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Article by DailyStocks_admin    (07-04-08 08:53 AM)

Winmark Corp. CEO JOHN L MORGAN bought 15415 shares on 7-2-2008 at $18.6

BUSINESS OVERVIEW

General



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. Wachovia Funding is a direct subsidiary of Wachovia Preferred Funding Holding Corp. (“Wachovia Preferred Holding”) and Wachovia Corporation (“Wachovia”) and an indirect subsidiary of Wachovia Bank, National Association (the “Bank”). Wachovia Preferred Holding owns 99.85% of our common stock and Wachovia owns the remaining 0.15%. The Bank owns 99.95% of the common stock of Wachovia Preferred Holding and Wachovia 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 Wachovia or its affiliates.



One of our subsidiaries, Wachovia Real Estate Investment Corp., 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 Wachovia Real Estate Investment Corp. common stock outstanding, we own 644 shares or 99.84% and the remaining 1 share is owned by Wachovia. Of the 667 shares of Wachovia Real Estate Investment Corp. preferred stock outstanding, we own 533.3 shares or 79.96%, 127 shares or 19.04% are owned by employees of Wachovia or its affiliates and 6.7 shares or 1.00% are owned by Wachovia.



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 FFBIC, Inc., another subsidiary of 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.

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, the majority 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 remainder of our assets was acquired directly from the Bank. 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. We may also acquire from time to time 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 of the residential mortgage loans to third parties, which are not affiliated with the Bank or us.



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”. We may 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”). 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.



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, aircraft, livestock, furniture and fixtures, and inventory. Participation interests acquired in commercial real estate loans are secured by real property such as office buildings, multi-family properties of five units or more, industrial, warehouse and self-storage properties, office and industrial condominiums, retail space, strip shopping centers, mixed use commercial properties, mobile home parks, nursing homes, hotels and motels, churches and farms. 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.



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:


Ÿ

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;


Ÿ

potential or existing environmental risks;


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


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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, second and third 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”). Under current regulations, the maximum principal balance allowed on conforming residential mortgage loans ranges from $417,000 for one-unit residential loans to $801,950 for four-unit residential loans. 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 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:



One-year Adjustable Rate Loans: A loan with interest adjustments in 12-month intervals. Payment frequencies may include biweekly, semimonthly or monthly. Such loans may have yearly and lifetime caps on the amount the interest rate may change at an interval. The interest rate change calculation is typically tied to a Treasury or LIBOR index rate. Typically, the interest rate is based on the weekly average yield on United States Treasury securities adjusted to a constant maturity of one year plus the margin stated in the note, subject to rounding and any caps.



Various Adjustable Rate Loans: A one-year ARM that is fixed for one of a number of various time periods which are typically between 3 and 10 years. After the initial fixed time period, the interest adjusts in 12- month intervals with caps on the initial change and each subsequent annual change and may be subject to a maximum cap on lifetime changes. Typically, the interest is based on the same Treasury security as the one-year ARM or the LIBOR index rate 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, which excludes capital gains. In order to remain qualified as a REIT, we are required to distribute annually at least 90% of our REIT taxable income to our 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, economic conditions, tax considerations and our continued qualification as a REIT. We currently expect that both our cash available for distribution and our REIT taxable income will be in excess of the amounts needed to pay dividends on all outstanding series of preferred securities, even in the event of a significant drop in interest rate levels 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;


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


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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;
Ÿ

unencumbered; and
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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 receive as capital contributions, interests in additional real estate-secured loans from the Bank or its affiliates. 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, 2007, we did not hold any mortgage-backed securities.



We currently anticipate that the Bank or its affiliates 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 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.



In accordance with the terms of the commercial, commercial real estate and residential loan 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.



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 Governance and Administration”.



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 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.

MANAGEMENT DISCUSSION FROM LATEST 10K

Allowance for Loan Losses and Reserve for Unfunded Lending Commitments



The allowance for loan losses and reserve for unfunded lending commitments (collectively, the “allowance for credit losses”) are maintained at levels we believe are adequate to absorb probable losses inherent in the loan portfolio and unfunded commercial lending commitments as of the date of the consolidated financial statements. We monitor qualitative and quantitative credit metrics and trends, including changes in the levels of past due, criticized and nonperforming loans as part of our allowance modeling process. In addition, we rely on estimates and exercise judgment in assessing credit risk.



As a subsidiary of Wachovia, our loans are subject to the same analysis of the adequacy of the allowance for loan losses as loans maintained in all of Wachovia’s subsidiaries including the Bank. Wachovia employs a variety of modeling and estimation tools for measuring credit risk. These tools are periodically reevaluated and refined, as appropriate.

The following provides a description of Wachovia’s methodology.



Our model for the allowance for loan losses has four components: formula-based components for both the commercial and consumer portfolios, each including a factor for historical loss variability, a reserve for impaired commercial loans and an unallocated component.



For commercial loans, the formula-based component of the allowance for loan losses is based on statistical estimates of the average losses observed by credit grade. Average losses for each credit grade reflect the annualized historical default rate and the average losses realized for defaulted loans.



For consumer loans, the formula-based component of the allowance for loan losses is based on statistical estimates of the average losses observed by product classification. We compute average losses for each product class using historical loss data, including analysis of delinquency patterns, origination vintage and various credit risk forecast indicators.



For both commercial and consumer loans, the formula-based components include additional amounts to establish reasonable ranges that consider observed historical variability in losses. This historical loss variability component represents a measure of the potential for significant volatility above average losses over short periods. Factors we may consider in setting these amounts include, but are not limited to, industry-specific data, geographic data, portfolio-specific risks or concentrations, and macroeconomic conditions.



At December 31, 2007, the formula-based components of the allowance were $33.6 million for commercial loans and $59.5 million for consumer loans compared with $40.5 million and $40.8 million, respectively, at December 31, 2006.



When applicable, we have established specific reserves within the allowance for loan losses for impaired loans, which we define as commercial loans on nonaccrual status. We individually review any impaired loans with a minimum total exposure of $5.0 million. The reserve for each individually reviewed loan is based on the difference between the loan’s carrying amount and the loan’s estimated fair value. No other reserve is provided on impaired loans that are individually reviewed. At December 31, 2007 and 2006, we did not have any impaired loans over $5.0 million.



The allowance for loan losses may be supplemented with an unallocated component which reflects the inherent uncertainty of our estimates. The amount of this component and its relationship to the total allowance for loan losses may change from one period to another as warranted by facts and circumstances. We anticipate the unallocated component of the allowance will generally not exceed 5 percent of the total allowance for loan losses. There was no unallocated component at December 31, 2007 or 2006.



The reserve for unfunded lending commitments, which relates only to commercial business where our intent is to classify the funded loan in the loan portfolio, is based on a modeling process that is consistent with the methodology described above for the commercial portion of the allowance for loan losses. In addition, this model includes as a key factor the historical average rate at which unfunded commercial exposures have been funded at time of default. At December 31, 2007 and 2006, the reserve for unfunded lending commitments was $488 thousand and $306 thousand, respectively.



The factors supporting the allowance for loan losses and the reserve for unfunded lending commitments as described above does not diminish the fact that the entire allowance for loan losses and reserve for unfunded lending commitments are available to absorb losses in the loan portfolio and the related commercial commitment portfolio, respectively. Our principal focus, therefore, is on the adequacy of the total allowance for loan losses and reserve for unfunded lending commitments.



Results of Operations



For purposes of this discussion, the term “loans” includes loans and loan participation interests, the term “residential loans” includes home equity loans and residential mortgages and the term “commercial loans” includes commercial and commercial real estate loans. See Table 1, Performance and Dividend Payout Ratios , following “—Accounting and Regulatory Matters” for certain performance and dividend payout ratios for the years ended December 31, 2007, 2006 and 2005.

Interest Expense . Interest expense increased to $28.6 million in 2007 compared with $17.5 million a year ago. Interest expense is directly related to our borrowings on our existing line of credit with the Bank, which funded our purchases of home equity loans in the first, second and fourth quarters of 2006 and the second and third quarters of 2007. The increase primarily reflects higher average balances and a higher interest rate environment in 2007. At December 31, 2007, $300.0 million was outstanding under the line of credit with the Bank.



Provision for Credit Losses . The provision for credit losses was $21.2 million in 2007 compared with a net benefit of $9.3 million in 2006. The increase in the provision for credit losses was driven mostly by the effect of significant weakness in certain housing markets. See “Critical Accounting Policies” for more information on the allowance for loan losses.



Gain (Loss) 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 $7.6 million in 2007 compared with a loss of $3.0 million in 2006. The gain in 2007 primarily reflects a lower short-term interest rate environment in 2007 compared with 2006 and a higher net present value as a result of the passage of time. Included in gain (loss) on interest rate swaps was expense associated with the derivative cash collateral received of $16.6 million and $18.9 million in 2007 and 2006, respectively.



Loan Servicing Costs . Loan servicing costs increased $7.9 million to $62.1 million in 2007 which reflects the impact of reinvesting pay-downs in home equity loans which have a higher servicing fee relating 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 loans, the monthly fee is equal to the outstanding principal balance of each loan multiplied by 0.50% per annum. For commercial loans, the monthly fee is equal to the total committed amount of each loan multiplied by 0.025% per annum. Servicing fees related to residential mortgages are negotiated when the Bank purchases loans from unrelated third parties, and are based on the purchase price of the loans.



Management Fees . Management fees were $39.1 million in 2007 compared with $47.6 million in 2006 reflecting Wachovia’s decreased allocable expense base. Management fees represent reimbursements to Wachovia for general overhead expenses paid on our behalf. Wachovia charges the management fee on a monthly basis 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 plus a 10% markup. The markup of 10% in 2007 compares with a markup of 5% in the prior year.

Other Expense . Other expense primarily consists of costs associated with foreclosures on residential properties. In 2007 and 2006, these costs were not significant.



Income Taxes . Income tax expense, which is primarily based on the pre-tax income of WPR, our taxable REIT subsidiary, was $16.8 million in 2007 compared with $13.4 million in 2006. WPR holds our interest rate swaps as well as certain cash investments. The increase in income tax expense in 2007 was driven by gains on interest rates swaps as well as higher interest income on cash invested in overnight eurodollar deposits compared with the prior year.



In the third quarter of 2007, we adopted FASB Staff Position No. FIN 39-1 (FIN 39-1), Amendment of FASB Interpretation No. 39 , which permits netting cash collateral received or posted against the applicable derivative asset or liability in situations where the applicable netting criteria are met. We have retrospectively adopted this standard which resulted in a net reduction in total assets and total liabilities in the consolidated balance sheets. In addition, interest expense related to cash collateral received has been reclassified to gain (loss) on interest rate swaps in the consolidated statements of income. Please refer to “—Notes to Consolidated Financial Statements” for additional information.



2007 to 2006 Fourth Quarter Comparison



Net income available to common stockholders increased to $167.6 million in the fourth quarter of 2007 compared with $166.5 million in the fourth quarter of 2006. The majority of the income for both quarters was associated with interest on commercial loans, home equity loans and residential mortgages. Net interest income increased $2.6 million to $301.4 million in the fourth quarter of 2007 compared with the fourth quarter of 2006 due to the impact of a higher yielding mix of loans. Average loans of $17.0 billion in the fourth quarter of 2007 increased $650.8 million, or 4%, from the fourth quarter of 2006. This increase was driven by higher average home equity loans of $12.9 billion compared with $11.3 billion in the fourth quarter of 2006. Substantially offsetting the increase was a $732.1 million, or 19%, decrease in commercial loans and a $238.8 million, or 22%, decrease in residential mortgages compared to the same period in 2006.



Provision for credit losses was $15.2 million in the fourth quarter of 2007 compared with $2.0 million in the fourth quarter of 2006. The higher provision expense in the fourth quarter of 2007 was driven mostly by the effect of significant weakness in certain housing markets.



Gains on interest rate swaps were $5.4 million in the fourth quarter of 2007 compared with a loss of $619 thousand in the fourth quarter of 2006. The gain in the fourth quarter of 2007 primarily reflects lower long-term interest rates and a higher net present value, as a result of the passage of time, compared with the fourth quarter of 2006.



Loan servicing costs increased $2.2 million to $16.3 million in the fourth quarter of 2007 compared with the fourth quarter of 2006 reflecting higher residential loan balances. Management fees of $6.8 million in the fourth quarter of 2007 decreased $4.5 million over the fourth quarter of 2006 reflecting Wachovia’s decreased allocable expense base.



Income tax expense was $5.0 million in the fourth quarter of 2007 compared with $6.2 million in the fourth quarter of 2006. The lower income tax expense in the fourth quarter of 2007 was driven by lower interest income on cash invested in overnight Eurodollar deposits compared with the fourth quarter of 2006, partially offset by gains on interest rate swaps in the fourth quarter of 2007 compared with losses on interest rate swaps in same quarter one year ago.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of Operations



For purposes of this discussion, the term “loans” includes loans and loan participation interests, the term “residential loans” includes home equity loans and residential mortgages and the term “commercial loans” includes commercial and commercial real estate loans. See Table 1 following “—Accounting and Regulatory Matters” for certain performance and dividend payout ratios for the quarters ended March 31, 2008 and 2007.



Although we have the authority to acquire interests in an unlimited number of loans and other assets from unaffiliated third parties, the majority 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 was 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.



2008 to 2007 Three Month Comparison



Net income available to common stockholders . We earned net income available to common stockholders of $151.8 million and $168.8 million in the first quarter of 2008 and 2007, respectively. This decrease was driven by higher provision for credit losses, lower net interest income and higher loan servicing costs, partially offset by a higher gain on interest rate swaps and lower management fees.



Interest Income . Interest income of $288.3 million in the first quarter of 2008 decreased $8.3 million, or 3%, compared with the first quarter of 2007. This was primarily driven by decreases in interest rates received on interest-earning assets, primarily commercial loans and overnight eurodollar deposits, compared with the same quarter one year ago. The average interest rate received on total interest-earning assets was 6.43% in the first quarter of 2008 compared with 6.71% in the first quarter of 2007 which reflects the impact of a lower interest rate environment in 2008. Average home equity loans increased $993.2 million to $12.6 billion compared with the first quarter of 2007 while average commercial loans decreased $613.9 million to $3.0 billion in the same period due to pay-downs. All loan pay-downs were reinvested in home equity loans. Average residential mortgages decreased $229.0 million to $837.0 million in the first quarter of 2008 compared with the same period one year ago. 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 $8.5 million to $12.9 million in the first quarter of 2008 compared with the first quarter of 2007 driven by lower short-term interest rates from the same quarter one year ago. See the interest rate risk management section under “Risk Governance and Administration” for more information on interest rates and interest income.

Interest Expense . Interest expense increased to $3.5 million in the first quarter of 2008 compared with $3.0 million in the first quarter of 2007. This reflects increased borrowings on our existing line of credit with the Bank, which funded our purchase of home equity loans in the second and third quarters of 2007 and the first quarter 2008. At March 31, 2008, $540.0 million was outstanding under the line of credit with the Bank.



Provision for Credit Losses . The provision for credit losses was an expense of $25.6 million in the first quarter of 2008 compared with a net benefit of $2.8 million in the first quarter of 2007. The increase in the provision for credit losses was driven mostly by the effect of significant weakness in certain housing markets. See “Critical Accounting Policies” in our 2007 Annual Report on Form 10-K for more information on the allowance for loan losses.



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 $8.2 million in the first quarter of 2008 compared with a gain of $957 thousand in the first quarter of 2007. The higher gain in 2008 primarily reflects a lower short-term interest rate environment in the first quarter of 2008 compared with the first quarter of 2007 and a higher net present value as a result of the passage of time. Included in gain on interest rate swaps was expense associated with the derivative cash collateral received of $2.4 million and $4.4 million in the first quarter of 2008 and 2007, respectively.



Loan Servicing Costs . Loan servicing costs increased $1.4 million to $15.9 million in the first quarter of 2008 which reflects the impact of reinvesting pay-downs in home equity loans 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 loans, the monthly fee is equal to the outstanding principal balance of each loan multiplied by 0.50% per annum. For commercial loans, the monthly fee is equal to the total committed amount of each loan multiplied by 0.025% per annum. Servicing fees related to residential mortgages are negotiated when the Bank purchases loans from unrelated third parties, and are based on the purchase price of the loans.



Management Fees. Management fees were $4.8 million in the first quarter of 2008 compared with $12.4 million in the first quarter of 2007 reflecting Wachovia’s decreased allocable expense base. Management fees represent reimbursements to Wachovia for general overhead expenses paid on our behalf. Wachovia charges the management fee 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 plus a 10% markup.



Other Expense . Other expense primarily consists of costs associated with foreclosures on residential properties. In the first quarter of 2008 and 2007, these costs were not significant.



Income Tax Expense. Income tax expense, which is primarily based on the pre-tax income of WPR, our taxable REIT subsidiary, was $5.4 million in the first quarter of 2008 compared with $4.0 million in the first quarter of 2007. WPR holds our interest rate swaps as well as certain cash investments. The increase in income tax expense in the first quarter of 2008 was driven by the higher gain on interest rate swaps in the first quarter of 2008. Partially offsetting was lower interest income on cash invested in overnight eurodollar deposits compared with the same period one year ago driven by lower short-term interest rates in the first quarter of 2008.

Balance Sheet Analysis



March 31, 2008 to December 31, 2007



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 March 31, 2008, compared with $18.2 billion at December 31, 2007. Net loans were 91% of total assets at both March 31, 2008, and December 31, 2007.



Loans . Net loans increased $139.8 million to $16.7 billion at March 31, 2008, compared with December 31, 2007, primarily reflecting an increase in home equity loans resulting from $1.2 billion in reinvestments offset by pay-downs across the entire portfolio. At March 31, 2008, and at December 31, 2007, home equity loans comprised 77% and 76% of loans, respectively, and commercial loans comprised 18% and 19% respectively. See Table 2 following “—Accounting and Regulatory Matters” for additional information related to loans.



Allowance for Loan Losses . The allowance for loan losses increased $18.1 million from December 31, 2007, to $111.2 million at March 31, 2008 driven mostly by the effect of deterioration in certain housing markets evidenced by higher net charge-offs and growth in nonaccrual loans primarily in the home equity loans portfolio. Net charge-offs increased $5.7 million from the first quarter of 2007 and $4.3 million from the fourth quarter of 2007 to $7.6 million in the first quarter of 2008. Nonaccrual loans increased from $36.8 million at December 31, 2007, to $45.3 million at March 31, 2008, as changes were driven by credit deterioration in the home equity loans portfolio. The allowance to loans ratio of 0.66% at March 31, 2008, increased from 0.56% at December 31, 2007. See Tables 3 and 4 following “—Accounting and Regulatory Matters” for additional information related to net charge-offs and nonaccrual loans.



The reserve for unfunded lending commitments, which is included in other liabilities, was $339 thousand at March 31, 2008, compared with $488 thousand at December 31, 2007.



See Table 3 following “—Accounting and Regulatory Matters” for additional information related to the allowance for loan losses.



Interest Rate Swaps. Interest rate swaps were $1.6 million at both March 31, 2008 and December 31, 2007, which represents the fair value of our net position in interest rate swaps.



Accounts Receivable—Affiliate, Net. Accounts receivable from affiliate, net was $333.4 million at March 31, 2008, compared with $229.8 million at December 31, 2007, as a result of intercompany cash transactions related to net loan paydowns, interest receipts and funding with the Bank. The increase was due to higher paydowns in March 2008 than occurred in December 2007.



Commitments



Our 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. 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 Governance and Administration—Credit Risk Management” section in our 2007 Annual Report on Form 10-K describes how Wachovia, as owner of the Bank which originates and services the loans, manages credit risk when extending credit.



Loan commitments create credit risk in the event 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. At March 31, 2008, and at December 31, 2007, unfunded commitments to extend credit were $666.9 million and $655.7 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 underlying 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, which primarily results from interest income on our loan portfolio. 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. Generally, we repay these borrowings within several months as we receive cash on loan pay-downs from our loan portfolio. Under the terms of that facility, we can borrow up to $2.0 billion under a revolving demand note at a rate equal to the federal funds rate. At March 31, 2008, borrowings on our line of credit with the Bank totaled $540.0 million. 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.


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