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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report under Section 13 or 15(d) of the Securities and
Exchange Act of 1934
For the quarterly period ended September 30, 2002
[ ] Transition report under Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _______________ to ________________
Commission File No. 000-22474
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
------------------------------------------
(Name of registrant as specified in its charter)
Delaware 87-0418807
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
111 Presidential Boulevard, Bala Cynwyd, PA 19004
-------------------------------------------------
(Address of principal executive offices) (zip code)
(610) 668-2440
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) filed all reports
required to be filed by Section 13 or 15(d) of the 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. [X] YES [ ] NO
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X] NO
The number of shares outstanding of the Registrant's sole class of
common stock as of November 1, 2002 was 2,938,764 shares.
American Business Financial Services, Inc. and Subsidiaries
INDEX
Page
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PART I FINANCIAL INFORMATION
Item 1. Financial Information
Consolidated Balance Sheets as of September 30, 2002 and June 30, 2002............................................1
Consolidated Statements of Income for the three months ended September 30, 2002 and 2001 .........................2
Consolidated Statement of Stockholders' Equity for the three months ended September 30, 2002 .....................3
Consolidated Statements of Cash Flow for the three months ended September 30, 2002 and 2001 ......................4
Notes to Consolidated Financial Statements........................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................18
Item 3. Quantitative and Qualitative Disclosure about Market Risk................................................65
Item 4. Controls and Procedures..................................................................................65
PART II OTHER INFORMATION
Item 1. Legal Proceedings........................................................................................66
Item 2. Changes in Securities....................................................................................66
Item 3. Defaults Upon Senior Securities..........................................................................66
Item 4. Submission of Matters to a Vote of Security Holders......................................................66
Item 5. Other Information........................................................................................67
Item 6. Exhibits and Reports on Form 8-K.........................................................................67
Part I FINANCIAL INFORMATION
Item 1. Financial Information
American Business Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollars in thousands)
September 30, June 30,
2002 2002
----------- --------
(Unaudited) (Note)
Assets
Cash and cash equivalents $106,923 $108,599
Loan and lease receivables, net
Available for sale 67,843 61,650
Interest and fees 11,568 12,292
Interest-only strips (includes the fair value of
overcollateralization related cash flows of $251,014 and
$236,629 at September 30, 2002 and June 30, 2002) 543,862 512,611
Servicing rights 128,856 125,288
Receivable for sold loans 7,396 5,055
Prepaid expenses 3,441 3,640
Property and equipment, net 18,823 18,446
Other assets 29,998 28,794
-------- --------
Total assets $918,710 $876,375
======== ========
Liabilities
Subordinated debt $669,691 $655,720
Warehouse lines and other notes payable 11,687 8,486
Accrued interest payable 45,496 43,069
Accounts payable and accrued expenses 19,619 13,690
Deferred income taxes 37,169 35,124
Other liabilities 61,878 50,908
-------- --------
Total liabilities 845,540 806,997
-------- --------
Stockholders' equity
Preferred stock, par value $.001, authorized, 1,000,000 shares,
issued and outstanding, none - -
Common stock, par value $.001, authorized, 9,000,000 shares,
issued: 3,653,037 shares at September 30, 2002 and 3,645,192
shares at June 30, 2002 (including Treasury shares of 753,048
at September 30, 2002 and 801,823 at June 30, 2002) 4 4
Additional paid-in capital 23,985 23,985
Accumulated other comprehensive income 13,629 11,479
Retained earnings 45,710 47,968
Treasury stock, at cost (9,558) (13,458)
-------- --------
73,770 69,978
Note receivable (600) (600)
-------- --------
Total stockholders' equity 73,170 69,378
-------- --------
Total liabilities and stockholders' equity $918,710 $876,375
======== ========
Note: The balance sheet at June 30, 2002 has been derived from the audited
financial statements at that date.
See accompanying notes to consolidated financial statements.
1
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Income
(amounts in thousands except per share data)
(unaudited)
Three Months Ended
September 30,
---------------------
2002 2001
------- -------
Revenues
Gain on sale of loans $58,011 $35,356
Interest and fees 4,168 5,941
Interest accretion on interest-only strips 10,747 7,736
Servicing income 1,537 1,636
Other income 4 3
------- -------
Total revenues 74,467 50,672
------- -------
Expenses
Interest 17,083 16,983
Provision for credit losses 1,538 1,436
Employee related costs 9,575 7,824
Sales and marketing 6,688 6,064
General and administrative 24,365 16,017
Interest-only strips valuation adjustment 12,078 -
------- -------
Total expenses 71,327 48,324
------- -------
Income before provision for income taxes 3,140 2,348
Provision for income taxes 1,319 986
------- -------
Net income $ 1,821 $ 1,362
======= =======
Earnings per common share:
Basic $ 0.64 $ 0.43
======= =======
Diluted $ 0.61 $ 0.40
======= =======
Average common shares:
Basic 2,856 3,198
======= =======
Diluted 2,985 3,402
======= =======
See accompanying notes to consolidated financial statements.
2
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity
(amounts in thousands, except per share data)
(unaudited)
Common Stock
------------------- Accumulated
Number of Additional Other Total
For the three months ended Shares Paid-In Comprehensive Retained Treasury Note Stockholders'
September 30, 2002: Outstanding Amount Capital Income Earnings Stock Receivable Equity
----------- ------ --------- ------------- -------- -------- ---------- -------------
Balance June 30, 2002 2,843 $ 4 $23,985 $11,479 $47,968 $(13,458) $(600) $69,378
Comprehensive income:
Net income -- -- -- -- 1,821 -- -- 1,821
Net unrealized gain on interest-only
strips -- -- -- 2,150 -- -- -- 2,150
----- ------ ------- ------- ------- -------- ------ -------
Total comprehensive income -- -- -- 2,150 1,821 -- -- 3,971
Exercise of non-employee stock options 57 -- -- -- (569) 619 -- 50
Stock dividend (10% of outstanding shares) -- -- -- -- (3,281) 3,281 -- --
Cash dividends ($0.08 per share) -- -- -- -- (229) -- -- (229)
----- ------ ------- ------- ------- -------- ------ -------
Balance September 30, 2002 2,900 $ 4 $23,985 $13,629 $45,710 $ (9,558) $ (600) $73,170
===== ====== ======= ======= ======= ======== ====== =======
See accompanying notes to consolidated financial statements.
3
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow
(in thousands)
(unaudited)
Three Months Ended
September 30,
-----------------------
2002 2001
--------- ---------
Cash flows from operating activities
Net income $ 1,821 $ 1,362
Adjustments to reconcile net income to net cash used in
operating activities:
Gain on sales of loans (58,011) (35,356)
Depreciation and amortization 11,163 9,346
Interest accretion on interest-only strips (10,747) (7,736)
Interest-only strips fair value adjustment 12,078 -
Provision for credit losses 1,538 1,436
Loans originated for sale (386,390) (328,269)
Proceeds from sale of loans 382,181 318,891
Principal payments on loans and leases 4,382 2,266
Decrease in accrued interest and fees on loan and lease
receivables 724 1,464
Required purchase of additional overcollateralization
on securitized loans (17,128) (13,508)
Cash flow from interest-only strips 33,464 23,987
Decrease in prepaid expenses 199 666
Increase in accrued interest payable 2,427 5,532
Increase in accounts payable and accrued expenses 5,929 1,617
Accrued interest payable reinvested in subordinated debt 7,863 5,366
(Decrease) increase in deferred income taxes (598) 469
(Decrease) increase in loans in process (529) 2,123
Other, net 1,106 (9,051)
--------- ---------
Net cash used in operating activities (8,528) (19,395)
--------- ---------
Cash flows from investing activities
Purchase of property and equipment, net (1,031) (1,305)
Principal receipts and maturity of investments 8 7
--------- ---------
Net cash used in investing activities (1,023) (1,298)
--------- ---------
4
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow (continued)
(in thousands)
(unaudited)
Three Months Ended
September 30,
-------------------------
2002 2001
-------- --------
Cash flows from financing activities
Proceeds from issuance of subordinated debt $ 40,006 $ 67,467
Redemptions of subordinated debt (33,898) (28,058)
Net borrowings on revolving lines of credit 3,110 1,064
Principal payments on lease funding facility (931) (867)
Net repayments of other notes payable - (80)
Financing costs incurred (233) (777)
Exercise of non-employee stock options 50 -
Cash dividends paid (229) (210)
Repurchase of treasury stock - (3,344)
-------- --------
Net cash provided by financing activities 7,875 35,195
-------- --------
Net (decrease) increase in cash and cash equivalents (1,676) 14,502
Cash and cash equivalents at beginning of year 108,599 91,092
-------- --------
Cash and cash equivalents at end of year $106,923 $105,594
======== ========
Supplemental disclosures:
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ (1,022) $ -
Increase in warehouse lines and other notes payable $ 1,022 $ -
Cash paid during the period for:
Interest $ 6,793 $ 6,721
Income taxes $ 700 $ 200
See accompanying notes to consolidated financial statements.
5
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 2002
1. Basis of Financial Statement Presentation
American Business Financial Services, Inc. ("ABFS"), together with its
subsidiaries (the "Company"), is a diversified financial services organization
operating predominantly in the eastern and central portions of the United
States. The Company originates, sells and services business purpose loans and
home equity loans, through its principal direct and indirect subsidiaries. The
Company also processes and purchases home equity loans from other financial
institutions through the Bank Alliance Program.
The Company's loans primarily consist of fixed interest rate loans
secured by first or second mortgages on single family residences. The Company's
customers are primarily credit-impaired borrowers who are generally unable to
obtain financing from banks or savings and loan associations and who are
attracted to its products and services. The Company originates loans through a
combination of channels including a national processing center located at a
centralized operating office in Bala Cynwyd, Pennsylvania, a regional processing
center in Roseland, New Jersey and several retail branch offices. In addition,
the Company offers subordinated debt securities to the public, the proceeds of
which are used for repayment of existing debt, loan originations, operations,
investments in systems and technology and for general corporate purposes.
Effective December 31, 1999 the Company de-emphasized and subsequent to that
date, discontinued the equipment leasing origination business but continues to
service the remaining portfolio of leases.
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
of America for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. Accordingly, they do not
include all the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals and the elimination of intercompany balances) considered
necessary for a fair presentation have been included. Operating results for the
three-month period ended September 30, 2002 are not necessarily indicative of
financial results that may be expected for the full year ended June 30, 2003.
These unaudited consolidated financial statements should be read in conjunction
with the audited consolidated financial statements and notes thereto included in
the Company's Annual Report on Form 10-K for the fiscal year ended June 30,
2002.
On August 21, 2002, the Company's Board of Directors declared a 10% stock
dividend, which was paid on September 13, 2002 to shareholders of record on
September 3, 2002. As a result of the stock dividend, all outstanding stock
options and the related exercise prices were adjusted. Accordingly, all
outstanding common shares, earnings per common share, dividends per share,
average common shares and stock option amounts for all periods presented have
been retroactively adjusted to reflect the effect of this stock dividend.
6
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
1. Basis of Financial Statement Presentation (continued)
Certain prior period financial statement balances have been reclassified to
conform to current period presentation.
Recent Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board issued a proposed
interpretation of Accounting Research Bulletin No. 51 "Consolidated Financial
Statements." The proposal provides guidance on consolidation by a business
enterprise of special purpose entities ("SPEs"). The proposal defines the
primary beneficiary of an SPE as a business enterprise that has a controlling
financial interest in the SPE. The proposal requires that the primary
beneficiary of an SPE consolidate an SPE's assets, liabilities and results of
the activities of the SPE in their financial statements and provide certain
disclosures regarding both consolidated and unconsolidated SPEs. SPEs whose
structures effectively disburse risk would not be required to be consolidated by
any party. Although the Company uses SPEs extensively in their loan
securitization activities, the proposal, if adopted as proposed, will not affect
the Company's current consolidation policies for SPEs. The proposed
interpretation does not change the guidance incorporated in Statement of
Financial Accounting Standards (SFAS) No. 140 which precludes consolidation of a
qualifying SPE by a transferor of assets to that SPE. The proposal as currently
contemplated will therefore have no effect on the Company's financial condition
or results of operations and would not be expected to affect it in the future.
Restricted Cash Balances
The Company held restricted cash balances of $9.4 million and $9.0 million
related to borrower escrow accounts at September 30, 2002 and June 30, 2003,
respectively, and $4.2 million at September 30, 2002 related to deposits for
future settlement of interest rate swap contracts.
7
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
2. Loan and Lease Receivables
Loan and lease receivables - available for sale were comprised of the following
(in thousands):
September 30, June 30,
2002 2002
------- -------
Real estate secured loans $48,725 $48,116
Leases, net of unearned income of $494 and $668 7,052 8,211
------- -------
55,777 56,327
Less: allowance for credit losses on loan and lease
receivables available for sale 3,184 3,705
------- -------
52,593 52,622
Receivable for securitized loans 15,250 9,028
------- -------
$67,843 $61,650
======= =======
In accordance with the Company's securitization trust agreements, the Company
has the right, but not the obligation, to repurchase a limited amount of
delinquent loans from securitization trusts. In accordance with the provisions
of SFAS No. 140, the Company has recorded an obligation for the repurchase of
loans subject to these removal of accounts provisions, whether or not the
Company plans to repurchase the loans. The obligation for the loans' purchase
price is recorded in Other liabilities. A corresponding receivable is recorded
at the lower of the loans' cost basis or fair value.
Real estate secured loans have contractual maturities of up to 30 years.
At September 30, 2002 and June 30, 2002, the accrual of interest income was
suspended on real estate secured loans of $7.1 million and $7.0 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $2.4 million and $2.9 million at
September 30, 2002 and June 30, 2002, respectively.
Substantially all leases are direct finance-type leases whereby the lessee has
the right to purchase the leased equipment at the lease expiration for a nominal
amount.
8
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
3. Interest-Only Strips
Activity for interest-only strip receivables for the three months ended
September 30, 2002 and 2001 were as follows (in thousands):
September 30,
2002 2001
-------- --------
Balance at beginning of period $512,611 $398,519
Initial recognition of interest-only strips 44,126 33,636
Cash flow from interest-only strips (33,464) (23,987)
Required purchases of additional
overcollateralization 17,128 13,508
Interest accretion 10,747 7,736
Net adjustments to fair value (a) 4,792 776
Other than temporary fair value adjustment (a) (12,078) -
-------- --------
Balance at end of period $543,862 $430,188
======== ========
(a) Net temporary adjustments to fair value are recorded through
other comprehensive income, which is a component of equity. Other
than temporary adjustments to decrease the fair value of
interest-only strips are recorded through the income statement.
Interest-only strips include overcollateralization balances that represent
undivided interests in securitizations maintained to provide credit enhancement
to investors in securitization trusts. At September 30, 2002 and 2001, the fair
value of overcollateralization related cash flows were $251.0 million and $195.7
million, respectively.
During the first three months of fiscal 2003, write downs of $16.7 million were
recorded on interest-only strips due to increases in prepayment experience. The
income statement impact for the first quarter of fiscal 2003 was a write down of
$12.1 million while the remaining $4.7 million was written down through other
comprehensive income in accordance with the provisions of SFAS No. 115
"Accounting for Certain Investments in Debt and Equity Securities" and Emerging
Issues Task Force guidance, referred to as EITF in this document, 99-20. The
following table details the pre-tax write downs of the interest-only strips (in
thousands):
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- ----------------------------------------- ---------- --------- --------------
September 30, 2002....................... $16,739 $12,078 $4,661
9
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
3. Interest-Only Strips (continued)
Beginning in the second quarter of fiscal 2002 and on a quarterly basis
thereafter the Company increased the prepayment rate assumptions used to value
interest-only strips. However, because prepayment rates throughout the mortgage
industry continued to remain at higher than expected levels, prepayment
experience exceeded even the revised assumptions. Based on current economic
conditions, published mortgage industry surveys and the Company's own prepayment
experience, the Company expects that prepayments will continue to remain at
higher than normal levels for the near term before returning to average
historical levels. As a result, the Company has increased our prepayment rate
assumptions for home equity loans for the near term, but at a declining rate,
before returning to historical levels. However, the Company cannot predict with
certainty what its prepayment experience will be in the future. Any unfavorable
difference between the assumptions used to value interest-only strips and actual
experience may have a significant adverse impact on the value of these assets.
4. Servicing Rights
Activity for the loan and lease servicing rights asset for the three months
ended September 30, 2002 and 2001 were as follows (in thousands):
September 30,
2002 2001
-------- --------
Balance at beginning of period $125,288 $102,437
Initial recognition of servicing rights 12,193 9,471
Amortization (8,625) (6,596)
-------- --------
Balance at end of period $128,856 $105,312
======== ========
5. Other Assets and Other Liabilities
Other assets were comprised of the following (in thousands):
September 30, June 30,
2002 2002
------- -------
Goodwill $15,121 $15,121
Financing costs, debt offerings 5,322 5,849
Real estate owned 4,508 3,784
Investments held to maturity 909 917
Due from securitization trusts for
servicing related activities 1,333 1,616
Other 2,805 1,507
------- -------
$29,998 $28,794
======= =======
10
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
5. Other Assets and Other Liabilities (continued)
Other liabilities were comprised of the following (in thousands):
September 30 June 30,
2002 2002
------- -------
Commitments to fund closed loans $29,337 $29,866
Obligation for repurchase of securitized
loans 17,941 10,621
Escrow deposits held 9,448 9,011
Trading liabilities, at fair value 4,364 461
Other 788 949
------- -------
$61,878 $50,908
======= =======
See Note 2 for an explanation of the obligation for repurchase of securitized
loans.
6. Subordinated Debt and Warehouse Lines and Other Notes Payable
Subordinated debt was comprised of the following (in thousands):
September 30, June 30,
2002 2002
-------- --------
Subordinated debt (a) $654,451 $640,411
Subordinated debt - money market notes (b) 15,240 15,309
-------- --------
Total subordinated debt $669,691 $655,720
======== ========
Warehouse lines and other notes payable were comprised of the following (in
thousands):
September 30, June 30,
2002 2002
------- ------
Warehouse and operating revolving line of credit (c) $ 8,203 $6,171
Lease funding facility (d) 1,198 2,128
Warehouse revolving line of credit (e) 1,060 187
Warehouse revolving line of credit (f) 204 -
Capitalized leases (g) 1,022 -
------- ------
Total warehouse lines and other notes payable $11,687 $8,486
======= ======
11
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
(a) Subordinated debt due October 2002 through September 2012, interest rates
ranging from 5.0% to 13.00%; average rate at September 30, 2002 was 9.62%,
average remaining maturity was 17 months, subordinated to all of the
Company's senior indebtedness.
(b) Subordinated debt-money market notes due upon demand, interest rate at
4.88%; subordinated to all of the Company's senior indebtedness.
(c) $50 million warehouse and operating revolving line of credit expiring
December 2002, collateralized by certain pledged loans, advances to
securitization trusts, real estate owned and certain interest-only strips.
The Company is currently renegotiating the terms of this facility. The
Company can make no assurances that the facility will be extended, or if
extended, will be on the same terms as described above.
(d) Lease funding facility matures through December 2004, collateralized by
certain lease receivables.
(e) $25 million warehouse revolving line of credit expiring October 2003,
collateralized by certain pledged loans.
(f) $200 million warehouse revolving line of credit expiring November 2002,
collateralized by certain pledged loans. The Company is currently
renegotiating the terms of this facility. The Company can make no
assurances that the facility will be extended, or if extended, will be on
the same terms as described above.
(g) Capitalized leases, maturing through January 2006, imputed interest rate of
8.0%, collateralized by computer equipment.
At September 30, 2002, warehouse lines and other notes payable were
collateralized by $13.1 million of loan and lease receivables and $1.0 million
of computer equipment.
In addition to the above the Company had available to it the following credit
facilities:
o $1.2 million operating line of credit expiring January 2003, fundings to be
collateralized by an investment in the 99-A lease securitization trust.
This line was unused at September 30, 2002.
o $100.0 million revolving line of credit expiring March 2003, fundings to be
collateralized by certain pledged loans. This line was unused at September
30, 2002.
o $300.0 million facility, expiring July 2003, which provides for the sale of
mortgage loans into an off-balance sheet funding facility. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Critical Accounting Policies -- Special Purpose Entities and
Off-Balance Sheet Facilities" for further discussion of the off-balance
sheet features of this facility. At September 30, 2002, $51.2 million of
this facility was utilized.
12
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
Interest rates on the revolving credit facilities range from London Inter-Bank
Offered Rate ("LIBOR") plus 1.25% to LIBOR plus 2.50% or the commercial paper
rate plus 0.99%. The weighted-average interest rate paid on the revolving credit
facilities was 3.34% and 3.35% at September 30, 2002 and June 30, 2002,
respectively.
The terms of the warehouse lines and operating lines of credit require the
Company to meet specific financial covenants and other standards. Each agreement
has multiple individualized financial covenant thresholds and ratio limits that
the Company must meet as a condition to drawing on that particular line of
credit. At September 30, 2002, the Company was in compliance with the terms of
all debt agreements.
Under a registration statement declared effective by the Securities and Exchange
Commission on October 16, 2001, the Company registered $325.0 million of
subordinated debt. Of the $325.0 million, $24.1 million of debt from this
registration statement was available for future issuance as of September 30,
2002. Subsequent to September 30, 2002, an additional $8.6 million of debt was
issued. The Company registered an additional $315.0 million of subordinated debt
under a registration statement declared effective by the Securities and Exchange
Commission on October 3, 2002.
The Company's subordinated debt securities are subordinated in right of payment
to, or subordinate to, the payment in full of all senior debt as defined in the
indentures related to such debt, whether outstanding on the date of the
applicable indenture or incurred following the date of the indenture. The
Company's assets, including the stock it holds in its subsidiaries, are
available to repay the subordinated debt in the event of default following
payment to holders of the senior debt. In the event of the Company's default and
liquidation of its subsidiaries to repay the debt holders, creditors of the
subsidiaries must be paid or provision made for their payment from the assets of
the subsidiaries before the remaining assets of the subsidiaries can be used to
repay the holders of the subordinated debt securities.
13
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
7. Legal Proceedings
On February 26, 2002, a purported class action titled Calvin Hale v.
HomeAmerican Credit, Inc., No. 02 C 1606, United States District Court for the
Northern District of Illinois, was filed in the Circuit Court of Cook County,
Illinois (subsequently removed by Upland Mortgage to the captioned federal
court) against the Company's subsidiary, HomeAmerican Credit, Inc., which does
business as Upland Mortgage, on behalf of borrowers in Illinois, Indiana,
Michigan and Wisconsin who paid a document preparation fee on loans originated
since February 4, 1997. The plaintiff alleges that the charging of, and the
failure to properly disclose the nature of, a document preparation fee were
improper under applicable state law. The plaintiff seeks restitution,
compensatory and punitive damages and attorney's fees and costs, in unspecified
amounts. The Company believes that its imposition of this fee is permissible
under applicable law and is vigorously defending the case.
The Company's lending subsidiaries, including HomeAmerican Credit, Inc. which
does business as Upland Mortgage, are involved, from time to time, in class
action lawsuits, other litigation, claims, investigations by governmental
authorities, and legal proceedings arising out of their lending activities from
time to time including the purported class action entitled, Calvin Hale v.
HomeAmerican Credit, Inc., d/b/a Upland Mortgage, described above. Due to the
Company's current expectation regarding the ultimate resolution of these
actions, management believes that the liabilities resulting from these actions
will not have a material adverse effect on the Company's consolidated financial
position or results of operations. The Company maintains a reserve which
management believes is sufficient to cover these matters. However, due to the
inherent uncertainty in litigation and since the ultimate resolutions of these
proceedings are influenced by factors outside of the Company's control, it is
possible that the Company's estimated liability under these proceedings may
change or that actual results will differ from its estimates.
In addition, from time to time, the Company is involved as plaintiff or
defendant in various legal proceedings arising in the normal course of business.
While the Company cannot predict the ultimate outcome of these various legal
proceedings, it is management's opinion that the resolution of these legal
actions should not have a material effect on the Company's financial position,
results of operations or liquidity.
14
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
8. Derivative Financial Instruments
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Interest Rate Risk Management" for a detailed discussion of the
Company's use of derivative financial instruments.
Hedging activity
A primary market risk exposure that the Company faces is interest rate risk.
Interest rate risk occurs due to potential changes in interest rates between the
date fixed rate loans are originated and the date of securitization. The Company
may, from time to time, utilize hedging strategies to mitigate the effect of
changes in interest rates between the date loans are originated and the date the
fixed rate pass-through certificates to be issued by a securitization trust are
priced, a period typically less than 90 days.
The Company recorded losses on the fair value of interest rate swap contracts
accounted for as hedges of $2.9 million and $2.6 million on futures contracts
during the three months ended September 30, 2002 and 2001, respectively, which
were offset by securitization gains during the periods. An additional $1.0
million of unrealized losses on interest rate swap contracts in the first
quarter of fiscal 2003 were offset by unrealized increases in the fair value of
items hedged. The losses in the first quarter of fiscal 2003 were recorded as
liabilities on the balance sheet as of September 30, 2002 and the losses
recorded in the first quarter of fiscal 2002 were settled in cash during the
period. Any ineffectiveness related to hedging transactions during the period
was immaterial. Ineffectiveness is a measure of the difference in the change in
fair value of the derivative financial instrument as compared to the change in
the fair value of the item hedged.
Trading activity
An additional $2.5 million in losses on interest rate swap contracts which were
used to protect the future securitization spreads on loans in our pipeline and
were therefore classified as trading. These losses were also recorded as
liabilities on the balance sheet at September 30, 2002.
In addition, for the three months ended September 30, 2002, the Company recorded
$0.7 million in losses on an interest rate swap contract, which is not
designated as an accounting hedge. This contract was designed to reduce the
exposure to changes in the fair value of certain interest-only strips due to
changes in one-month LIBOR. The loss on the swap contract was due to decreases
in the interest rate swap yield curve during the period the contract was in
place. Of the total losses recognized during the period, $0.4 million were
unrealized losses representing the net change in the fair value of the contract
during the quarter and $0.3 were cash losses. The cumulative net unrealized loss
of $0.9 million is included as a trading liability in Other liabilities at
September 30, 2002.
15
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
9. Earnings Per Share
Following is a reconciliation of the Company's basic and diluted earnings per
share calculations (in thousands, except per share data):
Three Months Ended
September 30,
------------------
2002 2001
------ ------
Earnings
(a) Net Income $1,821 $1,362
====== ======
Average Common Shares
(b) Average common shares outstanding 2,856 3,198
Average potentially dilutive shares 129 204
------ ------
(c) Average common and potentially dilutive
shares 2,985 3,402
====== ======
Earnings Per Common Share
Basic (a/b) $ 0.64 $ 0.43
Diluted (a/c) $ 0.61 $ 0.40
10. Segment Information
The Company has three operating segments: Loan Origination, Servicing and
Treasury and Funding.
The Loan Origination segment originates business purpose loans secured by real
estate and other business assets, home equity loans typically to credit-impaired
borrowers and loans secured by one to four family residential real estate.
The Servicing segment services the loans and leases originated by the Company
both while held as available for sale by the Company and subsequent to
securitization. Servicing activities include billing and collecting payments
from borrowers, transmitting payments to securitization trust investors,
accounting for principal and interest, collections and foreclosure activities
and disposing of real estate owned.
The Treasury and Funding segment offers the Company's subordinated debt
securities pursuant to a registered public offering and obtains other sources of
funding for the Company's general operating and lending activities.
All Other mainly represents segments that do not meet the SFAS No. 131 defined
thresholds for determining reportable segments, financial assets not related to
operating segments, mainly comprised of interest-only strips, unallocated
overhead and other expenses of the Company unrelated to the reportable segments
identified.
16
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
10. Segment Information (continued)
The reporting segments follow the same accounting policies used for the
Company's consolidated financial statements as described in the summary of
significant accounting policies. Management evaluates a segment's performance
based upon profit or loss from operations before income taxes.
Reconciling items represent elimination of inter-segment income and expense
items, and are included to reconcile segment data to the consolidated financial
statements (in thousands).
Treasury
Three months ended Loan and Reconciling
September 30, 2002: Origination Funding Servicing All Other Items Consolidated
----------- -------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 58,011 $ - $ - $ - $ - $ 58,011
Interest income................. 1,459 169 217 10,747 - 12,592
Non-interest income............. 2,178 1 10,277 - (8,592) 3,864
Inter-segment revenues - 18,314 - 18,192 (36,506) -
Operating expenses:
Interest expense................ 5,721 16,819 (36) 12,893 (18,314) 17,083
Non-interest expense............ 12,289 2,836 9,809 15,521 - 40,455
Depreciation and amortization .. 848 31 307 525 - 1,711
Interest-only strips valuation
adjustment................... - - - 12,078 - 12,078
Inter-segment expense........... 26,784 - - - (26,784) -
Income tax expense................. 6,723 (505) 174 (5,073) - 1,319
-------- -------- -------- -------- -------- --------
Net income (loss).................. $ 9,283 $ (697) $ 240 $ (7,005) $ - $ 1,821
======== ======== ======== ======== ======== ========
Segment assets..................... $100,400 $204,732 $126,823 $577,653 $(90,898) $918,710
======== ======== ======== ======== ======== ========
Treasury
Three months ended Loan and Reconciling
September 30, 2001: Origination Funding Servicing All Other Items Consolidated
----------- -------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 35,356 $ - $ - $ - $ - $ 35,356
Interest income................. 1,752 276 514 7,736 - 10,278
Non-interest income............. 3,449 - 8,137 - (6,548) 5,038
Inter-segment revenues - 17,225 - 16,202 (33,427) -
Operating expenses:
Interest expense................ 4,971 16,588 144 12,505 (17,225) 16,983
Non-interest expense............ 9,390 2,638 6,772 10,805 - 29,605
Depreciation and amortization .. 819 33 256 628 - 1,736
Inter-segment expense........... 22,750 - - - (22,750) -
Income tax expense................. 1,104 (739) 621 - - 986
-------- -------- -------- -------- -------- --------
Net income (loss).................. $ 1,523 $ (1,019) $ 858 $ - $ - $ 1,362
======== ======== ======== ======== ======== ========
Segment assets..................... $107,871 $180,371 $109,382 $494,308 $(73,402) $818,530
======== ======== ======== ======== ======== ========
17
American Business Financial Services, Inc. and Subsidiaries
PART I FINANCIAL INFORMATION (Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Our consolidated financial information set forth below should be read
in conjunction with the consolidated financial statements and the accompanying
notes to consolidated financial statements included in Item 1 of this Quarterly
Report on Form 10-Q, and the consolidated financial statements, notes to
consolidated financial statements and Management's Discussion and Analysis of
Financial Condition and Results of Operations and the risk factors contained in
our Annual Report on Form 10-K for the year ended June 30, 2002.
Forward Looking Statements
Some of the information in this Quarterly Report on Form 10-Q may
contain forward-looking statements. You can identify these statements by words
or phrases such as "will likely result," "may," "are expected to," "will
continue to," "is anticipated," "estimate," "believe," "projected," "intends to"
or other similar words. These forward-looking statements regarding our business
and prospects are based upon numerous assumptions about future conditions, which
may ultimately prove to be inaccurate. Actual events and results may materially
differ from anticipated results described in those statements. Forward-looking
statements involve risks and uncertainties which could cause our actual results
to differ materially from historical earnings and those presently anticipated.
When considering forward-looking statements, you should keep these risk factors
in mind as well as the other cautionary statements in this document. You should
not place undue reliance on any forward-looking statement.
General
We are a diversified financial services organization operating
predominantly in the eastern and central portions of the United States. We
originate, sell and service business purpose loans and home equity loans,
through our principal direct and indirect subsidiaries. We also process and
purchase home equity loans from other financial institutions through the Bank
Alliance Program.
Our loans primarily consist of fixed interest rate loans secured by
first or second mortgages on single family residences. Our customers are
primarily credit-impaired borrowers who are generally unable to obtain financing
from banks or savings and loan associations and who are attracted to our
products and services. We originate loans through a combination of channels
including a national processing center located at our centralized operating
office in Bala Cynwyd, Pennsylvania, a regional processing center in Roseland,
New Jersey and several retail branch offices. In addition, we offer subordinated
debt securities to the public, the proceeds of which are used for repayment of
existing debt, loan originations, our operations, investments in systems and
technology and for general corporate purposes.
18
Initially, we finance our loans under several secured and committed
credit facilities. These credit facilities are generally revolving lines of
credit, which we have with several financial institutions that enable us to
borrow on a short-term basis against our loans. We then securitize or sell our
loans to unrelated third parties on a whole loan basis to generate the cash to
pay off these revolving credit facilities. We also have a committed mortgage
conduit facility with a financial institution that enables us to sell our loans
into an off-balance sheet facility. Additionally, we rely upon funds generated
by the sale of subordinated debt and other borrowings to fund our operations and
to repay our debt as it matures. At September 30, 2002, $669.7 million of
subordinated debt was outstanding and revolving credit and conduit facilities
totaling $676.2 million were available, of which $60.6 million was drawn upon on
that date. We expect to continue to rely on the borrowings to fund our
operations and to repay maturing subordinated debt. For a description of our
credit facilities, subordinated debt and off-balance sheet facilities, see "--
Liquidity and Capital Resources."
In our mortgage loan securitizations, pools of mortgage loans are sold
to a trust. The trust then issues certificates or notes, which we refer to as
certificates in this document, to third-party investors, representing the right
to receive a pass-through interest rate and principal collected on the mortgage
loans each month. The difference between the average interest rate that is
charged to borrowers on the fixed interest rate pools of mortgage loans and the
weighted-average pass-through interest rate paid to investors is referred to as
the interest rate spread.
Our business strategy is dependent on our ability to emphasize lending
related activities that provide us with the most economic value. The
implementation of this strategy will depend in large part on a variety of
factors outside of our control, including, but not limited to, our ability to
obtain adequate financing on favorable terms and to profitably securitize our
loans on a regular basis. Our failure with respect to any of these factors could
impair our ability to successfully implement our strategy, which could adversely
affect our results of operations and financial condition.
Since fiscal 2000, declines in securitization pass-through interest
rates resulted in interest rate spreads improving by approximately 282 basis
points at September 30, 2002 compared to the fourth quarter of fiscal 2000.
Increased interest rate spreads result in increases in the residual cash flow we
will receive on securitized loans, the amount we received at the closing of a
securitization from the sale of notional bonds or premiums on bonds and
corresponding increases in the gains we recognized on the sale of loans in a
securitization. See "-- Securitizations" for further details. No assurances can
be made that market interest rates will continue to decline or remain at current
levels. However, in a rising interest rate environment we would expect our
ability to originate loans at interest rates that will maintain our current
level of securitization gain profitability to become more difficult than during
a stable or falling interest rate environment. This situation occurred from our
September 1998 mortgage loan securitization through the June 2000 mortgage loan
securitization when the pass-through interest rates on the asset-backed
securities issued in our securitizations had increased by approximately 155
basis points. During the same period, the average interest rate on our loans
securitized increased only 71 basis points. We would address the challenge
presented by a rising interest rate environment by carefully monitoring our
product pricing, the actions of our competition, market trends and the use of
hedging strategies in order to continue to originate loans in as profitable a
manner as possible. See "-- Interest Rate Risk Management -- Strategies for Use
of Derivative Financial Instruments" for a discussion of our hedging strategies.
19
A rising interest rate environment could also unfavorably impact our
liquidity and capital resources. Rising interest rates could impact our
short-term liquidity by widening investor interest rate spread requirements in
pricing future securitizations as described above, increasing the levels of
overcollateralization required in future securitizations, limiting our access to
borrowings in the capital markets and limiting our ability to sell our
subordinated debt securities at favorable interest rates. See "-- Liquidity and
Capital Resources" for a discussion of both long and short-term liquidity.
A declining interest rate environment could unfavorably impact the
valuations of our interest-only strips. In a declining interest rate environment
the level of mortgage refinancing activity tends to increase, which could result
in an increase in loan prepayment experience. See -- "Application of Critical
Accounting Policies -- Interest-Only Strips" and "Securitizations" for a
discussion of the impact of prepayment experience exceeding prepayment
assumptions.
State and federal banking regulatory agencies, state attorneys general
offices, the Federal Trade Commission, the U.S. Department of Justice, the U.S.
Department of Housing and Urban Development and state and local governmental
authorities have increased their focus on lending practices by companies in the
subprime lending industry, more commonly referred to as "predatory lending"
practices. State, local and federal governmental agencies have imposed sanctions
for practices including, but not limited to, charging borrowers excessive fees,
imposing higher interest rates than the borrower's credit risk warrants and
failing to adequately disclose the material terms of loans to the borrowers. As
a result of these initiatives, we are unable to predict whether state, local or
federal authorities will require changes in our lending practices in the future,
including the reimbursement of borrowers as a result of fees charged or the
imposition of fines, or the impact of those changes on our profitability.
The Office of Thrift Supervision has recently adopted a rule effective
in January 2003, which will preclude us and other non-bank, non-thrift creditors
from using the Parity Act to preempt state prepayment penalty and late fee laws
and regulations on new loan originations. Under the provisions of this rule we
will be required to modify or eliminate the practice of charging a prepayment
fee in some of the states where we originate loans and other fees we normally
charge will also be modified or eliminated. We are currently evaluating the
impact of the adoption of this rule on our future lending activities and results
of operations.
In addition to the regulatory initiatives with respect to so-called
"predatory lending" practices, we are also subject, from time to time, to
private litigation, including actual and purported class action suits. See Note
7 of the Consolidated Financial Statements for a description of one purported
class action suit currently pending. We expect, that as a result of the
publicity surrounding predatory lending practices, we may be subject to other
class action suits in the future.
Although we are licensed to originate loans in 44 states, our loan
originations are concentrated in the eastern half of the United States. The
concentration of loans in a specific geographic region subjects us to the risk
that a downturn in the economy or recession in the eastern half of the country
would more greatly affect us than if our lending business were more
geographically diversified. As a result, an economic downturn or recession in
this region could result in reduced profitability.
Effective December 31, 1999, we de-emphasized and subsequent to that
date, discontinued the origination of business equipment leases but continue to
service the remaining portfolio of leases.
20
Application of Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America. The
accounting policies discussed below are considered by management to be critical
to understanding our financial condition and results of operations. The
application of these accounting policies requires significant judgment and
assumptions by management, which are based upon historical experience and future
expectations. The nature of our business and our accounting methods make our
financial condition, changes in financial condition and results of operations
highly dependent on management's estimates. The line items on our income
statement and balance sheet impacted by management's estimates are described
below.
Revenue Recognition. Revenue recognition is highly dependent on the
application of Statement of Financial Accounting Standards, referred to as SFAS
in this document, No. 140 "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities" and "gain-on-sale" accounting to our
quarterly loan securitizations. Gains on sales of loans through securitizations
for the three months ended September 30, 2002 were 77.9% of total revenues.
Securitization gains represent the difference between the net proceeds to us,
including retained interests in the securitization, and the allocated cost of
loans securitized. The allocated cost of loans securitized is determined by
allocating their net carrying value between the loans, the interest-only strips
and the servicing rights we retain based upon their relative fair values.
Estimates of the fair values of the interest-only strips and the servicing
rights we retain are discussed below. We believe the accounting estimates
related to gain on sale are critical accounting estimates because more than 75%
in the first quarter of fiscal 2003 and 80% in fiscal 2002, of the
securitization gains were based on estimates of the fair value of retained
interests. The amount recognized as gain on sale for the retained interests we
receive as proceeds in a securitization, in accordance with accounting
principles generally accepted in the United States of America, is highly
dependent on management's estimates.
Interest-Only Strips. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 59.2% of our
total assets at September 30, 2002 and are carried at their fair values. Fair
value is based on a discounted cash flow analysis which estimates the present
value of the future expected residual cash flows and overcollateralization cash
flows utilizing assumptions made by management at the time the loans are sold.
These assumptions include the rates used to calculate the present value of
expected future residual cash flows and overcollateralization cash flows,
referred to as the discount rates, and expected prepayment and credit loss rates
on pools of loans sold through securitizations. We believe the accounting
estimates used in determining the fair value of interest-only strips are
critical accounting estimates because estimates of prepayment and credit loss
rates are made based on management's expectation of future experience, which is
based in part, on historical experience, current and expected economic
conditions and in the case of prepayment rate assumptions, consideration of the
impact of changes in market interest rates. The actual loan prepayment rate may
be affected by a variety of economic and other factors, including prevailing
interest rates, the availability of alternative financing to borrowers and the
type of loan. Our expected future cash flows from our interest-only strips are
periodically re-evaluated. The current assumptions for prepayment and credit
loss rates are monitored against actual experience and other economic and market
conditions and are changed if deemed necessary. Even a small unfavorable change
in our assumptions made as a result of unfavorable actual experience or other
considerations could have a significant adverse impact on our estimate of
residual cash flows and on the value of these assets. In the event of an
unfavorable change in these assumptions, the fair value of these assets would be
overstated, requiring an accounting adjustment, which would adversely affect our
income in the period of adjustment. See "-- Securitizations" for more detail on
the estimation of the fair value of interest-only strips and the sensitivities
of these balances to changes in assumptions and the impact on our financial
statements of changes in assumptions.
21
Interest accretion income represents the yield component of cash flows
received on interest-only strips. We use a prospective approach to estimate
interest accretion. As previously discussed, we periodically update estimates of
residual cash flow from our securitizations. Under the prospective approach,
when it is probable that there is a favorable or unfavorable change in estimated
residual cash flow from the cash flow previously projected, we recognize a
larger or smaller percentage of the cash flow as interest accretion. Any change
in value of the underlying interest-only strip could impact our current estimate
of residual cash flow earned from the securitizations. For example, a
significant change in market interest rates could increase or decrease the level
of prepayments, thereby changing the size of the total managed loan portfolio
and related projected cash flows. The managed portfolio includes loans held as
available for sale on our balance sheet and loans serviced for others.
Servicing Rights. Servicing rights, which represent the rights to
receive contractual servicing fees from securitization trusts and ancillary fees
from borrowers net of estimated compensation that would be required by a
substitute servicer represented 14.0% of our total assets at September 30, 2002.
Servicing rights are carried at the lower of cost or fair value. The fair value
of servicing rights is determined by computing the benefits of servicing in
excess of adequate compensation, which would be required by a substitute
servicer. The benefits of servicing are the present value of projected net cash
flows from contractual servicing fees and ancillary servicing fees. We believe
the accounting estimates used in determining the fair value of servicing rights
are critical accounting estimates because the projected cash flows from
servicing fees incorporate assumptions made by management, including prepayment
rates, credit loss rates and discount rates. These assumptions are similar to
those used to value the interest-only strips retained in a securitization. The
current assumptions for prepayment and credit loss rates are monitored against
actual experience and other economic and market conditions and are changed if
deemed necessary. Even a small unfavorable change in our assumptions, made as a
result of unfavorable actual experience or other considerations could have a
significant adverse impact on the value of these assets. In the event of an
unfavorable change in these assumptions, the fair value of these assets would be
overstated, requiring an adjustment, which would adversely affect our income in
the period of adjustment. See "-- Securitizations" for more detail on the
estimation of the fair value of servicing rights and the sensitivities of these
balances to changes in assumptions and the impact on our financial statements of
changes in assumptions.
22
Amortization of the servicing rights asset for securitized loans is
calculated individually for each securitized loan pool and is recognized in
proportion to, and over the period of estimated future servicing income on that
particular pool of loans. A review for impairment is periodically performed by
stratifying the serviced loans by loan type, which is considered to be the
predominant risk characteristic. If our analysis indicates the carrying value of
servicing rights is not recoverable through future cash flows from contractual
servicing and other ancillary fees, a valuation allowance would be required. As
of September 30, 2002, our valuation analysis has not indicated any impairment.
Impairment is measured as the excess of carrying value over fair value.
Special Purpose Entities and Off-Balance Sheet Facilities. Special
purpose entities and off-balance sheet facilities are used in our mortgage loan
securitizations. Asset securitizations are one of the most common off-balance
sheet arrangements in which a company transfers assets off its balance sheet by
selling them to a special purpose entity. The special purpose entities described
below meet our objectives for mortgage loan securitization structures and comply
with accounting principles generally accepted in the United States of America.
Accounting for special purpose entities is under review by the Financial
Accounting Standards Board, referred to as FASB in this document. In June 2002,
the FASB issued a proposed interpretation of Accounting Research Bulletin No. 51
"Consolidated Financial Statements." The proposal provides guidance on
consolidation by a business enterprise of special purpose entities. The
proposal, if adopted as proposed, will not affect our current consolidation
policies for special purpose entities or recognition of gains for the sale of
loans. In the event that the proposal is not adopted as proposed or accounting
rules are changed in the future, our use of special purpose entities, our
revenue recognition for securitization gains for securitized loans and our
off-balance sheet accounting treatment for securitized loans could be materially
impacted.
Our securitizations involve a two-step transfer that qualifies for sale
accounting under SFAS No. 140. First, we sell the loans to a special purpose
entity, which has been established for the limited purpose of buying and
reselling the loans and establishing a true sale under legal standards. Next,
the special purpose entity sells the loans to a qualified special purpose
entity, which we refer to as the trust, transferring title of the loans and
isolating those assets from our assets. Finally, the trust issues certificates
to investors to raise the cash purchase price for the loans being sold, collects
proceeds on behalf of the certificate holders, distributes proceeds and is a
distinct legal entity, independent from us. Under current accounting rules, the
trusts do not qualify for consolidation in our financial statements and carry
the loan collateral as assets and the certificates issued to investors as
liabilities. At September 30, 2002 and June 30, 2002, the mortgage
securitization trusts held loans with an aggregate principal balance due of $3.1
billion and $2.9 billion as assets and owed $2.9 billion and $2.8 billion of
investor certificates to third parties, respectively.
We also use special purpose entities in our sales of loans to a $300
million off-balance sheet mortgage conduit facility. Sales into the off-balance
sheet facility involve a two-step transfer that qualifies for sale accounting
under SFAS No. 140, similar to the process described above. This facility has a
revolving feature and can be directed by the sponsor to dispose of the loans.
Typically this has been accomplished by securitizing them in a term
securitization. The third party note purchaser also has the right to sell the
loans. Under this arrangement, the loans have been isolated from us and our
subsidiaries and as a result, transfers to the facility are treated as sales for
financial reporting purposes. When loans are sold to this facility, we perform a
probability assessment of the likelihood that the sponsor will transfer the
loans into a term securitization. As the sponsor has typically transferred the
loans to a term securitization in the past, the amount of gain on sale we have
recognized for loans sold to this facility is estimated based on the terms we
would obtain in a term securitization rather than the terms of this facility. At
September 30, 2002, the off-balance sheet mortgage conduit facility held loans
with principal balance due of $52.7 million as assets and owed $51.2 million to
third parties.
23
Allowance for Loan and Lease Losses. The allowance for loan and lease
losses is maintained primarily to account for loans and leases that are
delinquent and are expected to be ineligible for sale into a future
securitization and for delinquent loans that have been repurchased from
securitization trusts. The allowance is calculated based upon management's
estimate of our ability to collect on outstanding loans and leases based upon a
variety of factors, including, periodic analysis of the available for sale loans
and leases, economic conditions and trends, historical credit loss experience,
borrowers' ability to repay, and collateral considerations. Additions to the
allowance arise from the provision for credit losses charged to operations or
from the recovery of amounts previously charged-off. Loan and lease charge-offs
reduce the allowance. If the actual collection of outstanding loans and leases
is less than we anticipate, further write downs would be required which would
reduce our net income in the period the write down was required.
Development of Critical Accounting Estimates. On a periodic basis,
senior management reviews the estimates used in our critical accounting
policies. As a group, senior management discusses the development and selection
of the assumptions used to perform its estimates described above. Management has
discussed the development and selection of the estimates used in our critical
accounting policies as of September 30, 2002 with the Audit Committee of our
Board of Directors. In addition, management has reviewed its disclosure of the
estimates in Management's Discussion and Analysis of Financial Condition and
Results of Operations with the Audit Committee.
Impact of Changes in Critical Accounting Estimates. For a description
of the impacts of changes in critical accounting estimates in the three months
ended September 30, 2002, see "-- Securitizations."
Securitizations
During the first three months of fiscal 2003, write downs of $16.7
million were recorded on our interest-only strips due to increases in prepayment
experience. The income statement impact for the first quarter of fiscal 2003 was
a write down of $12.1 million while the remaining $4.7 million was written down
through other comprehensive income in accordance with the provisions of SFAS No.
115 "Accounting for Certain Investments in Debt and Equity Securities" and
Emerging Issues Task Force guidance, referred to as EITF in this document,
99-20. The following table details the pre-tax write downs of the interest-only
strips (in thousands):
Other
Total Income Comprehensive
Quarter Ended Write down Statement Impact Income Impact
- ------------------------------------------- ---------- ---------------- -------------
September 30, 2002......................... $16,739 $12,078 $4,661
24
Beginning in the second quarter of fiscal 2002 and on a quarterly basis
thereafter we increased the prepayment rate assumptions used to value our
interest-only strips. However, because prepayment rates throughout the mortgage
industry continued to remain at higher than expected levels our prepayment
experience exceeded even our revised assumptions. Based on current economic
conditions, published mortgage industry surveys and our own prepayment
experience, we believe prepayments will continue to remain at higher than normal
levels for the near term before returning to average historical levels. As a
result, we have increased our prepayment rate assumptions for home equity loans
for the near term, but at a declining rate, before returning to our historical
levels. However, we cannot predict with certainty what our prepayment experience
will be in the future. Any unfavorable difference between the assumptions used
to value our interest-only strips and our actual experience may have a
significant adverse impact on the value of these assets.
In fiscal 2002, write downs of $44.1 million were recorded on our
interest-only strips due to increases in prepayment experience. The income
statement impact for fiscal 2002 was a write down of $22.1 million while the
remaining $22.0 million was written down through other comprehensive income in
accordance with the provisions of SFAS No. 115 and EITF 99-20. The following
table details the pre-tax write downs of the interest-only strips by quarter (in
thousands):
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
---------------------------- ------- ------- -------
December 31, 2001 $11,322 $ 4,462 $ 6,860
March 31, 2002 15,513 8,691 6,822
June 30, 2002 17,244 8,900 8,344
------- ------- -------
Total fiscal 2002 $44,079 $22,053 $22,026
======= ======= =======
The following table summarizes the volume of loan securitizations and
whole loan sales for the three months ended September 30, 2002 and 2001 (dollars
in thousands):
Three months ended
September 30,
---------------------
2002 2001
-------- --------
Securitizations:
Business loans....................................... $ 29,998 $ 29,949
Home equity loans.................................... 336,410 259,856
-------- --------
Total............................................. $366,408 $289,805
======== ========
Gain on sale of loans through securitization....... $ 58,011 $ 35,356
Securitization gains as a percentage of total revenue 77.9% 69.8%
Whole loan sales..................................... $ 1,537 $ 28,901
Premiums on whole loan sales......................... $ 34 $ 1,193
Our quarterly revenues and net income may fluctuate in the future
principally as a result of the timing, size and profitability of our
securitizations. The strategy of selling loans through securitizations requires
building an inventory of loans over time, during which time we incur costs and
expenses. Since a gain on sale is not recognized until a securitization is
closed, which may not occur until a subsequent quarter, operating results for a
given quarter can fluctuate significantly. If securitizations do not close when
expected, we could experience a materially adverse effect on our results of
operations for a quarter. See "-- Liquidity and Capital Resources" for a
discussion of the impact of securitizations on our cash flow.
Several factors affect our ability to complete securitizations on a
profitable basis. These factors include conditions in the securities markets,
such as fluctuations in interest rates described below, conditions in the
asset-backed securities markets relating to the loans we originate and credit
quality of the managed portfolio of loans. Any substantial reduction in the size
or availability of the securitization market for loans could have a material
adverse effect on our results of operations and financial condition.
When we securitize our loans by selling them to trusts, we receive cash
and an interest-only strip, which represents our retained interest in
securitized loans. The trust issues multi-class securities, which derive their
cash flows from the pool of securitized loans. These securities, which are
senior in right to our interest-only strips in the trusts, are sold to public or
private investors. In addition, when we securitize our loans we retain the right
to service the loans for a fee, which creates an asset that we refer to as our
servicing rights. Servicing includes processing of mortgage payments, processing
of disbursements for tax and insurance payments, maintenance of mortgage loan
records, performance of collection efforts, including disposition of delinquent
loans, foreclosure activities and disposition of real estate owned, referred to
as REO, and performance of investor accounting and reporting processes.
25
Interest-Only Strips. As the holder of the interest-only strips, we are
entitled to receive excess (or residual) cash flows and cash flows from
overcollateralization. These cash flows are the difference between the payments
made by the borrowers on securitized loans and the sum of the scheduled and
prepaid principal and pass-through interest paid to trust investors, servicing
fees, trustee fees and, if applicable, surety fees. Surety fees are paid to an
unrelated insurance entity to provide protection for the trust investors.
Generally, all residual cash flows are initially retained by the trust
to establish required overcollateralization levels in the trust.
Overcollateralization is the excess of the aggregate principal balances of loans
in a securitized pool over the investor interests. Overcollateralization
requirements are established to provide credit enhancement for the trust
investors.
The overcollateralization requirements for a mortgage loan
securitization, which are different for each securitization, include:
(1) The initial requirement, if any, is a percentage of the
original balance of loans securitized and is paid in cash at
the time of sale;
(2) The final target is a percentage of the original balance of
loans securitized and is funded from the monthly excess cash
flow. Specific securitizations contain provisions requiring an
increase above the final target overcollateralizaton levels
during periods in which delinquencies exceed specified limits.
The overcollateralization levels return to the target levels
when delinquencies fall below the specified limits; and
(3) The stepdown overcollateralization requirement is a percentage
of the remaining balance of securitized loans. During the
stepdown period, the overcollateralization amount is gradually
reduced through cash payments to us until the
overcollateralization balance declines to a specific floor.
The stepdown period generally begins at the later of 30 to 36
months after the initial securitization of the loans or when
the remaining balance of securitized loans is less than 50% of
the original balance of securitized loans.
The fair value of our interest-only strips is a combination of the fair
values of our residual cash flows and our overcollateralization cash flows. At
September 30, 2002, investments in interest-only strips totaled $543.9 million,
including the fair value of overcollateralization related cash flows of $251.0
million.
26
The following tables provide information regarding the nature and
principal balances of mortgage loans securitized in each trust, the securities
issued by each trust, and the overcollateralization requirements of each trust.
Summary of Selected Mortgage Loan Securitization Trust Information
Current Balances as of September 30, 2002
(dollars in millions)
2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 2000-3
------- ------ ------ ------ ------- ------- ------- ------ -------
Original balance of loans securitized:
- --------------------------------------
Business loans..............................$ 34 $ 34 $ 32 $ 29 $ 31 $ 35 $ 29 $ 27 $ 16
Home equity loans........................... 336 346 288 287 269 320 246 248 134
------- ------ ------ ------ ------- ------- ------- ------ -------
Total.......................................$ 370 $ 380 $ 320 $ 316 $ 300 $ 355 $ 275 $ 275 $ 150
======= ====== ====== ====== ======= ======= ======= ====== =======
Current balance of loans securitized:
- -------------------------------------
Business loans..............................$ 34 $ 33 $ 30 $ 27 $ 26 $ 29 $ 23 $ 20 $ 11
Home equity loans........................... 335 338 266 245 206 213 144 130 67
------- ------ ------ ------ ------- ------- ------- ------ -------
Total.......................................$ 369 $ 371 $ 296 $ 272 $ 232 $ 242 $ 167 $ 150 $ 78
======= ====== ====== ====== ======= ======= ======= ====== =======
Weighted-average interest rate on loans
- ---------------------------------------
securitized:
------------
Business loans.............................. 15.89% 16.00% 15.82% 15.78% 15.93% 15.93% 16.06% 16.09% 16.10%
Home equity loans........................... 10.89% 10.97% 10.86% 10.71% 11.13% 11.21% 11.45% 11.60% 11.46%
Total....................................... 11.35% 11.43% 11.37% 11.22% 11.67% 11.78% 12.09% 12.19% 12.11%
Percentage of first mortgage loans............. 85% 85% 90% 89% 87% 89% 88% 85% 86%
Weighted-average loan-to-value................. 77% 76% 76% 77% 76% 76% 76% 76% 77%
Weighted-average remaining term (months) on
loans securitized.......................... 262 251 248 248 237 236 228 218 215
Original balance of Trust Certificates.........$ 370 $ 380 $ 320 $ 322 $ 306 $ 355 $ 275 $ 275 $ 150
Current balance of Trust Certificates..........$ 369 $ 368 $ 288 $ 267 $ 224 $ 227 $ 155 $ 138 $ 71
Weighted-average pass-through interest rate
to Trust Certificate holders(a)............ 6.73% 7.04% 5.46% 5.35% 5.72% 6.55% 7.31% 7.05% 7.61%
Highest Trust Certificate pass-through
interest rate.............................. 6.86% 7.39% 6.51% 5.35% 6.14% 6.99% 6.28% 7.05% 7.61%
Overcollateralization requirements:
- -----------------------------------
Required percentages:
Initial.................................... -- -- -- -- -- -- -- -- --
Final target............................... 3.50% 3.50% 4.50% 4.25% 4.00% 4.40% 4.10% 4.50% 4.75%
Stepdown overcollateralization............. 7.00% 7.00% 9.00% 8.50% 8.00% 8.80% 8.20% 9.00% 9.50%
Required dollar amounts:
Initial.................................... -- -- -- -- -- -- -- -- --
Final target...............................$ 13 $ 13 $ 14 $ 13 $ 12 $ 16 $ 11 $ 12 $ 7
Current status:
Overcollateralization amount............... -- $ 3 $ 8 $ 5 $ 8 $ 15 $ 12 $ 12 $ 7
Final target reached or anticipated date
to reach.................................10/2003 8/2003 5/2003 7/2003 3/2003 12/2002 Yes Yes Yes
Stepdown reached or anticipated date to
reach.................................... 5/2006 1/2006 7/2005 2/2005 11/2004 5/2004 10/2003 1/2004 10/2003
Annual surety wrap fee......................... (b) (b) 0.21% 0.20% 0.20% 0.20% 0.20% 0.21% 0.21%
Servicing rights:
- -----------------
Original balance............................$ 13 $ 15 $ 13 $ 13 $ 12 $ 15 $ 11 $ 14 $ 7
Current balance.............................$ 13 $ 15 $ 12 $ 11 $ 9 $ 10 $ 7 $ 8 $ 4
- ----------------------------
(a) Rates for securitizations 2001-1 and forward include rates on notional
bonds, or the impact of premiums received on certificates, included in
securitization structure. The sale of notional bonds allows us to receive
more cash at the closing of a securitization. See "-- Three Months Ended
September 30, 2002 Compared to Three Months Ended September 30, 2001 -- Gain
on Sale of Loans" for further description of the notional bonds.
(b) Credit enhancement was provided through a senior / subordinated certificate
structure.
27
Summary of Selected Mortgage Loan Securitization Trust Information (Continued)
Current Balances as of September 30, 2002
(dollars in millions)
2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998(a) 1997(a) 1996(a)
------ ------ ------- ------- ------- ------- ------- ------- -------
Original balance of loans securitized:
- --------------------------------------
Business loans..............................$ 28 $ 25 $ 25 $ 28 $ 30 $ 16 $ 57 $ 45 $ 29
Home equity loans........................... 275 212 197 194 190 169 448 130 33
------- ------ ------- ------- ------- ------- ------- ------- -------
Total.......................................$ 303 $ 237 $ 222 $ 222 $ 220 $ 185 $ 505 $ 175 $ 62
======= ====== ======= ======= ======= ======= ======= ======= =======
Current balance of loans securitized:
- -------------------------------------
Business loans..............................$ 18 $ 15 $ 16 $ 15 $ 16 $ 8 $ 19 $ 13 $ 6
Home equity loans........................... 134 100 95 90 94 71 152 26 5
------- ------ ------- ------- ------- ------- ------- ------- -------
Total.......................................$ 152 $ 115 $ 111 $ 105 $ 110 $ 79 $ 171 $ 39 $ 11
======= ====== ======= ======= ======= ======= ======= ======= =======
Weighted-average interest rate on loans
- ---------------------------------------
securitized:
------------
Business loans.............................. 16.07% 16.00% 16.11% 15.87% 15.74% 15.96% 15.95% 15.91% 15.91%
Home equity loans........................... 11.44% 11.33% 11.06% 10.87% 10.44% 10.67% 10.77% 11.52% 11.00%
Total....................................... 11.99% 11.92% 11.77% 11.57% 11.19% 11.19% 11.35% 12.92% 13.66%
Percentage of first mortgage loans............. 80% 80% 82% 85% 88% 91% 89% 75% 74%
Weighted-average loan-to-value................. 77% 78% 76% 77% 76% 77% 77% 74% 66%
Weighted-average remaining term (months) on
loans securitized........................... 227 216 209 214 220 216 199 158 118
Original balance of Trust Certificates.........$ 300 $ 235 $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61
Current balance of Trust Certificates..........$ 134 $ 101 $ 99 $ 94 $ 99 $ 70 $ 154 $ 33 $ 8
Weighted-average pass-through interest rate to
Trust Certificate holders................... 7.15% 7.14% 6.84% 6.81% 6.63% 6.56% 6.28% 7.19% 7.68%
Highest Trust Certificate pass-through interest
rate........................................ 8.04% 7.93% 7.68% 7.49% 7.13% 6.58% 7.15% 7.29% 7.67%
Overcollateralization requirements:
- -----------------------------------
Required percentages:
Initial..................................... 0.90% 0.75% 1.00% 1.00% 0.50% 0.50% 1.50% 2.43% 1.94%
Final target................................ 5.95% 5.95% 5.50% 5.00% 5.00% 5.00% 5.10% 7.43% 8.94%
Stepdown overcollateralization.............. 11.90% 11.90% 11.00% 10.00% 10.00% 10.00% 10.21% 14.86% 12.90%
Required dollar amounts:
Initial.....................................$ 3 $ 2 $ 2 $ 2 $ 1 $ 1 $ 7 $ 4 $ 1
Final target................................$ 18 $ 14 $ 12 $ 11 $ 11 $ 9 $ 26 $ 13 $ 6
Current status:
Overcollateralization amount................$ 18 $ 14 $ 12 $ 11 $ 11 $ 9 $ 17 $ 6 $ 3
Final target reached or anticipated date to
reach .................................... Yes Yes Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach..................................... 7/2003 4/2003 12/2002 10/2002 10/2002 12/2002 Yes Yes Yes
Annual surety wrap fee......................... 0.21% 0.19% 0.21% 0.21% 0.19% 0.19% 0.22% 0.26% 0.18%
Servicing rights:
- -----------------
Original balance............................$ 14 $ 10 $ 10 $ 10 $ 10 $ 8 $ 18 $ 7 $ 4
Current balance.............................$ 8 $ 5 $ 5 $ 5 $ 4 $ 3 $ 6 $ 3 $ 1
- ----------------------------
(a) Amounts represent combined balances and weighted-average percentages for
four 1998 securitization pools, two 1997 securitization pools and two 1996
securitization pools.
28
The estimation of the fair value of interest-only strips is based upon
a discounted cash flow analysis which estimates the present value of the future
expected residual cash flows and overcollateralization cash flows utilizing
assumptions made by management at the time loans are sold. These assumptions
include the rates used to calculate the present value of expected future
residual cash flows and overcollateralization cash flows, referred to as the
discount rates, prepayment rates and credit loss rates on the pool of loans.
These assumptions are monitored against actual experience and other economic and
market conditions and are changed if deemed necessary. Our methodology for
determining the discount rates, prepayment rates and credit loss rates used to
calculate the fair value of our interest-only strips is described below.
Discount rates. We use discount rates, which we believe are
commensurate with the risks involved in our securitization assets. While quoted
market prices on comparable interest-only strips are not available, we have
performed comparisons of our valuation assumptions and performance experience to
others in the non-conforming mortgage industry. We quantify the risks in our
securitization assets by comparing the asset quality and performance experience
of the underlying securitized mortgage pools to comparable industry performance.
In determining the discount rate applied to residual cash flows, we
believe that the practice of many companies in the non-conforming mortgage
industry has been to add an interest rate spread for risk to the all-in cost of
securitizations to determine their discount rates. The all-in cost of the
securitization trusts' investor certificates includes the highest trust
certificate pass-through interest rate in each mortgage securitization, trustee
fees, and surety fees, which generally range from 19 to 22 basis points
combined. From industry experience comparisons, we have determined an interest
rate spread, which is added to the all-in cost of our mortgage loan
securitization trusts' investor certificates. The 13% discount rate that we
apply to our residual cash flow portion of our interest-only strips compared to
rates used by others in the industry reflects our higher asset quality and
performance of our securitized assets compared to industry asset quality and
performance and the other characteristics of our securitized loans described
below:
o Underlying loan collateral with fixed yields, which are higher
than others in the non-conforming mortgage industry. Average
interest rate of securitized loans exceeds the industry average by
100 basis points or more. All of the securitized loans have fixed
interest rates, which are more predictable than adjustable rate
loans.
o Approximately 90% to 95% of securitized business purpose loans
have prepayment fees. Approximately 85% to 90% of securitized home
equity loans have prepayment fees. Our historical experience
indicates that prepayment fees lengthen the prepayment ramp
periods and slow annual prepayment speeds, which have the effect
of increasing the life of the securitized loans.
o A portfolio mix of first and second mortgage loans of 80-85% and
15-20%, respectively. Historically, the high proportion of first
mortgages has resulted in lower delinquencies and losses.
o A portfolio credit grade mix comprised of 60% A credits, 24% B
credits, 14% C credits, and 2% D credits. In addition, our
historical loss experience is below what is experienced by others
in the non-conforming mortgage industry.
29
Although market interest rates have declined from fiscal years 2001
through the first quarter of fiscal 2003, no reduction to the discount rate used
to value the residual portion of our interest-only strips has been made. We do
not believe a decrease in the discount rate is warranted as the current market
interest rate decline was mainly due to actions taken by the Federal Reserve
Board in an attempt to prevent the potential adverse effect of uncertain
economic conditions and to stimulate economic growth. Additionally, the
non-conforming mortgage lending industry generally has taken no actions to
reduce discount rates.
We apply a second discount rate to projected cash flows from the
overcollateralization portion of our interest-only strips. The discount rate
applied to projected overcollateralization cash flows in each mortgage
securitization is based on the highest trust certificate pass-through interest
rate in the mortgage securitization. In fiscal 2001, we instituted the use of a
minimum discount rate of 6.5%. At September 30, 2002, the average discount rate
applied to projected overcollateralization cash flows was 7%. The risk
characteristics of the projected overcollateralization cash flows do not include
prepayment risk and have minimal credit risk. For example, if the entire
collateral balance in a securitized pool of loans was prepaid by borrowers, we
would fully recover the overcollateralization portion of the interest-only
strips. In addition, historically, these overcollateralization balances have not
been impacted by credit losses as the residual cash flow portion of our
interest-only strips has always been sufficient to absorb credit losses and
stepdowns of overcollateralization have generally occurred as scheduled.
Overcollateralization represents our investment in the excess collateral in a
securitized pool of mortgage loans.
The blended discount rate used to value the interest-only strips,
including the overcollateralization cash flows, was 10% at September 30, 2002.
Prepayment rates. The assumptions we use to estimate future prepayment
rates are periodically compared to actual prepayment experience of the
individual securitization pool of mortgage loans and an average of the actual
experience of other similar pools of mortgage loans at the same number of months
after their inception. It is our practice to use an average historical
prepayment rate of similar pools for the expected constant prepayment rate
assumption while a pool of mortgage loans is less than a year old even though
actual experience may be different. During this period, before a pool of
mortgage loans reaches its expected constant prepayment rate, actual experience
both quantitatively and qualitatively is generally not sufficient to conclude
that final actual experience for an individual pool of mortgage loans would be
materially different from the average. For pools of mortgage loans greater than
one year old, prepayment experience trends for an individual pool is considered
to be more significant. For these pools, adjustments to prepayment assumptions
may be made to more closely conform the assumptions to actual experience if the
variance from average experience is significant and is expected to continue.
Current economic conditions, current interest rates and other factors are also
considered in our analysis.
As was previously discussed, during the three months ended September
30, 2002, our actual prepayment experience was generally higher, most
significantly on home equity loans, than our historical averages for
prepayments. The mortgage industry in general has had this experience. Our
recent increase in prepayment experience has been mainly due to loan
refinancings. We do not believe that the current growth in the rate of
refinancings is indicative of a long-term trend in the non-conforming mortgage
market. We believe this recent activity was due to significant decreases in
market interest rates which have occurred over a short period of time which have
generated a larger than normal volume of refinancing activity during this
period. Based on current economic conditions, published mortgage industry
surveys and our own prepayment experience, we believe prepayments will continue
to remain at higher than normal levels for the near term before returning to
average historical levels.
30
In addition to the use of prepayment fees on our loans, we have
implemented programs and strategies in an attempt to reduce loan prepayments in
the future. These programs and strategies may include providing information to a
borrower regarding costs and benefits of refinancing, which at times may
demonstrate a refinancing option is not in the best economic interest of the
borrower. Other strategies include offering second mortgages to existing
qualified borrowers or offering financial incentives to qualified borrowers to
deter prepayment of their loan. We cannot predict with certainty what our
prepayment experience will be in the future and any unfavorable difference
between the assumptions used to value our interest-only strips and our actual
experience may have a significant adverse impact on the value of these assets.
Credit loss rates. Credit loss rates are analyzed in a similar manner
to prepayment rates. Credit loss assumptions are compared to actual loss
experience averages for similar mortgage loan pools and for individual mortgage
loan pools. Delinquency trends and economic conditions are also considered. If
our periodic analysis indicates that loss experience may be different from our
assumptions, we would adjust our assumptions as necessary.
Floating interest rate certificates. Some of the securitization trusts
have issued floating interest rate certificates supported by fixed interest rate
mortgages. The fair value of the excess cash flow we will receive may be
affected by any changes in the interest rates paid on the floating interest rate
certificates. The interest rates paid on the floating interest rate certificates
are based on one-month LIBOR. The assumption used to estimate the fair value of
the excess cash flows received from these securitization trusts is based on a
forward yield curve.
31
Sensitivity analysis. The table below outlines the sensitivity of the
current fair value of our interest-only strips and servicing rights to 10% and
20% adverse changes in the key assumptions used in determining the fair value of
those assets. Our base prepayment, loss and discount rates are described in the
table "Summary of Material Mortgage Loan Securitization Valuation Assumptions
and Actual Experience." (dollars in millions):
Securitized collateral balance..................................... $3,136.7
Balance sheet carrying value of retained interests................. $ 672.7
Weighted-average collateral life (in years)........................ 4.1
Sensitivity of assumptions used to value retained interests:
Prepayment speed:
Impact on fair value for 10% adverse change........................ $27.5
Impact on fair value for 20% adverse change........................ $53.2
Credit loss rate:
Impact on fair value for 10% adverse change........................ $ 4.4
Impact on fair value for 20% adverse change........................ $ 8.9
Floating interest rate certificates (a):
Impact on fair value for 10% adverse change........................ $ 0.7
Impact on fair value for 20% adverse change........................ $ 1.4
Discount rate:
Impact on fair value for 10% adverse change........................ $22.1
Impact on fair value for 20% adverse change........................ $42.8
- ----------------------------
(a) The floating interest rate certificates are indexed to one-month LIBOR plus
a trust specific interest rate spread. The base one-month LIBOR assumption
used in this sensitivity analysis was derived from a forward yield curve.
The sensitivity analysis in the table above is hypothetical and should
be used with caution. As the figures indicate, changes in fair value based on a
10% or 20% variation in management's assumptions generally cannot easily be
extrapolated because the relationship of the change in the assumptions to the
change in fair value may not be linear. Also, in this table, the effect that a
change in a particular assumption may have on the fair value is calculated
without changing any other assumption. Changes in one assumption may result in
changes in other assumptions, which might magnify or counteract the impact of
the intended change.
These sensitivities reflect the approximate amount of the fair values
that our interest-only strips and servicing rights would be reduced for the
indicated adverse changes. These reductions would result in a charge to expense
in the income statement in the period incurred and a resulting reduction of
stockholders' equity, net of income taxes. The effect on our liquidity of
changes in the fair values of our interest-only strips and servicing rights are
discussed in "-- Liquidity and Capital Resources."
32
The following tables provide information regarding the initial and
current assumptions applied in determining the fair values of mortgage loan
related interest-only strips and servicing rights for each securitization trust.
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at September 30, 2002
2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 2000-3
------- ------ ------ ------ ------- ------- ------- ------ -------
Interest-only strip residual discount rate:
- -------------------------------------------
Initial valuation........................... 13% 13% 13% 13% 13% 13% 13% 13% 13%
Current valuation........................... 13% 13% 13% 13% 13% 13% 13% 13% 13%
Interest-only strip overcollateralization
- -----------------------------------------
discount rate............................... 7% 7% 7% 7% 7% 7% 6% 7% 8%
-------------
Servicing rights discount rate:
- ------------------------------
Initial valuation........................... 11% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation........................... 11% 11% 11% 11% 11% 11% 11% 11% 11%
Prepayment rates:
- -----------------
Initial assumption:
Expected Constant Prepayment Rate (CPR):
Business loans (b)........................ 11% 11% 11% 11% 11% 11% 11% 10% 10%
Home equity loans......................... 22% 22% 22% 22% 22% 22% 22% 24% 24%
Ramp period (months) (a):
Business loans............................ 27 27 27 27 24 24 24 24 24
Home equity loans......................... 30 30 30 30 30 30 30 24 24
Current assumptions:
Expected Constant Prepayment Rate (CPR):
Business loans (b) ....................... 11% 11% 11% 11% 11% 11% 11% 11% 11%
Home equity loans ........................ 22% 22% 22% 22% 22% 22% 22% 22% 22%
Ramp period (months) (a):
Business loans............................ 27 27 27 27 27 27 27 27 27
Home equity loans......................... 30 30 30 30 30 30 30 30 30
CPR adjusted to reflect ramp:
Business loans............................ 3% 5% 8% 10% 12% 15% 17% 20% 22%
Home equity loans(d)...................... 2% 19% 29% 32% 35% 35% 35% 35% 35%
Current prepayment experience (c):
Business loans............................ -- -- 4% 6% 19% 22% 19% 23% 15%
Home equity loans......................... -- -- 12% 19% 27% 37% 40% 39% 37%
Annual credit loss rates:
- -------------------------
Initial assumption.......................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Current assumption.......................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Actual experience........................... -- -- -- -- 0.04% 0.09% 0.10% 0.18% 0.29%
Servicing fees:
- ---------------
Contractual fees............................ 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.70% 0.50%
Ancillary fees.............................. 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25%
- ----------------------------
(a) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected Constant Prepayment Rate. The business loan prepayment
ramp begins at 3% in month one. The home equity loan prepayment ramp begins
at 2% in month one.
(b) Rate is the estimated expected weighted-average prepayment rate over the
securitization's estimated remaining life. Business CPR ramps to an expected
peak rate over 27 months then declines to the final expected CPR by
month 40.
(c) Rate is a six-month historical average.
(d) The home equity loan prepayment rate ramps have been increased for the next
6 months to provide for the expected near term continuation of higher than
average prepayment experience for trusts 2000-2 through 2002-2.
33
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at September 30, 2002 (Continued)
2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998(f) 1997(f) 1996(f)
------ ------ ------- ------- ------- ------- ------- ------- -------
Interest-only strip residual discount rate:
- -------------------------------------------
Initial valuation........................... 13% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation........................... 13% 13% 13% 13% 13% 13% 13% 13% 13%
Interest-only strip overcollateralization
- ------------------------------------------
discount rate............................... 8% 8% 8% 7% 7% 7% 7% 7% 8%
-------------
Servicing rights discount rate:
- ------------------------------
Initial valuation........................... 11% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation........................... 11% 11% 11% 11% 11% 11% 11% 11% 11%
Prepayment rates:
- -----------------
Initial assumption:
Expected Constant Prepayment Rate (CPR):
Business loans (b)........................ 10% 10% 10% 10% 10% 10% 13% 13% 13%
Home equity loans......................... 24% 24% 24% 24% 24% 24% 24% 24% 24%
Ramp period (months) (a):
Business loans............................ 24 24 24 24 24 24 24 24 24
Home equity loans......................... 24 18 18 18 18 18 12 12 12
Current assumptions:
Expected Constant Prepayment Rate (CPR):
Business loans (b)........................ 12% 12% 11% 11% 11% 10% 10% 10% 10%
Home equity loans......................... 22% 22% 22% 22% 22% 22% 24% 25% 21%
Ramp period (months) (a):
Business loans............................ 27 Na Na Na Na Na Na Na Na
Home equity loans......................... 30 30 Na Na Na Na Na Na Na
CPR adjusted to reflect ramp:
Business loans(d)......................... 22% 19% 16% 13% 24% 17% 21% 18% 17%
Home equity loans(d)(e)................... 37% 22% 29% 25% 24% 36% 27% 28% 32%
Current prepayment experience (c):
Business loans............................ 24% 33% 37% 25% 24% 17% 21% 18% 17%
Home equity loans......................... 38% 32% 29% 31% 28% 36% 28% 29% 34%
Annual credit loss rates:
- -------------------------
Initial assumption.......................... 0.40% 0.40% 0.30% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
Current assumption.......................... 0.40% 0.40% 0.45% 0.45% 0.30% 0.50% 0.57% 0.40% 0.38%
Actual experience........................... 0.28% 0.44% 0.45% 0.44% 0.30% 0.44% 0.57% 0.39% 0.36%
Servicing fees:
- ---------------
Contractual fees............................ 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%
Ancillary fees.............................. 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 0.75% 0.75% 0.75%
- -----------------------------
(a) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected Constant Prepayment Rate. The business loan prepayment
ramp begins at 3% in month one. The home equity loan prepayment ramp begins
at 2% in month one.
(b) Rate is the estimated expected weighted-average prepayment rate over the
securitization's estimated remaining life. Business CPR ramps to an expected
peak rate over 27 months then declines to the final expected CPR by month
40.
(c) Rate is a six-month historical average.
(d) Business loan assumption ramps down from current rate to 10% remaining
constant at 10% for trusts 1997-2 through 1999-2. Home Equity loan
assumption ramps down to 22% remaining constant for trusts 1998-3 through
trusts 1999-4.
(e) The home equity loan prepayment rate ramps have been increased for the next
6 months to provide for the expected near term continuation of higher than
average prepayment experience for trusts 2000-2 through 2002-2.
(f) Amounts represent weighted-average percentages for four 1998 securitization
pools, two 1997 securitization pools and two 1996 securitization pools.
Na = not applicable
34
Lease Securitizations. We have in the past securitized two pools of
leases. As of December 31, 1999, we de-emphasized, and subsequent to that date
discontinued, the lease origination business but continue to service the
remaining leases in our managed portfolio. The interest-only strips and
servicing rights we retain on these securitized pools represent less than 1% of
our securitization residual assets at September 30, 2002.
Servicing Rights. As the holder of servicing rights on securitized
loans, we are entitled to receive annual contractual servicing fees of 50 to 70
basis points on the aggregate outstanding loan balance. These fees are paid out
of accumulated mortgage loan payments before payments of principal and interest
are made to trust certificate holders. In addition, ancillary fees such as
prepayment fees, late charges, nonsufficient fund fees and other fees are
retained directly by us, as servicer, as payments are collected from the
borrowers. We also retain the interest paid on funds held in the trust's
collection account until these funds are distributed from the trust.
The fair value of servicing rights is determined by computing the
benefits of servicing in excess of adequate compensation, which would be
required by a substitute servicer. The benefits of servicing are the present
value of projected net cash flows from contractual servicing fees and ancillary
servicing fees. These projections incorporate assumptions, including prepayment
rates, credit loss rates and discount rates. These assumptions are similar to
those used to value the interest-only strips retained in a securitization.
Periodically, capitalized servicing rights are evaluated for impairment, which
is measured as the excess of unamortized cost over fair value.
The origination of a high percentage of loans with prepayment fees
impacts our servicing rights and income in two ways. Prepayment fees reduce the
likelihood of a borrower prepaying their loan. This results in prolonging the
length of time a loan is outstanding, which increases the contractual servicing
fees to be collected over the life of the loan. Additionally, the terms of our
servicing agreements with the securitization trusts allow us to retain
prepayment fees collected from borrowers as part of our compensation for
servicing loans.
In addition, although prepayments increased in recent periods compared
to our historical averages, we have generally found that the non-conforming
mortgage market is less sensitive to prepayments due to changes in interest
rates than the conforming mortgage market where borrowers have more favorable
credit history for the following reasons. First, there are relatively few
lenders willing to supply credit to non-conforming borrowers which limits those
borrowers' opportunities to refinance. Second, interest rates available to
non-conforming borrowers tend to adjust much slower than conforming mortgage
interest rates which reduces the non-conforming borrowers' opportunity to
capture economic value from refinancing.
As a result of the use of prepayment fees and the reduced sensitivity
to interest rate changes in the non-conforming mortgage market, the prepayment
experience on our managed portfolio is more stable than the mortgage market in
general. This stability favorably impacts our ability to value the future cash
flows from our servicing rights and interest-only strips because it increases
the predictability of future cash flows.
Whole Loan Sales. We also sell loans with servicing released referred
to as whole loan sales. Gains on whole loan sales equal the difference between
the net proceeds from such sales and the net carrying value of the loans. The
net carrying value of a loan is equal to its principal balance plus its
unamortized origination costs and fees. Gains from these sales are recorded as
fee income. See "-- Securitizations" for information on the volume of whole loan
sales and premiums recorded for the three months ended September 30, 2002 and
2001.
35
RESULTS OF OPERATIONS
Overview
For the first quarter of fiscal 2003, net income increased $0.5
million, or 33.7%, to $1.8 million compared to $1.4 million in the first quarter
of fiscal 2002.
Diluted earnings per common share increased to $0.61 on average common
shares of 2,985,000 compared to $0.40 per share on average common shares of
3,402,000 for the first quarter of fiscal 2002. The increase in net income per
share was due to the increase in net income and the lower number of shares
outstanding due to our repurchases of our common stock. Dividends of $0.08 and
$0.07 per share were paid for the quarters ended September 30, 2002 and 2001,
respectively. The common dividend payout ratio based on diluted earnings per
share was 13.1% for the first quarter of fiscal 2003 compared to 15.9% for the
first quarter of fiscal 2002.
Increases in the gain on sale recorded during the first quarter of
fiscal 2003 were partially offset by increases in general and administrative
expenses and other expenses and a $12.1 million valuation adjustment on
interest-only strips recorded during the three-month period ended September 30,
2002. See below for further discussion of gain on sale, general and
administrative expenses, other expenses and the interest-only strips valuation
adjustment recorded during the period.
In fiscal 1999, the Board of Directors initiated a stock repurchase
program in view of the price level of our common stock, which was at the time
and has continued to, trade at below book value. In addition, our consistent
earnings growth over the past several years did not result in a corresponding
increase in the market value of our common stock. The repurchase program was
extended in fiscal 2000, 2001 and 2002. The fiscal 2002 extension authorized the
purchase of up to 10% of the then outstanding shares, which totaled
approximately 2,661,000 shares on the date of the extension. To date, under the
current program, we have repurchased 43,000 shares. The current repurchase
program terminates in November 2002. We currently have no plans to continue to
repurchase additional shares or extend the repurchase program beyond this date.
The total number of shares repurchased under the stock repurchase
program was: 117,000 shares in fiscal 1999; 327,000 shares in fiscal 2000;
627,000 shares in fiscal 2001; and 352,000 shares in fiscal 2002. The cumulative
effect of the stock repurchase program was an increase in diluted net earnings
per share of $0.12 and $0.06 for the quarters ended September 30, 2002 and 2001,
respectively.
On August 21, 2002, the Board of Directors declared a 10% stock
dividend, which was paid on September 13, 2002 to shareholders of record on
September 3, 2002. As a result of the stock dividend, all outstanding stock
options and related exercise prices were adjusted. Accordingly, all outstanding
common shares, earnings per common share, average common share and stock option
amounts presented have been adjusted to reflect the effect of this stock
dividend.
36
The Board of Directors has approved an amendment to the Amended and
Restated Certificate of Incorporation, which provides for an increase in the
number of authorized shares of preferred stock from the 1.0 million shares
currently authorized, to 3.0 million shares subject to the approval of
stockholders. The Board of Directors has discretion with respect to designating
and establishing the terms of each series of preferred stock prior to issuance.
Loan Originations
The following schedule details our loan originations (in thousands):
Three Months Ended
September 30,
-------------------------
2002 2001
-------- --------
Business purpose loans....... $ 28,863 $ 29,624
Home equity loans............ 341,852 289,425
-------- --------
$370,715 $319,049
======== ========
Loan originations for our subsidiary, American Business Credit, Inc.,
which offers business purpose loans secured by real estate, decreased $0.8
million, or 2.6%, for the three months ended September 30, 2002, to $28.9
million from $29.6 million for the three months ended September 30, 2001.
American Business Credit is in the process of expanding its marketing efforts
into new geographic areas including the addition of personnel to serve the new
areas. American Business Credit is also beginning to build relationships with
loan brokers, which it believes will provide an additional source for loan
originations in the future. In addition, our business loan subsidiary is
focusing on cost control by identifying efficiencies and streamlining the
business purpose loan origination process.
Home equity loans originated by our subsidiaries, HomeAmerican Credit,
doing business as Upland Mortgage and American Business Mortgage Services, Inc.,
and purchased through the Bank Alliance Program, increased $52.4 million, or
18.1%, for the three months ended September 30, 2002, to $341.9 million from
$289.4 million for the three months ended September 30, 2001. Our home equity
loan origination subsidiaries continue to focus on increasing efficiencies and
productivity gains by refining marketing techniques and integrating
technological improvements into the loan origination process. In addition,
American Business Mortgage Services, Inc. is in the process of expanding its
network of loan brokers to include a larger geographical area in order to reduce
concentrations of loans in specific states.
37
Summary Financial Results
(dollars in thousands, except per share data)
Three months ended
September 30, Percentage
------------------------- Increase/
2002 2001 (Decrease)
------ ------ ----------
Total revenues........................... $ 74,467 $ 50,672 47.0%
Total expenses........................... $ 71,327 $ 48,324 47.6%
Net income............................... $ 1,821 $ 1,362 33.7%
Return on average assets................. 0.80% 0.68%
Return on average equity................. 10.14% 8.17%
Per Common Share Data:
Net income:
Basic................................. $ 0.64 $ 0.43 48.8%
Diluted............................... $ 0.61 $ 0.40 52.5%
Dividends declared per share............. $ 0.08 $ 0.07 14.3%
Total Revenues. For the first quarter of fiscal 2003, total revenues
increased $23.8 million, or 47.0%, to $74.5 million from $50.7 million for
fiscal 2002. Growth in total revenue was mainly the result of increases in gains
on the securitization of mortgage loans and increases in interest accretion
earned on our interest-only strips.
Gain on Sale of Loans. For the first quarter of fiscal 2003, gains of
$58.0 million were recorded on the securitization of $366.4 million of loans.
This represents an increase of $22.7 million, or 64.1%, over gains of $35.4
million recorded on securitizations of $289.8 million of loans for the first
quarter of fiscal 2002.
The increase in securitization gains for the three months ended
September 30, 2002 was due to both an increase in interest rate spreads earned
in our securitizations and an increase in the volume of loans securitized. The
securitization gain as a percentage of loans securitized increased to 15.8% for
the three months ended September 30, 2002 from 12.2% on loans securitized for
the three months ended September 30, 2001. Increases in interest rate spreads
increase expected residual cash flows to us, the amount of cash we receive at
the closing of a securitization from notional bonds or premiums on the sale of
trust certificates and result in increases in the gains we recognize on the sale
of loans into securitizations. See "-- Securitizations" for further detail of
how securitization gains are calculated.
The increase in interest rate spread for the three months ended
September 30, 2002 compared to the three months ended September 30, 2001
resulted from decreases in pass-through interest rates on investor certificates
issued by securitization trusts. For loans securitized during the three months
ended September 30, 2002, the average loan interest rate was 11.25%, a 0.40%
decrease from 11.65% on loans securitized during the three months ended
September 30, 2001. However, the average interest rate on trust certificates
issued in mortgage loan securitizations during the three months ended September
30, 2002 was 4.60%, a 1.12% decrease from 5.72% during the three months ended
September 30, 2001. The resulting net improvement in interest rate spread was
approximately 72 basis points.
38
Also contributing to the increase in the securitization gain
percentages for the three months ended September 30, 2002, was the increase in
the amount of cash received at the closing of our securitizations. The
improvement in the interest rate spread through fiscal 2002 to the present has
enabled us to enter into securitization transactions structured to provide cash
at the closing of the securitization through the sale of notional bonds,
sometimes referred to as interest-only bonds or the sale of trust certificates
at a premium. During the three months ended September 30, 2002 we received
additional cash at the closing of our securitizations, due to these modified
structures, of $14.9 million compared to $6.0 million in fiscal 2002.
Securitization gains and cash received at the closing of securitizations were
partially offset by hedging losses of $2.9 million during the three months ended
September 30, 2002, compared to losses of $2.6 million during the three months
ended September 30, 2001.
The Office of Thrift Supervision has recently adopted a rule effective
in January 2003, which will preclude us and other non-bank, non-thrift creditors
from using the Parity Act to preempt state prepayment penalty and late fee laws
and regulations on new loan originations. Under the provisions of this rule we
will be required to modify or eliminate the practice of charging a prepayment
fee in some of the states where we originate loans and other fees we normally
charge will also be modified or eliminated. This new rule will potentially
reduce the gain on sale recorded in new securitizations in two ways. First,
because the percentage of loans with prepayment fees will be reduced, the
prepayment rates on securitized loan pools may increase and therefore the value
of our interest-only strips will decrease due to the shorter average life of the
securitized loan pool. Second, the value of our servicing rights retained in a
securitization may decrease due a reduction in our ability to charge certain
fees. We are currently evaluating the impact of the adoption of this rule on our
future lending activities and results of operations.
Interest and Fees. For the first quarter of fiscal 2003, interest and
fee income decreased $1.8 million, or 29.8%, to $4.2 million compared to $5.9
million for the first quarter of fiscal 2002. Interest and fee income consists
primarily of interest income earned on available for sale loans, premiums earned
on whole loan sales and other ancillary fees collected in connection with loan
and lease originations.
During the three months ended September 30, 2002, interest income
decreased $0.7 million, or 27.4%, to $1.8 million from $2.5 million for the
three months ended September 30, 2001. This decrease was due to a lower
weighted-average interest rate on loans available for sale from the prior fiscal
year and lower interest rates earned on invested cash balances due to general
decreases in market interest rates.
Premiums on whole loan sales decreased $1.2 million, to $34 thousand
for the three months ended September 30, 2002 from $1.2 million for the three
months ended September 30, 2001. The volume of whole loan sales decreased 94.7%,
to $1.5 million for the three months ended September 30, 2002 from $28.9 million
for the three months ended September 30, 2001. The decrease in the volume of
whole loan sales for the three months ended September 30, 2002 resulted from
management's decision to securitize additional loans in the favorable
securitization market experienced during the past year.
Other fees increased $0.1 million for the three months ended September
30, 2002 from the three months ended September 30, 2001. The increase is due to
an increase in loan fees offset by a decrease in leasing income, which has
decreased due to our decision in fiscal 2000 to discontinue the origination of
new leases. The ability to collect certain fees on loans we originate in the
future may be impacted by proposed laws and regulations by various authorities.
39
Interest Accretion on Interest-Only Strips. Interest accretion of $10.7
million was earned in the three months ended September 30, 2002 compared to $7.7
million in the three months ended September 30, 2001. The increase reflects the
growth in the balance of our interest-only strips of $113.7 million, or 26.4%,
to $543.9 million at September 30, 2002 from $430.2 million at September 30,
2001. In addition, cash flows from interest-only strips for the three months
ended September 30, 2002 totaled $33.5 million, an increase of $9.5 million, or
39.5%, from the three months ended September 30, 2001 due to the larger size of
our more recent securitizations and additional securitizations reaching final
target overcollateralization levels and step-down overcollateralization levels.
Servicing Income. Servicing income is comprised of contractual and
ancillary fees collected on securitized loans less amortization of the servicing
rights assets that are recorded at the time loans are securitized. Ancillary
fees include prepayment fees, late fees and other servicing fee compensation.
For the three months ended September 30, 2002, servicing income decreased $0.1
million, or 6.1%, to $1.5 million from $1.6 million for the three months ended
September 30, 2001.
The following table summarizes the components of servicing income for
the three months ended September 30, 2002 and 2001 (in thousands):
Three Months Ended
September 30,
------------------------
2002 2001
------ ------
Contractual and ancillary fees....... $ 10,162 $ 8,232
Amortization of servicing rights..... (8,625) (6,596)
-------- --------
Net servicing income................. 1,537 $ 1,636
======== ========
Total Expenses. Total expenses increased $23.0 million, or 47.6%, to
$71.3 million for the three months ended September 30, 2002 compared to $48.3
million for the three months ended September 30, 2001. As described in more
detail below, this increase was mainly a result of a $12.1 million interest-only
strips valuation adjustment recorded during the three months ended September 30,
2002, increases in employee related costs and increases in general and
administrative expenses.
Interest Expense. For the first quarter of fiscal 2003, interest
expense increased $0.1 million, or 0.6%, to $17.1 million from $17.0 million for
the first quarter of fiscal 2002. Average subordinated debt outstanding during
the three months ended September 30, 2002 was $662.3 million compared to $567.0
million during the three months ended September 30, 2001. The effect of the
increase in outstanding debt was mostly offset by a decrease in the average
interest rates paid on subordinated debt. Average interest rates paid on
subordinated debt outstanding decreased to 9.71% during the three months ended
September 30, 2002 from 11.14% during the three months ended September 30, 2001.
40
Rates offered on subordinated debt were reduced beginning in the fourth
quarter of fiscal 2001 and have continued downward through the first quarter of
fiscal 2003 in response to decreases in market interest rates as well as our
lower cash needs. The average issuance rate of subordinated debt at its peak,
which was the month of February 2001, was 11.85% compared to the average rate of
subordinated debt issued in the month of September 2002 of 7.88%. As the higher
rate notes mature, we expect the average rate paid on subordinated debt to
decline provided that market rates do not significantly increase.
In addition, the interest expense in the first quarter of fiscal 2003
reflects a decrease in the average outstanding balances under warehouse lines of
credit and decreased interest rates paid on warehouse lines from the first
quarter of fiscal 2002. The average outstanding balances under warehouse lines
of credit were $24.1 million during the three months ended September 30, 2002,
compared to $28.0 million during the three months ended September 30, 2001.
Interest rates paid on warehouse lines are generally based on one-month LIBOR
plus an interest rate spread ranging from 1.25% to 2.5%. One-month LIBOR has
decreased from approximately 2.6% at September 30, 2001 to 1.8% at September 30,
2002.
Provision for Credit Losses. The provision for credit losses on
available for sale loans and leases for the three months ended September 30,
2002 increased $0.1 million, or 7.1%, to $1.5 million, compared to $1.4 million
for the three months ended September 30, 2001. The increase in the provision for
credit losses was primarily due to increases in loans in non-accrual status,
which were generally repurchased from securitization trusts. Non-accrual loans
were $7.1 million and $6.7 million at September 30, 2002 and 2001, respectively.
See "-- Managed Portfolio Quality" for further detail.
While we are under no obligation to do so, at times we elect to
repurchase delinquent loans from the securitization trusts, some of which may be
in foreclosure. We elect to repurchase loans in situations requiring more
flexibility for the administration and collection of these loans in order to
maximize their economic recovery and to avoid temporary discontinuations of
residual or stepdown overcollateralization cash flow from securitization trusts.
The purchase price of a delinquent loan is at the loan's outstanding contractual
balance. A foreclosed loan is one where we, as servicer, have initiated formal
foreclosure proceedings against the borrower and a delinquent loan is one that
is 30 days or more past due. The foreclosed and delinquent loans we typically
elect to repurchase are usually 90 days or more delinquent and the subject of
foreclosure proceedings, or where a completed foreclosure is imminent. The
related allowance for loan losses on these repurchased loans is included in our
provision for credit losses in the period of repurchase. Our ability to
repurchase these loans does not disqualify us for sale accounting under SFAS No.
140, which was adopted on a prospective basis in the fourth quarter of fiscal
2001, or other relevant accounting literature because we are not required to
repurchase any loan and our ability to repurchase a loan is limited by contract.
SFAS No. 140 was effective on a prospective basis for transfers and
servicing of financial assets and extinguishments of liabilities occurring after
March 31, 2001. SFAS 140 requires that we record an obligation to repurchase
loans from securitization trusts at the time we have the contractual right to
repurchase the loans, whether or not we actually repurchase them. For
securitization trusts 2001-2 and forward, to which this rule applies, we have
the contractual right to repurchase a limited amount of loans greater than 180
days past due.
In accordance with the provisions of SFAS No. 140, we have recorded on
our September 30, 2002 balance sheet a liability of $17.9 million for the
repurchase of loans subject to these removal of accounts provisions. A
corresponding asset for the loans, at the lower of their cost basis or fair
value, has also been recorded.
41
The following table summarizes the principal balances of loans and REO
we have repurchased from the mortgage loan securitization trusts for the three
months ended September 30, 2002 and fiscal year 2002 and 2001. We received $8.2
million of proceeds from the liquidation of repurchased loans and REO for the
three months ended September 30, 2002 and $19.2 million and $10.9 million for
the fiscal years 2002 and 2001, respectively. We had repurchased loans and REO
remaining on our balance sheet in the amounts of $9.3 million, $9.4 million and
$4.8 million at September 30, 2002 and June 30, 2002 and 2001, respectively. All
loans and REO were repurchased at the contractual outstanding balances at the
time of repurchase and are carried at the lower of their cost basis or fair
value. Mortgage loan securitization trusts are listed only if repurchases have
occurred.
Summary of Loans and REO Repurchased from Mortgage Loan Securitization Trusts
(dollars in thousands)
2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998-4
------ ------ ------ ------ ------ ------ ------ ------
Three months ended September 30, 2002:
Business loans...................... $ -- $ -- $1,410 $ 603 $ 103 $ -- $ 239 $ --
Home equity loans................... -- -- 2,678 1,476 1,285 614 2,494 --
------- ------ ------ ------ ------ ------ ------ -------
Total............................. $ -- $ -- $4,088 $2,079 $1,388 $ 614 $2,733 $ --
======= ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased......... -- -- 36 27 21 9 31 --
Year ended June 30, 2002:
Business loans...................... -- $ -- $ -- $ 194 $1,006 $ 341 $ 438 $ 632
Home equity loans................... -- -- 84 944 3,249 2,688 2,419 4,649
------- ------ ------ ------ ------ ------ ------ -------
Total............................. $ -- $ -- $ 84 $1,138 $4,255 $3,029 $2,857 $ 5,281
======= ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased......... -- -- 2 18 47 31 33 58
Year ended June 30, 2001:
Business loans...................... $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 173
Home equity loans................... 88 330 -- -- -- -- -- 1,310
------- ------ ------ ------ ------ ------ ------ -------
Total............................ $ 88 $ 330 $ -- $ -- $ -- $ -- $ -- $ 1,483
======= ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased......... 1 2 -- -- -- -- -- 10
(Continued) 1998-3 1998-2 1998-1 1997-2 1997-1 1996-2 1996-1 Total
------ ------ ------ ------ ------ ------ ------ ------
Three months ended September 30, 2002:
Business loans...................... $ -- $ -- $ -- $ -- $ -- $ 221 $ -- $ 2,576
Home equity loans................... 673 314 155 -- -- 355 -- 10,044
------- ------ ------ ------ ------ ------ ------ -------
Total............................. $ 673 $ 314 $ 155 $ -- $ -- $ 576 $ -- $12,620
======= ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased......... 9 4 2 -- -- 11 -- 150
Year ended June 30, 2002:
Business loans...................... $ 260 $ 516 $1,266 $1,729 $ 183 $ -- $ 104 $ 6,669
Home equity loans................... 5,575 1,548 1,770 223 239 60 123 23,571
------- ------ ------ ------ ------ ------ ------ -------
Total............................. $ 5,835 $2,064 $3,036 $1,952 $ 422 $ 60 $ 227 $30,240
======= ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased......... 61 24 37 18 8 1 3 341
Year ended June 30, 2001:
Business loans...................... $ 803 $ 215 $ 428 $2,252 $ -- $ 380 $ 250 $ 4,501
Home equity loans................... 3,886 1,284 1,686 1,764 -- 92 109 10,549
------- ------ ------ ------ ------ ------ ------ -------
Total............................ $ 4,689 $1,499 $2,114 $4,016 $ -- $ 472 $ 359 $15,050
======= ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased......... 48 13 31 37 -- 8 4 154
42
The allowance for credit losses was $3.2 million, or 5.7% of gross
receivables at September 30, 2002 compared to$3.7 million, or 6.6% of gross
receivables at June 30, 2002 and $3.4 million, or 4.2% of gross receivables at
September 30, 2001. Although we maintain an allowance for credit losses at the
level we consider adequate to provide for potential losses, there can be no
assurances that actual losses will not exceed the estimated amounts or that an
additional provision will not be required.
The following table summarizes changes in the allowance for credit
losses for the three months ended September 30, 2002 and 2001 (in thousands):
Three Months Ended
September 30,
---------------------
2002 2001
------ ------
Balance at beginning of period.................... $ 3,705 $ 2,480
Provision for credit losses........................ 1,538 1,436
(Charge-offs) recoveries, net...................... (2,059) (560)
-------- -------
Balance at end of period........................... $ 3,184 $ 3,356
======== =======
The following table summarizes the changes in the allowance for credit
losses by loan and lease type (in thousands):
Business Home
Purpose Equity Equipment
Three Months Ended September 30, 2002: Loans Loans Leases Total
- -------------------------------------- --------- -------- --------- --------
Balance at beginning of period........... $ 1,388 $ 1,998 $ 319 $ 3,705
Provision for credit losses.............. 71 1,293 174 1,538
(Charge-offs) recoveries, net............ (528) (1,314) (217) (2,059)
------- ------- ------ --------
Balance at end of period................. $ 931 $ 1,977 $ 276 $ 3,184
======= ======= ====== ========
Business Home
Purpose Equity Equipment
Three Months Ended September 30, 2002: Loans Loans Leases Total
- -------------------------------------- --------- -------- --------- --------
Balance at beginning of period........... $ 591 $ 1,473 $ 416 $ 2,480
Provision for credit losses.............. 617 758 61 1,436
(Charge-offs) recoveries, net............ (94) (348) (118) (560)
------- ------- ------ --------
Balance at end of period................. $ 1,114 $ 1,883 $ 359 $ 3,356
======= ======= ====== ========
The increase in charge-offs for the first quarter of fiscal 2003
compared to the first quarter of fiscal 2002 was due to increases in the
liquidation of loans repurchased from securitization trusts during the period.
Employee Related Costs. For the first quarter of fiscal 2003, employee
related costs increased $1.8 million, or 22.4%, to $9.6 million from $7.8
million in the first quarter of fiscal 2002. The increase was primarily
attributable to additions of personnel to originate, service and collect loans.
Total employees at September 30, 2002 were 1,017 compared to 889 at September
30, 2001. The remaining increase was attributable to annual salary increases as
well as increases in the costs of providing insurance benefits to employees.
43
Sales and Marketing Expenses. For the first quarter of fiscal 2002,
sales and marketing expenses increased $0.6 million, or 10.3%, to $6.7 million
from $6.1 million for the first quarter of fiscal 2002. This increase was
primarily due to an increase in expenses for direct mail advertising for home
equity loan originations.
General and Administrative Expenses. For the first quarter of fiscal
2002, general and administrative expenses increased $8.3 million, or 52.1%, to
$24.4 million from $16.0 million for the first quarter of fiscal 2002. This
increase was primarily attributable to increases of approximately $4.4 million
in costs associated with servicing and collecting our larger total managed
portfolio including expenses associated with REO and delinquent loans, in
addition to $3.3 million of trading losses on interest rate swap contracts
classified as trading.
Interest-Only Strips Valuation Adjustment. During the first three
months ended September 30, 2002, a write down through the Statement of Income of
$12.1 million was recorded on our interest-only strips. This adjustment reflects
the impact of higher prepayment experience on home equity loans than anticipated
during the period. This portion of the impact of increased prepayments was
considered to be other than temporary and was therefore recorded as an
adjustment to earnings in the current period in accordance with SFAS No. 115 and
EITF 99-20. See "-- Securitizations" for further detail of this adjustment.
44
BALANCE SHEET INFORMATION
Balance Sheet Data:
(Dollars in thousands, except per share data)
September 30, June 30,
2002 2002
---------- ----------
Cash and cash equivalents............................ $ 106,923 $ 108,599
Loan and lease receivables, net:
Available for sale................................ 67,843 61,650
Interest and fees................................. 11,568 12,292
Interest-only strips................................. 543,862 512,611
Servicing rights..................................... 128,856 125,288
Receivable for sold loans............................ 7,396 5,055
Total assets......................................... 918,710 876,375
Subordinated debt.................................... 669,691 655,720
Warehouse lines and other notes payable.............. 11,687 8,486
Accrued interest payable............................. 45,496 43,069
Deferred income taxes................................ 37,169 35,124
Total liabilities.................................... 845,540 806,997
Total stockholders' equity........................... 73,170 69,378
Book value per common share.......................... $ 25.23 $ 24.40
Total liabilities to tangible equity(c).............. 14.6x 14.9x
Adjusted debt to tangible equity (a)(c).............. 12.0x 12.2x
Subordinated debt to tangible equity(c).............. 11.5x 12.1x
Interest-only strips to adjusted
tangible equity (b)(c)............................ 4.3x 4.3x
- -----------------------------
(a) Total liabilities less cash and secured borrowings to tangible equity.
(b) Interest-only strips less overcollateralization interests to tangible
equity plus subordinated debt with a remaining maturity greater than five
years.
(c) Tangible equity is calculated as total stockholders' equity less goodwill.
Total assets increased $42.3 million, or 4.8%, to $918.7 million at
September 30, 2002 from $876.4 million at June 30, 2002 primarily due to
increases in loan and lease receivables available for sale, interest-only strips
and servicing rights.
Loan and lease receivables increased $6.2 million or 10.1% due to an
increase in loans receivable from securitization trusts. See note 2 of the
consolidated financial statements for an explanation of these loan receivables.
45
Activity of our interest-only strips for the three months ended
September 30, 2002 and 2001 were as follows (in thousands):
Three Months Ended
September 30,
---------------------
2002 2001
------ ------
Balance at beginning of period............................... $ 512,611 $ 398,519
Initial recognition of interest-only strips.................. 44,126 33,636
Cash flow from interest-only strips.......................... (33,464) (23,987)
Required purchases of additional overcollateralization....... 17,128 13,508
Interest accretion........................................... 10,747 7,736
Net temporary adjustments to fair value(a)................... 4,792 776
Other than temporary adjustments to fair value(a)............ (12,078) --
--------- ---------
Balance at end of period..................................... $ 543,862 $ 430,188
========= =========
(a) Net temporary adjustments to fair value are recorded through other
comprehensive income, which is a component of equity. Other than temporary
adjustments to decrease the fair value of interest-only strips are recorded
through the income statement.
The following table summarizes the purchases of overcollateralization
by trust for the three months ended September 30, 2002, and the years ended June
30, 2002 and 2001. See "-- Securitizations" for a discussion of
overcollateralization requirements.
Summary of Mortgage Loan Securitization Overcollateralization Purchases
(in thousands)
2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 Other Total
------ ------ ------ ------ ------ ------ ----- -----
Three Months Ended
September 30, 2002:
Required purchases
of additional
overcollateralization... $3,114 $3,925 $3,693 $3,213 $2,200 $651 $332 $17,128
2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1 Other Total
------ ------ ------ ------ ------ ------ ------ ------ ------ ----- -----
Year Ended June 30, 2002:
Required purchases
of additional
overcollateralization... $ 3,814 $ 908 $ 4,354 $11,654 $ 8,700 $ 6,326 $ 3,074 $ 4,978 $ 2,490 $ 973 $47,271
2001-2 2001-1 2000-4 2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 Other Total
------ ------ ------ ------ ------ ------ ------ ------ ------ ----- -----
Year Ended June 30, 2001:
Initial
overcollateralization..... $ -- $ -- $ -- $ -- $ 611 $ -- $ -- $ -- $ -- $ -- $ 611
Required purchases
of additional
overcollateralization... 959 2,574 6,049 4,051 10,160 7,519 5,960 3,719 2,316 638 43,945
------- ------ ------- ------- ------- ------- ------- ------- ------- ------ -------
Total.................. $ 959 $2,574 $ 6,049 $ 4,051 $10,771 $ 7,519 $ 5,960 $ 3,719 $ 2,316 $ 638 $44,556
======= ====== ======= ======= ======= ======= ======= ======= ======= ====== =======
Servicing rights increased $3.6 million, or 2.8%, to $128.9 million at
September 30, 2002 from $125.3 million at June 30, 2002, due to the
securitization of $366.4 million of loans during the three months ended
September 30, 2002, partially offset by amortization of the servicing asset for
fees collected during the same period.
Total liabilities increased $38.5 million, or 4.8%, to $845.5 million
from $807.0 million at June 30, 2002 primarily due to increases in subordinated
debt outstanding, accounts payable and accrued expenses, accrued interest
payable, warehouse lines and other notes payable and other liabilities. Accounts
payable and accrued expenses increased $5.9 million or 43.3% which includes a
payable of $2.8 million for the settlement of an interest rate swap contract
paid subsequent to the end of the first quarter of fiscal 2003.
46
During the three months ended September 30, 2002, subordinated debt
increased $14.0 million, or 2.1%, to $669.7 million due to sales of subordinated
debt used to repay existing debt, to fund loan originations and our operations
and for general corporate purposes. Approximately $7.9 million of the increase
in subordinated debt was due to the reinvestment of accrued interest on the
subordinated debt at maturity. Subordinated debt was 11.5 times tangible equity
at September 30, 2002, compared to 12.1 times as of June 30, 2002. See "--
Liquidity and Capital Resources" for further information regarding outstanding
debt. Warehouse lines and other notes payable increased $3.2 million due to $1.0
million of capitalized lease additions and a larger balance of loans available
for sale funded by the warehouse lines. Accrued interest payable increased $2.4
million, or 5.6%, to $45.5 million from $43.1 million at June 30, 2002 due to an
increase in the level of subordinated debt partially offset by a decrease in
average interest rates paid on debt.
Deferred income taxes increased $2.0 million, or 5.8%, to $37.2 million
at September 30, 2002 from $35.1 million at June 30, 2002. The increase was
primarily due to the tax effect of the net increase in the SFAS 115 adjustment
associated with interest-only strips. Our taxable securitization structure in
the first quarter will create a current tax liability of approximately $6.5
million that will be offset by the utilization of net operating loss
carryforwards.
47
Managed Portfolio Quality
The following table provides data concerning delinquency experience, real
estate owned and loss experience for the managed loan and lease portfolio
(dollars in thousands):
September 30, 2002 June 30, 2002 March 31, 2002
----------------------- -------------------- ---------------------
Delinquency by Type Amount % Amount % Amount %
- ------------------- -------------- -------- ------------- ------ ------------- -------
Business Purpose Loans
Total managed portfolio............. $ 369,148 $ 361,638 $ 347,879
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 3,852 1.04% $ 2,449 0.68% $ 2,932 0.84%
61-90 days...................... 4,025 1.09 1,648 0.46 2,577 0.74
Over 90 days.................... 34,467 9.34 32,699 9.03 31,371 9.02
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 42,344 11.47% $ 36,796 10.17% $ 36,880 10.60%
============ ===== =========== ===== =========== =====
REO................................. $ 8,267 $ 6,220 $ 8,227
============ =========== ===========
Home Equity Loans
Total managed portfolio............. $ 2,806,490 $ 2,675,559 $ 2,551,902
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 50,578 1.80% $ 37,213 1.39% $ 37,700 1.48%
61-90 days...................... 26,065 0.93 22,919 0.86 18,385 0.72
Over 90 days.................... 89,971 3.21 72,918 2.72 79,138 3.10
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 166,614 5.94% $ 133,050 4.97% $ 135,223 5.30%
============ ===== =========== ===== =========== =====
REO................................. $ 24,167 $ 27,825 $ 29,212
============ =========== ===========
Equipment Leases
Total managed portfolio............. $ 22,523 $ 28,992 $ 36,381
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 338 1.50% $ 411 1.42% $ 506 1.38%
61-90 days...................... 181 0.80 93 0.32 173 0.48
Over 90 days.................... 389 1.73 423 1.46 632 1.74
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 908 4.03% $ 927 3.20% $ 1,311 3.60%
============ ===== =========== ===== =========== =====
Combined
- --------
Total managed portfolio............. $ 3,198,161 $ 3,066,189 $ 2,936,162
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 54,768 1.71% $ 40,073 1.31% $ 41,138 1.40%
61-90 days...................... 30,271 0.95 24,660 0.80 21,135 0.72
Over 90 days.................... 124,827 3.90 106,040 3.46 111,141 3.79
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 209,866 6.56% $ 170,773 5.57% $ 173,414 5.91%
============ ===== =========== ===== =========== =====
REO................................. $ 32,434 1.01% $ 34,045 1.11% $ 37,439 1.28%
============ ===== =========== ===== =========== =====
Losses experienced during the
three month period(a)(b):
Loans........................... $ 7,863 1.01% $ 5,315 0.72% $ 3,747 0.53%
===== ===== =====
Leases.......................... 201 3.13% 390 4.83% 678 6.90%
------------ ===== ----------- ===== ----------- =====
Total managed portfolio......... $ 8,064 1.03% $ 5,705 0.76% $ 4,425 0.62%
============ ===== =========== ===== =========== =====
(a) Percentage based on annualized losses and average managed portfolio.
(b) Losses recorded on our books were $4.2 million ($1.9 million from
charge-offs through the provision for loan losses and $2.3 million for write
downs of real estate owned) and losses absorbed by loan securitization trusts
were $3.9 million for the three months ended September 30, 2002. Losses recorded
on our books were $3.5 million ($1.6 million from charge-offs through the
provision for loan losses and $1.9 million for write downs of real estate owned)
and losses absorbed by loan securitization trusts were $2.2 million for the
three months ended June 30, 2002. Losses recorded on our books were $2.4 million
($1.3 million from charge-offs through the provision for loan losses and $1.1
million for write downs of real estate owned) and losses absorbed by loan
securitization trusts were $2.0 million for the three months ended March 31,
2002. Losses recorded on our books include losses for loans we hold as available
for sale or real estate owned and loans repurchased from securitization trusts.
48
The following table summarizes key delinquency statistics related to
loans, leases and REO recorded on our balance sheet and their related percentage
of our available for sale portfolio (dollars in thousands):
September 30, June 30, March 31,
2002 2002 2002
------------- -------- ---------
Delinquencies held as available for sale (a).... $ 6,658 $ 5,918 $ 7,911
11.9% 11.2% 12.2%
Available for sale loans and leases in
non-accrual status (b).......................... $ 7,093 $ 6,991 $ 8,754
12.7% 13.2% 13.5%
Allowance for losses on available for sale
loans and leases................................ $ 3,184 $ 3,705 $ 3,297
5.7% 6.6% 4.9%
Real estate owned on balance sheet.............. $ 4,508 $ 3,784 $ 4,289
- ----------------------------
(a) Delinquent loans and leases held as available for sale are included in
total delinquencies in the previously presented "Managed Portfolio Quality"
table. Included in total delinquencies are loans in non-accrual status of
$6.2 million, $5.6 million, and $6.9 million at September 30, 2002, June
30, 2002, and March 31, 2002, respectively.
(b) It is our policy to suspend the accrual of interest income when a loan is
contractually delinquent for 90 days or more. Non-accrual loans and leases
are included in total delinquencies in the previously presented "Managed
Portfolio Quality" table.
Delinquent loans and leases. Total delinquencies (loans and leases with
payments past due greater than 30 days, excluding REO) in the total managed
portfolio were $209.9 million at September 30, 2002 compared to $170.8 million
and $173.4 million at June 30, 2002 and March 31, 2002, respectively. Total
delinquencies as a percentage of the total managed portfolio were 6.56% at
September 30, 2002 compared to 5.57% and 5.91% at June 30, 2002 and March 31,
2002, respectively. The increases in delinquencies and delinquency percentages
in the first quarter of fiscal 2003 were mainly due to the impact on our
borrowers of continued uncertain economic conditions, which may include the
reduction in other sources of credit to our borrowers, and the seasoning of the
managed portfolio. In addition, the delinquency percentage has increased due to
increased prepayment rates resulting from refinancing activities. Refinancing is
not typically available to delinquent borrowers, and therefore the remaining
portfolio is experiencing a higher delinquency rate. A leveling in the growth of
the managed portfolio as a result of higher prepayment rates and decreases in
the growth of the origination of new loans also contributed to the increase in
the delinquency percentage in the first quarter of fiscal 2003 from June 30,
2002. As the managed portfolio continues to season, and if economic conditions
continue to lag or worsen, the delinquency rate may continue to increase.
Delinquent loans and leases held as available for sale on our balance sheet
increased from $5.9 million at June 30, 2002 to $6.7 million at September 30,
2002 primarily due to repurchases of loans from our mortgage securitization
trusts.
49
Real estate owned. Total REO, comprising foreclosed properties and
deeds acquired in lieu of foreclosure, decreased to $32.4 million, or 1.01%, of
the total managed portfolio at September 30, 2002 compared to $34.0 million, or
1.11%, and $37.4 million, or 1.28%, at June 30, 2002 and March 31, 2002,
respectively. The decrease in the volume of REO reflects a concerted effort by
management to reduce the time a loan remains in seriously delinquent status
until the sale of an REO property. This has been accomplished by adding
additional personnel to the process and has included bulk sales of REO. Reducing
the time properties are carried reduces carrying costs for interest on funding
the cost of the property, legal fees, taxes, insurance and maintenance related
to these properties. As our portfolio seasons and if economic conditions
continue to lag or worsen, the REO balance may increase. REO held by us on our
balance sheet increased from $3.8 million at June 30, 2002 to $4.5 million at
September 30, 2002 primarily due to repurchases of foreclosed loans from our
mortgage securitization trusts.
Loss experience. During the first quarter of fiscal 2003, we
experienced net loan and lease charge-offs in our total managed portfolio of
$8.1 million. On an annualized basis, during the first quarter of fiscal 2003,
net loan and lease charge-offs were 1.03% of the total managed portfolio. During
the three months ended June 30, 2002, we experienced net loan and lease
charge-offs in our total managed portfolio of $5.7 million, or 0.76% of the
average total managed portfolio. For the three months ended March 31, 2002, net
loan and lease charge-offs in our total managed portfolio were $4.4 million, or
0.62% of the average total managed portfolio. Principal loss severity experience
on delinquent loans generally has ranged from 10% to 20% of principal and loss
severity experience on REO generally has ranged from 25% to 35% of principal.
The increase in net charge-offs from the prior periods was due to a larger
volume of loans and leases that became delinquent and/or were liquidated during
the period as well as the seasoning of the managed portfolio. As noted above, we
have attempted to reduce the time a loan remains in seriously delinquent status
until the sale of an REO property in order to reduce carrying costs on the
property. The increase in the charge-off percentage was partially offset by
reductions in our carrying costs due to the acceleration of the timing of the
disposition of REO. See "-- Summary of Loans and REO Repurchased from Mortgage
Loan Securitization Trusts" for further detail of loan repurchase activity. See
"-- Securitizations" for more detail on credit loss assumptions used to estimate
the fair value of our interest-only strips and servicing rights compared to
actual loss experience. Real estate values have generally continued to increase
in recent periods and their increases have exceeded the rate of increase of many
other types of investments in the current economy. If in the future this trend
reverses and real estate values begin to decline our loss severity could
increase.
50
Interest Rate Risk Management
A primary market risk exposure that we face is interest rate risk.
Profitability and financial performance is sensitive to changes in interest rate
swap yields, U.S. Treasury yields, one-month LIBOR yields and the interest rate
spread between the effective rate of interest received on loans available for
sale or securitized (all fixed interest rates) and the interest rates paid
pursuant to credit facilities or the pass-through interest rate to investors for
interests issued in connection with securitizations. A substantial and sustained
increase in market interest rates could adversely affect our ability to
originate and purchase loans and maintain our profitability. The overall
objective of our interest rate risk management strategy is to mitigate the
effects of changing interest rates on profitability and the fair value of
interest rate sensitive balances (primarily loans available for sale,
interest-only strips, servicing rights and subordinated debt). We would address
this challenge by carefully monitoring our product pricing, the actions of our
competition and market trends and the use of hedging strategies in order to
continue to originate loans in as profitable a manner as possible.
A component of our interest rate risk exposure relates to changes in
the fair value of certain interest-only strips due to changes in one-month
LIBOR. The structure of certain securitization trusts includes a floating
interest rate certificate, which pays interest based on one-month LIBOR plus an
interest rate spread. Floating interest rate certificates in a securitization
expose us to gains or losses due to changes in the fair value of the
interest-only strip from changes in the floating interest rate paid to the
certificate holders.
A rising interest rate environment could unfavorably impact our
liquidity and capital resources. Rising interest rates could impact our
short-term liquidity by widening investor interest rate spread requirements in
pricing future securitizations, increasing the levels of overcollateralization
in future securitizations, limiting our access to borrowings in the capital
markets and limiting our ability to sell our subordinated debt securities at
favorable interest rates. In a rising interest rate environment, short-term and
long-term liquidity could also be impacted by increased interest costs on all
sources of borrowed funds, including the subordinated debt, and by reducing
interest rate spreads on our securitized loans, which would reduce our cash
flows. See "-- Liquidity and Capital Resources" for a discussion of both long
and short-term liquidity.
51
Interest Rate Sensitivity. The following table provides information
about financial instruments that are sensitive to changes in interest rates. For
interest-only strips and servicing rights, the table presents projected
principal cash flows utilizing assumptions including prepayment and credit loss
rates. See "-- Securitizations" for more information on these assumptions. For
debt obligations, the table presents principal cash flows and related average
interest rates by expected maturity dates (dollars in thousands):
Amount Maturing After September 30, 2002
-----------------------------------------------------------------------------------
Months Months Months Months Months There- Fair
1 to 12 13 to 24 25 to 36 37 to 48 49 to 60 after Total Value
------- -------- -------- -------- -------- -------- ------- -------
Rate Sensitive Assets:
Loans and leases available for sale (a).. $ 60,611 $ 101 $ 114 $ 129 $ 147 $ 6,740 $ 67,842 $ 69,587
Interest-only strips..................... 94,086 129,285 113,680 98,342 79,893 283,099 798,385 543,862
Servicing rights......................... 41,148 32,927 25,926 20,288 15,892 51,543 187,724 128,856
Investments held to maturity............. 82 111 373 343 0 0 909 986
Rate Sensitive Liabilities:
Fixed interest rate borrowings........ $387,239 $ 134,163 $ 95,590 $16,272 $10,014 $ 27,435 $670,713 $669,805
Average interest rate................. 9.32% 9.76% 10.40% 11.93% 10.80% 11.66% 9.94%
Variable interest rate borrowings..... $ 9,466 $ 135 $ 878 $ 36 $ 150 $ -- $ 10,665 $ 10,665
Average interest rate................. 3.34% 3.59% 3.59% 3.59% 3.59% -- 3.37%
- ----------------------------
(a) For purposes of this table, all loans and leases which qualify for
securitization are reflected as maturing within twelve months, since loans
and leases available for sale are generally held for less than three months
prior to securitization.
Loans Available for Sale. Gain on sale of loans may be unfavorably
impacted to the extent fixed interest rate available for sale mortgage loans are
held prior to securitization. A significant variable affecting the gain on sale
of loans in a securitization is the interest rate spread between the average
interest rate on fixed interest rate loans and the weighted-average pass-through
interest rate to investors for interests issued in connection with the
securitization. Although the average loan interest rate is fixed at the time the
loan is originated, the pass-through interest rate to investors is not fixed
until the pricing of the securitization which occurs just prior to the sale of
the loans. Generally, the period between loan origination and pricing of the
pass-through interest rate is less than three months. If market interest rates
required by investors increase prior to securitization of the loans, the
interest rate spread between the average interest rate on the loans and the
pass-through interest rate to investors may be reduced or eliminated. This
factor could have a material adverse effect on our results of operations and
financial condition. We estimate that each 0.1% reduction in the interest rate
spread reduces the gain on sale of loans as a percentage of loans securitized by
approximately 0.22%. See "-- Strategies for Use of Derivative Financial
Instruments" for further detail of our interest rate risk management for
available for sale loans.
Interest-Only Strips and Servicing Rights. A portion of the
certificates issued to investors by certain securitization trusts are floating
interest rate certificates based on one-month LIBOR plus an interest rate
spread. The fair value of the excess cash flow we will receive from these trusts
would be affected by any changes in interest rates paid on the floating interest
rate certificates. At September 30, 2002, $152.1 million of debt issued by loan
securitization trusts was floating interest rate certificates based on one-month
LIBOR, representing 5.2% of total debt issued by loan securitization trusts. In
accordance with accounting principles generally accepted in the United States of
America, the changes in fair value are generally recognized as part of net
adjustments to other comprehensive income, which is a component of retained
earnings. As of September 30, 2002, the interest rate sensitivity for $92.8
million of floating interest rate certificates issued by securitization trusts
is managed with an interest rate swap contract effectively fixing our cost for
this debt. See "-- Strategies for Use of Derivative Financial Instruments" for
further detail.
52
A significant change in market interest rates could increase or
decrease the level of loan prepayments, thereby changing the size of the total
managed loan portfolio and the related projected cash flows. We attempt to
minimize prepayment risk on interest-only strips and servicing rights by
requiring prepayment fees on business loans and home equity loans, where
permitted by law. Currently, approximately 90-95% of business loans and 85-90%
of home equity loans in the total managed portfolio are subject to prepayment
fees. However, higher than anticipated rates of loan prepayments could result in
a write down of the fair value of related interest-only strips and servicing
rights, adversely impacting earnings during the period of adjustment.
Revaluation of our interest-only strips and servicing rights is periodically
performed. As part of the revaluation process, assumptions used for prepayment
rates are monitored against actual experience and adjusted if warranted. See "--
Securitizations" for further information regarding these assumptions and the
impact of prepayments during this period.
Subordinated Debt. We also experience interest rate risk to the extent
that as of September 30, 2002 approximately $283.5 million of our liabilities
were comprised of fixed interest rate subordinated debt with scheduled
maturities of greater than one year. To the extent that market interest rates
demanded for subordinated debt increase in the future, the interest rates paid
on replacement debt could exceed interest rates currently paid thereby
increasing interest expense and reducing net income.
Strategies for Use of Derivative Financial Instruments. All derivative
financial instruments are recorded on the balance sheet at fair value with
realized and unrealized gains and losses included in the statement of income in
the period incurred.
Hedging activity
From time to time derivative financial instruments are utilized in an
attempt to mitigate the effect of changes in interest rates between the date
loans are originated and the date the fixed interest rate pass-through
certificates to be issued by a securitization trust are priced. Generally, the
period between loan origination and pricing of the pass-through interest rate is
less than three months. Derivative financial instruments we use for hedging
changes in fair value due to interest rate changes may include interest rate
swaps, futures and forward contracts. The nature and quantity of hedging
transactions are determined based on various factors, including market
conditions and the expected volume of mortgage loan originations and purchases.
At the time the contract is executed, derivative contracts are specifically
designated as hedges of mortgage loans or our residual interests in mortgage
loans in our mortgage conduit facility, which we would expect to be included in
a term securitization at a future date. The mortgage loans and mortgage loans
underlying residual interests in mortgage pools consist of essentially similar
pools of fixed interest rate loans, collateralized by real estate (primarily
residential real estate) with similar maturities and similar credit
characteristics. Fixed interest rate pass-through certificates issued by
securitization trusts are generally priced to yield an interest rate spread
above interest rate swap yield curves with maturities to match the maturities of
the interest rate pass-through certificates. We may hedge potential interest
rate changes in interest rate swap yield curves with Eurodollar futures, forward
treasury sales, interest rate swaps or derivative contracts of similar
underlying securities. This practice has provided strong correlation between our
hedge contracts and the ultimate pricing we will receive on the subsequent
securitization. The unrealized gain or loss derived from these derivative
financial instruments, which are designated as fair value hedges, is reported in
earnings as it occurs with an offsetting adjustment to the fair value of the
item hedged. The fair value of derivative financial instruments are based on
quoted market prices. The fair value of the items hedged are based on current
pricing of these assets in a securitization. Cash flow related to hedging
activities is reported as it occurs. The effectiveness of our hedges are
continuously monitored. If correlation did not exist, the related gain or loss
on the hedged item would no longer be recognized as an adjustment to income.
53
We recorded losses on the fair value of interest rate swap contracts
accounted for as hedges of $2.9 million and $2.6 million on futures contracts
during the three months ended September 30, 2002 and 2001, respectively, which
were offset by securitization gains during the periods. An additional $1.0
million of unrealized losses on interest rate swap contracts in the first
quarter of fiscal 2003 were offset by unrealized increases in the fair value of
items hedged. The losses recorded in the first quarter of fiscal 2003 were
recorded as liabilities on our balance sheet as of September 30, 2002 and the
losses recorded in the first quarter of fiscal 2002 were settled in cash during
the period. Any ineffectiveness related to hedging transactions during the
period was immaterial. Ineffectiveness is a measure of the difference in the
change in fair value of the derivative financial instrument as compared to the
change in the fair value of the item hedged.
There were no derivative contracts accounted for as hedges at September
30, 2001 or June 30, 2002. Outstanding interest rate swap contracts by items
hedged and associated unrealized losses as of September 30, 2002 were as follows
(in thousands):
Interest rate swap contracts (in thousands):
Notional Unrealized
Item Hedged Amount Loss
----------- -------- ----------
Loans available for sale............ $37,661 $455
Mortgage conduit facility assets.... 42,339 512
------- ----
Total.............................. $80,000 $967
======= ====
The sensitivity of the interest rate swap contracts held as of
September 30, 2002 to a 0.1% change in market interest rates is $0.3 million.
Trading activity
Generally, we do not enter into derivative financial instrument
contracts for trading purposes. However, we have entered into derivative
financial instrument contracts which we have not designated as hedges in
accordance with accounting principles generally accepted in the United States of
America and were therefore accounted for as trading assets or liabilities.
During the three months ended September 30, 2002, we used interest rate swap
contracts to protect the future securitization spreads on loans in our pipeline.
Loans in the pipeline represent loan applications for which we are in the
process of obtaining all the documentation required for a loan approval or
approved loans, which have not been accepted by the borrower and are not
considered to be firm commitments. We believed there was a greater chance that
market interest rates we would obtain on the subsequent securitization of these
loans would increase rather than decline, and chose to protect the spread we
could earn in the event of rising rates. However due to a decline in market
interest rates during the period the contracts were in place, during the three
months ended September 30, 2002, $2.5 million in losses on derivative financial
instruments classified as trading were recorded. These losses are recorded as
liabilities on our balance sheet at the end of the period.
54
In addition, we had a derivative financial instrument in place that was
designed to reduce our exposure to changes in the fair value of certain
interest-only strips due to changes in one-month LIBOR. The structure of certain
securitization trusts includes a floating interest rate certificate based on
one-month LIBOR plus an interest rate spread. Floating interest rate
certificates in a securitization expose us to gains or losses due to changes in
the fair value of the interest-only strip from changes in the floating interest
rate paid to the certificate holders. In order to manage this exposure we have
entered into an interest rate swap agreement to lock in a fixed interest rate on
our third quarter fiscal 2002 securitization's variable rate certificate. The
swap agreement requires a net cash settlement on a monthly basis of the
difference between the fixed interest rate on the swap and the LIBOR paid on the
certificates. The fair value of this swap agreement is based on estimated market
values for the sale of the contract provided by a third party. For the three
months ended September 30, 2002, we recorded $0.7 million in losses on this swap
contract due to decreases in the interest rate swap yield curve. Of the total
losses recognized during the period, $0.4 million are unrealized losses
representing the net change in the fair value of the contract for the three
months ended September 30, 2002 and $0.3 million are cash losses. The total
accumulated net unrealized loss of $0.9 million is included in other
liabilities. Our interest-only strips are held as available for sale securities
and therefore changes in the fair value of the interest-only strips are recorded
as a component of equity unless the fair value of the interest-only strips falls
below its cost basis, which would require a write down through current period
income.
Terms of the interest rate swap agreement at September 30, 2002 were as
follows (dollars in thousands):
Notional amount............................................... $ 92,762
Rate received - Floating (a).................................. 1.80%
Rate paid - Fixed............................................. 2.89%
Maturity date................................................. April 2004
Unrealized loss............................................... $ 878
Sensitivity to 0.1% change in interest rates.................. $ 85
- ----------------------------
(a) Rate represents the spot rate for one-month LIBOR paid on the securitized
floating interest rate certificate at the end of the period.
55
Derivative transactions are measured in terms of a notional amount, but
this notional amount is not carried on the balance sheet. The notional amount is
not exchanged between counterparties to the derivative financial instrument, but
is only used as a basis to determine fair value, which is recorded on the
balance sheet and to determine interest and other payments between the
counterparties. Our exposure to credit risk in a derivative transaction is
represented by the fair value of those derivative financial instruments in a
gain position. We attempt to manage this exposure by limiting our derivative
financial instruments to those traded on major exchanges and where our
counterparties are major financial institutions. At September 30, 2002, we held
no derivative financial instruments in a gain position.
In the future, we may expand the types of derivative financial
instruments we use to hedge interest rate risk to include other types of
derivative contracts. However, an effective interest rate risk management
strategy is complex and no such strategy can completely insulate us from
interest rate changes. Poorly designed strategies or improperly executed
transactions may increase rather than mitigate risk. Hedging involves
transaction and other costs that could increase as the period covered by the
hedging protection increases. Although it is expected that such costs would be
offset by income realized from securitizations in that period or in future
periods, we may be prevented from effectively hedging fixed interest rate loans
held for sale without reducing income in current or future periods. In addition,
while Eurodollar rates, interest rate swap yield curves and the pass-through
interest rate of securitizations are generally strongly correlated, this
correlation has not held in periods of financial market disruptions (e.g., the
so-called Russian Crisis in the later part of 1998).
Liquidity and Capital Resources
Liquidity and capital resource management is a process focused on
providing the funding to meet our short and long-term cash needs. We have used a
substantial portion of our funding sources to build our managed portfolio and
investments in securitization residual assets with the expectation that they
will generate sufficient cash flows in the future to cover our operating
requirements, including repayment of maturing subordinated debt. Our cash needs
change as the managed portfolio grows, as our interest-only strips grow and
release more cash, as subordinated debt matures, as operating expenses change
and as revenues increase. Because we have historically experienced negative cash
flows from operations, our business requires continual access to short and
long-term sources of debt to generate the cash required to fund our operations.
Our cash requirements include funding loan originations and capital
expenditures, repaying existing subordinated debt, paying interest expense and
operating expenses, and in connection with our securitizations, funding
overcollateralization requirements and servicer obligations. At times, we have
used cash to repurchase our common stock and could in the future use cash for
unspecified acquisitions of related businesses or assets (although no
acquisitions are currently contemplated).
56
Following is a summary of future payments on our contractual
obligations as of September 30, 2002 (in thousands):
Less than 1 to 3 4 to 5 After
Obligation Total 1 year years years 5 years
- ------------------------------- ----- --------- -------- -------- ---------
Subordinated debt.............. $ 669,691 $ 386,230 $ 229,753 $ 26,287 $ 27,421
Accrued interest - subordinated
debt (a) ................... 45,401 26,598 12,694 2,855 3,254
Warehouse and operating lines
of credit................... 9,467 9,467 -- -- --
Capitalized lease (b).......... 1,174 375 751 48 --
Operating leases............... 5,275 3,881 1,133 223 38
--------- --------- --------- -------- --------
Total obligations.............. $ 731,008 $ 426,551 $ 244,331 $ 29,413 $ 30,713
========= ========= ========= ======== ========
(a) This table reflects interest payment terms elected by subordinated debt
holders as of September 30, 2002. In accordance with the terms of the
subordinated debt offering, subordinated debt holders have the right to
change the timing of the interest payment on their notes once during the
term of their investment.
(b) Amounts include principal and interest.
The following discussion of liquidity and capital resources should be
read in conjunction with the discussion of the Application of Critical
Accounting Policies.
When loans are sold through a securitization, we retain the rights to
service the loans. As the servicer of securitized loans we are obligated to
advance interest payments for delinquent loans if we deem that the advances will
ultimately be recoverable. These advances can first be made out of funds
available in a trust's collection account, then from our operating cash if there
are insufficient funds in a trust's collection account. These advances,
including those made from a trust's collection account, which if not recovered
from the borrower or proceeds from the liquidation of the loan, require
reimbursement from us. These advances may require funding from our capital
resources and may create greater demands on our cash flow than either selling
loans with servicing released or maintaining a portfolio of loans on balance
sheet. However, these advances have priority of repayment from the succeeding
month's mortgage loan payments to the applicable trust.
While we are under no obligation to do so, at times we elect to
repurchase delinquent loans from the securitization trusts, some of which may be
in foreclosure. We elect to repurchase loans in situations requiring more
flexibility for the administration and collection of these loans in order to
maximize their economic recovery and to avoid temporary discontinuations of
residual or stepdown overcollateralization cash flow from securitization trusts.
The purchase price of a delinquent loan is at the loan's outstanding contractual
balance. A foreclosed loan is one where we, as servicer, have initiated formal
foreclosure proceedings against the borrower and a delinquent loan is one that
is 31 days or more past due. The foreclosed and delinquent loans we typically
elect to repurchase are usually 90 days or more delinquent and the subject of
completed foreclosure proceedings, or where a completed foreclosure is imminent.
The related allowance for loan losses for these repurchased loans is included in
our provision for credit losses in the period of repurchase. Our ability to
repurchase these loans does not disqualify us for sale accounting under SFAS No.
140 or other relevant accounting literature because we are not required to
repurchase any loan and our ability to repurchase a loan is limited by contract.
See " -- Summary of Loans and REO Repurchased from Mortgage Loan Securitization
Trusts" for further detail of our repurchase activity.
57
Cash flow from operations, the issuance of subordinated debt and lines
of credit fund our operating cash needs. Loan originations are funded through
borrowings against warehouse credit facilities and sales into an off-balance
sheet facility. Each funding source is described in more detail below.
Cash flow from operations. One of our corporate goals is to achieve
positive cash flow from operations. However, we cannot assure you that we will
achieve our projections regarding declining negative cash flow or positive cash
flow from operations. The achievement of this goal is dependent on our ability
to:
o Manage levels of securitizations to maximize cash flows received
at closing and subsequently from interest-only strips and
servicing rights;
o Continue to grow a portfolio of mortgage loans which will generate
income and cash flows through our servicing activities and the
residual interests we hold in the securitized loans;
o Build on our established approaches to underwriting loans,
servicing and collecting loans and managing credit risks in order
to control delinquency and losses;
o Continue to invest in technology and other efficiencies to reduce
per unit costs in our loan originations and servicing process; and
o Control overall expense increases.
Our cash flow from operations is negatively impacted by a number of
factors. The growth of our loan originations negatively impacts our cash flow
from operations because we must bear the expenses of the origination, but
generally do not recover the cash outflow from these expenses until we
securitize or sell the underlying loans. With respect to loans securitized, we
may be required to wait more than one year to begin recovering the cash outflow
from loan origination expenses through cash inflows from our residual assets
retained in securitization. A second factor, which negatively impacts our cash
flow, is an increase in market interest rates. If market interest rates
increase, the interest rates that investors demand on the certificates issued by
securitization trusts will also increase. The increase in interest rates paid to
investors reduces the cash we will receive from our interest-only strips.
Although we may have the ability in a rising interest rate market to charge
higher loan interest rates to our borrowers, competition, laws and regulations
and other factors may limit or delay our ability to do so.
Even though our loan origination and servicing operations have expanded
during the first quarter of fiscal 2003, negative cash flow from operations
decreased $10.9 million, or 56.0%, for the three months ended September 30, 2002
from the three months ended September 30, 2001. Cash flow from operations for
the three months ended September 30, 2002 was a negative $8.5 million compared
to negative $19.4 million in the first quarter of fiscal 2002. Although we
expect negative cash flow from operations to continue in the foreseeable future,
our goal is to continue to reduce our negative cash flow from operations from
historical levels and then we expect that our cash flow from operations will
become positive. However, negative cash flow from operations in the current
fiscal year may increase from fiscal 2002 levels because due to the nature of
our operations, we generally expect the level of cash flow from operations to
fluctuate.
58
The decline in negative cash flow from operations for the three months
ended September 30, 2002 compared to the three months ended September 30, 2001,
has been achieved through a combination of items. In addition to our focus on
controlling overall expense increases and realizing efficiencies from our
investments in systems and technology (most significantly in our loan
origination areas), the improvement of our cash flow from operations was
attributable to two significant factors. First, the cash flow we received from
our interest-only strips grew by $9.5 million in the first quarter of fiscal
2003 from the first quarter of fiscal 2002 due to increases in our securitized
portfolio of loans which continued to grow and previous securitizations began to
provide us with additional residual cash and overcollateralization cash. Second,
due to increases in interest rate spreads received in our securitizations
beginning in fiscal 2002 and continuing into the first quarter of fiscal 2003,
we were able to structure our securitization transactions to provide cash at the
closing of the securitization through the sale of trust certificates to
investors at a premium or through the sale of notional bonds. In the first
quarter of fiscal 2003, we received $14.9 million of cash at the closing of our
securitizations from the sale of notional bonds compared to $6.0 million in the
first quarter of fiscal 2002 through the sale of trust certificates at a
premium. We do not expect to be able to maintain the levels of cash we received
at the closing of the fiscal 2003 securitization unless market interest rates
remain at, or near, the levels noted in the first quarter of fiscal 2003, the
market is willing to accept the structure and we can maintain the interest rate
spreads achieved in the fiscal 2003 securitization. Although negative cash flow
from operations in future periods may increase from the level experienced in the
first quarter of fiscal 2003, we believe that if our business projections prove
accurate, negative cash flow will decline and we will ultimately achieve
positive cash flow from operations in the future.
As was previously discussed, during the three months ended September
30, 2002, our actual prepayment experience on our managed portfolio was
generally higher than our average historical levels for prepayments. Prepayments
result in decreases in the size of our managed portfolio and decreases in the
expected future cash flows to us from our interest-only strips and servicing
rights. However, due to the favorable interest rate spreads, favorable
overcollateralization requirements and levels of cash received at closing on our
more recent securitizations we do not believe our recent increase in prepayment
experience will have a significant impact on our expected cash flows from
operations in the future.
Credit facilities. Borrowings against warehouse credit facilities
represent cash advanced to us for a limited duration, generally no more than 270
days, and are secured by the loans we pledge to the lender. These credit
facilities provide the primary funding source for loan originations. The
ultimate sale of the loans through securitization or whole loan sale generates
the cash proceeds necessary to repay the borrowings under the warehouse
facilities. We also have a committed mortgage conduit facility, which enables us
to sell our loans into an off-balance sheet facility. In addition, we have the
availability of revolving credit facilities, which may be used to fund our
operations. These credit facilities are generally extended for a one-year term
before the renewal of the facility must be re-approved by the lender. We
periodically review our expected future credit needs and negotiate credit
commitments for those needs as well as excess capacity in order to allow us
flexibility in the timing of the securitization of our loans.
59
The following is a description of the warehouse and operating lines of
credit and mortgage conduit facilities which were available to us at September
30, 2002 (in thousands):
Amount
Amount Utilized Off-
Facility Utilized On- Balance
Amount Balance Sheet Sheet
--------- ------------- -------------
Revolving credit and conduit facilities:
Mortgage conduit facility, expiring July 2003 (a)................. $ 300,000 $ Na $ 51,171
Warehouse revolving line of credit, expiring November 2002 (b).... 200,000 204 Na
Warehouse revolving line of credit, expiring March 2003 (c) ...... 100,000 -- Na
Warehouse and operating revolving line of credit, expiring
December 2002 (d)............................................... 50,000 8,203 Na
Warehouse revolving line of credit, expiring October 2003 (e)..... 25,000 1,060 Na
Operating revolving line of credit, expiring January 2003 (f)..... 1,200 -- Na
----------- --------- ---------
Total revolving credit facilities.................................... 676,200 9,467 51,171
Other facilities:
Commercial paper conduit for lease production, maturity
matches underlying leases (g)................................... 1,412 1,198 214
Capitalized leases, maturing January 2006 (h)..................... 1,022 1,022 Na
----------- --------- ---------
Total credit facilities.............................................. $ 678,634 $ 11,687 $ 51,385
=========== ========= =========
- ----------------------------
Na - not applicable for facility
(a) $300.0 million mortgage conduit facility. The facility provides for the
sale of loans into an off-balance sheet facility with UBS Principal
Finance, LLC, an affiliate of UBS Warburg. See "-- Application of Critical
Accounting Policies" for further discussion of the off-balance sheet
features of this facility.
(b) $200.0 million warehouse line of credit with Credit Suisse First Boston
Mortgage Capital, LLC. $100.0 million of the facility is continuously
committed for the term of the facility with the remaining $100.0 million
available at Credit Suisse's discretion. The interest rate on the facility
is based on one-month LIBOR plus a margin. Advances under this facility are
collateralized by pledged loans. We are currently renegotiating this credit
facility. We can make no assurances that this credit facility will be
extended, or if extended, will be on the same terms as described above.
(c) $100.0 million warehouse line of credit with Triple-A One Funding Corp., an
affiliate of MBIA Insurance Corporation. This facility was renewed in March
2002 and, based upon our review of our credit needs, the credit limit was
reduced from $200.0 million. Interest rates on this facility are based on
commercial paper rates plus a margin. Advances under this facility are
collateralized by pledged loans.
(d) $50.0 million warehouse and operating credit facility with JP Morgan Chase
Bank. Interest rates on the advances under this facility are based upon
one-month LIBOR plus a margin. Obligations under the facility are
collateralized by pledged loans, REO, and advances to securitization
trusts. Advances on this line for general operating purposes are limited to
$5.0 million and are collateralized by our Class R Certificate of the ABFS
Mortgage Loan Trusts 1997-2 and 1998-3. We are currently renegotiating this
credit facility. We can make no assurances that this credit facility will
be extended, or if extended, will be on the same terms as described above.
(e) $25.0 million warehouse line of credit facility from Residential Funding
Corporation. Under this warehouse facility, advances may be obtained,
subject to specific conditions described in the agreements. Interest rates
on the advances are based on one-month LIBOR plus a margin. The obligations
under this agreement are collateralized by pledged loans.
(f) $1.2 million revolving line of credit facility from Firstrust Savings Bank.
The obligations under this facility are collateralized by the cash flows
from our investment in the ABFS 99-A lease securitization trust. The
interest rate on the advances from this facility is one-month LIBOR plus a
margin.
(g) The commercial paper conduit for lease production provided for sale of
equipment leases using a pooled securitization. After January 2000, the
facility was no longer available for sales of equipment leases.
60
(h) Capitalized leases, imputed interest rate of 8.0%, collateralized by
computer equipment.
The warehouse credit agreements require that we maintain specific
financial covenants regarding net worth, leverage, net income, liquidity, total
debt and other standards. Each agreement has multiple individualized financial
covenant thresholds and ratio limits that we must meet as a condition to drawing
on that particular line of credit. At September 30, 2002, we were in compliance
with the terms of all financial covenants. Some of our financial covenants have
minimal flexibility and we cannot say with certainty that we will continue to
comply with the terms of all debt covenants. If we do not comply with the debt
covenants in one of our credit facilities, we can utilize excess capacity in our
other credit facilities for loan funding, request a waiver from our lender or
request a renegotiation of the terms of the agreement in order to allow us to
continue to draw down on the facility. There can be no assurance that a
waiver or modification of terms would be granted us should one be requested in
the future.
Subordinated debt securities. The issuance of subordinated debt funds
the majority of our remaining operating cash requirements. We rely significantly
on our ability to issue subordinated debt since our cash flow from operations is
not sufficient to meet these requirements. In order to expand our businesses we
have issued subordinated debt to partially fund growth and to partially fund
maturities of subordinated debt. In addition, at times we may elect to utilize
proceeds from the issuance of subordinated debt to fund loans instead of using
our warehouse credit facilities, depending on our determination of liquidity
needs. During the first quarter of fiscal 2003, we sold $14.0 million in
subordinated debt, net of redemptions compared to $44.3 million in the first
quarter of fiscal 2002. The reduction in the level of subordinated debt sold was
a result of our focus on becoming cash flow positive and reducing our reliance
on subordinated debt.
We registered $325.0 million of subordinated debt under a registration
statement, which was declared effective by the Securities and Exchange
Commission on October 16, 2001. Of the $325.0 million, $24.1 million of this
debt was available for future issuance at September 30, 2002. Subsequent to
September 30, 2002, an additional $8.6 million of debt was issued. Under a
registration statement declared effective by the Securities and Exchange
Commission on October 3, 2002, we registered an additional $315.0 million of
subordinated debt.
We intend to meet our obligation to repay such debt and interest as it
matures with cash flow from operations, cash flows from interest-only strips and
cash generated from additional debt financing. The utilization of funds for the
repayment of such obligations should not adversely affect operations. Our
unrestricted cash balances are sufficient to cover approximately 22.6% of the
$412.8 million of subordinated debt and accrued interest maturities due within
one year. Unrestricted cash balances were $93.3 million at September 30, 2002,
compared to $99.6 million at June 30, 2002 and $98.8 million at September 30,
2001.
61
The current low interest rate environment has provided an opportunity
to reduce the interest rates offered on our subordinated debt. The
weighted-average interest rate of our subordinated debt issued in the month of
September 2002 was 7.88%, compared to debt issued in September 2001, which had a
weighted-average interest rate of 8.74%. Debt issued at our peak rate, which was
in February 2001, was at a rate of 11.85%. Our ability to further decrease the
rates offered on subordinated debt, or maintain the current rates, depends on
market interest rates and competitive factors among other circumstances. The
weighted average remaining maturity of our subordinated debt has decreased from
18 months at September 2001 to 17 months at September 2002. This decrease is a
result of the reduction in the level of subordinated debt sold as related to our
focus on becoming cash flow positive from operations and our reduced reliance on
subordinated debt.
Sales into special purpose entities and off-balance sheet facilities.
We continue to significantly rely on access to the asset-backed securities
market through securitizations to provide permanent funding of our loan
production. Asset securitizations are one of the most common off-balance sheet
arrangements to apply special purpose entities, such as securitization trusts,
in their structures. The securitization trusts sell certificates to third party
investors which generate cash proceeds for the repayment of borrowings under
warehouse and credit facilities. The off-balance sheet trusts' activities are
restricted to holding title to the loan collateral, issuing certificates to
investors and distributing loan payments to the investors and us in accordance
with the agreement. We also retain the right to service the loans. Residual cash
from the loans after required principal and interest payments are made to the
investors provide us with cash flows from our interest-only strips. It is our
expectation that future cash flows from our interest-only strips and servicing
rights will generate more of the cash flows required to meet maturities of our
subordinated debt and our operating cash needs.
As of September 30, 2002 and June 30, 2002, there are loans with an
aggregate principal balance of $3.1 billion and $2.9 billion in 23 and 22
separate off-balance sheet entities which have $2.9 billion and $2.8 billion in
investor certificates outstanding, respectively. We have no additional
obligations to the off-balance sheet facilities other than those required as
servicer of the loans and are not required to make any additional investments in
the trusts. See "-- Securitizations -- Summary of Selected Mortgage Loan
Securitization Trust Information" for detail of the composition of each
securitization trust.
Other liquidity considerations. The Board of Directors has approved an
amendment to the Amended and Restated Certificate of Incorporation, which
provides for an increase in the number of authorized shares of preferred stock
from the 1.0 million shares currently authorized, to 3.0 million shares subject
to the approval of stockholders. The Board of Directors has discretion with
respect to designating and establishing the terms of each series of preferred
stock prior to issuance.
A failure to renew or obtain adequate funding under a warehouse credit
facility, offerings of subordinated debt, or any substantial reduction in the
size or pricing in the markets for loans, could have a material adverse effect
on our results of operations and financial condition. To the extent we are not
successful in maintaining or replacing existing financing, we may have to
curtail loan production activities or sell loans rather than securitize them,
thereby having a material adverse effect on our results of operations and
financial condition.
62
A significant portion of our loan originations are non-conforming
mortgages to subprime borrowers. Some participants in the non-conforming
mortgage industry have experienced greater than anticipated losses on their
securitization interest-only strips and servicing rights due to the effects of
increased delinquencies, increased credit losses and increased prepayment rates.
As a result, some competitors have exited the business or have recorded
valuation allowances or write downs for these conditions. Due to these
circumstances, some participants experienced restricted access to capital
required to fund loan originations and have been precluded from participation in
the asset-backed securitization market. However, we have maintained our ability
to obtain funding and to securitize loans. Factors that have minimized the
effect of adverse market conditions on our business include our ability to
originate loans through established retail channels, focus on credit
underwriting, assessment of prepayment fees on loans, diversification of lending
in the home equity and business loan markets and the ability to raise capital
through sales of subordinated debt securities pursuant to a registered public
offering. Subject to economic, market and interest rate conditions, we intend to
continue to transact additional securitizations for future loan originations.
Any delay or impairment in our ability to securitize loans, as a result of
market conditions or otherwise, could adversely affect our liquidity and results
of operations.
Our June 2002 and September 2002 securitizations were structured as
senior / subordinated certificate structures which provide credit enhancement
for senior certificates by the subordinated certificates. This structure
provided us with lower overcollateralization requirements among other benefits.
We were notified by a rating agency that we did not qualify as a select servicer
in connection with the September 2002 securitization due to some of the
financial requirements of such rating agency and were required to enter into an
agreement with an alternate servicer who would, among other responsibilities,
assume our responsibilities for servicing that securitization trust's loans
should we be unable to fulfill our servicing obligations. While we currently
believe we qualify as a select servicer with respect to the December 2002
securitization, if we do not qualify as a select servicer for the December 2002
securitization or in connection with future securitizations, due to financial
requirements or other factors and we desire to enter into such securitizations
structured as senior / subordinated certificate transactions, we would be
required to enter into an agreement with an alternate servicer who would, among
other responsibilities, assume our responsibilities for servicing that
securitization trust's loans should we be unable to fulfill our servicing
obligations. We do not anticipate that this servicing agreement requirement
would limit our ability to structure future securitizations as a senior /
subordinated structure or that the additional cost to structure such
securitizations would be material. Additionally, other structures could be
available to us including an insured structure, which was the structure of our
securitizations from 1996 to March of 2002.
A further decline in economic conditions, continued instability in
financial markets or further acts of terrorism in the United States may cause
disruption in our business and operations including reductions in demand for our
loan products and our subordinated debt securities, increases in delinquencies
and credit losses in our managed loan portfolio, changes in historical
prepayment patterns and declines in real estate collateral values. To the extent
the United States experiences an economic downturn, unusual economic patterns
and unprecedented behaviors in financial markets, these developments may affect
our ability to originate loans at profitable interest rates, to price future
loan securitizations profitably and to effectively hedge our loan portfolio
against market interest rate changes which could cause reduced profitability.
Should these disruptions and unusual activities occur, our profitability and
cash flow could be reduced and our ability to make principal and interest
payments on our subordinated debt could be impaired.
63
Related Party Transactions
We have a loan receivable from our Chairman and Chief Executive
Officer, Anthony J. Santilli, for $0.6 million, which was an advance for the
exercise of stock options to purchase 247,513 shares of our common stock in
1995. The loan is due in September 2005 (earlier if the stock is disposed of).
Interest at 6.46% is payable annually. The loan is secured by 247,513 shares of
our common stock, and is shown as a reduction of stockholders' equity in our
financial statements.
On April 2, 2001, we awarded 3,025 shares of our common stock to
Richard Kaufman, our director, as a result of services rendered in connection
with our stock repurchases.
We employ members of the immediate family of some of our directors and
executive officers in various positions. We believe that the salaries we pay
these individuals are competitive with salaries paid to other employees in
similar positions in our organization and in our industry.
We are involved in a transaction with Lanard & Axilbund, Inc., a real
estate brokerage and management firm in which our Director, Mr. Sussman, is a
partner, related to our possible lease of new office space. As a result of this
transaction, with Lanard & Axilbund, Inc. will receive a commission from the
owner of the building to be leased by the Company. We believe that any
commission to be received by Lanard & Axilbund, Inc. as a result of this
transaction will be consistent with market and industry standards.
Additionally, we have business relationships with other related
parties, including family members of directors and officers, through which we
have purchased appraisal services, office equipment and real estate advisory
services. None of our related party transactions, individually or collectively,
are material to our results of operations.
Recent Accounting Pronouncements
Set forth below is a proposed accounting pronouncements that may have a
future effect on operations. The following description should be read in
conjunction with the significant accounting policies, which have been adopted
that are set forth in Note 1 of the notes to the June 30, 2002 consolidated
financial statements.
In June 2002, the FASB issued a proposed interpretation of Accounting
Research Bulletin No. 51 "Consolidated Financial Statements." The proposal
provides guidance on consolidation by a business enterprise of special purpose
entities, referred to as an SPE. The proposal defines the primary beneficiary of
an SPE as a business enterprise that has a controlling financial interest in the
SPE. The proposal requires that the primary beneficiary of an SPE consolidate an
SPE's assets, liabilities and results of the activities of the SPE in their
financial statements and provide certain disclosures regarding both consolidated
and unconsolidated SPEs. SPEs whose structures effectively disburse risk would
not be required to be consolidated by any party. Although we use SPEs
extensively in our loan securitization activities, the proposal, if adopted as
proposed, will not affect our current consolidation policies for SPEs. The
proposed interpretation does not change the guidance incorporated in SFAS No.
140 which precludes consolidation of a qualifying SPE by a transferor of assets
to that SPE. The proposal as currently contemplated will therefore have no
effect on our financial condition or results of operations and would not be
expected to effect it in the future.
64
Property
We lease our corporate headquarters facilities in Bala Cynwyd,
Pennsylvania under a five-year operating lease expiring in July 2003 at a
minimum annual rental of approximately $2.9 million. We lease additional space
in Bala Cynwyd under a five-year lease expiring November 2004 at an annual
rental of approximately $0.7 million. We also lease a facility in Roseland, New
Jersey under an operating lease expiring July 2003 at an annual rental of $0.8
million. The Roseland lease has a renewal provision at an increased annual
rental. In addition, branch offices are leased on a short-term basis in various
cities throughout the United States. The leases for the branch offices are not
material to operations.
We are currently negotiating a lease for office space for our corporate
headquarters to replace our lease which expires in July 2003.
Availability of Reports
We make our annual and quarterly reports and other filings with the SEC
available free of charge on our web site, www.abfsonline.com, as soon as
reasonably practicable after filing with the SEC. We will provide, at no cost,
paper or electronic copies of our reports and other filings made with the SEC.
Requests should be directed to:
Stephen M. Giroux, Esquire
American Business Financial Services, Inc.
BalaPointe Office Centre
111 Presidential Boulevard
Bala Cynwyd, PA 19004
(610) 668-2440
The information on the web sites listed above, is not and should not be
considered part of this Quarterly Report on Form 10-Q and is not incorporated by
reference in this document. These web sites are and are only intended to be
inactive textual references.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Interest Rate Risk Management."
Item 4. Controls and Procedures
Quarterly evaluation of Disclosure Controls and Internal Controls.
Within the 90 days prior to the date of this Quarterly Report on Form 10-Q, we
evaluated the effectiveness of the design and operation of the Company's
disclosure controls and procedures ("Disclosure Controls"). This evaluation
("Controls Evaluation") was done under the supervision and with the
participation of management, including the Chief Executive Officer ("CEO") and
Chief Financial Officer ("CFO").
Limitations on the Effectiveness of Controls. Our management, including
the CEO and CFO, does not expect that our Disclosure Controls and/or our
internal controls and procedures for financial reporting ("Internal Controls")
will prevent all errors and all fraud. A control system, no matter how well
conceived and operated, can provide only reasonable, not absolute, assurance
that the objectives of the control system are met. Further, the design of a
control system must reflect the fact that there are constraints on financial
resources, and the benefits of controls must be considered relative to their
costs. Because of the inherent limitations in all control systems, no evaluation
of controls can provide absolute assurance that all control issues and instances
of fraud, if any, within our Company have been detected. These inherent
limitations include the realities that judgments in decision-making can be
faulty, and that breakdowns can occur because of simple error or mistake.
Additionally, controls can be circumvented by the individual acts of some
persons, by collusion of two or more people, or by management override of the
control. The design of any system of controls also is based in part upon certain
assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions; and over time, controls may become inadequate because of
changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
not be detected.
Conclusions. Based upon the Controls Evaluation, the CEO and CFO have
concluded that, subject to the limitations noted above, the Disclosure Controls
are effective to timely alert management to material information relating to our
Company during the period when the Company's periodic reports are being
prepared.
In accord with SEC requirements, the CEO and CFO note that, since the
date of the Controls Evaluation to the date of this Quarterly Report, there have
been no significant changes in Internal Controls or in other factors that could
significantly affect Internal Controls, including any corrective actions with
regard to significant deficiencies and material weaknesses.
65
PART II OTHER INFORMATION
Item 1. Legal Proceedings
On February 26, 2002, a purported class action titled Calvin Hale v.
HomeAmerican Credit, Inc., No. 02 C 1606, United States District Court for the
Northern District of Illinois, was filed in the Circuit Court of Cook County,
Illinois (subsequently removed by Upland Mortgage to the captioned federal
court) against our subsidiary, HomeAmerican Credit, Inc., which does business as
Upland Mortgage, on behalf of borrowers in Illinois, Indiana, Michigan and
Wisconsin who paid a document preparation fee on loans originated since February
4, 1997. The plaintiff alleges that the charging of, and the failure to properly
disclose the nature of, a document preparation fee were improper under
applicable state law. The plaintiff seeks restitution, compensatory and punitive
damages and attorney's fees and costs, in unspecified amounts. We believe that
our imposition of this fee is permissible under applicable law and we are
vigorously defending the case.
Our lending subsidiaries, including HomeAmerican Credit, Inc. which
does business as Upland Mortgage, are involved, from time to time, in class
action lawsuits, other litigation, claims, investigations by governmental
authorities, and legal proceedings arising out of their lending activities,
including the purported class action entitled, Calvin Hale v. HomeAmerican
Credit, Inc., d/b/a Upland Mortgage, described above. Due to our current
expectation regarding the ultimate resolution of these actions, management
believes that the liabilities resulting from these actions will not have a
material adverse effect on our consolidated financial position or results of
operations. However, due to the inherent uncertainty in litigation and since the
ultimate resolutions of these proceedings are influenced by factors outside of
our control, it is possible that our estimated liability under these proceedings
may change or that actual results will differ from our estimates. We expect,
that as a result of the publicity surrounding predatory lending practices, we
may be subject to other class action suits in the future.
In addition, from time to time, we are involved as plaintiff or
defendant in various other legal proceedings arising in the normal course of our
business. While we cannot predict the ultimate outcome of these various legal
proceedings, it is management's opinion that the resolution of these legal
actions should not have a material effect on our financial position, results of
operations or liquidity.
Item 2. Changes in Securities - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
66
Item 5. Other Information - None
Item 6. Exhibits and Reports on Form 8-K
Exhibits
Exhibit
Number Description
- ----------- --------------------------------------------------------------
10.1 Agreement with Lanard & Axilbund, Inc. Dated December 1, 2000
related to the leasing of office space at 1 Presidential Blvd,
Bala Cynwyd, PA.
99.1 Chief Executive Officer's Certificate
99.2 Chief Financial Officer's Certificate
Reports on Form 8-K -
Form 8-K filed on August 5, 2002 regarding the company's June 30, 2002
financial results.
67
SIGNATURE
Pursuant to the requirements of the Securities and Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
DATE: November 13, 2002 By: /s/ Albert W. Mandia
----------------- ---------------------------------------
Albert W. Mandia
Executive Vice President and Chief
Financial Officer
68
CERTIFICATIONS
I, Anthony J. Santilli, certify that:
1. I have reviewed the quarterly report on Form 10-Q of American Business
Financial Services, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered in
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of the registrant's board of directors:
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
69
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 13, 2002 /s/ Anthony J. Santilli
-----------------------------------------------
Anthony J. Santilli
Chairman, President, Chief Executive Officer,
Chief Operating Officer, and Director (principal
executive officer)
I, Albert W. Mandia, certify that:
1. I have reviewed the quarterly report on Form 10-Q of American Business
Financial Services, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered in
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
70
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of the registrant's board of directors:
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 13, 2002 /s/ Albert W. Mandia
--------------------------------------------
Albert W. Mandia
Executive Vice President and
Chief Financial Officer (principal financial
officer)
71
EXHIBIT INDEX
Exhibit
Number Description
--------- --------------------------------------------------------------
10.1 Agreement with Lanard & Axilbund, Inc. Dated December 1, 2000
related to the leasing of office space at 1 Presidential Blvd,
Bala Cynwyd, PA.
99.1 Chief Executive Officer's Certificate
99.2 Chief Financial Officer's Certificate
72