, fund our lending commitments, purchase loans as the underlying loans mature or repay, and pay dividends. Operating

 

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expenses and dividends are expected to be funded through cash generated by operations, while funding commitments and the acquisition of additional participation interests in loans are intended to be funded with the proceeds obtained from repayment of principal balances by individual borrowers. We do not have and do not anticipate having any material capital expenditures in the foreseeable future.

 

To the extent that Wachovia Funding’s board of directors determines that additional funding is required, we may raise funds through additional equity offerings, debt financings, retention of cash flow or a combination of these methods. However, 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. In addition, any necessary liquidity could be obtained by drawing on lines of credit with the Bank. Wachovia Funding has a $1.0 billion line of credit with the Bank, and our subsidiaries WREIC and WPR have lines of credit with the Bank of $1.0 billion and $200.0 million, respectively. Each of those lines is under a revolving demand note at a rate equal to the federal funds rate. During 2009, we made various draws which totaled $1.1 billion under our lines of credit with the Bank with a maximum of $720.0 million outstanding at any point in time. There were no outstandings on the lines of credit with the Bank at the end of 2009.

 

At December 31, 2009, our liabilities principally consist of deferred income tax liabilities. Our certificate of incorporation does not contain any limitation on the amount or percentage of debt, funded or otherwise, we may incur, except the incurrence of debt for borrowed money or our guarantee of debt for borrowed money in excess of amounts borrowed or guaranteed. However, as part of issuing our Series A preferred securities, we have a covenant in which we agree not to incur indebtedness over 20% of our stockholders’ equity unless approved by two-thirds of the Series A preferred securities, voting as a separate class.

 

Controls and Procedures

 

As a subsidiary of Wells Fargo, we are a part of Wells Fargo’s internal control procedures, including internal controls over financial reporting. See Item 9A. Controls and Procedures in this Form 10-K for more information.

 

Transactions with Related Parties

 

We are subject to certain income and expense allocations from affiliated parties for various services received. In addition, we enter into transactions with affiliated parties in the normal course of business. The nature of the transactions with affiliated parties is discussed below. Further information, including amounts involved, is presented in Note 8 to Notes to Consolidated Financial Statements.

 

The Bank or WFBNA services our loans on our behalf, which includes delegating servicing to third parties in the case of a portion of our residential mortgage products. We pay the Bank or WFBNA a percentage per annum fee for this service on commercial loans and a percentage per annum fee on home equity loan products. For servicing fees related to residential mortgage products the monthly fee is equal to the outstanding principal of each loan multiplied by a percentage per annum or a flat fee per month. The Notes to Consolidated Financial Statements has information about the accounting treatment of loan purchases. Additionally, we are subject to the Bank’s and WFBNA’s management fee policy and are assessed monthly management fees based on our relative percentage of the Bank’s total consolidated assets and noninterest expense. We also have a swap servicing and fee arrangement with the Bank, whereby the Bank provides operations, back office, book entry, record keeping and valuation services related to our interest rate swaps, for which we pay a fee to the Bank as discussed in “Results of Operations.”

 

Eurodollar deposits with the Bank are our primary cash management vehicle. In each of the years in the three-year period ended in 2009, we have also entered into certain loan participations with affiliates and are allocated a portion of all income associated with these loans.

 

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In 2009, we paid the Bank $2.7 billion in cash for consumer loans, which reflected fair value purchase prices. In conjunction with these purchases, we borrowed $1.1 billion under our existing line of credit with the Bank and incurred $380 thousand in interest expense owed to the Bank in 2009. The interest accrued under this line of credit at a rate equal to the federal funds rate. Our borrowings on our line of credit with the Bank were zero at December 31, 2009. The Notes to Consolidated Financial Statements has information about the accounting treatment of these loan purchases.

 

The Bank acts as our collateral custodian in connection with collateral pledged to us related to our interest rate swaps. For this service, we pay the Bank a fee based on the value of the collateral. In addition, the Bank is permitted to rehypothecate and use as its own the collateral held by the Bank as our custodian. The Bank pays us a fee based on the value of the collateral involved for this right. The Bank also provides a guaranty of our obligations under the interest rate swaps when the swaps are in a net payable position, for which we pay a monthly fee based on the absolute value of the net notional amount of the interest rate swaps.

 

Accounting and Regulatory Matters

 

Various legislative and regulatory proposals concerning the financial services industry are pending in Congress, the legislatures in states in which we conduct operations and before various regulatory agencies that supervise our operations. Given the uncertainty of the legislative and regulatory process, we cannot assess the impact of any such legislation or regulations on our consolidated financial condition or results of operations.

 

The following information addresses significant new developments in accounting standard-setting that may affect us.

 

ASU 2010-6 changes the disclosure requirements for fair value measurements. Companies are now required to disclose significant transfers in and out of Levels 1 and 2 of the fair value hierarchy, whereas existing rules only require the disclosure of transfers in and out of Level 3. Additionally, in the rollforward of Level 3 activity, companies should present information on purchases, sales, issuances, and settlements on a gross basis rather than on a net basis as is currently allowed. The update also clarifies that fair value measurement disclosures should be presented for each class of assets and liabilities. A class is typically a subset of a line item in the statement of financial position. Companies should also provide information about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring instruments classified as either Level 2 or Level 3. ASU 2010-6 is effective for us in first quarter 2010 with prospective application, except for the new requirement related to the Level 3 rollforward. Gross presentation in the Level 3 rollforward is effective for us in first quarter 2011 with prospective application. Our adoption of the update will not affect our consolidated financial results since it amends only the disclosure requirements for fair value measurements.

 

ASU 2009-16 (FAS 166) modifies certain guidance contained in FASB ASC 860, Transfers and Servicing. This pronouncement eliminates the concept of qualifying special purpose entities (QSPEs) and provides additional criteria transferors must use to evaluate transfers of financial assets. To determine if a transfer is to be accounted for as a sale, the transferor must assess whether it and all of the entities included in its consolidated financial statements have surrendered control of the assets. A transferor must consider all arrangements or agreements made or contemplated at the time of transfer before reaching a conclusion on whether control has been relinquished. The new guidance addresses situations in which a portion of a financial asset is transferred. In such instances the transfer can only be accounted for as a sale when the transferred portion is considered to be a participating interest. The update also requires that any assets or liabilities retained from a transfer accounted for as a sale be initially recognized at fair value. This pronouncement is effective for us as of January 1, 2010, with adoption applied prospectively for transfers that occur on and after the effective date. Upon adoption, this standard did not have a significant impact on our financial statements.

 

 

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ASU 2009-17 (FAS 167) amends several key consolidation provisions related to variable interest entities (VIEs), which are included in FASB ASC 810, Consolidation. First, the scope of the new guidance includes entities that are currently designated as QSPEs. Second, companies are to use a different approach to identify the VIEs for which they are deemed to be the primary beneficiary and are required to consolidate. Under existing rules, the primary beneficiary is the entity that absorbs the majority of a VIE’s losses and receives the majority of the VIE’s returns. The new guidance identifies a VIE’s primary beneficiary as the entity that has the power to direct the VIE’s significant activities, and has an obligation to absorb losses or the right to receive benefits that could be potentially significant to the VIE. Third, companies will be required to continually reassess whether they are the primary beneficiary of a VIE. Existing rules only require companies to reconsider primary beneficiary conclusions when certain triggering events have occurred. The Update is effective for us as of January 1, 2010, and applies to all existing QSPEs and VIEs, and VIEs created after the effective date. Upon adoption, FAS 167 did not have a significant impact on our financial statements.

 

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

 

Information required by this Item 7A is set forth in Item 7 under the caption “Risk Management”.

 

Item 8.    Financial Statements and Supplementary Data.

 

The following consolidated financial statements of Wachovia Funding and its subsidiaries at December 31, 2009, are included in this report at the pages indicated:

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Balance Sheets

   F-3

Consolidated Statements of Operations

   F-4

Consolidated Statements of Changes in Stockholders’ Equity

   F-5

Consolidated Statements of Cash Flows

   F-6

Notes to Consolidated Financial Statements

   F-7

 

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Quarterly Financial Data

Condensed Consolidated Statement of Operations—Quarterly (Unaudited)

 

    2009
Quarter ended
(Successor)
  2008
Quarter ended
(Predecessor)
   

(In thousands, except per
share amounts)

  Dec. 31     Sept. 30   June 30   Mar. 31   Dec. 31   Sept. 30   June 30     Mar. 31

INTEREST INCOME

  $ 275,481      314,386   293,948   278,107   310,998   296,134   277,015      288,034

INTEREST EXPENSE

    —        148   68   164   349   961   1,344      3,494
                                     

Net interest income

    275,481      314,238   293,880   277,943   310,649   295,173   275,671      284,540

Provision for credit losses

    76,031      48,321   79,337   13,884   134,500   36,325   125,219      25,561
                                     

Net interest income after provision for credit losses

    199,450      265,917   214,543   264,059   176,149   258,848   150,452      258,979
                                     

OTHER INCOME

               

Gain (loss) on interest rate swaps

    554      1,853   328   1,349   11,511   1,586   (5,205   8,167

Other income

    407      321   258   180   5,874   150   187      232
                                     

Total other income

    961      2,174   586   1,529   17,385   1,736   (5,018   8,399
                                     

NONINTEREST EXPENSE

               

Loan servicing costs

    16,218      15,750   16,591   17,411   17,014   16,552   15,799      15,922

Management fees

    1,644      2,797   2,697   3,102   5,667   1,150   7,071      4,787

Other

    999      1,754   569   442   774   647   659      451
                                     

Total noninterest expense

    18,861      20,301   19,857   20,955   23,455   18,349   23,529      21,160
                                     

Income before income tax expense

    181,550      247,790   195,272   244,633   170,079   242,235   121,905      246,218

Income tax expense (benefit)

    (1,827   856   1,430   1,136   5,492   2,365   (101   5,405
                                     

Net income

    183,377      246,934   193,842   243,497   164,587   239,870   122,006      240,813

Dividends on preferred stock

    36,757      34,975   43,004   45,942   78,004   63,688   62,499      89,038
                                     

Net income available to common stockholders

  $ 146,620      211,959   150,838   197,555   86,583   176,182   59,507      151,775
                                     

PER COMMON SHARE DATA

               

Basic earnings

  $ 1.47      2.12   1.51   1.98   0.87   1.76   0.60      1.52

Diluted earnings

  $ 1.47      2.12   1.51   1.98   0.87   1.76   0.60      1.52

AVERAGE SHARES

               

Average common shares outstanding

    99,999,900      99,999,900   99,999,900   99,999,900   99,999,900   99,999,900   99,999,900      99,999,900

Diluted average common shares outstanding

    99,999,900      99,999,900   99,999,900   99,999,900   99,999,900   99,999,900   99,999,900      99,999,900

 

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Item 9.    Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None.

 

Item 9A.    Controls and Procedures.

 

As a subsidiary of Wells Fargo, we are a part of Wells Fargo’s internal control procedures, including internal controls over financial reporting. The following is a discussion of our process of evaluating and maintaining internal controls over financial reporting.

 

Disclosure Controls and Procedures

 

As required by SEC rules, Wachovia Funding’s management evaluated the effectiveness, as of December 31, 2009, of Wachovia Funding’s disclosure controls and procedures. Wachovia Funding’s chief executive officer and chief financial officer participated in the evaluation. Based on this evaluation, Wachovia Funding’s chief executive officer and chief financial officer concluded that the disclosure controls and procedures were effective as of December 31, 2009.

 

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, Wachovia Funding’s principal executive and principal financial officer and effected by Wachovia Funding’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 GAAP and includes those policies and procedures that:

 

  Ÿ  

pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets;

 

  Ÿ  

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 Wells Fargo are being made only in accordance with authorizations of management and directors of Wells Fargo; and

 

  Ÿ  

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of 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 any quarter in 2009 that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting. Management’s report on internal control over financial reporting is set forth below, and should be read with these limitations in mind.

 

Management’s Report on Internal Control Over Financial Reporting

 

Management assessed the effectiveness of internal control over financial reporting as of December 31, 2009, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. Based on this assessment, management concluded that as of December 31, 2009, Wachovia Funding’s internal control over financial reporting was effective.

 

 

40


Table of Contents

Management is also responsible for the preparation and fair presentation of the consolidated financial statements and other financial information contained in this report. The accompanying consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles and include, as necessary, best estimates and judgments by management.

 

KPMG LLP, an independent, registered public accounting firm, has audited Wachovia Funding’s consolidated balance sheets as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2009, as stated in their report which is included herein. This Annual Report on Form 10-K does not include an attestation report of Wachovia Funding’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by Wachovia Funding’s independent registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit Wachovia Funding to provide only management’s report in this Annual Report on Form 10-K.

 

Item 9B.    Other Information.

 

Not applicable.

 

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PART III

 

Item 10.    Directors and Executive Officers and Corporate Governance.

 

Information required by this item is set forth under the captions “Nominees for Election at the 2010 Annual Meeting”, “Section 16(a) Beneficial Ownership Reporting Compliance”, “Attendance and Committees of the Board – Communications with Directors”, “Attendance and Committees of the Board – Code of Ethics”, and “Attendance and Committees of the Board – Audit Committee” of Wachovia Funding’s 2010 proxy statement to be filed with the SEC no later than April 30, 2010, and incorporated by reference herein.

 

Executive Officers of Wachovia Funding

 

Howard I. Atkins (age 59). Chief Financial Officer since February 2009. Also, Senior Executive Vice President and Chief Financial Officer, Wells Fargo, since August 2005 and Executive Vice President and Chief Financial Officer, Wells Fargo, from August 2001 to August 2005.

 

Mark C. Oman (age 55). Chief Executive Officer since February 2009. Also, Senior Executive Vice President (Home and Consumer Finance), Wells Fargo, since August 2005 and Group Executive Vice President (Home and Consumer Finance), Wells Fargo, from September 2002 to August 2005.

 

Item 11.    Executive Compensation.

 

Information required by this item is set forth under the captions “Director Compensation” and “Executive Compensation” of Wachovia Funding’s 2010 proxy statement to be filed with the SEC no later than April 30, 2010, and incorporated by reference herein.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

 

Information required by this item is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” of Wachovia Funding’s 2010 proxy statement to be filed with the SEC no later than April 30, 2010, and incorporated by reference herein.

 

Item 13.    Certain Relationships and Related Transactions, and Director Independence.

 

Information required by this item is set forth under the caption “Director Independence” of Wachovia Funding’s 2010 proxy statement to be filed with the SEC no later than April 30, 2010, and incorporated by reference herein.

 

Item 14.    Principal Accounting Fees and Services.

 

Information required by this item is set forth under the caption “Independent Registered Public Accounting Firm” of Wachovia Funding’s 2010 proxy statement to be filed with the SEC no later than April 30, 2010, and incorporated by reference herein.

 

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PART IV

 

Item 15.    Exhibits, Financial Statement Schedules.

 

The following consolidated financial statements of Wachovia Funding and its subsidiaries at December 31, 2009, are included in this report at the pages indicated.

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Balance Sheets

   F-3

Consolidated Statements of Operations

   F-4

Consolidated Statements of Changes in Stockholders’ Equity

   F-5

Consolidated Statements of Cash Flows

   F-6

Notes to Consolidated Financial Statements

   F-7

 

A list of the exhibits to this Form 10-K is set forth on the Exhibit Index immediately preceding such exhibits and is incorporated herein by reference. All financial statement schedules are omitted since the required information is either not applicable, is immaterial or is included in our consolidated financial statements and notes thereto.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

Consolidated Financial Statements

 

December 31, 2009, 2008 and 2007

 

(With Report of Independent Registered Public Accounting Firm Thereon)

 

F-1


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors

Wachovia Preferring Funding Corp.

 

We have audited the accompanying consolidated balance sheets of Wachovia Preferred Funding Corp. and subsidiaries, a subsidiary of Wells Fargo & Company, as of December 31, 2009 and 2008 (Successor), and the related consolidated statements of operations , changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2009 (Successor in 2009 and Predecessor in 2008 and 2007). These consolidated financial statements are the responsibility of Wachovia Preferred Funding Corp.’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Wachovia Preferred Funding Corp. and subsidiaries as of December 31, 2009 and 2008 (Successor), and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009 (Successor in 2009 and Predecessor in 2008 and 2007), in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 1 to the consolidated financial statements, effective December 31, 2008, Wells Fargo & Company acquired all of the outstanding stock of Wachovia Corporation in a business combination accounted for as a purchase. Prior to the acquisition, Wachovia Preferred Funding Corp. was a subsidiary of Wachovia Corporation. As a result of the acquisition, the consolidated financial information of Wachovia Preferred Funding Corp. for the period after the acquisition is presented on a different cost basis than that for the periods before the acquisition, and therefore, is not comparable.

 

As discussed in Note 1 to the consolidated financial statements, Wachovia Preferred Funding Corp. changed its method of accounting for collateral associated with derivative contracts during 2007.

 

/s/    KPMG LLP

 

Charlotte, North Carolina

March 23, 2010

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

December 31, 2009 and December 31, 2008

 

     December 31,     December 31,  

(In thousands, except share data)

   2009     2008  
     (Successor)     (Successor)  

ASSETS

    

Cash and cash equivalents

   $ 2,092,523      1,358,129   

Loans, net of unearned income

     16,401,604      17,481,505   

Allowance for loan losses

     (337,431   (269,343
              

Loans, net

     16,064,173      17,212,162   
              

Interest rate swaps

     976      1,273   

Accounts receivable—affiliates, net

     166,388      167,004   

Other assets

     86,068      98,347   
              

Total assets

   $ 18,410,128      18,836,915   
              

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Liabilities

    

Line of credit with affiliate

   $ —        170,000   

Deferred income tax liabilities

     49,971      62,129   

Other liabilities

     24,834      18,758   
              

Total liabilities

     74,805      250,887   
              

Stockholders’ equity

    

Preferred stock

    

Series A preferred securities, $0.01 par value per share, $750 million liquidation preference, non-cumulative and conditionally exchangeable, 30,000,000 shares authorized, issued and outstanding in 2009 and 2008

     300      300   

Series B preferred securities, $0.01 par value per share, $1.0 billion liquidation preference, non-cumulative and conditionally exchangeable, 40,000,000 shares authorized, issued and outstanding in 2009 and 2008

     400      400   

Series C preferred securities, $0.01 par value per share, $4.2 billion liquidation preference, cumulative, 5,000,000 shares authorized, 4,233,754 shares issued and outstanding in 2009 and 2008

     43      43   

Series D preferred securities, $0.01 par value per share, $913,000 liquidation preference, non-cumulative, 913 shares authorized, issued and outstanding in 2009 and 2008

     —        —     

Common stock, $0.01 par value, 100,000,000 shares authorized, 99,999,900 shares issued and outstanding in 2009 and 2008

     1,000      1,000   

Additional paid-in capital

     18,526,608      18,584,285   

Retained earnings (deficit)

     (193,028   —     
              

Total stockholders’ equity

     18,335,323      18,586,028   
              

Total liabilities and stockholders’ equity

   $ 18,410,128      18,836,915   
              

 

See accompanying notes to consolidated financial statements.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

Years Ended December 31, 2009, 2008 and 2007

 

(In thousands, except per share data and average shares)

   2009    2008    2007
     (Successor)    (Predecessor)    (Predecessor)

INTEREST INCOME

   $ 1,161,922    1,172,181    1,227,916

INTEREST EXPENSE

     380    6,148    28,618
                

Net interest income

     1,161,542    1,166,033    1,199,298

Provision for credit losses

     217,573    321,605    21,162
                

Net interest income after provision for credit losses

     943,969    844,428    1,178,136
                

OTHER INCOME

        

Gain on interest rate swaps

     4,084    16,059    7,565

Other income

     1,166    6,443    1,117
                

Total other income

     5,250    22,502    8,682
                

NONINTEREST EXPENSE

        

Loan servicing costs

     65,970    65,287    62,108

Management fees

     10,240    18,675    39,132

Other

     3,764    2,531    1,707
                

Total noninterest expense

     79,974    86,493    102,947
                

Income before income tax expense

     869,245    780,437    1,083,871

Income tax expense

     1,595    13,161    16,838
                

Net income

     867,650    767,276    1,067,033

Dividends on preferred stock

     160,678    293,229    387,483
                

Net income available to common stockholders

   $ 706,972    474,047    679,550
                

PER COMMON SHARE DATA

        

Basic earnings

   $ 7.07    4.74    6.80

Diluted earnings

   $ 7.07    4.74    6.80

AVERAGE SHARES

        

Basic

     99,999,900    99,999,900    99,999,900

Diluted

     99,999,900    99,999,900    99,999,900

 

See accompanying notes to consolidated financial statements.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

 

Years Ended December 31, 2009, 2008 and 2007

 

(In thousands, except per share data)

  Preferred
Stock
  Common
Stock
  Additional
Paid-in Capital
    Retained
Earnings
    Total  

Balance, December 31, 2006 (Predecessor)

  $ 743   1,000   17,467,786      361,663      17,831,192   

Net income

    —     —     —        1,067,033      1,067,033   

Cash dividends

         

Series A preferred securities at $1.81 per share

    —     —     —        (54,375   (54,375

Series B preferred securities at $1.79 per share

    —     —     —        (71,559   (71,559

Series C preferred securities at $61.76 per share

    —     —     —        (261,471   (261,471

Series D preferred securities at $85.00 per share

    —     —     —        (78   (78

Common stock at $6.67 per share

    —     —     —        (667,000   (667,000
                           

Balance, December 31, 2007 (Predecessor)

    743   1,000   17,467,786      374,213      17,843,742   

Net income

    —     —     —        767,276      767,276   

Cash dividends

         

Series A preferred securities at $1.81 per share

    —     —     —        (54,375   (54,375

Series B preferred securities at $1.34 per share

    —     —     —        (53,550   (53,550

Series C preferred securities at $43.75 per share

    —     —     —        (185,226   (185,226

Series D preferred securities at $85.00 per share

    —     —     —        (78   (78

Common stock at $6.95 per share

    —     —     —        (695,000   (695,000

Changes incident to business combinations

    —     —     1,116,499      (153,260   963,239   
                           

Balance, December 31, 2008 (Successor)

    743   1,000   18,584,285      —        18,586,028   

Net income

    —     —     —        867,650      867,650   

Cash dividends

         

Series A preferred securities at $1.81 per share

    —     —     —        (54,375   (54,375

Series B preferred securities at $0.68 per share

    —     —     —        (27,123   (27,123

Series C preferred securities at $18.68 per share

    —     —     —        (79,102   (79,102

Series D preferred securities at $85.00 per share

    —     —     —        (78   (78

Common stock at $9.00 per share

    —     —     —        (900,000   (900,000

Changes incident to business combinations

    —     —     (57,677   —        (57,677
                           

Balance, December 31, 2009 (Successor)

  $ 743   1,000   18,526,608      (193,028   18,335,323   
                           

 

See accompanying notes to consolidated financial statements.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years Ended December 31, 2009, 2008 and 2007

(In thousands)

   2009     2008     2007  
     (Successor)     (Predecessor)     (Predecessor)  

OPERATING ACTIVITIES

      

Net income

   $ 867,650      767,276      1,067,033   

Adjustments to reconcile net income to net cash provided (used) by operating activities

      

Amortization/(accretion) of premium/discount on loans

     (126,903   1,510      3,686   

Provision for loan losses

     217,573      321,605      21,162   

Deferred income tax benefits

     (12,158   (8,236   (3,369

Interest rate swaps

     (4,444   (21,627   (24,150

Accounts receivable/payable—affiliates, net

     1,874      —        2,115   

Other assets and other liabilities, net

     20,506      (4,128   (156
                    

Net cash provided by operating activities

     964,098      1,056,400      1,066,321   
                    

INVESTING ACTIVITIES

      

Increase in cash realized from

      

Loans, net

     996,318      3,201      177,782   

Interest rate swaps

     71,046      71,046      70,849   
                    

Net cash provided by investing activities

     1,067,364      74,247      248,631   
                    

FINANCING ACTIVITIES

      

Decrease in cash realized from

      

Line of credit with affiliate

     (170,000   (130,000   (200,000

Collateral held on interest rate swaps

     (66,305   (49,103   (47,630

Cash dividends paid

     (1,060,763   (988,144   (1,054,614
                    

Net cash used by financing activities

     (1,297,068   (1,167,247   (1,302,244
                    

Increase (decrease) in cash and cash equivalents

     734,394      (36,600   12,708   

Cash and cash equivalents, beginning of period

     1,358,129      1,394,729      1,382,021   
                    

Cash and cash equivalents, end of period

   $ 2,092,523      1,358,129      1,394,729   
                    

CASH PAID FOR

      

Interest

   $ 740      11,717      45,203   

Income taxes

     13,278      25,838      23,711   

CHANGE IN NONCASH ITEMS

      

Dividends payable to affiliates

     (85   85      (131

Loan payments, net, settled through affiliate

     (1,258   62,781      1,559   

Transfers from loans to foreclosed assets

   $ 2,370      1,472      1,408   
                    

 

See accompanying notes to consolidated financial statements.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

NOTE 1:    SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES

 

GENERAL

 

Wachovia Preferred Funding Corp. and its subsidiaries (“Wachovia Funding”) is a subsidiary of its parent company, Wachovia Preferred Funding Holding Corp. (“Wachovia Preferred Holding”), which owns 99.85%, or 99,851,752 shares, of Wachovia Funding’s common stock. Wells Fargo & Company, a Delaware corporation (“Wells Fargo”) owns the remaining 148,148 shares, or 0.15%, of Wachovia Funding. Wachovia Preferred Holding is an indirect subsidiary of Wachovia Bank, National Association (the “Bank”), which owns 99.95%, or 4,368 shares, of Wachovia Preferred Holding’s common stock. Wells Fargo owns the remaining 0.05%, or 2 shares, of Wachovia Preferred Holding’s common stock. The Bank is a wholly-owned subsidiary of Wells Fargo. Wachovia Funding has publicly-traded preferred stock outstanding and has a principal business objective to acquire, hold and manage domestic mortgage assets and other authorized investments that will generate income for distribution to Wachovia Funding’s stockholders. On March 20, 2010, the Bank merged into Wells Fargo Bank, National Association (“WFBNA”), with WFBNA as the surviving entity.

 

On December 31, 2008, Wells Fargo acquired Wachovia Corporation, a North Carolina corporation (“Wachovia”). As a result of this acquisition, each outstanding share of Wachovia common stock was converted into 0.1991 shares of Wells Fargo common stock and each share of Wachovia preferred stock outstanding or reserved for issuance was converted into a share of Wells Fargo preferred stock with substantially identical terms. Following the acquisition, all subsidiaries of Wachovia became subsidiaries of Wells Fargo. On January 2, 2009, Wells Fargo created a new legal entity, Wachovia Corporation, a Delaware corporation (“New Wachovia”), to which it contributed all former subsidiaries of Wachovia. The acquisition did not directly affect the outstanding shares of capital stock of Wachovia Funding. However, the Wachovia Funding Series A preferred securities are now conditionally exchangeable for shares of Wells Fargo preferred stock instead of Wachovia preferred stock. In November 2009, in a corporate reorganization, New Wachovia was merged into Wells Fargo.

 

As a result of the Wells Fargo acquisition of Wachovia, under purchase accounting, the assets and liabilities of Wachovia Funding were recorded at their respective fair values at December 31, 2008. The more significant fair value adjustments were recorded to the loan portfolio. Because the acquisition occurred on the last day of the reporting period, the income statement for 2008 was not affected by purchase accounting. Information for periods not affected by purchase accounting are labeled herein as “predecessor” and post-acquisition periods reflecting purchase accounting are labeled “successor.”

 

One of Wachovia Funding’s subsidiaries, Wachovia Real Estate Investment Corp. (“WREIC”), a Delaware corporation, has operated as a real estate investment trust (“REIT”) since its formation in 1996. Of the 645 shares of WREIC common shares outstanding, Wachovia Funding owns 644 shares, or 99.84%, and the remaining 1 share is owned by Wells Fargo. Of the 667 shares of preferred stock outstanding, Wachovia Funding owns 533.3 shares, 127 shares are owned by employees of Wells Fargo or its affiliates and 6.7 shares are owned by Wells Fargo.

 

Wachovia Funding’s other subsidiary is Wachovia Preferred Realty, LLC (“WPR”), a Delaware limited liability company. Under the REIT Modernization Act, a REIT is permitted to own “taxable REIT subsidiaries,” which are subject to taxation similar to corporations that do not qualify as REITs or for other special tax rules. WPR is a taxable REIT subsidiary that holds assets that earn non-qualifying REIT income.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

WPR holds interest-rate swaps and related cash collateral. Wachovia Funding owns 98.20% of the outstanding member interests in WPR and the remaining 1.80% is owned by the Bank.

 

The accounting and reporting policies of Wachovia Funding are in accordance with U.S. generally accepted accounting principles (“GAAP”). The more significant of these policies used in preparing the consolidated financial statements are described in this summary. The preparation of the financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

 

Effective July 1, 2009, the Financial Accounting Standards Board (“FASB”) established the FASB Accounting Standards CodificationTM (“Codification”) as the source of authoritative GAAP for companies to use in the preparation of their financial statements. SEC rules and interpretive releases are also authoritative GAAP for SEC registrants. The guidance contained in the Codification supersedes all existing non-SEC accounting and reporting standards. We adopted the Codification, as required, in third quarter 2009. As a result, references to accounting literature contained in our financial statement disclosures have been updated to reflect the new Accounting Standards Codification (“ASC”) structure. References to superseded authoritative literature are shown parenthetically under “New Accounting Standards” within this Note.

 

BUSINESS COMBINATIONS

 

A business combination occurs when an entity acquires net assets that constitute a business, or acquires equity interests in one or more other entities that are businesses and obtains control over those entities. Business combinations may be effected through the transfer of consideration such as cash, other financial or nonfinancial assets, debt, or common or preferred shares. The assets and liabilities of an acquired entity or business are recorded at their respective fair values as of the closing date of the merger. Fair values are preliminary and subject to refinement for up to one year after the closing date of a merger as information relative to closing date fair values becomes available. All business combinations are accounted for using the purchase method.

 

As a result of the December 31, 2008, Wells Fargo acquisition of Wachovia, the assets and liabilities of Wachovia Funding were adjusted to their respective acquisition date fair values. Certain loans acquired from Wachovia had evidence of deterioration in credit quality since origination, and it was probable at the date of acquisition that we would not collect all contractual principal and interest. These loans are accounted for using the measurement provisions for purchased credit-impaired (“PCI”) loans, which are contained in the Receivables topic (FASB ASC 310) of the Codification and were previously referred to as “SOP 03-3” loans. In accordance with the accounting guidance for PCI loans, no allowance for loan losses was carried over or initially recorded. At December 31, 2008, Wachovia Funding’s purchase accounting adjustments totaled $963.2 million and included a net increase of $907.1 million to loans, a reduction of $55.6 million to the allowance for loan losses related to PCI loans, an increase of $0.8 million to other assets, and an increase of $0.3 million to other liabilities. There was no goodwill recorded for Wachovia Funding in relation to the acquisition; the net purchase accounting adjustments were recorded as a net increase of $963.2 million in additional paid-in capital. The net adjustment to loans included a decrease for PCI loans.

 

Because the transaction closed on the last day of the 2008 annual reporting period, certain fair value purchase accounting adjustments were based on data as of an interim period with estimates through year end.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

Accordingly, we have re-validated and, where necessary, refined our purchase accounting adjustments. During 2009, Wachovia Funding’s December 31, 2008, purchase accounting adjustments were revised by $57.7 million which included a decrease of $59.4 million to loans. These refinements to the initial December 31, 2008, purchase accounting adjustments of $963.2 million resulted in revised total purchase accounting adjustments of $905.5 million.

 

At December 31, 2009 and 2008, PCI loans had an unpaid principal balance of $227.4 million and $410.9 million, respectively. At December 31, 2009 and 2008, the carrying value of PCI loans was $161.4 million and $227.3 million, respectively. The nonaccretable difference declined $121.2 million from December 31, 2008 to December 31, 2009, primarily from usage due to the recognition of losses from loan resolutions and write-downs. The balance of the accretable yield for PCI loans declined $6.3 million, from $24.5 million at December 31, 2008 to $18.2 million at December 31, 2009, primarily as a result of income accretion. At December 31, 2009, the allowance for loan losses included $10.0 million related to PCI loans. Amounts for PCI loans at December 31, 2008 were refined during 2009, as permitted under purchase accounting, to reflect additional loans as PCI based on additional information that became available.

 

CONSOLIDATION

 

The consolidated financial statements include the accounts of Wachovia Funding and its subsidiaries. In consolidation, all significant intercompany accounts and transactions are eliminated.

 

CASH AND CASH EQUIVALENTS

 

Cash and cash equivalents include cash and due from banks and interest-bearing bank balances. Generally, cash and cash equivalents have maturities of three months or less, and accordingly, the carrying amount of these instruments is deemed to be a reasonable estimate of fair value.

 

LOANS

 

Wachovia Funding purchases certain loans from the Bank at fair value. While these transfers represent legal sales by the Bank, they are not treated as sales under GAAP because of the Bank’s direct and indirect ownership interest in Wachovia Funding. Accordingly, Wachovia Funding’s assets represent non-recourse receivables from the Bank which are fully collateralized by the underlying loans. The assets continue to be classified as loans in Wachovia Funding’s financial statements because the returns on and recoverability of these non-recourse receivables are entirely dependent on the performance of the underlying loans. At December 31, 2009, the outstanding balance of these loans purchased from the Bank amounted to $12.9 billion. The remainder of Wachovia Funding’s outstanding loan balance was received through a contribution of assets in 2005 and prior years from Wachovia Preferred Holding, its parent corporation. Immediately prior to the contribution, Wachovia Preferred Holding received a contribution of the same assets from the Bank. These contributed assets were recorded as an increase to loans and to additional paid-in capital.

 

Loans are recorded at the principal balance outstanding, net of any charge-offs and applicable premium or discount. Interest income is recognized on an accrual basis. Premiums and discounts are amortized as an adjustment to the yield over the term of the loan. If a prepayment occurs on a loan, any related premium or discount is recognized as an adjustment to yield in the results of operations in the period in which the prepayment occurs.

 

A loan is considered to be impaired when based on current information, it is probable Wachovia Funding will not receive all amounts due in accordance with the contractual terms of a loan agreement. The amount of a loan’s impairment is measured based on either the present value of expected future cash flows

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. A loan is also considered impaired if its terms are modified in a troubled debt restructuring.

 

When the ultimate collectibility of the principal balance of an impaired loan is in doubt, all cash receipts are applied to principal. Once the recorded principal balance has been reduced to zero, future cash receipts are recorded as recoveries of any amounts previously charged off, and then applied to interest income, to the extent any interest has been foregone.

 

The accrual of interest is generally discontinued on commercial loans that become 90 days past due as to principal or interest, or where reasonable doubt exists as to collection, unless well secured and in the process of collection. Consumer real estate loans that become 120 days past due are placed on nonaccrual status. When borrowers demonstrate over an extended period the ability to repay a loan in accordance with the contractual terms of a loan classified as nonaccrual, the loan is returned to accrual status. These loans are charged off or charged down to the net realizable value of the collateral when deemed uncollectible, due to bankruptcy or other factors, or when they reach a defined number of days past due based on loan product, industry practice, terms and other factors.

 

PURCHASED CREDIT-IMPAIRED LOANS

 

Loans acquired in a transfer, including business combinations where there is evidence of credit deterioration since origination and it is probable at the date of acquisition that we will not collect all contractually required principal and interest payments are accounted for using the guidance for PCI loans, which is contained in the Receivables topic of the Codification. PCI loans are initially recorded at fair value, and any related allowance for loan losses cannot be carried over.

 

Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status, recent borrower credit scores and recent loan-to-value percentages. Generally, acquired loans that meet our definition for nonaccrual status are considered to be credit-impaired.

 

Accounting for PCI loans at acquisition involves estimating fair value using the principal and interest cash flows expected to be collected on the credit impaired loans and discounting those cash flows at a market rate of interest. The excess of cash flows expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan, or pool of loans, in situations where there is a reasonable expectation about the timing and amount of cash flows to be collected. The difference between contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference.

 

Subsequent to acquisition, we complete quarterly evaluations of expected cash flows. Decreases in the expected cash flows will generally result in a charge to the provision for credit losses resulting in an increase to the allowance for loan losses. Increases in the expected cash flows will generally result in an increase in interest income over the remaining life of the loan, or pool of loans. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or part by the borrower, and foreclosure of the collateral result in removal of the loan from the PCI loan portfolio at its carrying amount.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

Because PCI loans are written down at acquisition to an amount estimated to be collectible, such loans are not classified as nonaccrual even though they may be contractually past due. We expect to fully collect the new carrying values of such loans (that is, the new cost basis arising out of purchase accounting). PCI loans are also excluded from the disclosure of loans 90 days or more past due and still accruing interest. Even though substantially all of them are 90 days or more contractually past due, they are considered to be accruing because the interest income on these loans relates to the establishment of an accretable yield that is accreted into interest income over the estimated life of the PCI loans using the effective yield method.

 

ALLOWANCE FOR LOAN LOSSES AND RESERVE FOR UNFUNDED CREDIT COMMITMENTS

 

The allowance for loan losses and reserve for unfunded credit commitments (collectively, the “allowance for credit losses”) is management’s estimate of credit losses inherent in the loan portfolio and in unfunded commercial lending commitments, respectively, as of the date of the consolidated financial statements.

 

DERIVATIVES

 

All derivatives (primarily interest rate swaps) are recorded at fair value on the balance sheet. Realized and unrealized gains and losses are included as a gain (loss) on interest rate swaps in the results of operations. In connection with Wachovia Fundings’ derivative activities, Wachovia Funding may obtain collateral from, or deliver collateral to derivative counterparties. The amount of collateral required is based on the level of credit risk and on the strength of the individual counterparty. Generally, the form of the collateral required is cash. All of our derivatives are economic hedges and none are treated as accounting hedges.

 

Derivatives are reported net of cash collateral received and paid. Additionally, positions with the same counterparty are netted as a part of a legally enforceable master netting agreement between Wachovia Funding and the derivative counterparty in accordance with FASB ASC 815, Derivatives and Hedging.

 

At December 31, 2009, receive-fixed interest rate swaps with a notional amount of $4.1 billion had a weighted average maturity of 2.46 years, weighted average receive rate of 7.45% and weighted average pay rate of 0.25%. Pay-fixed interest rate swaps with a notional amount of $4.1 billion had a weighted average maturity of 2.46 years, weighted average receive rate of 0.25% and weighted average pay rate of 5.72% at December 31, 2009. All of the interest rate swaps have variable pay or receive rates based on three- or six-month LIBOR.

 

INCOME TAXES

 

Wachovia Funding and WREIC are taxed as REITs under relevant sections of the Internal Revenue Code (the “Code”). A REIT is generally not subject to federal income tax to the extent it complies with the relevant provisions of the Code, including distributing the majority of its taxable earnings to shareholders and as long as certain asset, income and stock ownership tests are met. For the tax year ended December 31, 2009, Wachovia Funding and WREIC complied with these provisions and, with the exception of WPR, are not subject to federal income tax. Wachovia Funding and WREIC file separate federal income tax returns for the tax years ended December 31, 2009, 2008, and 2007, and therefore are not included in the Wells Fargo (2009) or Wachovia (2008 and 2007) consolidated tax returns or subject to the allocation of federal income tax liability (benefit) resulting from these consolidated tax returns. In addition, Wachovia Funding and WREIC will file unitary state income tax returns along with other subsidiaries of Wells Fargo in 2009 and filed with Wachovia in 2008 and 2007.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

For the tax year ending December 31, 2009, we expect to be taxed as a REIT, and we intend to comply with the relevant provisions of the Code to be taxed as a REIT. These provisions for qualifying as a REIT for federal income tax purposes are complex, involving many requirements, including among others, distributing the majority of our earnings to shareholders and satisfying certain asset, income and stock ownership tests. To the extent we meet those provisions, with the exception of the income of our taxable REIT subsidiary, WPR, we will not be subject to federal income tax on net income. We currently believe that we continue to satisfy each of these requirements and therefore continue to qualify as a REIT. We continue to monitor each of these complex tests.

 

In the event we do not continue to qualify as a REIT, we believe there should be minimal adverse effect of that characterization to us or to our shareholders:

 

  Ÿ  

From a shareholder’s perspective, the dividends we pay as a REIT are ordinary income not eligible for the dividends received deduction for corporate shareholders or for the favorable maximum 15% rate applicable to qualified dividends received by non-corporate taxpayers. If we were not a REIT, dividends we pay generally would qualify for the dividends received deduction and the favorable tax rate applicable to non-corporate taxpayers.

 

  Ÿ  

In addition, we would no longer be eligible for the dividends paid deduction, thereby creating a tax liability for us. Wells Fargo agreed to make, or cause its subsidiaries to make, a capital contribution to us equal in amount to any income taxes payable by us. Therefore, we believe a failure to qualify as a REIT would not result in any net capital impact to us.

 

WPR has elected to be taxed as a corporation and a taxable REIT subsidiary. WPR files its own separate federal income tax return, and current federal income taxes, if any, for WPR are separately calculated and paid. In addition, WPR will file unitary state income tax returns along with other subsidiaries of Wells Fargo in 2009 and has filed with Wachovia in 2008 and 2007.

 

EARNINGS PER SHARE

 

Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share is computed by dividing income available to common stockholders by the sum of the weighted average number of shares adjusted to include the effect of potentially dilutive shares. Income available to common stockholders is computed as net income less dividends on preferred stock. There were no potentially dilutive shares in any period presented and accordingly, basic and diluted earnings per share are the same.

 

NEW ACCOUNTING STANDARDS

 

In first quarter 2009, we adopted new guidance related to the following Codification topics:

 

  Ÿ  

FASB ASC 815-10, Derivatives and Hedging (FAS 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133);

 

  Ÿ  

FASB ASC 810-10, Consolidation (FAS 160, Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51); and

 

  Ÿ  

FASB ASC 820-10, Fair Value Measurements and Disclosures (FASB Staff Position (FSP) FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly).

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

In second quarter 2009, we adopted new guidance related to the following Codification topics:

 

  Ÿ  

FASB ASC 825-10, Financial Instruments (FSP FAS 107-1 and APB Opinion 28-1, Interim Disclosures about Fair Value of Financial Instruments); and

 

  Ÿ  

FASB ASC 855-10, Subsequent Events (FAS 165, Subsequent Events).

 

In third quarter 2009, we adopted new guidance related to the following Codification topic:

 

  Ÿ  

FASB ASC 105-10, Generally Accepted Accounting Principles (FAS 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162).

 

In fourth quarter 2009, we adopted the following new accounting guidance:

 

  Ÿ  

Accounting Standards Update (ASU or Update) 2009-5, Measuring Liabilities at Fair Value.

 

Our adoption of the Codification in third quarter 2009 is discussed earlier in this Note. The remaining pronouncements are described in more detail below.

 

FASB ASC 815-10 changes the disclosure requirements for derivative instruments and hedging activities. It requires enhanced disclosures about how and why an entity uses derivatives, how derivatives and related hedged items are accounted for, and how derivatives and hedged items affect an entity’s financial position, performance and cash flows. We adopted this pronouncement for first quarter 2009 reporting. See Note 6 in this Report for disclosures on derivatives and hedging activities. This standard does not affect our consolidated financial statements since it amends only the disclosure requirements for derivative instruments and hedged items.

 

FASB ASC 810-10 requires that noncontrolling interests (previously referred to as minority interests) be reported as a component of equity in the balance sheet. Prior to our adoption of this standard, noncontrolling interests were classified in liabilities or between liabilities and equity. This new standard also changes the way a noncontrolling interest is presented in the income statement such that a parent’s consolidated income statement includes amounts attributable to both the parent’s interest and the noncontrolling interest. When a subsidiary is deconsolidated, a parent is required to recognize a gain or loss with any remaining interest recorded at fair value. Other changes in ownership interest where the parent continues to have a majority ownership interest in the subsidiary are accounted for as equity transactions. This guidance was effective for us on January 1, 2009. Adoption of the new accounting treatment prescribed for noncontrolling interests was not material to Wachovia Funding.

 

FASB ASC 820-10 addresses the use of price quotes when measuring fair value in situations where markets are inactive and transactions are not orderly. Using all available facts and circumstances, companies are required to estimate the degree to which orderly transactions are occurring in markets. Price quotes based upon transactions that are orderly must be considered in determining fair value measurement, and the weight given to the quotes is based upon various factors, including transaction volume and comparability of the transactions to the assets or liabilities being measured. Price quotes based upon transactions that are not orderly should be given little, if any, weight in measuring fair value. Adoption of this pronouncement did not affect our financial statement results.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

FASB ASC 825-10 states that entities must disclose the fair value of financial instruments in interim reporting periods as well as in annual financial statements. Entities must also disclose the methods and assumptions used to estimate fair value as well as any changes in methods and assumptions that occurred during the reporting period. See Note 10 in this Report for related disclosures on financial instruments. Because the new provisions of FASB ASC 825-10 amend only the disclosure requirements related to the fair value of financial instruments, the adoption of this pronouncement does not affect our consolidated financial statements.

 

FASB ASC 855-10 describes two types of subsequent events that previously were addressed in the auditing literature, one that requires post-period end adjustment to the financial statements being issued, and one that requires footnote disclosure only. The requirements for disclosing subsequent events were effective in second quarter 2009 with prospective application. Our adoption of this standard did not have a material impact on our consolidated financial statements.

 

ASU 2009-5 describes the valuation techniques companies should use to measure the fair value of liabilities for which there is limited observable market data. If a quoted price in an active market is not available for an identical liability, an entity should use one of the following approaches: (1) the quoted price of the identical liability when traded as an asset, (2) quoted prices for similar liabilities or similar liabilities when traded as an asset, or (3) another valuation technique that is consistent with the principles of FASB ASC 820, Fair Value Measurements and Disclosures. When measuring the fair value of liabilities, this Update reiterates that companies should apply valuation techniques that maximize the use of relevant observable inputs, which is consistent with existing accounting provisions for fair value measurement. In addition, this Update clarifies when an entity should adjust quoted prices of identical or similar assets that are used to estimate the fair value of liabilities. For example, an entity should not include separate adjustments for contractual restrictions that prevent the transfer of the liability because the restriction would be factored into other inputs used in the fair value measurement of the liability. However, separate adjustments are needed in situations where the unit of account for the asset is not the same as for the liability. This guidance was effective for us in fourth quarter 2009 with adoption applied prospectively. Our adoption of this standard did not have a material impact on our consolidated financial statements.

 

RECLASSIFICATIONS

 

Certain amounts in 2008 and 2007 were reclassified to conform with the presentation in 2009. These reclassifications had no effect on Wachovia Funding’s previously reported consolidated financial position or results of operations.

 

SUBSEQUENT EVENTS

 

We have evaluated the effects of subsequent events that have occurred subsequent to period end December 31, 2009, and through March 23, 2010, which is the date we issued our financial statements. During this period there have been no material events that would require recognition in our 2009 consolidated financial statements or disclosure in the Notes to Consolidated Financial Statements. On March 20, 2010, the Bank merged into WFBNA, with WFBNA as the surviving entity.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

NOTE 2:     FAIR VALUE MEASUREMENTS

 

Wachovia Funding adopted accounting provisions for fair value measurements on January 1, 2008, which established a framework for measuring fair value and expanded disclosures about fair value measurements. Under the fair value framework, fair value measurements must reflect assumptions market participants would use in pricing an asset or liability.

 

The accounting guidance for fair value measurement is included in FASB ASC 820, Fair Value Measurements and Disclosures, which defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market. If there is no principal market, an entity should use the most advantageous market for the specific asset or liability at the measurement date (referred to as an exit price). FASB ASC 820 also includes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels of the fair value hierarchy are:

 

  Ÿ  

Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.

 

  Ÿ  

Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

 

  Ÿ  

Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.

 

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. In accordance with fair value measurement accounting requirements, Wachovia Funding is to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

DETERMINATION OF FAIR VALUE

 

In determining fair value, Wachovia Funding uses market prices of the same or similar instruments whenever such prices are available. A fair value measurement assumes that an asset or liability is exchanged in an orderly transaction between market participants, and accordingly, fair value is not determined based upon a forced liquidation or distressed sale. Where necessary, Wachovia Funding estimates fair value using other market observable data such as prices for synthetic or derivative instruments, market indices, industry ratings of underlying collateral or models employing techniques such as discounted cash flow analyses. The assumptions used in the models, which typically include assumptions for interest rates, credit losses and prepayments, are corroborated by and independently verified against market observable data where possible. Market observable real estate data is used in valuing instruments where the underlying collateral is real estate or where the fair value of an instrument being valued highly correlates to real estate prices. Where appropriate, Wachovia Funding may use a combination of these valuation approaches.

 

Where the market price of the same or similar instruments is not available, the valuation of financial instruments becomes more subjective and involves a high degree of judgment. Where modeling techniques are used, the models are subject to independent validation procedures in accordance with risk management policies and procedures. Further, pricing data is subject to independent verification.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

DERIVATIVES

 

Wachovia Funding’s derivatives are executed over the counter (“OTC”). As no quoted market prices exist for such instruments, OTC derivatives are valued using internal valuation techniques. Valuation techniques and inputs to internally-developed models depend on the type of derivative and the nature of the underlying rate, price or index upon which the derivative’s value is based. Key inputs can include yield curves, credit curves, foreign-exchange rates, prepayment rates, volatility measurements and correlation of such inputs. Where model inputs can be observed in a liquid market and the model selection does not require significant judgment, such derivatives are typically classified within Level 2 of the fair value hierarchy. Examples of derivatives within Level 2 include generic interest rate swaps.

 

ITEMS MEASURED AT FAIR VALUE ON A RECURRING BASIS

 

The following table presents Wachovia Funding’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2009, for each of the fair value hierarchy levels.

 

     December 31, 2009
     (Successor)
(In thousands)    Level 1    Level 2    Level 3    Netting (a)     Total

ASSETS

             

Interest rate swaps

   $  —      578,790      —      (577,814   976
                         

Total assets at fair value

   $  —      578,790       (577,814   976
                         

LIABILITIES

             

Interest rate swaps

   $  —      404,203       (404,203  
                         

Total liabilities at fair value

   $  —      404,203       (404,203  
                         

 

(a) Derivatives are reported net of cash collateral received and paid. Additionally, positions with the same counterparty are netted as a part of a legally enforceable master netting agreement between Wachovia Funding and the derivative counterparty in accordance with FASB ASC 815, Derivatives and Hedging. See Note 6 for additional information on the treatment of master netting arrangements related to derivative contracts.

 

As of December 31, 2009, Wachovia Funding assets or liabilities measured at fair value on a nonrecurring basis were insignificant. Additionally, Wachovia Funding did not elect 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.

 

NOTE 3:    LOANS

 

Wachovia Funding obtains from the Bank participation interests in loans originated or purchased by the Bank. By the nature of Wachovia Funding’s status as a REIT, the composition of the loans underlying the participation interests are highly concentrated in real estate. Underlying loans are concentrated primarily in Florida, Pennsylvania, New Jersey, North Carolina, Virginia and Georgia. These markets include approximately 70% and 78% of Wachovia Funding’s total loan balance at December 31, 2009 and 2008, respectively.

 

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WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

The following table reflects the major categories of the loan portfolio at December 31, 2009 and 2008.

 

     December 31,

(In thousands)

   2009    2008
     (Successor)    (Successor)

COMMERCIAL AND COMMERCIAL REAL ESTATE

     

Commercial

   $ 287,578    386,780

Real estate mortgage

     1,617,576    1,996,050

Real estate construction

     86,579    141,202
           

Total commercial and commercial real estate

     1,991,733    2,524,032
           

CONSUMER

     

Real estate 1-4 family first mortgage

     9,133,283    8,351,320

Real estate 1-4 family junior lien mortgage

     5,276,588    6,606,153
           

Total consumer

     14,409,871    14,957,473
           

Total loans

   $ 16,401,604    17,481,505
           

 

At December 31, 2009 and 2008, nonaccrual loans amounted to $207.5 million and $175 thousand, respectively; restructured loans were $110.6 million at December 31, 2009. At December 31, 2009, nonaccruing restructured loans were $10.0 million. Impairment measurement for TDRs is based on the discounted cash flow method. PCI loans have been classified as accruing. In 2009, $8.0 million in gross interest income would have been recorded if all nonaccrual loans had been performing in accordance with their original terms and if they had been outstanding throughout the entire period, or since origination if held for part of the period. Loans past due 90 days or more as to interest or principal and still accruing interest were $50.5 million at December 31, 2009, and $3.1 million at December 31, 2008.

 

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NOTE 4: ALLOWANCE FOR CREDIT LOSSES

 

The allowance for credit losses consists of the allowance for loan losses and the reserve for unfunded credit commitments. Changes in the allowance for credit losses were:

 

(in thousands)

   2009     2008     2007  
     (Successor)     (Predecessor)     (Predecessor)  

Balance, beginning of year

   $ 269,913      93,583      81,656   

Provision for credit losses

     217,573      321,605      21,162   

Loan charge-offs:

      

Commercial and commercial real estate:

      

Commercial

     (6   826      —     

Real estate mortgage

     (198   (1,073   —     

Real estate construction

     (27   —        —     
                    

Total commercial and commercial real estate

     (231   (247   —     
                    

Consumer:

      

Real estate 1-4 family first mortgage

     (57,770   (45,745   (5,737

Real estate 1-4 family junior lien mortgage

     (95,052   (43,868   (4,189
                    

Total consumer

     (152,822   (89,613   (9,926
                    

Total loan charge-offs

     (153,053   (89,860   (9,926
                    

Loan recoveries:

      

Commercial and commercial real estate:

      

Commercial

     —        —        86   

Real estate mortgage

     4      135      —     

Real estate construction

     —        —        —     
                    

Total commercial and commercial real estate

     4      135      86   
                    

Consumer:

      

Real estate 1-4 family first mortgage

     1,349      279      638   

Real estate 1-4 family junior lien mortgage

     1,920      270      333   
                    

Total consumer

     3,269      549      971   
                    

Total loan recoveries

     3,273      684      1,057   
                    

Net loan charge-offs

     (149,780   (89,176   (8,869
                    

Allowances related to business combinations/other (1)

     165      (56,099   (366
                    

Balance, end of year

   $ 337,871      269,913      93,583   
                    

Components:

      

Allowance for loan losses

   $ 337,431      269,343      93,095   

Reserve for unfunded credit commitments

     440      570      488   
                    

Allowance for credit losses

   $ 337,871      269,913      93,583   
                    

Net loan charge-offs as a percentage of average total loans

     0.88   0.55      0.05   

Allowance for loan losses as a percentage of total loans

     2.06      1.54      0.56   

Allowance for credit losses as a percentage of total loans

     2.06      1.54      0.57   
                    

 

(1) As a result of purchase accounting, the allowance for loan losses is not carried over for PCI loans. Further information on PCI loans is presented in Note 1.

 

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

NOTE 5:    STOCKHOLDERS’ EQUITY

 

Wachovia Funding has authorized preferred and common stock. The preferred securities consist of Series A, Series B, Series C and Series D. Series A, Series B and Series D preferred securities are non- cumulative and only receive dividends when declared by the board of directors. If declared, Series A, Series B and Series D holders will receive 7.25%, three-month LIBOR plus 1.83% and 8.5% per security, respectively. Series C preferred securities have cumulative dividend rights in which holders are entitled to dividends at the rate equal to three-month LIBOR plus 0.85% per annum per security for the first seven years after issuance after which the dividend increased to three-month LIBOR plus 2.25% per annum per security. This increased dividend rate took effect in the fourth quarter of 2009. In order to remain qualified as a REIT, Wachovia Funding must distribute annually at least 90% of taxable earnings.

 

In the event that Wachovia Funding is liquidated or dissolved, the holders of the preferred securities 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 or general unsecured creditors. The liquidation preference is $25.00 for Series A and Series B preferred securities, and $1,000 for Series C and Series D preferred securities. With respect to the payment of dividends and liquidation preference, the Series A preferred securities rank on parity with Series B and Series D preferred securities and senior to the common stock and Series C preferred securities. In the event that a supervisory event occurs in which the Bank is placed into conservatorship or receivership, the Series A and Series B preferred securities are convertible into certain preferred stock of Wells Fargo.

 

NOTE 6:    DERIVATIVES

 

We use derivative financial instruments as economic hedges and none are treated as accounting hedges. By using derivatives, we are exposed to credit risk if counterparties to the derivative contracts do not perform as expected. If a counterparty fails to perform, our counterparty credit risk is equal to the amount reported as a derivative asset in our balance sheet. The amounts reported as a derivative asset are derivative contracts in a gain position, and to the extent subject to master netting arrangements, net of derivatives in a loss position with the same counterparty and cash collateral received. We minimize counterparty credit risk through credit approvals, limits, monitoring procedures, master netting arrangements and collateral, where appropriate. Derivatives balances and related cash collateral amounts are shown net in the balance sheet as long as they are subject to master netting agreements and meet the criteria for net presentation in accordance with FASB ASC 815, Derivatives and Hedging. Counterparty credit risk related to derivatives is considered and, if material, accounted for separately.

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

The total notional amounts and fair values for derivatives of which none of the derivatives are designated as hedging instruments as prescribed in FASB ASC 815 were:

 

     December 31, 2009
(Successor)
    December 31, 2008
(Successor)
 
          Fair value          Fair value  

(In thousands)

   Notional Or
Contractual
Amount
   Asset
Derivatives
    Liability
Derivatives
    Notional Or
Contractual
Amount
   Asset
Derivatives
    Liability
Derivatives
 

Interest rate swaps

   $ 8,200,000      578,790      404,203      8,200,000    775,768      534,578   

Netting (1)

        (577,814   (404,203      (774,495   (534,578
                                

Total

      $ 976      —           1,273      —     
                                

 

(1) Derivatives are reported net of cash collateral received and paid. Additionally, positions with the same counterparty are netted as part of a legally enforceable master netting agreement between Wachovia Funding and the derivative counterparty.

 

Gains recognized in the consolidated statements of income related to derivatives not designated as hedging instruments for 2009 were $4.1 million.

 

NOTE 7:    INCOME TAXES

 

The components of income tax expense were:

 

(In thousands)

   2009     2008     2007  
     (Successor)     (Predecessor)     (Predecessor)  

CURRENT INCOME TAX EXPENSE

      

Federal

   $ 14,928      18,175      17,324   

State

     1,238      3,222      2,883   
                    

Total current income tax expense

     16,166      21,397      20,207   
                    

DEFERRED INCOME TAX EXPENSE (BENEFIT)

      

Federal

     (13,455   (8,245   (3,271

State

     (1,116   9      (98
                    

Total deferred income tax expense (benefit)

     (14,571   (8,236   (3,369
                    

Total income tax expense

   $ 1,595      13,161      16,838   
                    

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

The reconciliation of federal income tax rates and amounts to the effective income tax rates and amounts for each of the years in the three-year period ended December 31, 2009, is presented below.

 

     2009     2008     2007  
     (Successor)     (Predecessor)     (Predecessor)  

(In thousands)

   Amount     % of
Pre-tax
Income
    Amount     % of
Pre-tax
Income
    Amount     % of
Pre-tax
Income
 

Income before income tax expense

   $ 869,245        $ 780,437        $ 1,083,871     
                              

Tax at federal income tax rate

   $ 304,235      35.0   $ 273,153      35.0   $ 379,355      35.0

Reasons for differences in federal income tax rate and effective tax rate

            

REIT income not subject to federal taxation

     (302,720   (34.8     (263,091   (33.7     (365,230   (33.7

State income taxes, net

     80      —          3,099      0.4        2,713      0.3   
                                          

Total

   $ 1,595      0.2   $ 13,161      1.7   $ 16,838      1.6
                                          

 

In 2009, 2008 and 2007, the income before income tax expense of $869.2 million, $780.4 million and $1.1 billion, respectively, included $864.9 million, $751.7 million and $1.0 billion, respectively, of REIT income not subject to federal taxation. The remaining income before income taxes of $4.3 million, $28.7 million and $40.4 million in 2009, 2008 and 2007, respectively, is income before income taxes of WPR. Income tax expense was $1.6 million, $13.2 million and $16.8 million, respectively, for 2009, 2008 and 2007. The decrease in income tax expense for 2009 is primarily related to the decrease in income before income tax expense of WPR and a decrease in state income tax expense related to the adoption of the Wells Fargo tax settlement policy.

 

The sources of temporary differences that give rise to deferred income tax liabilities are interest rate swap contracts. The related tax effects at December 31, 2009, 2008 and 2007, were $50.0 million, $62.1 million and $70.4 million, respectively. In addition, a change in the 2009 net deferred income tax liability of $2.4 million relates to the purchase accounting adjustments recorded due to the acquisition of Wachovia by Wells Fargo.

 

Deferred income tax assets and liabilities are established for WPR to recognize the expected future tax consequences attributable to temporary differences between the financial statement carrying amount and the tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred income tax assets and liabilities is recognized in income during the period that includes the enactment date.

 

At December 31, 2009, WPR had no federal net operating loss carryforwards.

 

Wachovia Funding evaluates uncertain tax positions in accordance with FASB ASC 740, Income Taxes. Based upon its current evaluation, Wachovia Funding has concluded that there are no significant uncertain tax positions relevant to the jurisdictions where it is required to file income tax returns requiring recognition in the financial statements at December 31, 2009.

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

Wachovia Funding recognizes accrued interest and penalties, as appropriate, related to unrecognized income tax benefits in the effective tax rate. Wachovia Funding recognized no interest in 2009 and the balance of accrued interest was zero at December 31, 2009.

 

Management monitors proposed and issued tax law, regulations and cases to determine the potential impact to uncertain income tax positions. At December 31, 2009, management had not identified any potential subsequent events that would have a material impact on unrecognized income tax benefits within the next twelve months.

 

On December 21, 2009, the Internal Revenue Service (the “IRS”) issued a Revenue Agent’s Report for Wachovia for the tax years 2003-2005. There were no material adjustments for Wachovia Funding or its subsidiaries in the IRS report.

 

NOTE 8:    TRANSACTIONS WITH AFFILIATED PARTIES

 

Wachovia Funding, as a subsidiary, is subject to certain income and expense allocations from affiliated parties for various services received. In addition, Wachovia Funding enters into transactions with affiliated parties in the normal course of business. The principal items related to transactions with affiliated parties included in the accompanying consolidated balance sheets and consolidated statements of operations are described below. Due to the nature of common ownership of Wachovia Funding and the affiliated parties by Wells Fargo in 2009, the following transactions could differ from those conducted with unaffiliated parties.

 

Included in loan servicing costs are fees paid to affiliates of $63.0 million in 2009, $64.6 million in 2008 and $61.8 million in 2007. In 2009, Wachovia Funding was assessed monthly management fees based on our relative percentage of the Bank’s total consolidated assets and noninterest expense. Wachovia Funding believes this allocation method represents a reasonable basis for allocating general overhead expenses. For 2008 and 2007, as an affiliate qualifying for an allocation with over $10 million in qualifying assets, Wachovia Funding was assessed management fees based on its relative percentage of total consolidated assets and noninterest expense. These expenses amounted to $10.2 million in 2009, $18.7 million in 2008 and $39.1 million in 2007.

 

At December 31, 2009 and 2008, eurodollar deposit investments due from the Bank included in cash and cash equivalents were $2.1 billion and $1.3 billion, respectively. Interest income earned on eurodollar deposit investments included in interest income was $1.4 million in 2009, $30.9 million in 2008 and $78.5 million in 2007.

 

As part of its investment activities, Wachovia Funding obtains loans and/or 100% interests in loan participations (which are both reflected as loans in the accompanying consolidated financial statements). As of December 31, 2009 and 2008, substantially all of Wachovia Funding’s loans are in the form of loan participation interests. Although Wachovia Funding may purchase loans from third parties, Wachovia Funding has historically purchased from the Bank loan participation interests in loans originated or purchased by the Bank.

 

Wachovia Funding has a swap servicing and fee agreement with the Bank whereby the Bank provides operational, back office, book entry, record keeping and valuation services related to Wachovia Funding’s interest rate swaps. In consideration of these services, Wachovia Funding pays the Bank 0.015% multiplied by

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

the net amount actually paid under the interest rate swaps on the swaps’ payment date. Amounts paid under this agreement were $13 thousand in 2009, $11 thousand in 2008 and $8 thousand in 2007, and were included in loan servicing costs.

 

The Bank acts as collateral custodian for Wachovia Funding in connection with collateral pledged to Wachovia Funding related to the interest rate swaps. For this service, Wachovia Funding pays the Bank a fee equal to the sum of 0.05% multiplied by the fair value of noncash collateral and 0.05% multiplied by the amount of cash collateral. Amounts paid under this agreement were $113 thousand in 2009, $155 thousand in 2008 and $152 thousand in 2007. In addition, the Bank is permitted to rehypothecate and use as its own the collateral held by the Bank as custodian for Wachovia Funding. The Bank pays Wachovia Funding a fee equal to the sum of 0.05% multiplied by the fair value of the noncash collateral the Bank holds as custodian and the amount of cash collateral held multiplied by a market rate of interest. The collateral agreement with the counterparty allows Wachovia Funding to repledge the collateral free of any right of redemption or other right of the counterparty in such collateral without any obligation on Wachovia Funding’s part to maintain possession or control of equivalent collateral. Pursuant to the rehypothecation agreement, Wachovia Funding had invested $173.6 million, $239.9 million and $289.0 million of cash collateral in interest-bearing investments with the Bank or other Wells Fargo subsidiaries at December 31, 2009, 2008 and 2007, respectively. Amounts received under this agreement were $595 thousand in 2009, $13.4 million in 2008 and $34.5 million in 2007, and were included in interest income on eurodollar investments noted above.

 

The Bank also provides a guaranty of Wachovia Funding’s obligations under the interest rate swaps when the swaps are in a net payable position. In consideration, Wachovia Funding pays the Bank a monthly fee in arrears equal to 0.03% multiplied by the absolute value of the net notional amount of the interest rate swaps. No amount was paid under this agreement in 2009, 2008 and 2007.

 

Wachovia Funding has a line of credit with the Bank. Under the terms of that facility, Wachovia Funding can borrow up to $2.2 billion under revolving demand notes at a rate of interest equal to the average federal funds rate. At December 31, 2009, Wachovia Funding had zero outstanding under this facility compared to $170.0 million at December 31, 2008.

 

NOTE 9:    COMMITMENTS, GUARANTEES AND OTHER MATTERS

 

Wachovia Funding’s commercial loan portfolio includes unfunded loan commitments that are provided in the normal course of business. For commercial borrowers, loan commitments generally take the form of revolving credit arrangements to finance customers’ working capital requirements. These instruments are not recorded on the balance sheet until funds are advanced under the commitment. For lending commitments, the contractual amount of a commitment represents the maximum potential credit risk if the entire commitment is funded and the borrower does not perform according to the terms of the contract. A large majority of these commitments expire without being funded, and accordingly, total contractual amounts are not representative of actual future credit exposure or liquidity requirements.

 

Loan commitments create credit risk in the event that the counterparty draws on the commitment and subsequently fails to perform under the terms of the lending agreement. This risk is incorporated into an overall evaluation of credit risk, and to the extent necessary, reserves are recorded on these commitments. Uncertainties around the timing and amount of funding under these commitments may create liquidity risk for Wachovia Funding.

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

The contract or notional amount of commitments to extend credit at December 31, 2009, was $666.7 million. The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the current creditworthiness of the counterparties. The estimated fair value of commitments to extend credit at December 31, 2009, was negative $440 thousand. The estimated fair value of lending commitments is negative due to the current economic environment, and represents the estimated amount that Wachovia Funding would need to pay a third party to assume our December 31, 2009, exposure on lending commitments.

 

As part of the loan participation agreements with the Bank, Wachovia Funding provides an indemnification to the Bank if certain events occur. These contingencies generally relate to claims or judgments arising out of participated loans that are not the result of gross negligence or intentional misconduct by the Bank. Wachovia Funding has not been required to make payments under the indemnification clauses in 2009, 2008 or 2007. Since there are no stated or notional amounts included in the indemnification clauses and the contingencies triggering the obligation to indemnify have not occurred and are not expected to occur, Wachovia Funding is not able to estimate the maximum amount of future payments under the indemnification clauses. There are no amounts reflected on the consolidated balance sheet at December 31, 2009, related to these indemnifications.

 

Wachovia Funding 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 consolidated financial position or results of operations. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, could be material to our results of operations for any particular period.

 

NOTE 10:    CARRYING AMOUNTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Information about the fair value of on-balance sheet financial instruments at December 31, 2009 and 2008, is presented below.

 

     December 31,
2009
(Successor)
   December 31,
2008
(Successor)

(In thousands)

   Carrying
Amount
   Estimated
Fair Value
   Carrying
Amount
   Estimated
Fair Value

FINANCIAL ASSETS

           

Cash and cash equivalents

   $ 2,092,523    2,092,523    1,358,129    1,358,129

Loans, net of unearned income and allowance for loan losses (a)

     16,064,173    16,183,305    17,212,162    17,212,162

Interest rate swaps (b)

     976    976    1,273    1,273

Accounts receivable—affiliates, net

     166,388    166,388    167,004    167,004

Other financial assets

   $ 82,621    82,621    90,882    90,882
                     

FINANCIAL LIABILITIES

           

Line of credit with affiliate

     —      —      170,000    170,000

Other financial liabilities

   $ 19,259    19,259    16,666    16,666
                     

 

(a) The fair value of loans at December 31, 2008, reflects the value assigned in purchase accounting as a result of the Wells Fargo acquisition of Wachovia.

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

(b) Interest rate swaps are reported net of cash collateral received of $173.6 million and $239.9 million at December 31, 2009 and 2008, respectively, pursuant to the accounting requirements for net presentation as prescribed in FASB ASC 815. See Note 6 for additional information on derivatives.

 

We have not included assets and liabilities that are not financial instruments in our disclosure, such as certain other assets, deferred income tax liabilities and certain other liabilities. The total of the fair value calculations presented does not represent, and should not be construed to represent, the underlying value of Wachovia Funding.

 

Wachovia Funding does not record loans at fair value on a recurring basis. As such, valuation techniques discussed herein for loans are primarily for disclosing estimated fair values as required by FASB ASC 825, Financial Instruments. However, from time to time, we record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that are based on the observable market price or current appraised value of the collateral, or (2) the full charge-off of the loan carrying value.

 

The fair value estimates for disclosure purposes differentiate loans based on their financial characteristics, such as product classification, loan category, pricing features and remaining maturity. Prepayment and credit loss estimates are evaluated by product and loan rate.

 

The fair value of commercial and commercial real estate loans is calculated by discounting contractual cash flows, adjusted for credit loss estimates, using discount rates that reflect our current pricing for loans with similar characteristics and remaining maturity.

 

For consumer loans, fair value is calculated by discounting contractual cash flows, adjusted for prepayment and credit loss estimates, using discount rates based on current industry pricing (where readily available) or our own estimate of an appropriate risk adjusted discount rate for loans of similar size, type, remaining maturity and repricing characteristics.

 

Wachovia Funding’s interest rate swaps are recorded at fair value. The fair value of interest rate swaps is estimated using discounted cash flow analyses based on observable market data. Substantially all the other financial assets and liabilities have maturities of three months or less, and accordingly, the carrying amount is deemed to be a reasonable estimate of fair value.

 

NOTE 11:    WACHOVIA PREFERRED FUNDING CORP. (PARENT)

 

The Parent, under the terms of a revolving credit agreement, can borrow from the Bank up to $1.0 billion at a rate of interest equal to the federal finds rate. At December 31, 2009, there were no borrowings outstanding between the Parent and the Bank.

 

The Parent’s condensed balance sheets as of December 31, 2009 and 2008, and the related condensed statements of income and cash flows for each of the years in the three-year period ended December 31, 2009, follow.

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009 and 2008

 

CONDENSED BALANCE SHEETS

 

      December 31,  

(In thousands, except share data)

   2009     2008  
     (Successor)     (Successor)  

ASSETS

    

Cash and cash equivalents

   $ 521,947      528,943   

Loans, net of unearned income

     12,635,555      12,753,796   

Allowance for loan losses

     (267,969   (203,545
              

Loans, net

     12,367,586      12,550,251   
              

Investment in wholly owned subsidiaries

     5,248,461      5,314,051   

Accounts receivable—affiliates, net

     127,248      125,451   

Other assets

     73,803      70,292   
              

Total assets

   $ 18,339,045      18,588,988   
              

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Liabilities

    

Other liabilities

   $ 3,722      2,960   
              

Total liabilities

     3,722      2,960   
              

Stockholders’ equity

    

Preferred stock

    

Series A preferred securities, $0.01 par value per share, $750 million liquidation preference, non-cumulative and conditionally exchangeable, 30,000,000 shares authorized, issued and outstanding in 2009 and 2008

     300      300   

Series B preferred securities, $0.01 par value per share, $1.0 billion liquidation preference, non-cumulative and conditionally exchangeable, 40,000,000 shares authorized, issued and outstanding in 2009 and 2008

     400      400   

Series C preferred securities, $0.01 par value per share, $4.2 billion liquidation preference, cumulative, 5,000,000 shares authorized, 4,233,754 shares issued and outstanding in 2009 and 2008

     43      43   

Series D preferred securities, $0.01 par value per share, $913,000 liquidation preference, non-cumulative, 913 shares authorized, issued and outstanding in 2009 and 2008

     —        —     

Common stock, $0.01 par value, 100,000,000 shares authorized, 99,999,900 shares issued and outstanding in 2009 and 2008

     1,000      1,000   

Additional paid-in capital

     18,526,608      18,584,285   

Retained earnings (deficit)

     (193,028   —     
              

Total stockholders’ equity

     18,335,323      18,586,028   
              

Total liabilities and stockholders’ equity

   $ 18,339,045      18,588,988   
              

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

CONDENSED STATEMENTS OF INCOME

 

     Years Ended December 31,

(In thousands)

   2009    2008    2007
     (Successor)    (Predecessor)    (Predecessor)

INTEREST INCOME

   $ 924,400    872,958    868,326

INTEREST EXPENSE .

     346    3,171    7,409
                

Net interest income

     924,054    869,787    860,917

Provision for credit losses

     165,912    248,459    12,858
                

Net interest income after provision for credit losses

     758,142    621,328    848,059
                

OTHER INCOME

        

Other income . . . . .

     422    5,976    351
                

Total other income . .

     422    5,976    351
                

NONINTEREST EXPENSE

        

Loan servicing costs

     49,669    50,267    47,246

Management fees . . . . . .

     7,461    13,328    27,083

Other expense . . .

     2,814    1,697    1,017
                

Total noninterest expense .

     59,944    65,292    75,346
                

Income before income taxes and equity in undistributed net income of subsidiaries .

     698,620    562,012    773,064

Income taxes . . . . .

     —      2,102    1,858
                

Income before equity in undistributed net income of subsidiaries

     698,620    559,910    771,206

Equity in undistributed net income of subsidiaries . . . . . .

     169,030    207,366    295,827
                

Net income. . . . . . . . . . . . .

     867,650    767,276    1,067,033

Dividends on preferred stock . . . .

     160,678    293,229    387,483
                

Net income available to common stockholders

   $ 706,972    474,047    679,550
                

 

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Table of Contents

WACHOVIA PREFERRED FUNDING CORP.

AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2009, 2008 and 2007

 

CONDENSED STATEMENTS OF CASH FLOWS

 

     Years Ended December 31,  

(In thousands)

   2009     2008     2007  
     (Successor)     (Predecessor)     (Predecessor)  

OPERATING ACTIVITIES

      

Net income

   $ 867,650      767,276      1,067,033   

Adjustments to reconcile net income to net cash provided (used) by operating activities

      

Amortization/(accretion) of premium/discount on loans

     (126,903   1,510      3,686   

Equity in undistributed net income of subsidiaries

     (169,030   (207,366   (295,827

Provision for credit losses

     165,912      248,459      12,858   

Accounts receivable/payable—affiliates, net

     2,235      (195   1,230   

Other assets and other liabilities, net

     (818   (2,611   7,428   
                    

Net cash provided by operating activities

     739,046      807,073      796,408   
                    

INVESTING ACTIVITIES

      

Increase (decrease) in cash realized from

      

Investment in subsidiaries, net

     234,619      234,682      276,615   

Loans, net

     80,017      (185,694   1,021,972   
                    

Net cash provided by investing activities

     314,636      48,988      1,298,587   
                    

FINANCING ACTIVITIES

      

Decrease in cash realized from

      

Line of credit with affiliate

     —        —        (500,000

Cash dividends paid

     (1,060,678   (988,229   (1,054,614
                    

Net cash used by financing activities . . .

     (1,060,678   (988,229   (1,554,614
                    

Increase (decrease) in cash and cash equivalents

     (6,996   (132,168   540,381   

Cash and cash equivalents, beginning of year

     528,943      661,111      120,730   
                    

Cash and cash equivalents, end of year

   $ 521,947      528,943      661,111   
                    

CASH PAID FOR

      

Interest

   $ 346      3,171      7,409   

Taxes

     3,033      1,985      1,286   

NONCASH ITEMS

      

Loan payments, net, settled through affiliate

     (4,031   44,742      23,365   

Transfers from loans to foreclosed assets

   $ 2,370      1,472      1,408   
                    

 

F-28


Table of Contents

SIGNATURES

 

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

 

  WACHOVIA PREFERRED FUNDING CORP.
 

By:

 

/s/    RICHARD D. LEVY        

   

Richard D. Levy

Executive Vice President and Controller

(Principal Accounting Officer)

 

Date: March 23, 2010

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on the date indicated.

 

Signature

  

Capacity

MARK C. OMAN*

Mark C. Oman

  

Chief Executive Officer and Director, Wachovia Preferred Funding Corp. (Principal Executive Officer)

HOWARD I. ATKINS*

Howard I. Atkins

  

Chief Financial Officer, Wachovia Preferred Funding Corp. (Principal Financial Officer)

RICHARD D. LEVY*

Richard D. Levy

  

Executive Vice President and Controller, Wachovia Preferred Funding Corp. (Principal Accounting Officer)

JAMES E. ALWARD*

James E. Alward

  

Director

HOWARD T. HOOVER*

Howard T. Hoover

  

Director

CHARLES F. JONES*

Charles F. Jones

  

Director

* By Ross E. Jeffries, Jr., Attorney-in-Fact

  

/S/    Ross E. Jeffries, Jr.

Ross E. Jeffries, Jr.

  

 

Date: March 23, 2010


Table of Contents

EXHIBIT INDEX

 

Exhibit
No.
   

Description

  

Location

(3 )(a)   

Certificate of Incorporation.

   Incorporated by reference to Exhibit (3)(a) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(3 )(b)    Form of Certificates of Designations for Series A, B, C and D preferred securities.    Incorporated by reference to Exhibit (3)(b) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(3 )(c)   

Form of Bylaws.

   Incorporated by reference to Exhibit (3)(c) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(10 )(a)    Form of Loan Participation Agreement and Agreement for Contribution between the Bank and Wachovia Preferred Holding.    Incorporated by reference to Exhibit (10)(a) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(10 )(b)    Form of Loan Participation Assignment Agreement between Wachovia Preferred Holding and Wachovia Funding.    Incorporated by reference to Exhibit (10)(b) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(10 )(c)    Form of Exchange Agreement among Wachovia, Wachovia Funding, and the Bank.    Incorporated by reference to Exhibit (10)(c) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(10 )(d)    Promissory Note, dated as of September 1, 2002, between the Bank and Wachovia Funding.    Incorporated by reference to Exhibit (10)(d) to Wachovia Funding’s Registration Statement on Form S-11 No. 333-99847.
(12 )(a)    Computations of Consolidated Ratios of Earnings to Fixed Charges.    Filed herewith.
(12 )(b)    Computations of Consolidated Ratios of Earnings to Fixed Charges and Preferred Stock Dividends.    Filed herewith.
(21  

List of Subsidiaries.

   Filed herewith.
(24  

Power of Attorney.

   Filed herewith.
(31 )(a)    Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.    Filed herewith
(31 )(b)    Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.    Filed herewith
(32 )(a)    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.    Filed herewith.
(32 )(b)    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.    Filed herewith.
(99 )(a)    Selected Wells Fargo & Company and Subsidiaries and Wachovia Corporation and Subsidiaries Supplementary Consolidating Financial Information.    Filed herewith.
(99 )(b)    Selected unaudited financial information for Wachovia Bank, National Association.    Filed herewith.