e10vq
Table of Contents

 
United States
Securities and Exchange Commission
Washington, D.C. 20549
 
Form 10-Q
 
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2010
 
Commission file number 1-13805
 
Harris Preferred Capital Corporation
(Exact name of registrant as specified in its charter)
 
 
     
Maryland
(State or other jurisdiction
of incorporation or organization)
  #36-4183096
(I.R.S. Employer
Identification No.)
     
111 West Monroe Street, Chicago, Illinois
(Address of principal executive offices)
  60603
(Zip Code)
 
Registrant’s telephone number, including area code:
(312) 461-2121
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
    Name of each exchange on
Title of each class
  which registered
 
73/8% Noncumulative Exchangeable Preferred Stock,
Series A, par value $1.00 per share
  New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
  Yes þ     No o
 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T(232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
  Yes o     No o
 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o Accelerated filer o Non-accelerated filer þ Smaller reporting company o
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company ( as defined in Rule 12b-2 of the Act).
  Yes o     No þ
 
 
The number of shares of Common Stock, $1.00 par value, outstanding on August 12, 2010 was 1,180. No common equity is held by nonaffiliates.
 


 

 
HARRIS PREFERRED CAPITAL CORPORATION
 
TABLE OF CONTENTS
 
             
Part I
  FINANCIAL INFORMATION        
Item 1.
  Financial Statements:        
    Consolidated Balance Sheets     2  
    Consolidated Statements of Income and Comprehensive Income     3  
    Consolidated Statements of Changes in Stockholders’ Equity     4  
    Consolidated Statements of Cash Flows     5  
    Notes to Consolidated Financial Statements     6  
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     10  
  Quantitative and Qualitative Disclosures about Market Risk     23  
  Controls and Procedures     24  
           
PART II   OTHER INFORMATION        
  Exhibits     25  
    26  
 EX-31.1
 EX-31.2
 EX-32.1


Table of Contents

HARRIS PREFERRED CAPITAL CORPORATION
 
CONSOLIDATED BALANCE SHEETS
 
                         
    June 30
    December 31
    June 30
 
    2010     2009     2009  
    (unaudited)     (audited)     (unaudited)  
    (in thousands, except share data)  
 
Assets
                       
Cash on deposit with Harris N.A.
  $ 829     $ 916     $ 729  
Securities purchased from Harris N.A. under agreement to resell
    12,500       22,000       10,672  
                         
Total cash and cash equivalents
  $ 13,329     $ 22,916     $ 11,401  
Notes receivable from Harris N.A.
    3,459       3,584       3,896  
Securities available for sale, at fair value
                       
Mortgage-backed
    515,492       515,190       566,047  
U.S. Treasury Bills
    59,998       39,999        
Other assets
    1,808       1,885       2,094  
                         
Total assets
  $ 594,086     $ 583,574     $ 583,438  
                         
Liabilities and Stockholders’ Equity
                       
Accrued expenses
  $ 111     $ 111     $ 869  
Deferred state tax liabilities
    1,720       973       846  
                         
Total liabilities
  $ 1,831     $ 1,084     $ 1,715  
                         
Stockholders’ Equity
                       
73/8% Noncumulative Exchangeable Preferred Stock, Series A ($1 par value); liquidation value of $250,000; 20,000,000 shares authorized; 10,000,000 shares issued and outstanding
  $ 250,000     $ 250,000     $ 250,000  
Common stock ($1 par value); 5,000 shares authorized; 1,180 issued and outstanding
    1       1       1  
Additional paid-in capital
    320,733       320,733       320,733  
Earnings in excess of (less than) distributions
    (320 )     (601 )     250  
Accumulated other comprehensive income — net unrealized gains on available-for-sale securities, net of tax
    21,841       12,357       10,739  
                         
Total stockholders’ equity
  $ 592,255     $ 582,490     $ 581,723  
                         
Total liabilities and stockholders’ equity
  $ 594,086     $ 583,574     $ 583,438  
                         
 
The accompanying notes are an integral part of these financial statements.


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HARRIS PREFERRED CAPITAL CORPORATION
 
CONSOLIDATED STATEMENTS OF INCOME
AND COMPREHENSIVE INCOME
 
                                 
    Quarter Ended
    Six Months Ended  
    June 30,     June 30,  
    2010     2009     2010     2009  
    (in thousands, except share date)  
 
Interest income:
                               
Securities purchased from Harris N.A. under agreement to resell
  $ 27     $ 8     $ 38     $ 17  
Notes receivable from Harris N.A.
    56       62       113       127  
Securities available for sale:
                               
Mortgage-backed
    5,126       5,612       10,407       10,994  
U.S. Treasury Bills
    2       1       3       1  
                                 
Total interest income
  $ 5,211     $ 5,683     $ 10,561     $ 11,139  
                                 
Operating expenses:
                               
Loan servicing fees paid to Harris N.A.
  $ 3     $ 3     $ 6     $ 6  
Advisory fees paid to Harris N.A.
    39       41       102       97  
General and administrative
    77       74       207       194  
                                 
Total operating expenses
  $ 119     $ 118     $ 315     $ 297  
                                 
Income before income taxes
  $ 5,092     $ 5,565     $ 10,246     $ 10,842  
Applicable state income taxes
    371       406       747       791  
                                 
Net Income
  $ 4,721     $ 5,159     $ 9,499     $ 10,051  
Preferred stock dividends
    4,609       4,609       9,218       9,218  
                                 
Net income available to common stockholder
  $ 112     $ 550     $ 281     $ 833  
                                 
Basic and diluted earnings per common share
  $ 94     $ 466     $ 237     $ 746  
                                 
Net income
  $ 4,721     $ 5,159     $ 9,499     $ 10,051  
Other comprehensive income:
                               
Available-for-sale securities:
                               
Unrealized holding gains (losses) arising during the period, net of deferred state taxes
    6,289       (2,728 )     9,484       907  
Less reclassification adjustment for realized (gains) losses included in net income
                       
                                 
Comprehensive income
  $ 11,010     $ 2,431     $ 18,983     $ 10,958  
                                 
 
The accompanying notes are an integral part of these financial statements.


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HARRIS PREFERRED CAPITAL CORPORATION
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 
                 
    Six Months Ended
 
    June 30  
    2010     2009  
    (in thousands)  
 
Balance at January 1
  $ 582,490     $ 500,244  
Net income
    9,499       10,051  
Other comprehensive income
    9,484       907  
Capital contribution and issuance of common stock
          80,000  
Dividends on common stock
          (261 )
Dividends on preferred stock ($0.4609 per share)
    (9,218 )     (9,218 )
                 
Balance at June 30
  $ 592,255     $ 581,723  
                 
 
The accompanying notes are an integral part of these financial statements.


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HARRIS PREFERRED CAPITAL CORPORATION
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                 
    Six Months Ended
 
    June 30,  
    2010     2009  
    (in thousands)  
 
Operating Activities:
               
Net income
  $ 9,499     $ 10,051  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Net decrease (increase) in other assets
    75       (209 )
Net increase in accrued expenses
          756  
                 
Net cash provided by operating activities
  $ 9,574     $ 10,598  
                 
Investing Activities:
               
Repayments of notes receivable from Harris N.A.
  $ 125     $ 388  
Purchases of securities available for sale
    (189,499 )     (261,617 )
Proceeds from maturities/redemptions of securities available-for-sale
    179,431       184,832  
                 
Net cash used in investing activities
  $ (9,943 )   $ (76,397 )
                 
Financing Activities:
               
Cash dividends paid on preferred stock
  $ (9,218 )   $ (9,218 )
Cash dividends paid on common stock
          (261 )
Capital contribution and issuance of common stock
          80,000  
                 
Net cash (used in) provided by financing activities
  $ (9,218 )   $ 70,521  
                 
Net (decrease) increase in cash and cash equivalents with Harris N.A.
  $ (9,587 )   $ 4,722  
Cash and cash equivalents with Harris N.A. at beginning of period
    22,916       6,679  
                 
Cash and cash equivalents with Harris N.A. at end of period
  $ 13,329     $ 11,401  
                 
 
The accompanying notes are an integral part of these financial statements.


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HARRIS PREFERRED CAPITAL CORPORATION
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.  Basis of Presentation
 
Harris Preferred Capital Corporation (the “Company”) is a Maryland corporation whose principal business objective is to acquire, hold, finance and manage qualifying real estate investment trust (“REIT”) assets (the “Mortgage Assets”), consisting of a limited recourse note or notes (the “Notes”) issued by Harris N.A. (the “Bank”) secured by real estate mortgage assets (the “Securing Mortgage Loans”) and other obligations secured by real property, as well as certain other qualifying REIT assets, primarily U.S. treasury securities and securities collateralized with real estate mortgages. The Company holds its assets through a Maryland real estate investment trust subsidiary, Harris Preferred Capital Trust. Harris Capital Holdings, Inc., owns 100% of the Company’s common stock. The Bank owns all common stock outstanding issued by Harris Capital Holdings, Inc.
 
The accompanying consolidated financial statements have been prepared by management from the books and records of the Company. These statements reflect all adjustments and disclosures which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented and should be read in conjunction with the notes to financial statements included in the Company’s 2009 Form 10-K. Certain reclassifications were made to conform prior years’ financial statements to the current year’s presentation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.
 
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
2.  Commitments and Contingencies
 
Legal proceedings in which the Company is a defendant may arise in the normal course of business. There is no pending litigation against the Company at June 30, 2010.
 
3.  Securities
 
The amortized cost and estimated fair value of securities available for sale were as follows:
 
                                 
    June 30, 2010  
    Amortized
    Unrealized
    Unrealized
    Fair
 
    Cost     Gains     Losses     Value  
    (in thousands)  
 
Available-for-Sale Securities
                               
Residential mortgage-backed
  $ 491,931     $ 23,561     $     $ 515,492  
U.S. Treasury Bills
    59,998                   59,998  
                                 
Total Securities
  $ 551,929     $ 23,561     $     $ 575,490  
                                 
 


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HARRIS PREFERRED CAPITAL CORPORATION
 
                                 
    December 31, 2009  
    Amortized
    Unrealized
    Unrealized
    Fair
 
    Cost     Gains     Losses     Value  
    (in thousands)  
 
Available-for-Sale Securities
                               
Residential mortgage-backed
  $ 501,861     $ 14,214     $ 885     $ 515,190  
U.S. Treasury Bills
    40,000             1       39,999  
                                 
Total Securities
  $ 541,861     $ 14,214     $ 886     $ 555,189  
                                 
 
                                 
    June 30, 2009  
    Amortized
    Unrealized
    Unrealized
    Fair
 
    Cost     Gains     Losses     Value  
    (in thousands)  
 
Available-for-Sale Securities
                               
Residential mortgage-backed
  $ 554,463     $ 13,207     $ 1,623     $ 566,047  
 
The Company classifies all securities as available for sale. The Company has no intent to sell specific securities and the Company has the ability to hold all securities to maturity. Available-for-sale securities are reported at fair value with unrealized gains and losses included as a separate component of stockholders’ equity. At June 30, 2010, net unrealized gains on available-for-sale securities were $23.6 million compared to $13.3 million of net unrealized gains on December 31, 2009 and $11.6 million of net unrealized gains at June 30, 2009.
 
In making a determination of temporary vs. other-than-temporary impairment of an investment, a major consideration of management is whether the Company will be able to collect all amounts due according to the contractual terms of the investment. Such a determination involves estimation of the outcome of future events as well as knowledge and experience about past and current events. Factors considered include the following: whether the fair value is significantly below cost and the decline is attributable to specific adverse conditions in an industry or geographic area; the period of time the decline in fair value has existed; if an outside rating agency has downgraded the investment; if dividends have been reduced or eliminated; if scheduled interest payments have not been made and finally, whether the financial condition of the issuer has deteriorated. In addition, it may be necessary for the Company to demonstrate its ability and intent to hold a debt security to maturity.
 
The following tables summarize residential mortgage-backed and U.S. Treasuries securities with unrealized losses, the amount of the unrealized loss and the related fair value of the securities with unrealized losses. The unrealized losses have been further segregated by mortgage-backed and U.S. Treasury securities that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position. As of June 30, 2010 and 2009, there were no securities that were in a loss position for 12 or more months. Management believes that all of the unrealized losses, caused by interest rate increases on investments in mortgage-backed securities and U.S. Treasuries, are temporary. The contractual cash flows of these securities are guaranteed directly by a U.S. government-sponsored enterprise. It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments and does not anticipate being required to sell these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired. There were no reclassification adjustments for security sales

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HARRIS PREFERRED CAPITAL CORPORATION
 
during the periods ended June 30, 2010 and June 30, 2009. There were no unrealized losses on securities as of June 30, 2010.
 
                                                 
    December 31, 2009  
    Length of Continuous Unrealized Loss Position  
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
          Unrealized
 
    Fair Value     Losses     Fair Value     Losses     Fair Value     Losses  
                (in thousands)              
 
Residential mortgage-backed
  $ 104,988     $ 885     $     $     $ 104,988     $ 885  
U.S. Treasury Bills
    39,999       1                   39,999       1  
                                                 
    $ 144,987     $ 886     $     $     $ 144,987     $ 886  
 
                                                 
    June 30, 2009  
    Length of Continuous Unrealized Loss Position  
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
          Unrealized
 
    Fair Value     Loss     Fair Value     Losses     Fair Value     Losses  
                (in thousands)              
 
Residential mortgage-backed
  $ 146,066     $ 1,623     $     $     $ 146,066     $ 1,623  
 
The amortized cost and estimated fair value of total available-for-sale securities as of June 30, 2010, by contractual maturity, are shown below. Expected maturities can differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
                 
    June 30, 2010  
    Amortized
    Fair
 
    Cost     Value  
    (in thousands)  
 
Maturities:
               
Within 1 year
  $ 75,827     $ 76,014  
1 to 5 years
    17,563       17,968  
5 to 10 years
    140,906       150,518  
Over 10 years
    317,633       330,990  
                 
Total
  $ 551,929     $ 575,490  
                 
 
4.  Fair Value Measurements
 
The Company uses a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Level 1 relies on the use of quoted market prices. Level 2 relies on valuation models using observable market information as inputs and Level 3 relies on internal models without observable market information. The Company has investments in U.S. Treasuries that are classified in Level 1 of the fair value hierarchy. The Company has investments in U.S. government sponsored mortgage-backed securities that are classified in Level 2 of the fair value hierarchy. External vendors typically use pricing models to determine fair values for the securities. Standard market inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets and additional market reference data.


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HARRIS PREFERRED CAPITAL CORPORATION
 
Assets that are measured at fair value on a recurring basis at June 30, 2010, December 31, 2009 and June 30, 2009 are presented in the following table:
 
                                 
    Fair Value
    Fair Value Measurements Using  
    June 30, 2010     Level 1     Level 2     Level 3  
          (in thousands)  
 
Available-for-sale securities
                               
Residential mortgage-backed
  $ 515,492     $     $ 515,492     $  
U.S. Treasury
    59,998       59,998              
                                 
    $ 575,490     $ 59,998     $ 515,492     $  
                                 
 
                                 
    Fair Value
    Fair Value Measurements Using  
    December 31, 2009     Level 1     Level 2     Level 3  
          (in thousands)  
 
Available-for-sale securities
                               
Residential mortgage-backed
  $ 515,190     $     $ 515,190     $  
U.S. Treasury
    39,999       39,999              
                                 
    $ 555,189     $ 39,999     $ 515,190     $  
                                 
 
                                 
    Fair Value
    Fair Value Measurements Using  
    June 30, 2009     Level 1     Level 2     Level 3  
          (in thousands)  
 
Available-for-sale securities
                               
Residential mortgage-backed
  $ 566,047     $     $ 566,047     $  
 
5.  Fair Value of Financial Instruments
 
Generally accepted accounting principles require the disclosure of estimated fair values for both on and off-balance-sheet financial instruments. The Company’s fair values are based on quoted market prices when available. For financial instruments not actively traded, fair values have been estimated using various valuation methods and assumptions. Although management used its best judgment in estimating these values, there are inherent limitations in any estimation methodology. In addition, accounting pronouncements require that fair values be estimated on an item-by-item basis, thereby ignoring the impact a large sale would have on a thin market and intangible values imbedded in established lines of business. Therefore, the fair value estimates presented herein are not necessarily indicative of the amounts the Company could realize in an actual transaction. The fair value estimation methodologies employed by the Company were as follows:
 
The carrying amounts for cash and demand balances due from banks along with short-term money market assets (including securities purchased under agreement to resell) and accrued interest receivable reported on the Company’s Consolidated Balance Sheets were considered to be the best estimates of fair value for these financial instruments due to their short term nature.
 
The fair value of notes receivable from Harris N.A. was estimated using a discounted cash flow calculation utilizing current market rates offered by Harris N.A. as the discount rates.
 
The fair value of securities available for sale and the methods used to determine fair value are provided in Notes 3 and 4 to the Consolidated Financial Statements.


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HARRIS PREFERRED CAPITAL CORPORATION
 
The estimated fair values of the Company’s financial instruments at June 30, 2010 are presented in the following table.
 
                 
    June 30, 2010  
    Carrying
    Fair
 
    Value     Value  
    (in thousands)  
 
Assets
               
Cash on deposit with Harris N.A.
  $ 829     $ 829  
Securities purchased from Harris N.A. under agreement to resell
    12,500       12,500  
Notes receivable from Harris N.A.
    3,459       5,317  
Securities available for sale
    575,490       575,490  
Accrued interest receivable
    1,808       1,808  
                 
Total on-balance-sheet financial assets
  $ 594,086     $ 595,944  
                 
 
6.  Operating Segment
 
The Company’s operations consist of monitoring and evaluating the investments in mortgage assets. Accordingly, the Company operates in only one segment. The Company has no external customers and transacts most of its business with the Bank.
 
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Information
 
The statements contained in this Report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company’s expectation, intentions, beliefs or strategies regarding the future. Forward-looking statements include the Company’s statements regarding tax treatment as a real estate investment trust, liquidity, provision for loan losses, capital resources and investment activities. In addition, in those and other portions of this document, the words “anticipate,” “believe,” “estimate,” “expect,” “intend” and other similar expressions, as they relate to the Company or the Company’s management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future events and are subject to certain risks, uncertainties and assumptions. It is important to note that the Company’s actual results could differ materially from those described herein as anticipated, believed, estimated or expected. Among the factors that could cause the results to differ materially are the risks discussed in Item 1A. “Risk Factors” in the Company’s 2009 Form 10-K and in the “Risk Factors” section included in the Company’s Registration Statement on Form S-11 (File No. 333-40257), with respect to the Preferred Shares declared effective by the Securities and Exchange Commission on February 5, 1998. The Company assumes no obligation to update any such forward-looking statement.
 
Results of Operations
 
Second Quarter 2010 Compared with Second Quarter 2009
 
The Company’s net income for the second quarter of 2010 was $4.7 million, compared to $5.2 million from the second quarter 2009.
 
Interest income on securities purchased under agreement to resell for the second quarter of 2010 was $27 thousand, on an average balance of $72 million, with an annualized yield of 0.15%. During the same period in 2009, the interest income on securities purchased under agreement to resell was $8 thousand, on an average balance of $31 million, with an annualized yield of 0.10%. The Federal Funds rate at June 30, 2010 was 0.18%. Second quarter 2010 interest income on the Notes totaled $56 thousand and yielded 6.4% on $3.5 million of average principal


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HARRIS PREFERRED CAPITAL CORPORATION
 
outstanding for the quarter compared to $62 thousand and a 6.4% yield on $3.9 million average principal outstanding for second quarter 2009. The decrease in interest income was attributable to a reduction in the Notes balance resulting from customer payoffs in the Securing Mortgage Loans. At June 30, 2010 and 2009, there were no Securing Mortgage Loans on nonaccrual status. Interest income on securities available for sale for the current quarter was $5.1 million resulting in a yield of 4.17% on an average balance of $492 million, compared to $5.6 million with a yield of 4.16% on an average balance of $539 million for the same period a year ago. Virtually all income in the current quarter was attributable to the residential mortgage-backed security portfolio.
 
There were no Company borrowings during second quarter 2010 or 2009.
 
Second quarter 2010 operating expenses totaled $119 thousand, an increase of 1% from the second quarter of 2009. General and administrative expenses totaled $77 thousand, an increase of $3 thousand over the same period in 2009, primarily due to increases in processing costs. Advisory fees for the second quarter 2010 were $39 thousand compared to $41 thousand a year earlier.
 
On June 30, 2010, the Company paid a cash dividend of $0.46094 per share on outstanding Preferred Shares to the stockholders of record on June 15, 2010 as declared on May 26, 2010. On June 30, 2009, the Company paid a cash dividend of $0.46094 per share on outstanding Preferred Shares to the stockholders of record on June 15, 2009 as declared on May 28, 2009. On June 22, 2009 the Company paid a cash dividend in the amount of $261,477 to the common stockholder of record on June 15, 2009.
 
The National Bank Act requires all national banks, including the Bank, to obtain prior approval from the OCC if dividends declared by the national bank (including subsidiaries of the national bank (except for dividends paid by such subsidiary to the national bank)) in any calendar year, will exceed its net income for that year, combined with its retained income (as defined in the applicable regulations) for the preceding two years. These provisions apply to a national bank and its subsidiaries on a consolidated basis, notwithstanding the earnings of any subsidiary on a stand-alone basis. Beginning in 2009, the Bank no longer had sufficient capacity to declare and pay dividends without prior regulatory approval of the OCC. As a result, the Company, as an indirect subsidiary of the Bank, became subject to the provisions relating to dividend approval, and the Bank must receive prior approval from the OCC before the Company declares dividends on the Preferred Shares. Prior approval from the OCC was received for the most recent dividend declaration in June 2010. With respect to any dividends on the Preferred Shares that may be declared by the Company’s Board of Directors in the third quarter ended September 30, 2010, the Company has sought and received permission from the OCC for such a declaration, subject to the Company’s determination that such dividends are appropriate. The Company anticipates the need to request similar approvals from the OCC for subsequent quarters of 2010. At this time, the Company has no reason to expect that such approvals will not be received. There is no assurance that the Bank and the Company will not be subject to the requirement to receive prior regulatory approvals for Preferred Shares dividend payments in the future or that, if required, such approvals will be obtained.
 
Six Months Ended June 30, 2010 compared with June 30, 2009
 
The Company’s net income for the six months ended June 30, 2010 was $9.5 million. This represented a $553 thousand or 5.5% decrease from earnings for the six months ended June 30, 2009. Earnings decreased primarily because of lower interest yields on lower average balances of earning assets in 2010 compared to 2009.
 
Interest income on securities purchased under agreement to resell for the six months ended June 30, 2010 was $38 thousand, on an average balance of $66 million, with a yield of 0.12%. During the same period in 2009, the interest income on securities purchased under agreement to resell was $17 thousand on an average balance of $32 million, with a yield of 0.10%. Interest income on the Notes for the six months ended June 30, 2010 totaled $113 thousand, yielding 6.4% on $3.6 million of average principal outstanding compared to $127 thousand of income yielding 6.4% on $4.0 million of average principal outstanding for the same period in 2009. The decrease in income was attributable to a reduction in the Notes balance resulting from customer payoffs on the Securing Mortgage Loans. Interest income on securities available-for-sale for the six months ended June 30, 2010 was $10.4 million resulting in a yield of 4.2% on an average balance of $495 million, compared to $11.0 million


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HARRIS PREFERRED CAPITAL CORPORATION
 
resulting in a yield of 4.3% on an average balance of $508 million for the same period a year ago. The decrease in interest income from available-for-sale securities is primarily attributable to maturities in the portfolio of mortgage-backed securities with reinvestment in similar securities at a lower yield. There were no Company borrowings during either period.
 
Operating expense for the six months ended June 30, 2010 totaled $315 thousand, an increase of $18 thousand from the same period a year ago. Advisory fees for the six months ended June 30, 2010 were $102 thousand compared to $97 thousand for the same period a year ago. General and administrative expenses totaled $207 thousand, an increase of $13 thousand or 7% from the same period in 2009 as a result of increased costs for director fees and also due to a change in assessing certain affiliate services. Loan servicing expenses for the six months ended June 30, 2010 and 2009 totaled $6 thousand.
 
Liquidity Risk Management
 
The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company’s financial commitments. In managing liquidity, the Company takes into account various legal limitations placed on a REIT.
 
The Company’s principal asset management requirements are to maintain the current earning asset portfolio size through the acquisition of additional Notes or other qualifying assets in order to pay dividends to its stockholders after satisfying obligations to creditors. The acquisition of additional Notes or other qualifying assets is funded with the proceeds obtained as a result of repayment of principal balances of individual Securing Mortgage Loans or maturities or sales of securities. The payment of dividends on the Preferred Shares is made from legally available funds, arising from operating activities of the Company. The Company’s cash flows from operating activities principally consist of the collection of interest on the Notes, mortgage-backed securities and other earning assets. The Company does not have and does not anticipate having any material capital expenditures.
 
In order to remain qualified as a REIT, the Company must distribute annually at least 90% of its adjusted REIT ordinary taxable income, as provided for under the Internal Revenue Code, to its common and preferred stockholders. The Company currently expects to distribute dividends annually equal to 90% or more of its adjusted REIT ordinary taxable income.
 
The Company anticipates that cash and cash equivalents on hand and the cash flow from the Notes and mortgage-backed and U.S. treasury securities will provide adequate liquidity for its operating, investing and financing needs including the capacity to continue preferred dividend payments on an uninterrupted basis.
 
As presented in the accompanying Consolidated Statements of Cash Flows, the primary sources of funds in addition to $9.6 million provided from operations during the six months ended June 30, 2010, were $179.4 million from the maturities of securities available-for-sale. In the prior period ended June 30, 2009, the primary sources of funds other than $10.6 million from operations were $184.8 million from the maturities of securities available-for-sale and the $80 million capital contribution received by the Company from the sale of its common stock. The primary uses of funds for the six months ended June 30, 2010 were $189.5 million for purchases of securities available-for-sale and $9.2 million in preferred stock dividends paid. For the prior year’s period ended June 30, 2009, the primary uses of funds were $261.6 million for purchases of securities available-for-sale and $9.2 million in preferred stock dividends paid. Net cash used in financing activities were $9.2 million of cash compared to $70.5 million of cash provided in the prior period ended June 30, 2009. The primary reason was the issuance of stock and capital contribution from the Company’s parent totaling $80 million in 2009.
 
Market Risk Management
 
The Company’s market risk is composed primarily of interest rate risk. There have been no material changes in market risk or the manner in which the Company manages market risk since December 31, 2009.


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HARRIS PREFERRED CAPITAL CORPORATION
 
Tax Matters
 
As of June 30, 2010, the Company believes that it is in full compliance with the REIT federal tax rules, and expects to qualify as a REIT under the provisions of the Internal Revenue Code. The Company expects to meet all REIT requirements regarding the ownership of its stock and anticipates meeting the annual distribution requirements. Beginning January 1, 2009, Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single person. Management believes that the Company would be classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the Company’s outstanding common shares are held by Harris Capital Holdings, Inc. a wholly owned subsidiary of Harris N.A. and (2) the Company’s Common Stock represent more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. Management believes that the state tax expense to be incurred by the Company in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the preferred shares. The current Illinois statutory tax rate is 7.3%. This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock. For the second quarter and first six months of 2010, $371,000 and $747,000 of Illinois income tax expense was recorded compared to $406,000 in the second quarter 2009 and $791,000 in the first six months of 2009.
 
Financial Statements of Harris N.A.
 
The following unaudited financial information for the Bank is included because the Company’s Preferred Shares are automatically exchangeable for a new series of preferred stock of the Bank upon the occurrence of certain events.


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HARRIS N.A. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CONDITION
 
                         
    June 30
    December 31
    June 30
 
    2010     2009     2009  
    (unaudited)     (audited)     (unaudited)  
    (in thousands except share data)  
 
ASSETS
                       
Cash and demand balances due from banks
  $ 686,350     $ 904,865     $ 1,102,486  
Money market assets:
                       
Interest-bearing deposits at banks ($10.2 billion, $8.4 billion, and $3.0 billion held at Federal Reserve Bank at June 30, 2010, December 31, 2009, and June 30, 2009 respectively)
    10,788,872       9,231,581       4,311,466  
Federal funds sold and securities purchased under agreement to resell
    141,050       174,979       78,538  
                         
Total cash and cash equivalents
  $ 11,616,272     $ 10,311,425     $ 5,492,490  
Securities available-for-sale at fair value
    5,496,483       5,898,831       7,616,642  
Trading account assets and derivative instruments
    1,207,521       1,353,509       1,336,124  
Loans, net of unearned income
    22,735,050       23,175,717       24,250,612  
Allowance for loan losses
    (701,490 )     (680,782 )     (646,184 )
                         
Net loans
  $ 22,033,560     $ 22,494,935     $ 23,604,428  
Loans held for sale
    21,755       29,974       92,775  
Premises and equipment
    524,664       526,623       527,451  
Bank-owned insurance
    1,358,149       1,339,657       1,320,877  
Goodwill and other intangible assets
    908,379       817,507       766,582  
Other assets
    1,775,740       1,199,166       815,350  
                         
Total assets
  $ 44,942,523     $ 43,971,627     $ 41,572,719  
                         
LIABILITIES
                       
Deposits in domestic offices — noninterest-bearing
  $ 8,274,901     $ 9,704,773     $ 7,494,673  
 — interest-bearing (includes $1.1 billion, $707.4 million and $187.4 million measured at fair value at June 30, 2010, December 31, 2009 and June 30, 2009, respectively)
    21,724,858       18,968,058       19,130,311  
Deposits in foreign offices     — interest-bearing
    1,511,593       1,622,410       2,351,579  
                         
Total deposits
  $ 31,511,352     $ 30,295,241     $ 28,976,563  
Federal funds purchased
    247,270       236,099       328,963  
Securities sold under agreement to repurchase
    1,347,299       2,512,490       661,927  
Short-term borrowings
    642,454       717,050       992,516  
Short-term senior notes
                400,000  
Accrued interest, taxes and other expenses
    180,803       172,618       194,813  
Accrued pension and post-retirement
    22,898       58,393       109,725  
Other liabilities
    757,754       643,289       450,415  
Long-term notes — senior/unsecured
    2,396,500       2,396,500       2,646,500  
Long-term notes — senior/secured
    2,375,000       2,375,000       2,375,000  
Long-term notes — subordinated
    200,000       292,750       292,750  
                         
Total liabilities
  $ 39,681,330     $ 39,699,430     $ 37,429,172  
                         
STOCKHOLDER’S EQUITY
                       
Common stock ($10 par value); authorized 40,000,000 shares; issued and outstanding 19,989,512 shares at June 30, 2010, 17,534,512 shares at December 31, 2009, and 17,149,512 shares at June 30, 2009
  $ 199,895     $ 175,345     $ 171,495  
Surplus
    3,291,667       2,322,917       2,173,757  
Retained earnings
    1,637,817       1,621,719       1,693,581  
Accumulated other comprehensive loss
    (118,241 )     (97,784 )     (145,286 )
                         
Stockholder’s equity before noncontrolling interest — preferred stock of subsidiary
  $ 5,011,138     $ 4,022,197     $ 3,893,547  
Noncontrolling interest — preferred stock of subsidiary
    250,055       250,000       250,000  
                         
Total stockholder’s equity
  $ 5,261,193     $ 4,272,197     $ 4,143,547  
                         
Total liabilities and stockholder’s equity
  $ 44,942,523     $ 43,971,627     $ 41,572,719  
                         
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


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HARRIS N.A. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
                                 
    Quarter Ended June 30,     Six Months Ended June 30,  
    2010     2009     2010     2009  
    (in thousands)  
 
Interest Income
                               
Loans
  $ 277,188     $ 273,201     $ 532,246     $ 561,179  
Money market assets:
                               
Deposits at banks
    6,629       3,693       12,412       10,079  
Federal funds sold and securities purchased under agreements to resell
    21       (310 )     84       145  
Trading account assets
    2,797       2,559       5,747       5,097  
Securities available-for-sale:
                               
U.S. Treasury and federal agency
    12,187       25,233       28,184       59,502  
State and municipal
    12,067       13,552       24,488       27,405  
Other
    4,399       5,607       5,868       9,716  
                                 
Total interest income
  $ 315,288     $ 323,535     $ 609,029     $ 673,123  
                                 
Interest Expense
                               
Deposits
  $ 45,891     $ 80,850     $ 88,659     $ 192,830  
Short-term borrowings
    1,910       2,413       3,663       4,310  
Short-term senior notes
          1,313             1,319  
Long-term notes — senior/unsecured
    22,782       8,162       45,261       18,479  
Long-term notes — senior/secured
    8,371       2,495       20,611       5,328  
Long-term notes — subordinated
    365       1,081       832       2,731  
                                 
Total interest expense
  $ 79,319     $ 96,314     $ 159,026     $ 224,997  
                                 
Net Interest Income
  $ 235,969     $ 227,221     $ 450,003     $ 448,126  
Provision for loan losses
    92,019       147,142       183,746       240,236  
                                 
Net Interest Income after Provision for Loan Losses
  $ 143,950     $ 80,079     $ 266,257     $ 207,890  
                                 
Noninterest Income
                               
Trust and investment management fees
  $ 23,433     $ 19,856     $ 43,995     $ 38,638  
Net money market and bond trading income, including derivative activity
    11,283       4,776       25,140       9,209  
Foreign exchange trading gains, net
    1,303       2,775       4,216       5,400  
Service charges and fees
    53,331       51,815       100,241       99,462  
Charge card income
    29,454       277       58,748       333  
Equity securities gains, net
    1,913       2,835       4,088       3,937  
Net securities gains, other than trading
    642       500       2,316       30,019  
Other-than-temporary impairment on securities
    (110 )     (850 )     (131 )     (1,033 )
Bank-owned insurance
    11,238       11,423       23,138       22,526  
Letter of credit fees
    6,207       5,268       11,593       10,362  
Net gains on loans held for sale
    3,573       9,400       7,668       11,618  
Other
    9,494       9,902       20,194       18,418  
                                 
Total noninterest income
  $ 151,761     $ 117,977     $ 301,206     $ 248,889  
                                 
Noninterest Expenses
                               
Salaries and other compensation
  $ 111,750     $ 105,238     $ 205,761     $ 198,117  
Pension, profit sharing and other employee benefits
    24,666       23,575       54,405       54,306  
Net occupancy
    24,051       24,035       49,020       51,019  
Equipment
    18,484       17,079       38,532       34,581  
Marketing
    14,752       9,792       26,643       18,617  
Communication and delivery
    8,131       7,249       15,503       14,896  
Professional fees
    27,673       21,160       48,799       49,378  
Outside information processing, database and network fees
    7,351       8,702       15,856       17,681  
FDIC Insurance
    12,137       28,670       23,371       43,704  
Intercompany services, net
    (2,314 )     (198 )     (5,262 )     (382 )
Visa indemnification reversal
    (2,800 )           (2,800 )      
Charge card expense
    6,997             14,302        
Amortization of intangibles
    6,554       7,080       12,242       14,186  
Other
    34,839       22,789       58,592       41,032  
                                 
Total noninterest expenses
  $ 292,271     $ 275,171     $ 554,964     $ 537,135  
                                 
Income (loss) before income tax benefit
  $ 3,440     $ (77,115 )   $ 12,499     $ (80,356 )
Applicable income tax benefit
    (8,658 )     (37,349 )     (12,818 )     (48,684 )
                                 
Net income (loss)
  $ 12,098     $ (39,766 )   $ 25,317     $ (31,672 )
Less: noncontrolling interest — dividends on preferred stock of subsidiary
    4,610       4,609       9,219       9,219  
                                 
Net Income (Loss) Available for Common Stockholder
  $ 7,488     $ (44,375 )   $ 16,098     $ (40,891 )
                                 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


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HARRIS N.A. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
                                 
    Quarter Ended
       
    June 30,     Six Months Ended June 30,  
    2010     2009     2010     2009  
    (in thousands)  
 
Net income (loss) available for common stockholder
  $ 12,098     $ (39,766 )   $ 25,317     $ (31,672 )
Other comprehensive (loss) income:
                               
Cash flow hedges:
                               
Net unrealized (loss) gain on derivative instruments, net of tax (benefit) expense for the quarter of ($6,966) in 2010 and $20,770 in 2009 and net of tax (benefit) expense for the year-to-date period of ($17,179) in 2010 and $29,918 in 2009
    (12,939 )     38,573       (31,905 )     55,560  
Reclassification adjustment for realized loss included in net income (loss), net of tax benefit for the quarter of $548 in 2010 and $401 in 2009 and net of tax benefit for the year-to-date period of $938 in 2010 and $2,081 in 2009
    1,020       744       1,743       3,866  
Pension and postretirement medical benefit plans:
                               
Net (loss) gain and net prior service cost included in net income (loss), net of tax benefit for the quarter of $0 in 2010 and 2009 and net of tax expense for the year-to-date period of $1,318 in 2010 and $3,531 in 2009
    (319 )           4,574       6,556  
Reclassification adjustment for amortization included in net income (loss), net of tax benefit for the quarter of $663 in 2010 and $367 in 2009 and net of tax benefit for the year-to-date period of $1,326 in 2010 and $733 in 2009
    1,231       681       2,462       1,362  
Available-for-sale securities:
                               
Unrealized holding gain arising during the period, net of tax expense for the quarter of $2,749 in 2010 and $6,148 in 2009 and net of tax (benefit) expense for the year-to-date period of ($2,155) in 2010 and $6,947 in 2009
    10,536       11,426       4,174       12,921  
Reclassification adjustment for realized gain included in net income (loss), net of tax expense for the quarter of $225 in 2010 and $473 in 2009 and net of tax expense for the year-to-date period of $811 in 2010 and $10,507 in 2009
    (417 )     (877 )     (1,505 )     (19,512 )
                                 
Other comprehensive (loss) income
  $ (888 )   $ 50,547     $ (20,457 )   $ 60,753  
                                 
Comprehensive income
  $ 11,210     $ 10,781     $ 4,860     $ 29,081  
Comprehensive income related to noncontrolling interest
    4,610       4,609       9,219       9,219  
                                 
Comprehensive income (loss) available for common stockholder
  $ 6,600     $ 6,172     $ (4,359 )   $ 19,862  
                                 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


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HARRIS N.A. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER’S EQUITY
(Unaudited)
 
                                                 
                      Accumulated
    Noncontrolling
       
                      Other
    Interest —
    Total
 
    Common
          Retained
    Comprehensive
    Preferred Stock
    Stockholder’s
 
    Stock     Surplus     Earnings     Loss     of Subsidiary     Equity  
    (in thousands except per share data)  
 
Balance at December 31, 2009
  $ 175,345     $ 2,322,917     $ 1,621,719     $ (97,784 )   $ 250,000     $ 4,272,197  
Stock option exercise
          300                         300  
Net income
                16,098             9,219       25,317  
Dividends — preferred stock of subsidiary
                            (9,219 )     (9,219 )
Change in noncontrolling interest ownership
                            55       55  
Other comprehensive loss
                      (20,457 )           (20,457 )
Issuance of common stock and contribution to capital surplus
    24,550       968,450                         993,000  
                                                 
Balance at June 30, 2010
  $ 199,895     $ 3,291,667     $ 1,637,817     $ (118,241 )   $ 250,055     $ 5,261,193  
                                                 
Balance at December 31, 2008
  $ 171,495     $ 2,172,030     $ 1,734,471     $ (206,039 )   $ 250,000     $ 4,121,957  
Stock option exercise
          494                         494  
Tax benefit from stock option exercise
          1,234                         1,234  
Net income
                (40,891 )           9,219       (31,672 )
Dividends — preferred stock of subsidiary
                            (9,219 )     (9,219 )
Other comprehensive income
                      60,753             60,753  
                                                 
Balance at June 30, 2009
  $ 171,495     $ 2,173,758     $ 1,693,580     $ (145,286 )   $ 250,000     $ 4,143,547  
                                                 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


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HARRIS N.A. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
                 
    Six Months Ended June 30  
    2010     2009  
 
Cash Flows from Operating Activities:
               
Net income (loss)
  $ 25,317     $ (31,672 )
Less: noncontrolling interest — dividends on preferred stock of subsidiary
    9,219       9,219  
                 
Net income (loss) available for common stockholder
  $ 16,098     $ (40,891 )
Adjustments to determine net cash flows provided by operating activities:
               
Provision for loan losses
    183,746       240,236  
Depreciation and amortization, including intangibles
    53,063       56,316  
Deferred tax expense (benefit)
    62,536       (20,758 )
Excess tax expense from stock options exercise
    119       1,234  
Other-than-temporary impairment on securities
    131       1,033  
Net gains on securities, other than trading
    (2,316 )     (30,019 )
Net equity investment gains
    (4,088 )     (3,937 )
Increase in bank-owned insurance
    (18,492 )     (16,562 )
Net decrease in trading securities
    237,391       31,672  
Decrease in accrued interest receivable
    16,058       33,547  
(Increase) decrease in prepaid expenses
    (85,788 )     5,507  
Decrease in accrued interest payable
    (706 )     (49,683 )
Net (increase) decrease in accrued tax payable
    (65,930 )     15,362  
Net (decrease) increase in other accrued expenses
    (42,285 )     72,734  
Net increase in pension and post retirement benefits
    (25,815 )     (51,492 )
Origination of loans held for sale
    (372,086 )     (688,859 )
Proceeds from sale of loans held for sale
    387,973       637,246  
Net gains on loans held for sale
    (7,668 )     (11,618 )
Net gains on sale of premises and equipment
    (803 )     (1,477 )
Recoveries on charged-off loans
    38,369       33,124  
Net increase in settlement clearing account
    (1 )     (13,875 )
Net increase (decrease) in trading hedging derivatives
    27,635       (88,238 )
Visa indemnification reversal
    (2,800 )      
Other, net
    17,266       (49,037 )
                 
Net cash provided by operating activities
  $ 411,607     $ 61,565  
                 
Cash Flows from Investing Activities:
               
Proceeds from sales of securities available-for-sale
  $ 463,525     $ 2,830,608  
Proceeds from maturities of securities available-for-sale
    2,330,121       2,245,203  
Purchases of securities available-for-sale
    (2,393,605 )     (3,372,114 )
Net decrease in loans
    1,493,028       1,944,369  
Proceeds from loans sold to affiliates
    273,522        
Purchases of premises and equipment
    (51,815 )     (49,662 )
Sales of premises and equipment
    18,045       17,867  
Acquisitions, net of cash received
    191,663       (3,423 )
                 
Net cash provided by investing activities
  $ 2,324,484     $ 3,612,848  
                 
Cash flows from Financing Activities:
               
Net decrease in deposits
  $ (1,326,658 )   $ (24,487,001 )
Net increase in deposits measured at fair value
    370,227       109,720  
Net decrease in Federal funds purchased and securities
               
sold under agreement to repurchase
    (1,154,020 )     (2,589,393 )
Net (decrease) increase in other short-term borrowings
    (74,596 )     633,040  
Net increase in short-term senior notes
          325,000  
Proceeds from issuance long-term notes — senior
          550,000  
Repayment of long-term notes — senior/secured
    (137,409 )      
Repayment of long-term notes — subordinated
    (92,750 )      
Net proceeds from stock options exercise
    300       494  
Excess tax expense from stock options exercise
    (119 )     (173 )
Capital contributions
    993,000        
Cash dividends paid on preferred stock
    (9,219 )     (9,219 )
                 
Net cash used in financing activities
  $ (1,431,244 )   $ (25,467,532 )
                 
Net increase (decrease) in cash and cash equivalents
  $ 1,304,847     $ (21,793,119 )
Cash and cash equivalents at January 1
    10,311,425       27,285,609  
                 
Cash and cash equivalents at June 30
  $ 11,616,272     $ 5,492,490  
                 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


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HARRIS N.A. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.   Basis of Presentation
 
Harris N.A. (the “Bank”) is a wholly-owned subsidiary of Harris Bankcorp, Inc. (“Bankcorp”), a wholly-owned subsidiary of Harris Financial Corp. (“HFC”), a wholly-owned U.S. subsidiary of Bank of Montreal. The consolidated financial statements of the Bank include the accounts of the Bank and its wholly-owned subsidiaries. Significant inter-company accounts and transactions have been eliminated. Certain reclassifications were made to conform prior year’s financial statements to the current year’s presentation.
 
On April 23, 2010, the Bank acquired certain assets and liabilities of Rockford, Illinois-based, AMCORE Bank N.A. (“AMCORE”) from the FDIC for $221.5 million. The Bank assumed approximately $2.5 billion in assets, including approximately $2.1 billion in loans, and $2.2 billion in deposits. The Bank recorded a core deposit intangible of $22.1 million to be amortized over 10 years on an accelerated basis and a customer relationship intangible of $1.3 million to be amortized over 13 years on an accelerated basis. The acquisition includes a loss share agreement with the FDIC and the related indemnification asset was estimated at $427.5 million. The Bank recorded goodwill of $84.3 million which is expected to be deductible for tax purposes. Acquisition costs of $4.4 million were recorded to noninterest expense during the quarter ended June 30, 2010. The acquisition provides the Bank the opportunity to expand its branch network into communities in northern Illinois and southern Wisconsin. The results of AMCORE’s operations have been included in the Bank’s consolidated financial statements since April 23, 2010.
 
On December 31, 2009, BMO and the Bank acquired the net cardholder receivables and other assets and obligations of the Diners Club North American franchise from Citigroup for initial cash consideration of $678 million, subject to a post-closing adjustment based on all parties’ final agreement of the net asset value transferred. The acquisition of the net cardholder receivables of Diners Club gives the Bank the right to issue Diners Club cards to corporate and professional clients in the United States and will accelerate the Bank’s initiative to expand in the travel-and-entertainment card sector. As part of this acquisition, the Bank recorded a purchased credit card relationship intangible asset estimated at $44.3 million which will be amortized on an accelerated basis over 15 years. The Bank recorded goodwill of $17.8 million which is expected to be deductible for tax purposes. The gross contractual amount of receivables was $743.2 million and the fair value was $704.6 million. Acquisition-related costs of $0.6 million for the year ended December 31, 2009 were recorded to noninterest expense. The results of the operations have been included in the Bank’s consolidated financial statements since January 1, 2010. As of March 31, 2010 a preliminary contractual true up of $48.4 million was received from Citigroup mainly due to the overestimation of initial credit card loan balances of $56.7 million. As a result, goodwill was decreased by $6.3 million and the credit card relationship intangible asset was increased by $3.4 million. During the quarter ended June 30, 2010 a $15.2 million fair value adjustment to credit card receivables was recorded as an increase to interest income.
 
On February 13, 2009, the Bank completed the acquisition of selected assets of Pierce, Givens & Associates, LLC (“Pierce Givens”) for cash consideration of $3.4 million. The Bank acquired a customer relationship intangible asset estimated at $3.0 million with an expected life of 5 years. No goodwill was recorded in the transaction. Acquisition-related costs of $0.4 million for the year-ended December 31, 2009 were recorded to noninterest expense. The acquisition provides the Bank with the opportunity to expand its tax planning and compliance capabilities in the ultra high-net-worth market. The results of Pierce Givens’ operations have been included in the Bank’s consolidated financial statements since February 14, 2009.
 
The interim consolidated financial statements have been prepared by management from the books and records of the Bank, without audit by independent certified public accountants. However, these statements reflect all adjustments and disclosures which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. Events occurring subsequent to the date of the balance sheet have been evaluated for potential recognition or disclosure in the consolidated financial statements.


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Because the results of operations are so closely related to and responsive to changes in economic conditions, the results for any interim period are not necessarily indicative of the results that can be expected for the entire year.
 
2.   Contingent Liabilities and Litigation
 
Harris N.A. and certain of its subsidiaries are party to legal proceedings in the ordinary course of their businesses. While there is inherent difficulty in predicting the outcome of these proceedings, management does not expect the outcome of any of these proceedings, individually or in the aggregate, to have a material adverse effect on the Bank’s consolidated financial position or results of operations.
 
3.   Cash Flows
 
In the Consolidated Statements of Cash Flows, cash and cash equivalents include cash and demand balances due from banks, interest-bearing deposits at banks and federal funds sold and securities purchased under agreement to resell. Cash interest payments for the six months ended June 30 totaled $156.8 million and $274.7 million in 2010 and 2009, respectively. Cash income tax refunds received for the six months ended June 30, 2010 and 2009 totaled $12.7 million and $59.7 million, respectively.
 
4.   Visa Indemnification Charge
 
HNA was a member of Visa U.S.A. Inc. (“Visa U.S.A.”) and in 2007 received shares of restricted stock in Visa, Inc. (“Visa”) as a result of its participation in the global restructuring of Visa U.S.A., Visa Canada Association, and Visa International Service Association in preparation for an initial public offering by Visa. HNA and other Visa U.S.A. member banks are obligated to share in potential losses resulting from certain indemnified litigation involving Visa that has been settled.
 
A member bank such as HNA is also required to recognize the contingent obligation to indemnify Visa under Visa’s bylaws (as those bylaws were modified at the time of the Visa restructuring on October 3, 2007) for potential losses arising from the other indemnified litigation that has not yet settled at its estimated fair value. HNA is not a direct party to this litigation and does not have access to any specific, non-public information concerning the matters that are the subject of the indemnification obligations. While the estimation of any potential losses is highly judgmental, as of December 31, 2007, HNA recorded a liability and corresponding charge of $34 million (pretax) for the remaining litigation.
 
The initial public offering (IPO) occurred on March 25, 2008 followed by a mandatory partial redemption of Harris’ restricted stock in Visa that took place in two parts: exchange for cash and funding of the covered litigation escrow account. During the first quarter of 2008, HNA received $37.8 million in cash in conjunction with the mandatory partial redemption which was recognized as an equity security gain in the Consolidated Statements of Operations since there was no basis in the stock. In addition, Visa funded the U.S. litigation escrow account with IPO proceeds. Harris’ share of the U.S. litigation escrow account funding was $17 million which was recognized as a reversal to the litigation reserve and as a decrease to non-interest expense.
 
In June 2010, July 2009 and December 2008, HNA recorded decreases to non-interest expense of $2.8 million, $3.0 million and $6.3 million, respectively, as a reduction in the Visa litigation reserve to reflect Visa’s use of a portion of the Bank’s restricted Visa stock to fund the escrow account available to settle certain litigation matters. Visa’s funding of amounts required beyond the current escrow, if any, will be obtained via additional mandatory redemptions of restricted shares. As of June 30, 2010, December 31, 2009 and June 30, 2009, the recorded reserve relating to the Visa litigation matter included in the Consolidated Statements of Condition was $12.0 million, $14.8 million and $17.8 million, respectively.
 
5.   Auction Rate Securities Purchase Program
 
Auction-rate securities (ARS) are typically short-term notes issued in the United States to fund long-term, fixed rate debt instruments (corporate or municipal bonds primarily issued by municipalities, student loan


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HARRIS N.A. AND SUBSIDIARIES
 
authorities and other sponsors). The interest rate on ARS is regularly reset every 7 to 35 days through auctions managed by financial institutions. A disruption in the market for ARS occurred in the early part of 2008. Certain customer-managed portfolios held these securities, which were no longer liquid. Certain of the Bank’s affiliates voluntarily offered to purchase such securities from customers, at par value.
 
In addition, in 2008 a settlement with the Financial Industry Regulatory Authority (“FINRA”) required Harris Investor Services, Inc. (“HIS”), an affiliate of the Bank, to purchase specific holdings of ARS from certain client accounts at par value plus accrued interest. In addition to the required terms of the FINRA settlement, management of certain other legal entities within HFC offered to purchase certain other customer ARS holdings under similar terms. For the ARS holdings purchased by the Bank, the gross par value of ARS holdings purchased was $93.1 million plus accrued interest. A discounted cash flow valuation methodology was applied to estimate the fair value of the securities. The methodology included management assumptions about future cash flows, discount rates, market liquidity and credit spreads.
 
Remaining ARS were purchased during 2009 and had a gross par value of $8.6 million. A minimal pre-tax charge was recorded for the year ended December 31, 2009 for the difference between the estimated fair values and the par values paid by the Bank. The charge was recorded in noninterest expense in the Consolidated Statements of Operations. During the six months ended June 30, 2010 ARS with a gross par value of $16.5 million were called and a gain of $3.6 million was recorded to net securities gains, other than trading in the Consolidated Statements of Operations. The fair value of ARS was $51.8 million as of June 30, 2010, $73.6 million as of December 31, 2009 and $76.8 million as of June 30, 2009. The ARS purchased are classified as available-for-sale.
 
6.   Health Care Legislation
 
In March 2010, new health care legislation (The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act) was enacted that changed the tax treatment of the subsidy associated with postretirement medical benefits. The legislation reduced the tax deductions for the cost of providing postretirement prescription drug coverage by the amount of subsidies received. With enactment of the legislation, the Bank was required to write off any deferred tax asset as a tax expense through the income statement, even if a portion of such asset had initially been established through OCI. As a result of this legislation, the Bank recorded tax expense of $5.5 million during the quarter ended March 31, 2010. Nothing material was recorded during the quarter ended June 30, 2010.
 
7.   Noncontrolling Interests
 
The Bank adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 160, “Noncontrolling Interests in Consolidated Financial Statements-An Amendment of ARB 51,” (subsequently codified in Accounting Standards Codification (“ASC”) Topic 810-10-65) on January 1, 2009. The standard requires noncontrolling interests held by parties other than the parent to be reported as equity in the consolidated financial statements. The Bank has two subsidiaries that are less than wholly-owned and the noncontrolling interest in the preferred stock of the subsidiaries is held by third parties. The noncontrolling interest in the preferred stock of the subsidiaries is presented as a component of stockholder’s equity in the Consolidated Statements of Condition. Net income attributable to the noncontrolling interest is separately presented in the Consolidated Statements of Operations, outside of net income (loss).
 
8.   FDIC Special Assessment
 
On December 30, 2009 the FDIC required insured depository institutions to prepay their estimated quarterly risk-based assessments for all of 2010, 2011, and 2012. The Bank made a payment of $114 million which was recorded as prepaid expense within other assets. As the Bank is charged monthly for FDIC insurance, the Bank will decrease the prepaid expense and charge FDIC insurance expense until the prepaid amount is exhausted. Any prepaid amounts unused at June 30, 2013 will be returned to the Bank. Starting in 2010, fees increased from 10 basis points on an annual basis, to 15 basis points.


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9.   Recent accounting standards
 
The FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 166, “Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140,” (subsequently codified in FASB ASC 860) in June 2009. The standard removes the concept of a qualifying special-purpose entity (“QSPE”). It also creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale. The standard is effective January 1, 2010. The adoption of the standard did not impact the Bank’s financial position or results of operations.
 
The FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),” (subsequently codified in FASB ASC 810) in June 2009. The standard changes the criteria by which an enterprise determines whether it must consolidate a variable interest entity (“VIE”). It amends the existing guidance to require an enterprise to consolidate a VIE if it has both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses or the right to receive benefits from the VIE. Existing guidance requires an enterprise to consolidate a VIE if it absorbs a majority of the expected losses or residual returns, or both. A continuous assessment of which party must consolidate a VIE will be required, rather than an assessment only when certain trigger events occur. In addition, the new standard requires an enterprise to assess if VIEs that were previously QSPEs must be consolidated by the enterprise. The standard is effective January 1, 2010. The adoption of this standard did not impact the Bank’s financial position or results of operations.
 
The FASB issued Accounting Standards Update (“ASU”) 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, in July 2010. The standard requires companies to significantly increase disclosures about the credit quality of financing receivables and the credit reserves held against them. The additional disclosures include aging of past due receivables, credit quality information such as credit risk scores or external credit agency ratings and the modification of financing receivables. Further disaggregation of information by certain classification of the total portfolio will be required. The FASB also amended ASC 310-10-50, Receivables — Overall — Disclosure, in order to expand the requirements for separate reporting and disclosure of allowances for credit losses and the policies for managing credit exposures. The disclosures will be effective for the Bank for the annual reporting period ending December 31, 2011. The Bank does not expect the adoption of this standard to impact it’s financial position or results of operations.


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HARRIS N.A. AND SUBSIDIARIES
 
FINANCIAL REVIEW
 
Second Quarter 2010 Compared with Second Quarter 2009
 
Summary
 
For the second quarter 2010, Harris N.A. and subsidiaries (“Bank”) reported net income of $7.5 million, an increase of $51.9 million from the second quarter of 2009, reflecting a significant reduction in the provision for loan losses as well as earnings associated with the Diners Club North American franchise purchased from Citigroup, which closed at the end of December 2009. The results also include the acquisition of certain assets and liabilities of Rockford, IL based AMCORE Bank, N.A. (AMCORE) from the Federal Deposit Insurance Corporation (FDIC) in April, 2010 (Note 1).
 
Net interest income was $236.0 million, up $8.7 million or 3.8 percent from a year ago, largely due to lower cost of deposits and the additional net interest income associated with the acquisition of AMCORE. Average earning assets increased to $40.1 billion in the second quarter of 2010 from $39.2 billion in 2009. This primarily reflects an increase in interest bearing deposits placed at the Federal Reserve Bank ($5.3 billion) largely offset by decreases in loan balances ($1.7 billion) and the available-for-sale securities portfolio ($2.1 billion). The higher average earning asset level was partially offset by a 2 basis point decrease in the net interest margin to 2.42 percent from 2.44 percent in the second quarter of 2009. The lower margin reflects a lower rate of return on securities available-for-sale plus an increase in the level of low-yield interest bearing deposits placed at the Federal Reserve Bank largely offset by reduced interest costs on deposits and improved loan yields.
 
Provision for loan losses for the second quarter 2010 was $92.0 million, a decrease of $55.1 million or 37.5 percent from second quarter 2009 mainly attributable to a decrease in reserves for specific commercial credits partially offset by $21.3 million of provision associated with the Diners Club portfolio. Net loan charge-offs during the quarter were $83.6 million compared to $108.5 million in the same period last year primarily due to decreases in both commercial and consumer loan charge-offs. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio under current economic conditions and management’s estimate of losses inherent in the portfolio.
 
Noninterest income for the second quarter 2010 was $151.8 million, an increase of $33.8 million or 28.6 percent. This increase largely reflects $29.2 million of additional charge card income due to the Diners Club acquisition. Additionally, higher trading revenues ($6.5 million) and trust fees ($3.6 million) were partially offset by a year over year decrease in net gains on loans held for sale ($5.8 million).
 
Second quarter 2010 noninterest expenses were $292.3 million, up $17.1 million or 6.2 percent from second quarter 2009. Higher costs associated with the Diners Club credit card portfolio ($11.0 million) and the acquisition of AMCORE ($22.8 million) were partially offset by a $16.8 million reduction in FDIC insurance expense, which reflects a $19.0 million FDIC special assessment in 2009 (Note 8). Additionally, a $5.4 million increase in mortgage servicing rights impairment was partially offset by the Bank’s reversal of $2.8 million of reserves in conjunction with the Visa litigation escrow account funding and lower intangible amortization expense ($1.9 million). The income tax benefit decreased $28.7 million from the second quarter of 2009 primarily due to the increase in pre-tax income between periods. A tax benefit was recorded this quarter despite positive pre-tax earnings due to the benefit of certain tax exempt loans and investments as well as bank owned life insurance.
 
Nonperforming loans at June 30, 2010 totaled $686.1 million or 3.02 percent of total loans, up from $486.0 million or 2.10 percent of total loans at December 31, 2009 and $549.5 million or 2.27 percent a year earlier, primarily attributable to higher commercial non-performing loans. At June 30, 2010, the allowance for loan losses was $701.5 million, equal to 3.09 percent of loans outstanding compared to $680.8 million or 2.94 percent of loans outstanding and $646.2 million or 2.66 percent of loans outstanding at December 31, 2009 and June 30, 2009, respectively. Coverage of nonperforming loans by the allowance for loan losses decreased from 118 percent at June 30, 2009 to 101 percent at June 30, 2010, largely due to higher non-performing loan levels. At December 31, 2009, the ratio was 140 percent. Ratios reflect the sale of loans to psps Holdings, LLC, a subsidiary of Harris


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Financial Corp., in the amount of $502.7 million during the full year 2009 and $273.5 million in the second quarter 2010.
 
At June 30, 2010 consolidated stockholder’s equity of the Bank amounted to $5.3 billion, up $1.0 billion from December 31, 2009, mainly due to a capital contribution from Harris Bankcorp, Inc. during the year. Return (loss) on equity was 0.72 percent in the current quarter, compared to (4.57) percent in last year’s second quarter. Return (loss) on assets was 0.07 percent compared to (0.41) percent a year ago. The Bank did not declare any dividends on common stock in either the current quarter or in the year-ago quarter.
 
At June 30, 2010 Tier 1 capital of the Bank amounted to $4.5 billion, up $1.1 billion from a year ago, while risk-weighted assets declined by $3.0 billion to $28.5 billion. The Bank’s June 30, 2010 Tier 1 and total risk-based capital ratios were 15.73 percent and 17.60 percent compared to respective ratios of 11.46 percent and 13.55 percent at December 31, 2009 and 10.68 percent and 12.73 percent at June 30, 2009. The regulatory leverage capital ratio was 10.35 percent for the second quarter of 2010 compared to 8.82 percent at year-end 2009 and 7.95 percent a year ago. The Bank’s capital ratios significantly exceed the prescribed regulatory minimum for “well-capitalized” banks.
 
Six Months Ended June 30, 2010 Compared with Six Months Ended June 30, 2009
 
Summary
 
For the six months ended June 30, 2010, the Bank reported net income of $16.1 million, an increase of $57.0 million from the net loss of $40.9 million for the same period last year, mainly due to higher charge card fees resulting from the purchase of the Diners Club North American franchise from Citigroup, which closed at the end of December 2009, as well as a reduction in the provision for loan losses. The results also include the acquisition of certain assets and liabilities of Rockford, IL based AMCORE Bank, N.A. (AMCORE) from the Federal Deposit Insurance Corporation (FDIC) in April (Note 1). Return (loss) on equity was 0.80 percent in the current year, compared to (2.14) percent for first six months of last year. Return (loss) on assets was 0.08 percent compared to (0.17) percent a year ago.
 
Net interest income was $450.0 million, up slightly from the $448.1 million reported a year ago as reduced loan income and interest on securities available for sale were offset by reduced interest costs on deposits. Net interest margin increased to 2.37 percent in 2010 from 2.15 percent in the same period in 2009, reflecting lower costs of deposits and improved yield on loans. Average earning assets of $39.3 billion decreased $3.9 billion with a $2.4 billion decline in loans and a decrease of $2.2 billion in available-for-sale securities due to maturities partially offset by a $1.1 billion increase in Federal Reserve Bank deposits.
 
Year-to-date 2010 provision for loan losses was $183.7 million compared to $240.2 million in 2009. This is primarily attributable to a decrease in reserves for specific commercial credits partially offset by $29.7 million provision associated with the Diners Club portfolio acquired in December of 2009. Net charge-offs decreased to $163.2 million from $166.8 million in the prior year, reflecting a lower level of commercial charge-offs.
 
Noninterest income was $301.2 million, up $52.7 million or 21.0 percent from a year ago. This reflects $58.4 million of charge card income due to the Diners Club acquisition plus higher trading revenues ($15.9 million) and trust fees ($5.4 million) partially offset by a decrease in net gains on loans held for sale ($27.7 million).
 
Noninterest expenses were $555.0 million, an increase of $17.8 million or 3.3 percent. Several items affect the year over year comparison including higher costs associated with the Diners Club credit card portfolio ($22.6 million) and the acquisition of AMCORE ($23.0 million, including integration expense of $6.5 million). These additional costs were partially offset by a $20.3 million reduction in FDIC Insurance expense, which reflects a $19.0 million FDIC special assessment in 2009 (Note 8). Excluding the impact of these items, expenses were down $7.4 million or 1.5 percent with lower professional fees ($6.3 million), inter-company service charges ($5.9 million), employee costs ($5.6 million), amortization of intangibles ($3.7 million) and the Bank’s reversal of $2.8 million of reserves in conjunction with the Visa litigation escrow account funding being partially offset by higher marketing expense ($7.5 million), mortgage servicing rights impairment ($5.4 million) and other credit related costs ($5.5 million). The income tax benefit decreased $35.9 million from the first six months of 2009 primarily due to the increase in pre-tax income between periods. Results reflect a tax benefit despite positive pre-tax earnings due to the benefit of certain tax exempt loans and investments as well as bank owned life insurance.


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Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
See “Liquidity Risk Management” and “Market Risk Management” under Management’s Discussion and Analysis of Financial Condition and Results of Operations on page 10.
 
The following table stratifies the Company’s available-for-sale securities by maturity date (dollars in thousands):
 
                                                                 
    July 1, 2010 to
    Year Ending December 31,                 Fair Value at
 
    Dec. 31, 2010     2011     2012     2013     2014     Thereafter     Total     June 30, 2010  
 
Residential mortgage-backed
                                                               
Amortized cost
  $ 4,242     $ 11,587     $     $ 9,720     $ 5,738     $ 460,644     $ 491,931     $ 515,492  
Average Yield
    4.00%       4.00%             4.00%       4.00%       4.42%       4.40%          
U.S. Treasury Bills
                                                               
Amortized cost
  $ 59,998     $     $     $     $     $     $ 59,998     $ 59,998  
Average Yield
    0.070%                                     0.070%          
 
At June 30, 2010, December 31, 2009 and June 30, 2009, the Company’s investments held in mortgage-backed securities are secured by adjustable and fixed interest rate residential mortgage loans. The yield to maturity on each security depends on, among other things, the price at which each such security is purchased, the rate and timing of principal payments (including prepayment rates as well as default rates, which in turn would impact the value and yield to maturity of the Company’s mortgage-backed securities. These investments are guaranteed by the Federal National Mortgage Association, (“FNMA”) or Federal Home Loan Mortgage Corporation (“Freddie Mac”) and none of the underlying loan collateral is represented by sub-prime mortgages.


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Item 4T.  Controls and Procedures
 
(a)  Evaluation of Disclosure Controls and Procedures
 
Harris Preferred Capital Corporation’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, has evaluated the Company’s disclosure controls and procedures as of June 30, 2010. Based on this evaluation, management has concluded that the disclosure controls and procedures are effective to provide reasonable assurance that the information required to be disclosed by the Company in the reports filed under the Securities Exchange Act of 1934, as amended is (i) recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission’s rules and forms, and (ii) accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer , as appropriate to allow timely decisions regarding required disclosure.
 
(b)  Changes in Internal Control over Financial Reporting
 
There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2010 that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.


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Part II. OTHER INFORMATION
 
Items 1, 1A, 2, 3, 4 and 5 are being omitted from this Report because such items are not applicable to the reporting period.
 
None
 
Item 6.  Exhibits
 
31.1  Certification of Pamela C. Piarowski pursuant to rule 13a-14(a)
 
31.2  Certification of Paul R. Skubic pursuant to rule 13a-14(a)
 
32.1  Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002


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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, Harris Preferred Capital Corporation has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 12th day of August 2010.
 
/s/  Paul R. Skubic
Paul R. Skubic
Chairman of the Board and President
 
/s/  Pamela C. Piarowski
Pamela C. Piarowski
Chief Financial Officer


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