Wachovia Funding is engaged in acquiring, holding and managing domestic real estate-related assets, and other authorized investments that generate net income for distribution to our shareholders. We are classified as a real estate investment trust (REIT) for income tax purposes. As of June 30, 2011, we had $13.6 billion in assets, which included $13.5 billion in loans. One of our subsidiaries, Wachovia Real Estate Investment Corp. (WREIC), has operated as a REIT since its formation in 1996. Our other subsidiary, Wachovia Preferred Realty, LLC (WPR), provides us with additional flexibility to hold assets that earn non-qualifying REIT income while we maintain our REIT status. 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 are a direct subsidiary of Wachovia Preferred Holding and an indirect subsidiary of Wells Fargo and the Bank. At June 30, 2011, the Bank was considered “well-capitalized” under risk-based capital guidelines issued by banking regulators.

REIT Tax Status

For the tax year ending December 31, 2011, we expect to be taxed as a REIT, and we intend to comply with the relevant provisions of the Internal Revenue Code (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, 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:

•		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.
•		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.

Financial Performance

We earned $250.3 million in second quarter 2011, or $2.04 diluted earnings per common share, compared with $169.5 million, or $1.24 per common share, in second quarter 2010. For the first half of 2011, our net income was $461.2 million, or $3.69 per common share, compared with $301.0 million, or $2.10 per common share a year ago. The increase in the first half of 2011 net income from a year ago was largely due to lower provision for credit losses recorded in 2011, partially offset by a decrease in net interest income. The provision for credit losses was $27.5 million for the first half of 2011, compared with $216.4 million for the same period of 2010. Net charge-offs were $116.8 million (1.64% of average total loans outstanding, annualized) for the first half of 2011 compared with $152.2 million (1.94%) in the same period a year ago.

Overview (continued)

Capital Distributions

Distributions made to holders of our preferred securities totaled $46.1 million and $92.0 million for the three- and six-month periods ended June 30, 2011, which included $13.6 million and $27.2 million, respectively, in dividends paid on our Series A preferred securities held by non-affiliated investors. Distributions on preferred stock were $45.8 million and $91.1 million for the three- and six-month periods ended June 30, 2010, which included $13.6 million and $27.2 million, respectively, in dividends on our Series A preferred securities.

     Distributions made to holders of our common stock totaled $2.2 billion and $4.9 billion for the three- and six-month periods ended June 30, 2011, which included $168.0 million and $392.0 million, respectively, in dividends and $2.0 billion and $4.5 billion, respectively, of special capital distributions. During the first half of 2011, higher than expected loan pay-down rates, together with a temporary halt in reinvestments in loan participations, resulted in high levels of cash accumulating on our balance sheet. These special capital distributions reduced our cash balance in order to maintain real estate assets greater than 80% of total assets to continue to qualify for the exemption from registration under the Investment Company Act. In the second half of 2011, we expect to be able to resume reinvesting loan pay-downs in loan participations. If we do not reinvest loan pay-downs at anticipated levels, management may request our board of directors to consider an additional return of capital to holders of our common stock.

Loans

Although we have the authority to acquire interests in an unlimited number of mortgage and other assets from unaffiliated third parties, as of June 30, 2011, substantially all of our interests in mortgage and other assets were acquired from the Bank or an affiliate pursuant to loan participation agreements between the Bank or its affiliates and us. The Bank 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, as well as mortgage assets or other assets from unaffiliated third parties. 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.

     Loans, which include loans and loan participation interests, totaled $13.5 billion at June 30, 2011, down from $15.5 billion at December 31, 2010, primarily due to pay-downs, charge-offs and loan sales. Loans represented approximately 99% and 85% of assets at June 30, 2011 and December 31, 2010, respectively. Our consumer loans include real estate 1-4 family first mortgages and real estate 1-4 family junior lien mortgages, and our commercial loans

include commercial and industrial and commercial real estate (CRE) loans.

     Certain loans acquired by Wells Fargo in the Wachovia acquisition completed on December 31, 2008, including loans held by Wachovia Funding, had evidence of credit deterioration since origination and it was probable that we would not collect all contractual principal and interest. Such purchased credit-impaired (PCI) loans were recorded at fair value with no carryover of the related allowance for loan losses. PCI loans were less than 1 percent of total loans at June 30, 2011 and December 31, 2010.

     Nonaccrual loans at June 30, 2011 were $363.2 million, up from $354.5 million at March 31, 2011 and down from $366.8 million at December 31, 2010. The decrease in nonaccrual loans from December 31, 2010 largely reflected a decrease in loans entering nonaccrual status as well as increasing levels of nonaccrual loan resolutions.

     We believe it is important to maintain a well controlled operating environment and manage risks inherent in our business. We manage our credit risk by setting what we believe are sound credit policies for acquired loans, while monitoring and reviewing the performance of our loan portfolio. We manage interest rate and market risks inherent in our asset and liability balances within established ranges, while ensuring adequate liquidity and funding.

     In the first half of 2011, we did not purchase any loans from the Bank. In the six months ended June 30, 2010 we purchased $864.0 million of consumer loans from the Bank.

Net income available to common stockholders

We earned net income available to common stockholders of $369.3 million and $209.9 million in the first half of 2011 and 2010, respectively. For second quarter 2011, net income available to common stockholders was $204.3 million compared with $123.7 million in second quarter 2010. The first half and second quarter increase in year over year net income was primarily attributable to lower provision for credit losses, partially offset by a decline in interest income.

Interest Income

Interest income of $523.2 million in the first half of 2011 decreased $27.8 million, or 5%, compared with the first half of 2010, due to lower average interest-earning assets, partially offset by a higher average yield on total interest-earning assets.

     Average total interest-earning assets decreased $2.5 billion compared with the first half of 2010 and were primarily attributable to $4.5 billion of special capital distributions made during the first half of 2011. Average consumer loans decreased $1.1 billion to $12.9 billion compared with the first half of 2010 while average commercial loans decreased $358.2

million to $1.5 billion in the same period due to pay-downs, charge-offs and loan sales. To the extent we reinvest loan pay-downs or make purchases, we anticipate that we will primarily acquire consumer real-estate secured loans and other REIT-eligible assets.

     The average yield on total interest-earning assets was 6.63% in the first half of 2011 compared with 6.02% in the first half of 2010. The overall increase in the average yield on the combined consumer and commercial loan portfolio was primarily attributable to an acceleration of accretion due to loan pay-downs or loan pay-offs attributable to loan refinancing activity and an increase in amount of accretable discount resulting from consumer loan purchases during 2010. In the first half of 2011 and 2010, interest income included discount accretion of $108.6 million and $76.3 million, respectively. 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 six months ended June 30, 2011 and 2010, are presented in Table 1.

 

     Interest income of $242.9 million in second quarter 2011 decreased $35.7 million, or 13%, compared with second quarter 2010, due to lower average interest-earning assets, partially offset by a higher average yield on total interest-earning assets.

     Average total interest-earning assets decreased $3.0 billion compared with second quarter of 2010 and were primarily attributable to special capital distributions made during the first half of 2011. Average consumer loans decreased $1.5 billion to $12.4 billion compared with second quarter 2010

while average commercial loans decreased $373.7 million to $1.5 billion in the same period due to pay-downs, charge-offs and loan sales.

     The average yield on total interest-earning assets was 6.31% in second quarter 2011 compared with 6.08% in second quarter 2010.

     The average balances, interest income and rates related to interest-earning assets for the quarters ended June 30, 2011 and 2010, are presented in Table 2.

 

 

Earnings Performance (continued)

Interest Expense

Based on sufficient levels of cash and cash equivalents, we did not borrow on our line of credit in the first half of 2011 or 2010; accordingly, we did not incur interest expense during these periods.

Provision for Credit Losses

The provision for credit losses was $27.5 million in the first half of 2011 compared with $216.4 million in the first half of 2010. Second quarter 2011 reversal of provision for credit losses was $25.0 million compared with provision for credit losses of $92.2 million for second quarter 2010. The 2011 decrease in the provision for credit losses resulted from lower net charge-offs and a credit allowance release, while 2010 included an allowance build. The decrease in charge-offs and allowance was primarily due to improvement in consumer delinquency levels as well as lower loan balances, partially offset by a higher level of troubled debt restructurings (TDRs). Please refer to the “—Balance Sheet Analysis and Risk Management—Allowance for Credit Losses” sections in this Report for further information on the allowance for loan losses.

Noninterest Income

Noninterest income totaled $658 thousand in the first half of 2011 compared with $1.7 million in the first half of 2010. Second quarter 2011 noninterest income was $198 thousand compared with $654 thousand for second quarter 2010. The first half of 2011 included a loss on loan sales to affiliate of $128 thousand, compared with a $260 thousand loss in the same period of 2010. Noninterest income also includes gains 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 $253 thousand in the first half of 2011 compared with a gain of $1.6 million in the first half of 2010. The lower gain in the first half of 2011 primarily reflects a lower magnitude of interest rate decreases compared with the first half of 2010. Included in gain on interest rate swaps was expense associated with derivative cash collateral received of $65 thousand and $141 thousand in the first half of 2011 and 2010, respectively.

Noninterest Expense

Noninterest expense totaled $35.0 million in the first half of 2011 compared with $34.9 million in the same period a year ago. Second quarter 2011 noninterest expense was $17.6 million compared with $17.4 million in second quarter 2010. Noninterest expense primarily consists of loan servicing costs, and to a lesser extent, management fees and other expenses.

     Loan servicing costs decreased $5.7 million to $25.2 million in the first half of 2011, which reflected a decrease in the commercial and consumer loan portfolios. These costs are driven by the size and mix of our loan portfolio. Home equity loan products generally cost more to service than other loan products. All loans are serviced by the

Bank pursuant to our participation and servicing agreements. For home equity loan products, the monthly servicing fee charge 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 based on the total committed amount of each loan multiplied by a percentage per annum.

     Management fees were $3.2 million in the first half of 2011 compared with $2.2 million in the first half of 2010. Management fees represent reimbursements for general overhead expenses paid on our behalf. Management fees are calculated based on Wells Fargo’s total monthly allocated costs, as determined in the prior year, multiplied by a formula. The formula is based on Wachovia Funding’s proportion of Wells Fargo’s consolidated: 1) full-time equivalent employees (FTEs); 2) total average assets; and 3) total revenue.

     Other expense primarily consists of costs associated with foreclosures on residential properties, which increased $3.5 million to $4.8 million in the first half of 2011 compared with the first half of 2010. This increase was mainly attributable to an increase in the volume of loans going into foreclosure.

Income Tax Expense

Income tax expense, which is based on the pre-tax income of WPR, our taxable REIT subsidiary, was $158 thousand in the first half of 2011 compared with $605 thousand in the first half of 2010. WPR holds our interest rate swaps as well as certain cash investments. The decrease in income tax expense for 2011 was primarily related to the reduction in pre-tax income for WPR.

 

Total Assets

Our assets primarily consist of commercial and consumer loans, although we have the authority to hold assets other than loans. Total assets were $13.6 billion at June 30, 2011, compared with $18.2 billion at December 31, 2010. The decrease in total assets was primarily attributable to a $2.4 billion decrease in cash and cash equivalents and a $2.0 billion decrease in loans, net of unearned income. The corresponding decrease was primarily a $4.5 billion reduction in additional paid-in capital, reflecting the special capital distributions paid to common shareholders in the first half of 2011. Loans, net of unearned income were 99% of total assets at June 30, 2011, compared with 85% at December 31, 2010.

Cash and Cash Equivalents

Cash and cash equivalents decreased $2.4 billion to $332.6 million at June 30, 2011, compared with $2.8 billion at December 31, 2010. The decrease in the first half of 2011 was attributable to the special capital distributions paid to common shareholders, partially offset by loan pay-downs and pay-offs and cash provided by operating activities.

Loans

Loans, net of unearned income decreased $2.0 billion to $13.5 billion at June 30, 2011, compared with December 31, 2010, primarily reflecting pay-downs, charge-offs and loan sales across the entire portfolio. In the first half of 2011 we did not purchase any loans. In the first half of 2010 we purchased consumer loans from the Bank at an estimated fair value of $864.0 million. At June 30, 2011 and December 31, 2010, consumer loans represented 89% and 90% of loans, respectively, and commercial loans represented the balance of our loan portfolio.

Allowance for Loan Losses

The allowance for loan losses decreased $91.5 million from December 31, 2010, to $311.5 million at June 30, 2011. The allowance decrease from the end of 2010 was primarily due to continued improvement in consumer delinquency levels as well as lower loan balances, partially offset by a higher level of loan modifications accounted for as TDRs.

     At June 30, 2011, the allowance for loan losses included $284.4 million for consumer loans and $27.1 million for commercial loans. The total allowance reflects management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. The “—Risk Management—Allowance for Credit Losses” section in this Report describes how management estimates the allowance for loan losses and the allowance for unfunded credit commitments.

Interest Rate Swaps

Interest rate swaps, net were $992 thousand at June 30, 2011, and $1.0 million at December 31, 2010, which represents the fair value of our net position in interest rate swaps.

Accounts Receivable/Payable—Affiliates, Net

The accounts payable and receivable from affiliates result from intercompany transactions related to net loan pay-downs, interest receipts, and other transactions with the Bank.

 

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

Credit Risk Management

Table 3: Total Loans Outstanding by Portfolio

Segment and Class of Financing Receivable

     We employ various credit risk management and monitoring activities to mitigate risks associated with multiple risk factors affecting loans we hold or plan to acquire including:

•		Loan concentrations and related credit quality
•		Counterparty credit risk
•		Economic and market conditions
•		Legislative or regulatory mandates
•		Changes in interest rates
•		Merger and acquisition activities
•		Reputation risk

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

     A key to our credit risk management is adhering to a well controlled underwriting process, which we believe is appropriate for the needs of our customers as well as investors who purchase the loans or securities collateralized by the loans. Our underwriting of loans collateralized by residential real property includes appraisals or estimates from automated valuation models (AVMs) to support property values. AVMs are computer-based tools used to estimate the market value of homes. AVMs are a lower-cost alternative to appraisals and support valuations of large numbers of properties in a short period of time using

market 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. AVMs are generally used in underwriting to support property values on loan originations only where the loan amount is under $250,000. We generally require property visitation appraisals by a qualified independent appraiser for larger residential property loans.

     We continue to modify real estate 1—4 family mortgage loans to assist homeowners and other borrowers in the current difficult economic cycle. Loans are underwritten at the time of the modification in accordance with underwriting guidelines established for governmental and proprietary loan modification programs. As a participant in the U.S. Treasury’s Making Home Affordable (MHA) programs, we are focused on helping customers stay in their homes. The MHA programs create a standardization of modification terms including incentives paid to borrowers, servicers, and investors. MHA includes the Home Affordable Modification Program (HAMP) for first lien loans and the Second Lien Modification Program (2MP) for junior lien loans. Under both our proprietary programs and the MHA programs, we may provide concessions such as interest rate reductions, forbearance of principal, and in some cases, principal forgiveness. These programs generally include trial periods of three months, and after successful completion and compliance with terms during this period, the loan is considered to be modified. See the “Allowance for Credit Losses” section in this Report for discussion on how we determine the allowance attributable to our modified residential real estate portfolios.

     We continually evaluate and modify our credit policies to address appropriate levels of risk. Measuring and monitoring our credit risk is an ongoing process that tracks delinquencies, collateral values, Fair Isaac Corporation (FICO) scores, economic trends by geographic areas, loan-level risk grading for certain portfolios (typically commercial) and other indications of credit risk. Our credit risk monitoring process is designed to enable early identification of developing risk and to support our determination of an adequate allowance for credit losses. The following analysis reviews the relevant concentrations and certain credit metrics of our significant portfolios. See Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for more analysis and credit metric information.

     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 Bank and/or other Wells Fargo affiliates act as servicer to our loan portfolio, including our consumer real

estate loans. The Board of Governors of the Federal Reserve System (FRB) and the Office of the Comptroller of the Currency (OCC) recently issued consent orders that require Wells Fargo and the Bank to correct deficiencies in residential mortgage loan servicing and foreclosure practices that were identified by the FRB and OCC in their review of foreclosure practices at large mortgage servicers conducted in fourth quarter 2010. The FRB and OCC examination of foreclosure processing evaluated the adequacy of controls and governance over bank foreclosure processes, including compliance with applicable federal and state law. The consent orders require that Wells Fargo and the Bank improve servicing and foreclosure practices and incorporate remedial requirements for identified deficiencies; however, civil money penalties have not been assessed at this time. Wells Fargo and the Bank have been working with regulators for an extended period on servicing improvements and have already instituted enhancements. Wells Fargo and the Bank have committed to full compliance with the consent orders. Wachovia Funding does not expect the consent orders to have an adverse effect on its financial condition or loan portfolio.

HOME EQUITY PORTFOLIOS Our Home Equity Portfolio consists of real estate 1-4 family junior lien mortgages secured by real estate. The majority of our junior lien loan products are amortizing payment loans with fixed interest rates and repayment periods between 5 to 30 years. Junior lien loans with balloon payments at the end of the

repayment term represent a small portion of our junior lien loans.

     The following table includes recent quarterly data, by geographical area, for our home equity portfolio, which reflected the largest portion of our credit losses in the first half of 2011.

NONACCRUAL LOANS AND FORECLOSED ASSETS We generally place loans on nonaccrual status when:

•		the full and timely collection of interest or principal becomes uncertain (generally based on an assessment of the borrower’s financial condition and the adequacy of collateral, if any);
•		they are 90 days (120 days with respect to real estate 1-4 family first and junior lien mortgages) past due for interest or principal, unless both well-secured and in the process of collection; or

•

part of the principal balance has been charged off and no restructuring has occurred.

     Table 9 provides the comparative data for nonaccrual loans and foreclosed assets. Foreclosed assets declined to $3.5 million at June 30, 2011 resulting from sales to the Bank in second quarter of 2011, partially offset by additional loans migrating into foreclosure. Table 10 provides an analysis of the changes in nonaccrual loans.

     Typically, changes to nonaccrual loans period-over-period represent the difference of inflows for loans that reach a specified past due status or where we believe that the full collection of principal is in doubt, and outflows of loans that are charged off, sold, transferred to foreclosed properties, or are no longer classified as nonaccrual because they return to accrual status.

     Nonaccrual loans decreased to $363.2 million at June 30, 2011, from $366.8 million at December 31, 2010. The decrease was primarily related to consumer real estate 1-4 family mortgage loans, largely reflecting a decrease in loans entering nonaccrual status as well as an increase in nonaccrual outflows. The decrease in nonaccrual inflow is in part due to improvements in delinquency performance.

     Table 11 provides information regarding the recorded investment of loans modified in TDRs. We establish an allowance for loan losses when a loan is modified in a TDR, which for consumer loans was $79.4 million at June 30, 2011, and $51.9 million at December 31, 2010. Total charge-offs related to loans modified in a TDR were $3.5 million in the first half of 2011 and $2.9 million in the first half of 2010.

     We do not forgive principal for a majority of our TDRs, but in those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. We sometimes delay the required timing of repayment of a portion of principal (principal forbearance) and charge off the amount of forbearance if that amount is not considered fully collectible.

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

LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING Loans included in this category are 90 days or more past due as to interest or principal and still accruing, because they are (1) well-secured and in the process of collection or (2) real estate 1-4 family mortgage loans exempt under regulatory rules from being classified as nonaccrual until later delinquency, usually 120 days past due. PCI loans of $9.1 million at June 30, 2011, and $10.9 million at December 31, 2010, are excluded from this disclosure even though they are 90 days or more contractually past due. These PCI loans are considered to be accruing due to the existence of the

accretable yield and not based on consideration given to contractual interest payments.

     The decrease from December 31, 2010 to June 30, 2011 was primarily related to a decrease in loans entering 90 days past due and still accruing status coupled with the migration of loans from 90 days or more past due and still accruing to a nonaccrual status.

     Table 12 reflects loans 90 days or more past due and still accruing.

Net charge-offs in the first half of 2011 were $116.8 million (1.64% of average total loans outstanding, annualized) compared with $152.2 million (1.94%) a year ago. The decrease in net charge-offs was in part due to modest improvement in economic conditions as well as aggressive loss mitigation activities. The majority of losses were in consumer real estate, which has a higher concentration of home equity loans secured by properties located in the eastern United States. Collateral value stabilization and delinquency improvements are materializing in this portfolio, and we expect continued improvement from the still-elevated level of current losses.

     Net charge-offs in the 1-4 family first mortgage portfolio totaled $42.2 million in the first half of 2011 compared with $51.1 million a year ago. Net charge-offs in the real estate 1-4 family junior lien portfolio were $74.5 million in the first half of 2011 compared with $100.1 million a year ago. The real estate 1-4 family mortgage portfolio continued to reflect relatively low loss rates compared with industry trends.

     Commercial and industrial and CRE net charge-offs in the first half of 2011 and 2010 were not significant. Although economic stress and decreased CRE values have resulted in the deterioration of our commercial and industrial and CRE credit portfolios, there have been relatively small losses. Due to the larger dollar amounts associated with individual commercial and industrial and CRE loans, loss recognition tends to be irregular and exhibits more variation than consumer loan portfolios.

ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses, which consists of the allowance for loan losses and the allowance for unfunded credit commitments, is management’s estimate of credit losses inherent in the loan portfolio and unfunded credit commitments at the balance sheet date, excluding loans carried at fair value. The detail of the changes in the allowance for credit losses by portfolio segment (including charge-offs and recoveries by loan class) is in Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.

     We employ a disciplined process and methodology to establish our allowance for credit losses each quarter. This

process takes into consideration many factors, including historical and forecasted loss trends, loan-level credit quality ratings and loan grade-specific loss factors. The process involves subjective as well as complex judgments. In addition, we review a variety of credit metrics and trends. However, these trends do not solely determine the adequacy of the allowance as we use several analytical tools in determining its adequacy. For additional information on our allowance for credit losses, see the “Critical Accounting Policies — Allowance for Credit Losses” section in our 2010 Form 10-K and Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.

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

     Total provision for credit losses was $27.5 million in the first half of 2011, compared with $216.4 million a year ago. The first half of 2011 provision was $89.3 million less than credit losses, compared with a provision that exceeded net charge-offs by $64.1 million in the first half of 2010.

     In determining the appropriate allowance attributable to our residential mortgage portfolio, we incorporate the default rates and high severity of loss for junior lien mortgages behind delinquent first lien mortgages into our forecasting calculations. In addition, the loss rates we use in determining our allowance include the impact 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. Accordingly, the loss content associated with the effects of existing and probable loan modifications and junior lien mortgages behind delinquent first lien mortgages has been considered in our allowance methodology.

     Changes in the allowance reflect changes in statistically derived loss estimates, historical loss experience, current trends in borrower risk and/or general economic activity on portfolio performance, and management’s estimate for imprecision and uncertainty, including ongoing discussions with regulatory and government agencies regarding mortgage foreclosure-related matters.

     We believe the allowance for credit losses of $311.7 million was adequate to cover credit losses inherent in the loan portfolio, including unfunded credit commitments, at June 30, 2011. The allowance for credit losses is evaluated on a quarterly basis and considers existing factors at the time, including economic or market conditions and ongoing internal and external examination processes. Due to the sensitivity of the allowance for credit losses to changes in our external business environment, it is possible that we will have to record incremental credit losses not anticipated as of the balance sheet date. However, absent significant deterioration in the economy, we expect future allowance releases. Our process for determining the adequacy of the allowance for credit losses is discussed in the “Critical Accounting Policies” section in our 2010 Form 10-K.

Asset/Liability Management

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

INTEREST RATE RISK Interest rate risk is the sensitivity of earnings to changes in interest rates. Approximately 18% of our loan portfolio consisted of variable rate loans at June 30, 2011. 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 June 30, 2011, approximately 82% 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 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 June 30, 2011, $2.7 billion, or 20% of our assets, had variable interest rates and could be expected to reprice with changes in interest rates. At June 30, 2011, our liabilities were $47.8 million, or less than 1% of our assets, while stockholders’ equity was $13.6 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.

     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 sheet. 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 sheet. Realized and

unrealized gains and losses are recorded as a net gain or loss on interest rate swaps in our consolidated statement of income.

     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 June 30, 2011, our position in interest rate swaps was an asset of $290.2 million, a liability of $219.1 million, and a payable for cash deposited as collateral by counterparties of $70.1 million. The position in the interest rate swap is recorded as a net amount on our consolidated balance sheet at fair value, as positions with the same counterparty are netted as part of a legally enforceable master netting agreement between Wachovia Funding and the derivative counterparty, and is reported net of the cash collateral received and paid.

     At June 30, 2011, our receive-fixed interest rate swaps with a notional amount of $4.1 billion had a weighted average maturity of 0.97 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 maturity of 0.97 years, weighted average receive rate of 0.25% and weighted average pay rate of 5.72% at June 30, 2011. 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 June 30, 2011.

MARKET RISK 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 $500 thousand or $1.0 million, respectively. If interest rates were to increase 100 basis points or 200 basis points, we would recognize short-term net losses on our interest rate swaps of $500 thousand or $1.0 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.

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

     Proceeds received from 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 June 30, 2011, there were no borrowings outstanding on our line of credit with the Bank.

     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 expenses and dividends are expected to be funded through cash generated by operations or paid-in capital, 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. During the first half of 2011, we did not purchase any loan participations from the Bank. In the second half of 2011, we expect to resume reinvesting loan pay-downs in loan participations. If we do not reinvest loan pay-downs at anticipated levels, management may request our board of directors to consider an additional return of capital to holders of our common stock. We expect to distribute annually an aggregate amount of dividends with respect to outstanding capital stock equal to approximately 100 percent of our REIT taxable income for federal tax purposes. Such distributions may in some periods exceed net income determined under U.S. generally accepted accounting principles (GAAP).

     To the extent that we determine that additional funding is required, we could issue additional common or preferred stock, subject to any pre-approval rights of our shareholders or raise funds through debt financings, retention of cash flows or a combination of these methods. 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. 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.

     Except in certain circumstances, our Series A preferred securities may not be redeemed prior to December 31, 2022. Prior to that date, among other things, if regulators adopt capital standards that do not permit Wells Fargo or the Bank to treat our Series A preferred securities as Tier 1 capital, we may determine to redeem the Series A preferred securities, as provided in our certificate of incorporation. Regulatory authorities have yet to propose final regulations to implement certain capital standards required in the Dodd-Frank Act. It is possible that such capital standards, when proposed and adopted, will affect Wells Fargo’s or the Bank’s ability to treat our Series A preferred securities as Tier 1 capital. We will continue to monitor the proposed capital standards and whether such capital standards would result in our determination that a Regulatory Capital Event, as defined in our certificate of incorporation, has occurred and therefore cause the Series A preferred securities to become redeemable under their terms. Although any such redemption must be in whole for a redemption price of $25.00 per Series A security, plus all authorized, declared but unpaid dividends to the date of redemption, such event may have an adverse effect on the trading price for the Series A preferred securities.

     At June 30, 2011, 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.

 

Our significant accounting policies (see Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2010 Form 10-K) are fundamental to understanding our results of operations and financial condition because they require that we use estimates and assumptions that may affect the value of our assets or liabilities and financial results. One of these policies is critical because it requires management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under

different conditions or using different assumptions. We have identified the allowance for credit losses policy as being particularly sensitive in terms of judgments and the extent to which estimates are used.

     Management has reviewed and approved this critical accounting policy and has discussed this policy with the Audit Committee of Wachovia Funding’s board of directors. This policy is described in the “Critical Accounting Policy” section in our 2010 Form 10-K.

 

The following accounting pronouncements have been issued by the Financial Accounting Standards Board (FASB) but are not yet effective:

•		ASU 2011-4, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs; and
•		ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.

ASU 2011-04 modifies accounting guidance and expands existing disclosure requirements for fair value measurements. The Accounting Standards Update (ASU or Update) clarifies how fair values should be measured for instruments classified in stockholders’ equity and under what circumstances premiums and discounts should be applied in fair value measurements. The guidance also permits entities to measure fair value on a net basis for financial instruments that are managed based on net exposure to market risks and/or counterparty credit risk. Required new disclosures for financial instruments classified as Level 3 include: 1) quantitative information about unobservable inputs used in measuring fair value, 2) qualitative discussion of the sensitivity of fair value measurements to changes in unobservable inputs, and 3) a description of valuation processes used. The Update also requires disclosure of fair value levels for financial instruments that are not recorded at fair value but for which fair value is required to be disclosed. The guidance is effective for us in first quarter 2012 with prospective application. Early adoption is not permitted. We are evaluating the effect this Update may have on our consolidated financial statements.

ASU 2011-02 provides guidance clarifying under what circumstances a creditor should classify a restructured receivable as a TDR. A receivable is a TDR if both of the following exist: 1) a creditor has granted a concession to the debtor, and 2) the debtor is experiencing financial difficulties. The Update clarifies that a creditor should consider all aspects of a restructuring when evaluating whether it has granted a concession, which include determining whether a debtor can

obtain funds from another source at market rates and assessing the value of additional collateral and guarantees obtained at the time of restructuring. The Update also provides factors a creditor should consider when determining if a debtor is experiencing financial difficulties, such as probability of payment default and bankruptcy declarations. The Update is effective for us in third quarter 2011 with retrospective application to January 1, 2011. Early adoption is permitted. These accounting changes will impact our TDR disclosures but are not expected to have a material effect on our financial results.

 

This Report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects,” “target”, “projects,” “outlook,” “forecast,” “will,” “may,” “could,” “should,” “can” and similar references to future periods. Examples of forward-looking statements include, but are not limited to, statements we make about: future results of Wachovia Funding; expectations for consumer and commercial credit losses, life-of-loan losses, and the sufficiency of our credit loss allowance to cover future credit losses; possible capital distributions; the expected outcome and impact of legal, regulatory and legislative developments, including regulatory capital standards; and Wachovia Funding’s plans, objectives and strategies.

     Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. Our actual results may differ materially from those contemplated by the forward-looking statements. We caution you, therefore, against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. While there is no assurance that any list of risks and uncertainties or risk factors is complete, important factors that could cause actual results to differ materially from those in the forward-looking statements include the following, without limitation:

•		the effect of political and economic conditions and geopolitical events;
•		economic conditions that affect the general economy, housing prices, the job market, consumer confidence and spending habits, including our borrowers repayment of our loan participations;
•		the level and volatility of the capital markets, interest rates, currency values and other market indices that affect the value of our assets and liabilities;
•		the availability and cost of both credit and capital as well as the credit ratings assigned to our debt instruments;
•		investor sentiment and confidence in the financial markets;
•		our reputation;
•		the impact of current, pending and future legislation, regulation and legal actions, including capital standards applicable to the Bank or Wells Fargo;
•		changes in accounting standards, rules and interpretations;
•		mergers and acquisitions, and our ability to integrate them;
•		various monetary and fiscal policies and regulations of the U.S. and foreign governments;
•		financial services reform and other current, pending or future legislation or regulation that could have a negative

		effect on our revenue and businesses, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) and legislation; and
•		the other factors described in “Risk Factors” in our 2010 Form 10-K and in this Report.

     In addition to the above factors, we also caution that there is no assurance that our allowance for credit losses will be adequate to cover future credit losses, especially if credit markets, housing prices and unemployment do not continue to stabilize or improve. Increases in loan charge-offs or in the allowance for credit losses and related provision expense could materially adversely affect our financial results and condition.

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

 

An investment in Wachovia Funding involves risk, including the possibility that the value of the investment could fall substantially and that dividends or other distributions on the investment could be reduced or eliminated. We discuss previously under “Forward-Looking Statements” and elsewhere in this Report, as well as in other documents we file with the SEC, risk factors that could adversely affect our financial results and condition and the value of, and return on, an investment in Wachovia Funding. We refer you to the Financial Review section and Financial Statements (and related Notes) in this Report for more information about credit, interest rate, market, and litigation risks and to the “Risk Factors” sections in our 2010 Form 10-K and 2011 First Quarter Report on Form 10-Q for more information about risks. Any factor described in this Report or in our 2010 Form 10-K and 2011 First Quarter Report on Form 10-Q could by itself, or together with other factors, adversely affect our financial results and condition, or the value of an investment in Wachovia Funding. There are factors elsewhere in this Report that could adversely affect our financial results and condition.