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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 March 31, 2003
[ ] 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 May 12, 2003 was 2,942,764 shares.
American Business Financial Services, Inc. and Subsidiaries
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2003 and June 30, 2002...............................................1
Consolidated Statements of Income for the three and nine months ended March 31, 2003 and 2002....................2
Consolidated Statement of Stockholders' Equity for the nine months ended March 31, 2003..........................3
Consolidated Statements of Cash Flow for the nine months ended March 31, 2003 and 2002...........................4
Notes to Consolidated Financial Statements.......................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................23
Item 3. Quantitative and Qualitative Disclosure about Market Risk..............................................80
Item 4. Controls and Procedures................................................................................80
PART II OTHER INFORMATION
Item 1. Legal Proceedings......................................................................................81
Item 2. Changes in Securities..................................................................................82
Item 3. Defaults Upon Senior Securities........................................................................82
Item 4. Submission of Matters to a Vote of Security Holders....................................................82
Item 5. Other Information......................................................................................82
Item 6. Exhibits and Reports on Form 8-K.......................................................................82
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
American Business Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollars in thousands)
March 31, June 30,
2003 2002
----------- -----------
(Unaudited) (Note)
Assets
Cash and cash equivalents $ 87,232 $ 108,599
Loan and lease receivables, net
Available for sale 52,651 52,622
Interest and fees 14,154 12,292
Other 21,254 9,028
Interest-only strips (includes the fair value of
overcollateralization related cash flows of $290,650 and
$236,629 at March 31, 2003 and June 30, 2002) 609,891 512,611
Servicing rights 132,925 125,288
Prepaid expenses 3,584 3,640
Receivable for sold loans - 5,055
Property and equipment, net 18,092 18,446
Other assets 33,156 28,794
----------- -----------
Total assets $ 972,939 $ 876,375
=========== ===========
Liabilities
Subordinated debt $ 710,218 $ 655,720
Warehouse lines and other notes payable 6,782 8,486
Accrued interest payable 45,513 43,069
Accounts payable and accrued expenses 21,268 13,690
Deferred income taxes 38,898 35,124
Other liabilities 73,033 50,908
----------- -----------
Total liabilities 895,712 806,997
----------- -----------
Stockholders' equity
Preferred stock, par value $.001, authorized, 3,000,000 shares
at March 31, 2003 and 1,000,000 shares at June 30, 2002,
issued and outstanding, none - -
Common stock, par value $.001, authorized, 9,000,000 shares,
issued: 3,653,037 shares at March 31, 2003 and 3,645,192 shares
at June 30, 2002 (including Treasury shares of 710,273 at March
31, 2003 and 801,823 at June 30, 2002) 4 4
Additional paid-in capital 23,985 23,985
Accumulated other comprehensive income 15,442 11,479
Retained earnings 47,411 47,968
Treasury stock, at cost (9,015) (13,458)
----------- -----------
77,827 69,978
Note receivable (600) (600)
----------- -----------
Total stockholders' equity 77,227 69,378
----------- -----------
Total liabilities and stockholders' equity $ 972,939 $ 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 Nine Months Ended
March 31, March 31,
---------------------------- -----------------------------
2003 2002 2003 2002
----------- ------------ ------------ ----------
Revenues
Gain on sale of loans $ 54,504 $ 49,220 $ 170,394 $ 129,139
Interest and fees 4,661 5,292 13,422 16,759
Interest accretion on interest-only strips 12,114 9,538 34,361 25,920
Servicing income 486 1,282 2,667 4,216
Other income 1 103 7 107
----------- ------------ ------------ ----------
Total revenues 71,766 65,435 220,851 176,141
----------- ------------ ------------ ----------
Expenses
Interest 16,824 17,191 51,057 51,467
Provision for credit losses 1,718 1,728 4,692 4,434
Employee related costs 9,418 9,467 29,965 25,953
Sales and marketing 6,963 6,498 20,136 18,937
General and administrative 26,157 18,824 74,890 52,589
Securitization assets valuation adjustment 10,657 8,691 33,303 13,153
----------- ------------ ------------ ----------
Total expenses 71,737 62,399 214,043 166,533
----------- ------------ ------------ ----------
Income before provision for income taxes 29 3,036 6,808 9,608
Provision (benefit) for income taxes (192) 1,275 2,655 4,035
----------- ------------ ------------ ----------
Net Income $ 221 $ 1,761 $ 4,153 $ 5,573
=========== ============ ============ ==========
Earnings per common share:
Basic $ 0.07 $ 0.58 $ 1.43 $ 1.88
=========== ============ ============ ==========
Diluted $ 0.06 $ 0.55 $ 1.36 $ 1.74
=========== ============ ============ ==========
Average common shares:
Basic 2,941 2,844 2,909 2,963
=========== ============ ============ ==========
Diluted 3,103 3,034 3,043 3,202
=========== ============ ============ ==========
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 nine months ended Shares Paid-In Comprehensive Retained Treasury Note Stockholders'
March 31, 2003: Outstanding Amount Capital Income Earnings Stock Receivable Equity
----------- ------ ---------- ------------- -------- -------- ---------- -------------
Balance June 30, 2002 2,844 $ 4 $ 23,985 $ 11,479 $ 47,968 $ (13,458) $ (600) $ 69,378
Comprehensive income:
Net income -- -- -- -- 4,153 -- -- 4,153
Net unrealized gain on
interest-only strips -- -- -- 3,963 -- -- -- 3,963
----- ----- --------- --------- -------- --------- ------- ---------
Total comprehensive income -- -- -- 3,963 4,153 -- -- 8,116
Exercise of non-employee stock
options 57 -- -- -- (569) 619 -- 50
Shares issued to employees 38 -- -- -- (119) 492 -- 373
Shares issued to directors 4 -- -- -- (42) 51 -- 9
Stock dividend (10% of
outstanding shares) -- -- -- -- (3,281) 3,281 -- --
Cash dividends ($0.24 per
share) -- -- -- -- (699) -- -- (699)
----- ----- --------- --------- -------- --------- ------- ---------
Balance March 31, 2003 2,943 $ 4 $ 23,985 $ 15,442 $ 47,411 $ (9,015) $ (600) $ 77,227
===== ===== ========= ========= ======== ========= ======= =========
See accompanying notes to consolidated financial statements.
3
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow
(dollars in thousands)
(unaudited)
Nine Months Ended
March 31,
-----------------------------------
2003 2002
------------- ------------
Cash flows from operating activities
Net income $ 4,153 $ 5,573
Adjustments to reconcile net income to net cash used in operating
activities:
Gain on sales of loans (170,394) (129,139)
Depreciation and amortization 38,085 29,806
Interest accretion on interest-only strips (34,361) (25,920)
Securitization assets valuation adjustment 33,303 13,153
Provision for credit losses 4,692 4,434
Loans originated for sale (1,226,712) (1,048,706)
Proceeds from sale of loans 1,208,940 1,049,999
Principal payments on loans and leases 14,626 8,098
(Increase) decrease in accrued interest and fees on loan and lease
receivables (1,862) 3,216
Purchase of initial overcollateralization on securitized loans (3,800) -
Required purchase of additional overcollateralization on securitized
loans (53,496) (35,468)
Cash flow from interest-only strips 109,849 70,729
Decrease in prepaid expenses 56 50
Increase in accrued interest payable 2,444 11,589
Increase in accounts payable and accrued expenses 7,953 2,254
Accrued interest payable reinvested in subordinated debt 28,174 20,545
(Decrease) increase in deferred income taxes (549) 2,738
Increase in loans in process 1,884 762
Other, net (4,493) (4,697)
------------- ------------
Net cash used in operating activities (41,508) (20,984)
------------- ------------
Cash flows from investing activities
Purchase of property and equipment, net (4,277) (3,090)
Principal receipts and maturity of investments 25 19
------------- ------------
Net cash used in investing activities (4,252) (3,071)
------------- ------------
4
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow (continued)
(dollars in thousands)
(unaudited)
Nine Months Ended
March 31,
-----------------------------------
2003 2002
------------- ------------
Cash flows from financing activities
Proceeds from issuance of subordinated debt $ 136,977 $ 177,820
Redemptions of subordinated debt (110,653) (95,579)
Net borrowings on revolving lines of credit (495) (7,311)
Principal payments on lease funding facility (2,091) (2,474)
Principal payments under capital lease obligations (138) -
Net repayments of other notes payable - (156)
Financing costs incurred (688) (1,497)
Lease incentive receipts 2,123 -
Exercise of employee stock options (2) -
Exercise of non-employee stock options 50 -
Grant of restricted stock option 9 -
Cash dividends paid (699) (628)
Repurchase of treasury stock - (5,652)
------------- ------------
Net cash provided by financing activities 24,393 64,523
------------- ------------
Net (decrease) increase in cash and cash equivalents (21,367) 40,468
Cash and cash equivalents at beginning of year 108,599 91,092
------------- ------------
Cash and cash equivalents at end of year $ 87,232 $ 131,560
============= ============
Supplemental disclosures:
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ (1,020) $ -
Increase in warehouse lines and other notes payable $ 1,020 $ -
Cash paid during the period for:
Interest $ 20,439 $ 19,324
Income taxes $ 759 $ 1,086
See accompanying notes to consolidated financial statements.
5
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
March 31, 2003
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 Services 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, the Company's operations
(including repurchases of delinquent assets from securitization trusts),
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
nine-month period ended March 31, 2003 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)
March 31, 2003
1. Basis of Financial Statement Presentation (continued)
In December 2002, the Company's shareholders approved an increase in the number
of shares of authorized preferred stock from 1.0 million shares to 3.0 million
shares. The preferred shares may be used to raise equity capital, redeem
outstanding debt or acquire other companies, although no such acquisitions are
currently contemplated. The Board of Directors has discretion with respect to
designating and establishing the terms of each series of preferred stock prior
to issuance.
Certain prior period financial statement balances have been reclassified to
conform to current period presentation.
Recent Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Financial Interpretation No. ("FIN") 45 "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others." FIN 45 standardizes practices related to the recognition of a liability
for the fair value of a guarantor's obligation. The rule requires companies to
record a liability for the fair value of its guarantee to provide or stand ready
to provide services, cash or other assets. The rule applies to contracts that
require a guarantor to make payments based on an underlying factor such as
change in market value of an asset, collection of the scheduled contractual cash
flows from individual financial assets held by an SPE, non-performance of a
third party, for indemnification agreements, or for guarantees of the
indebtedness of others among other things. The provisions of FIN 45 are
effective on a prospective basis for guarantees that are issued or modified
after December 31, 2002. The disclosure requirements were effective for
statements of annual or interim periods ending after December 15, 2002.
Based on the requirements of this guidance for the quarter ended March 31, 2003,
the Company has recorded a $0.7 million liability in conjunction with the sale
of mortgage loans to the ABFS 2003-1 securitization trust which occurred in
March 2003. This liability represents the fair value of periodic interest
advances that the Company, as servicer of the securitized loans, is obligated to
pay on behalf of delinquent loans in the trust. Recording of this liability
reduces the gain on sale recorded for the securitization. The Company would
expect to record a similar liability for each subsequent securitization, which
generally occurs on a quarterly basis. The amount of the liability that will be
recorded is dependent mainly on the volume of loans the Company securitizes, the
expected performance of those loans and the interest rate of the loans. In the
quarter ended March 31, 2003, the adoption of FIN 45 reduced net income by
approximately $0.3 million and diluted earnings per share by $0.11. See Note 8
for further detail of this obligation.
In December 2002, the FASB issued Statement of Financial Accounting Standard
("SFAS") No. 148 "Accounting for Stock-Based Compensation - Transition and
Disclosure." SFAS No. 148 amends SFAS No. 123 "Accounting for Stock-Based
Compensation." SFAS No. 148 provides alternative methods of transition
7
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
1. Basis of Financial Statement Presentation (continued)
Recent Accounting Pronouncements (continued)
for a voluntary change to the fair value method of accounting for stock-based
compensation and requires pro forma disclosures of the effect on net income and
earnings per share had the fair value method been used to be included in annual
and interim reports and disclosure of the effect of the transition method used
if the accounting method was changed, among other things. SFAS No. 148 is
effective for annual reports of fiscal years beginning after December 15, 2002
and interim reports for periods beginning after December 15, 2002. The Company
plans to continue using the intrinsic value method of accounting for stock-based
compensation and therefore the new rule will have no effect on the Company's
financial condition or results of operations. The Company has adopted the new
standard related to disclosure in the interim period beginning January 1, 2003.
See Note 11 for further detail of the adoption of this rule.
In April 2003, the FASB began reconsidering the current alternatives available
for accounting for stock-based compensation. The Company cannot predict whether
the guidance will change the Company's current accounting for stock-based
compensation, or what effect, if any, changes may have on the Company's current
financial condition or results of operations.
In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest
Entities." FIN 46 provides guidance on the identification of variable interest
entities that are subject to consolidation requirements by a business
enterprise. A variable interest entity subject to consolidation requirements is
an entity that does not have sufficient equity at risk to finance its operations
without additional support from third parties and the equity investors in the
entity lack certain characteristics of a controlling financial interest as
defined in the guidance. Special purpose entities ("SPEs") are one type of
entity, which under certain circumstances may qualify as a variable interest
entity. Although the Company uses unconsolidated SPEs extensively in its loan
securitization activities, the guidance will not affect the Company's current
consolidation policies for SPEs as the guidance does not change the guidance
incorporated in SFAS No. 140 "Accounting for Transfers and Servicing of
Financial Assets and Extinguishment of Liabilities" which precludes
consolidation of a qualifying SPE by a transferor of assets to that SPE. FIN 46
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. In March 2003,
the FASB announced that it is reconsidering the permitted activities of a
qualifying SPE. The Company cannot predict whether the guidance will change or
what effect, if any, changes may have on the Company's current consolidation
policies for SPEs.
Restricted Cash Balances
The Company held restricted cash balances of $9.4 million and $9.0 million
related to borrower escrow accounts at March 31, 2003 and June 30, 2002,
respectively, and $3.4 million at March 31, 2003 related to deposits for future
settlement of interest rate swap contracts. There was no restricted cash related
to interest rate swap contracts at June 30, 2002.
8
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
2. Loan and Lease Receivables
Loan and lease receivables - Available for sale - were comprised of the
following (in thousands):
March 31, June 30,
2003 2002
--------- ---------
Real estate secured loans (a) $ 49,121 $ 48,116
Leases, net of unearned income of $806 and $668 (b) 5,483 8,211
--------- ---------
54,604 56,327
Less: allowance for credit losses on loan and lease
receivables available for sale 1,953 3,705
--------- ---------
$ 52,651 $ 52,622
========= =========
(a) Includes deferred direct loan origination costs of $1.4 million at March 31,
2003 and June 30, 2002.
(b) Includes deferred direct lease origination costs of $0.1 million and $0.4
million at March 31, 2003 and June 30, 2002, respectively.
Real estate secured loans have contractual maturities of up to 30 years.
At March 31, 2003 and June 30, 2002, the accrual of interest income was
suspended on real estate secured loans of $5.9 million and $7.0 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $1.3 million and $2.9 million at
March 31, 2003 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.
Loan and lease receivables - Interest and fees - are comprised mainly of accrued
interest and fees on loans and leases that are less than 90 days delinquent.
Additionally, Interest and fees include forbearance and deferment advances. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Managed Portfolio Quality" for a further description of these
agreements. These amounts are carried at their estimated net recoverable value.
Loan and lease receivables - Other - is comprised of receivables for securitized
loans. In accordance with the Company's securitization 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. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Off-Balance Sheet Arrangements - Trigger Management" for more detail of removal
of accounts provisions for securitized loans.
9
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
3. Interest-Only Strips
Activity for interest-only strip receivables for the nine months ended March 31,
2003 and 2002 were as follows (in thousands):
March 31,
2003 2002
---------------------------------
Balance at beginning of period $ 512,611 $ 398,519
Initial recognition of interest-only strips, including
initial overcollateralization of $3.8 million and $0 141,511 112,869
Cash flow from interest-only strips (109,849) (70,729)
Required purchases of additional overcollateralization 53,496 35,468
Interest accretion 34,361 25,920
Termination of lease securitization (a) (1,741) -
Net temporary adjustments to fair value (b) 8,286 1,253
Other than temporary fair value adjustment (b) (28,784) (13,153)
---------------------------------
Balance at end of period $ 609,891 $ 490,147
=================================
(a) Reflects release of lease collateral from a lease securitization trust which
was terminated in accordance with the trust documents after the full payout
of trust note certificates. Lease receivables of $1.6 million were recorded
on the balance sheet as a result of the termination.
(b) 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 the
excess of the principal balance of loans in a securitized pool over investor
interests. Overcollateralization is established to provide credit enhancement to
investors in securitization trusts. At March 31, 2003 and 2002, the fair value
of overcollateralization related cash flows were $290.6 million and $223.1
million, respectively.
After a two-year period during which management's estimates required no
valuation adjustments to its interest-only strips and servicing rights,
declining interest rates and high prepayment rates over the last six quarters
have required revisions to management's estimates of the value of these retained
interests. Beginning in the second quarter of fiscal 2002 and on a quarterly
basis thereafter, the Company increased the prepayment rate assumptions used to
value its securitization assets, thereby lowering the fair value of these
assets. However, because the Company's prepayment rates as well as those
throughout the mortgage industry continued to remain at higher than expected
levels due to continuous declines in interest rates during this period to
40-year lows, the Company's prepayment experience exceeded even management's
revised assumptions. As a result, over the last six quarters the Company has
recorded cumulative write downs to its interest-only strips in the aggregate
amount of $89.5 million and
10
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
3. Interest-Only Strips (continued)
an adjustment to the value of servicing rights of $4.5 million, for total
adjustments of $94.0 million mainly due to its higher than expected prepayment
experience. Of this amount, $55.3 million was expensed through the income
statement and $38.7 million resulted in a write down through other comprehensive
income, a component of stockholders' equity.
During the first nine months of fiscal 2003, write downs of $50.0 million were
recorded on the Company's securitization assets, including $45.5 million on
interest-only strips and $4.5 million on servicing rights. Within the $50.0
million write down was a charge of $58.3 million mainly due to increases in
prepayment experience, offset by $8.3 million of favorable fair value
adjustments. The income statement impact on interest-only strips for the first
nine months of fiscal 2003 was a write down of $33.3 million while the remaining
$16.7 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 Issue No. 99-20.
The long duration of historically low interest rates has given borrowers an
extended opportunity to engage in mortgage refinancing activities which resulted
in elevated prepayment experience. The persistence of historically low interest
rate levels, unprecedented in the last 40 years, has made the forecasting of
prepayment levels in future fiscal periods difficult. The Company had assumed
that the decline in interest rates had stopped and a rise in interest rates
would occur in the near term. Consistent with this view, the Company had
utilized derivative financial instruments to manage interest rate risk exposure
on the Company's loan production and loan pipeline to protect the fair value of
these fixed rate items against potential increases in market interest rates.
Based on current economic conditions and published mortgage industry surveys
including the Mortgage Bankers Association's Refinance Indexes available at the
time of the Company's quarterly revaluation of its interest-only strips and
servicing rights, and the Company's own prepayment experience, the Company
believes prepayments will continue to remain at higher than normal levels for
the near term before returning to average historical levels. The Mortgage
Bankers Association of America has forecast as of April 8, 2003 that mortgage
refinancings as a percentage share of total mortgage originations will decline
from 71% in the first quarter to 33% in the fourth quarter of calendar 2003. The
Mortgage Bankers Association of America has also projected in its April 2003
economic forecast that the 10-year treasury rate (which generally affects
mortgage rates) will increase over the next three quarters. As a result of the
analysis of these factors, the Company has increased its prepayment rate
assumptions for home equity loans for the near term, but at a declining rate,
before returning to its 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 the Company's
securitization assets and its actual experience may have a significant adverse
impact on the value of these assets.
11
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
3. Interest-Only Strips (continued)
The following table details the pre-tax write downs of the securitization assets
(in thousands):
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- ---------------------- ---------- --------- -------------
September 30, 2002 $ 16,739 $ 12,078 $ 4,661
December 31, 2002 (a) 16,346 10,568 5,778
March 31, 2003 (b) 16,877 10,657 6,220
--------- -------- ---------
Total Fiscal 2003 $ 49,962 $ 33,303 $ 16,659
========= ======== =========
(a) includes a write down of $2.6 million to the carrying value of servicing
rights through the income statement.
(b) Includes a write down of $1.9 million to the carrying value of servicing
rights through the income statement.
4. Servicing Rights
Activity for the loan servicing rights asset for the nine months ended March 31,
2003 and 2002 were as follows (in thousands):
March 31,
2003 2002
-------------------------
Balance at beginning of period $ 125,288 $ 102,437
Initial recognition of servicing rights 42,171 37,371
Amortization (30,015) (21,614)
Write down (4,519) -
-------------------------
Balance at end of period $ 132,925 $ 118,194
=========================
A write down of $4.5 million was recorded for the nine-month period ended March
31, 2003 on the value of servicing rights mainly due to the impact of increases
in prepayment experience. This adjustment was recorded on the income statement
for the nine months ended March 31, 2003 in accordance with SFAS No. 140, as a
component of the securitization assets valuation adjustment.
12
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
5. Other Assets and Other Liabilities
Other assets were comprised of the following (in thousands):
March 31, June 30,
2003 2002
----------- ------------
Goodwill $ 15,121 $ 15,121
Real estate owned 6,348 3,784
Financing costs, debt offerings 4,424 5,849
Due from securitization trusts for
servicing related activities 2,805 1,616
Investments held to maturity 892 917
Other 3,566 1,507
----------- ------------
$ 33,156 $ 28,794
=========== ============
Other liabilities were comprised of the following (in thousands):
March 31, June 30,
2003 2002
----------- ------------
Commitments to fund closed loans $ 31,750 $ 29,866
Obligation for repurchase of securitized loans 25,005 10,621
Escrow deposits held 9,460 9,011
Hedging liabilities, at fair value 2,809 -
Unearned lease incentives 2,123 -
Periodic advance guarantee 667 -
Trading liabilities, at fair value 562 461
Other 657 949
----------- ------------
$ 73,033 $ 50,908
=========== ============
See Note 2 for an explanation of the obligation for the repurchase of
securitized loans and Note 9 for an explanation of the Company's hedging and
trading activities.
Unearned lease incentives represent reimbursements received in conjunction with
the lease agreement for the Company's new corporate office space. These funds
represent reimbursement from the landlord for leasehold improvements and
furniture and equipment in the rented space and will be recognized as an offset
to rent expense over the term of the lease.
13
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable
Subordinated debt was comprised of the following (in thousands):
March 31, June 30,
2003 2002
--------- ---------
Subordinated debt (a) $ 690,781 $ 640,411
Subordinated debt - money market notes (b) 19,437 15,309
--------- ---------
Total subordinated debt (a) $ 710,218 $ 655,720
========= =========
Warehouse lines and other notes payable were comprised of the following (in
thousands):
March 31, June 30,
2003 2002
---------- ---------
Warehouse and operating revolving line of credit (c) $ 5,862 $ 6,171
Lease funding facility (d) 38 2,128
Warehouse revolving line of credit (e) - 187
Capitalized leases (f) 882 -
--------- ---------
Total warehouse lines and other notes payable $ 6,782 $ 8,486
========= =========
(a) Subordinated debt due April 2003 through March 2012, interest rates ranging
from 4.00% to 13.00%; average rate at March 31, 2003 was 9.05%, average
remaining maturity was 18 months, subordinated to all of the Company's
senior indebtedness. The average rate on subordinated debt including money
market notes was 8.91% at March 31, 2003.
(b) Subordinated debt-money market notes due upon demand, interest rate at
4.00%; subordinated to all of the Company's senior indebtedness.
(c) $50 million warehouse and operating revolving line of credit expiring
December 2003, which includes a sublimit for a letter of credit that
expires in December 2003 to secure lease obligations for corporate office
space, collateralized by certain pledged loans, advances to securitization
trusts, real estate owned and certain interest-only strips. The amount of
the letter of credit was $8.0 million at March 31, 2003 and will vary over
the term of the office lease.
(d) Lease funding facility matures through May 2003, collateralized by certain
lease receivables.
(e) $25 million warehouse revolving line of credit expiring October 2003,
collateralized by certain pledged loans.
(f) Capitalized leases, maturing through January 2006, imputed interest rate of
8.0%, collateralized by computer equipment.
At March 31, 2003, warehouse lines and other notes payable were collateralized
by $8.2 million of loan and lease receivables and $1.0 million of computer
equipment.
14
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
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 2004, fundings to be
collateralized by an investment in the 99-A lease securitization trust. This
line was unused at March 31, 2003.
o $200 million warehouse revolving line of credit expiring November 2003,
collateralized by certain pledged loans. This line was unused at March 31,
2003.
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 --
Off-Balance Sheet Arrangements" for further discussion of the off-balance
sheet features of this facility. At March 31, 2003, $29.5 million of this
facility was utilized.
Interest rates paid on the revolving credit facilities range from London
Inter-Bank Offered Rate ("LIBOR") plus 1.25% to LIBOR plus 2.50%. The
weighted-average interest rate paid on the revolving credit facilities was 2.80%
and 3.35% at March 31, 2003 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 a particular line of credit.
At March 31, 2003, 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 3, 2002, the Company registered $315.0 million of
subordinated debt. Of the $315.0 million, $187.5 million of debt from this
registration statement was available for future issuance as of March 31, 2003.
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.
15
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
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 Hale case consists of five separate counts - three purported class action
counts and two individual counts. On November 22, 2002 the Illinois Federal
District Court granted Upland Mortgage's motion to dismiss the three class
action counts, but a judgment erroneously dismissing all five counts of the case
was entered in the docket. The plaintiff appealed the dismissal to the United
States Court of Appeals for the Seventh Circuit but, on February 14, 2003, the
Court of Appeals dismissed the appeal for lack of jurisdiction, on the grounds
that the judgment entered by the Illinois Federal District Court was erroneous
and did not constitute a final disposition of all counts of the case. Action on
the two remaining individual counts in the Illinois Federal District Court has
resumed and discovery has been scheduled.
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.
16
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
8. Commitments
Lease Agreements
In December 2002, the Company entered into a new lease for an office space for
the relocation of the Company's corporate headquarters into Philadelphia,
Pennsylvania. The eleven-year operating lease is expected to commence in fiscal
2004. The terms of the rental agreement require increased payments annually for
the term of the lease with average minimum annual rental payments of $4.2
million.
The Company has entered into contracts, or may engage parties in the future,
related to the relocation of the corporate headquarters such as contracts for
building improvements to the leased space, office furniture and equipment and
moving services. As of March 31, 2003, the Company has contracted for services
and equipment totaling $10.5 million related to the office relocation. The
provisions of the lease and local and state grants will provide the Company with
reimbursement of a substantial amount of these costs related to the relocation,
subject to certain conditions and limitations. The Company does not believe that
its unreimbursed expenses or unreimbursed cash outlay related to the relocation
will be material to its operations.
The lease requires the Company to maintain a letter of credit in favor of the
landlord to secure the Company's obligations to the landlord throughout the term
of the lease. The amount of the letter of credit is currently $8.0 million and
will decline over time to $4.0 million. The letter of credit is currently issued
by JPMorgan Chase under the Company's current lending facility with JPMorgan
Chase.
In March 2003, the Company entered into a new lease agreement for office space
in Roseland, New Jersey for the relocation of the Company's regional processing
center presently located in Roseland, New Jersey. The nine-year lease is
expected to commence in May 2003. The terms of the rental agreement require
increased payments periodically for the term of the lease with average minimum
annual rental payments of $0.8 million. The provisions of the lease require the
landlord to assume the costs to ready the premises for occupancy, subject to
certain conditions and limitations. The Company does not believe that its
expenses or cash outlay related to the relocation will be material to its
operations.
Periodic Advance Guarantees
As the servicer of securitized loans, the Company is 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. If the funds available from the
trust's collection account are insufficient to make the required interest
advances, then the Company is required to make the advance from its operating
cash. The advances made from a trust's collection account, if not recovered from
the borrower or proceeds from the liquidation of the loan, require reimbursement
from the Company. However, the Company can recover any advances the Company
makes from its operating cash from the subsequent month's mortgage loan
17
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
8. Commitments (continued)
Periodic Advance Guarantees (continued)
payments to the applicable trust prior to any distributions to the certificate
holders.
The Company adopted FIN 45 on a prospective basis for guarantees that are issued
or modified after December 31, 2002. Based on the requirements of this guidance
for the quarter ended March 31, 2003, the Company has recorded a $0.7 million
liability in conjunction with the sale of mortgage loans to the ABFS 2003-1
securitization trust which occurred in March 2003. This liability represents its
estimate of the fair value of periodic interest advances that the Company as
servicer of the securitized loans, is obligated to pay to the trust on behalf of
delinquent loans. The fair value of the liability was estimated based on an
analysis of historical periodic interest advances and recoveries from
securitization trusts.
9. 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.
18
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
9. Derivative Financial Instruments (continued)
The Company recorded the following gains and losses on the fair value of
derivative financial instruments accounted for as hedges for the three and
nine-month periods ended March 31, 2003 and 2002. 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 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
---------------------------- --------------------------
2003 2002 2003 2002
---------------------------- --------------------------
Offset by gains and losses recorded on
securitizations:
Losses on derivative financial instruments $ (2,071) $ (135) $ (3,806) $ (4,923)
Offset by gains and losses recorded on the
fair value of hedged items:
Losses on derivative financial instruments (16) -- (3,070) --
Amount settled in cash - paid (2,619) (135) (5,041) (4,923)
At March 31, 2003 outstanding forward starting interest rate swap contracts
accounted for as hedges and unrealized losses recorded as liabilities on the
balance sheet were as follows (in thousands):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate swaps $47,497 $ 2,809
Trading activity
The Company recorded the following losses on forward starting interest rate swap
contracts, which were used to manage interest rate risk on loans in the
Company's pipeline and were therefore classified as trading for the three and
nine-month periods ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
---------------------------- --------------------------
2003 2002 2003 2002
---------------------------- --------------------------
Trading losses on forward starting interest
rate swaps $ (784) $ -- $ (3,708) $ --
Amount settled in cash - paid -- -- (2,671) --
At March 31, 2003 outstanding forward starting interest rate swap contracts used
to manage interest rate risk on loans in the Company's pipeline and associated
unrealized losses recorded as liabilities on the balance sheet were as follows
(in thousands):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate swaps $72,503 $ 22
19
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
9. Derivative Financial Instruments (continued)
In addition, for the three and nine-month periods ended March 31, 2003,
respectively, the Company recorded losses of $0.1 million and $1.1 million on an
interest rate swap contract which is not designated as an accounting hedge, and
gains of $0.5 million for the three and nine-month periods ended March 31, 2002.
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 losses recognized during the
nine-month period, $0.3 million were unrealized losses representing the net
change in the fair value of the contract during the period and $0.8 million were
cash losses. The cumulative net unrealized loss of $0.5 million is included as a
trading liability in Other liabilities at March 31, 2003.
10. 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 Nine Months Ended
March 31, March 31,
------------------------- ------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
Earnings
(a) Net Income $ 221 $ 1,761 $ 4,153 $ 5,573
========= ========= ========= ========
Average Common Shares
(b) Average common shares outstanding 2,941 2,844 2,909 2,963
Average potentially dilutive shares 162 190 134 239
--------- --------- --------- --------
(c) Average common and potentially
dilutive shares 3,103 3,034 3,043 3,202
========= ========= ========= ========
Earnings Per Common Share
Basic (a/b) $ 0.07 $ 0.58 $ 1.43 $ 1.88
Diluted (a/c) $ 0.06 $ 0.55 $ 1.36 $ 1.74
11. Stock Option and Stock Incentive Plans
The Company has stock option plans that provide for the periodic granting of
options to key employees and non-employee directors. These plans have been
approved by the Company's shareholders. Options are generally granted to key
employees at the market price of the Company's stock on the date of grant and
expire five to ten years from date of grant. Options either fully vest when
granted or over periods of up to five years.
The Company accounts for stock options issued under these plans using the
intrinsic value method, and accordingly, no expense is recognized where the
exercise price equals or exceeds the fair value of the common stock at the date
of grant. Had the Company accounted for stock options granted under these plans
using the fair value method, pro forma net income and earnings per share would
have been as follows (in thousands, except per share data):
20
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
11. Stock Option and Stock Incentive Plans (continued)
Three Months Ended Nine Months Ended
March 31, March 31,
------------------------------- -----------------------------
2003 2002 2003 2002
------------------------------- -----------------------------
Net income
As reported $ 221 $ 1,761 $ 4,153 $ 5,573
Pro forma $ 285 $ 1,694 $ 4,101 $ 5,488
Earnings per share - basic
As reported $ 0.07 $ 0.58 $ 1.43 $ 1.88
Pro forma $ 0.10 $ 0.60 $ 1.41 $ 1.85
Earnings per share - diluted
As reported $ 0.06 $ 0.55 $ 1.36 $ 1.74
Pro forma $ 0.09 $ 0.56 $ 1.35 $ 1.71
12. 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 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.
The All Other caption on the following tables mainly represents segments that do
not meet the SFAS No. 131 "Disclosures about Segments of an Enterprise and
Related Information" defined thresholds for determining reportable segments,
financial assets not related to operating segments and is mainly comprised of
interest-only strips, unallocated overhead and other expenses of the Company
unrelated to the reportable segments identified.
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.
21
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
12. Segment Information (continued)
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
Nine months ended Loan and Reconciling
March 31, 2003: Origination Funding Servicing All Other Items Consolidated
----------- ------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 170,394 $ - $ - $ - $ - $ 170,394
Interest income................. 5,930 322 590 34,361 - 41,203
Non-interest income............. 6,169 3 33,031 - (29,949) 9,254
Inter-segment revenues - 56,681 - 57,673 (114,354) -
Operating expenses:
Interest expense................ 17,263 50,025 (247) 40,697 (56,681) 51,057
Non-interest expense............ 37,621 7,068 30,221 49,087 - 123,997
Depreciation and amortization... 2,467 84 885 2,250 - 5,686
Securitization assets valuation
adjustment.................... - - - 33,303 - 33,303
Inter-segment expense........... 87,622 - - - (87,622) -
Income tax expense (credit)........ 14,633 (67) 1,077 (12,988) - 2,655
--------- --------- --------- --------- --------- ---------
Net income (loss).................. $ 22,887 $ (104) $ 1,685 $ (20,315) $ - $ 4,153
========= ========= ========= ========= ========= =========
Segment assets..................... $ 100,636 $ 192,470 $ 126,763 $ 647,729 $ (94,659) $ 972,939
========= ========= ========= ========= ========= =========
Treasury
Nine months ended Loan and Reconciling
March 31, 2002: Origination Funding Servicing All Other Items Consolidated
----------- ------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 129,139 $ - $ - $ - $ - $ 129,139
Interest income................. 5,705 738 1,041 25,920 - 33,404
Non-interest income............. 9,222 1 25,762 102 (21,489) 13,598
Inter-segment revenues - 56,028 - 53,754 (109,782) -
Operating expenses:
Interest expense................ 14,485 50,417 99 42,494 (56,028) 51,467
Non-interest expense............ 30,005 8,297 22,883 35,537 - 96,722
Depreciation and amortization... 2,518 105 823 1,745 - 5,191
Securitization assets valuation
adjustment.................... - - - 13,153 - 13,153
Inter-segment expense........... 75,243 - - - (75,243) -
Income tax expense (credit)........ 9,162 (862) 1,259 (5,524) - 4,035
--------- --------- --------- --------- --------- ---------
Net income (loss).................. $ 12,653 $ (1,190) $ 1,739 $ (7,629) $ - $ 5,573
========= ========= ========= ========= ========= =========
Segment assets..................... $ 87,211 $ 204,993 $ 119,069 $ 551,845 $ (77,772) $ 885,346
========= ========= ========= ========= ========= =========
22
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. Factors that could affect our assumptions
include, but are not limited to, general economic conditions, including interest
rate risk, future residential real estate values, regulatory changes
(legislative or otherwise) affecting the real estate market and mortgage lending
activities, competition, demand for American Business Financial Services, Inc.
and its subsidiaries' services, availability of funding, loan payment rates,
delinquency and default rates, changes in factors influencing the loan
securitization market and other risks identified in our Securities and Exchange
Commission filings. 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
Services 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 (including repurchases of
delinquent assets from securitization trusts), investments in systems and
technology and for general corporate purposes.
23
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 March 31, 2003, $710.2 million of
subordinated debt was outstanding and revolving credit and conduit facilities
totaling $576.2 million were available, of which $35.4 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 and subordinated debt see "-- Liquidity and Capital
Resources." For a description of our securitization activity see "-- Off-Balance
Sheet Arrangements."
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.
Local, state and federal legislatures, 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, failing to adequately disclose
the material terms of loans to the borrowers and abusive servicing and
collections practices. As a result of initiatives such as these, 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. These laws and regulations may limit our ability
to securitize loans originated in certain states or localities due to rating
agency, investor or market restrictions. As a result, we have limited the types
of loans we offer in some states and may discontinue originating loans in other
states or localities.
24
Additionally, the United States Congress is currently considering a
number of proposed bills or proposed amendments to existing laws, such as the
"Ney - Lucas Responsible Lending Act of 2003" introduced February 11, 2003 into
the U.S. House of Representatives, which could affect our lending activities and
make our business less profitable. These bills and amendments, if adopted as
proposed, could reduce our profitability by limiting the fees we are allowed to
charge, including prepayment fees, restricting the terms we are allowed to
include in our loan agreements and increasing the amount of disclosure we are
required to give to potential borrowers. While we cannot predict whether or in
what form Congress may adopt these bills or amendments, we are currently
evaluating the potential impact of these bills and amendments, if adopted, on
our lending practices and results of operations.
In addition to new regulatory initiatives with respect to so-called
"predatory lending" practices, current laws or regulations in some states
restrict our ability to charge prepayment penalties and late fees. We have used
the Federal Alternative Mortgage Transactions Parity Act of 1982, which we refer
to as the Parity Act, to preempt these state laws for loans which meet the
definition of alternative mortgage transactions under the Parity Act. However,
the Office of Thrift Supervision has adopted a rule effective in July 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 on new loan
originations. Under the provisions of this rule, we will be required to modify
or eliminate the practice of charging prepayment and other fees in some of the
states where we originate loans. Additionally, in a recent decision, the
Appellate Division of the Superior Court of New Jersey determined that the
Parity Act's preemption of state law was invalid and that the state laws
precluding some lenders from imposing prepayment fees are applicable to loans
made in New Jersey, including alternative mortgage transactions. We are
currently evaluating the impact of the adoption of the new rule by the Office of
Thrift Supervision and of the recent court decision in New Jersey on our future
lending activities and results of operations.
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 and the recent New Jersey court decision
regarding the Parity Act, 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.
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 nine months ended March 31, 2003 were 77.2% 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 80%
in the first nine months of fiscal 2003 and 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.
25
Interest-Only Strips. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 62.7% of our
total assets at March 31, 2003 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 re-evaluated on a
quarterly basis. 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 appropriate. 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. In accordance with the
provisions of Emerging Issues Task Force guidance, referred to as EITF 99-20 in
this document, changes in the fair value of interest-only strips that are deemed
to be temporary changes are recorded through other comprehensive income, a
component of stockholders' equity. Other than temporary adjustments to decrease
the fair value of interest-only strips are recorded through the income statement
which would adversely affect our income in the period of adjustment. See "--
Off-Balance Sheet Arrangements -- 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.
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 update estimates of residual
cash flow from our securitizations on a quarterly basis. 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.
26
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 13.7% of our total assets at March 31, 2003.
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 appropriate. 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 "-- Off-Balance Sheet Arrangements --
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.
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 performed on a quarterly
basis 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 or write
down would be required. During the nine months ended March 31, 2003, our
valuation analysis indicated that valuation adjustments of $4.5 million were
required for impairment due to higher than expected prepayment experience. The
write downs were recorded in the income statement in the second and third
quarters of fiscal 2003. Impairment is measured as the excess of carrying value
over fair value.
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.
27
Development of Critical Accounting Estimates. On a quarterly 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 March 31, 2003 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 nine months
ended March 31, 2003, see "-- Off-Balance Sheet Arrangements --
Securitizations."
Initial Adoption of Accounting Policies. In conjunction with the
relocation of our corporate headquarters to new leased office space, we have
entered into a lease agreement and are in the process of finalizing certain
governmental grant agreements that will provide us with reimbursement for
certain expenditures related to our office relocation. The reimbursable
expenditures include both capitalizable items for leasehold improvements,
furniture and equipment and expense items such as legal costs, moving costs and
employee communication programs. Amounts reimbursed to us in accordance with our
lease agreement will be initially recorded as a liability on our balance sheet
and will be recognized in the income statement on a straight-line basis over the
term of the lease as a reduction of rent expense. Amounts received from
government grants will be initially recorded as a liability. Grant funds
received to offset expenditures for capitalizable items will be reclassified as
a reduction of the related fixed asset and amortized to income over the
depreciation period of the related asset as an offset to depreciation expense.
Amounts received to offset expense items will be recognized in the income
statement as an offset to the expense item.
OFF-BALANCE SHEET ARRANGEMENTS
We use off-balance sheet arrangements extensively in our business
activities. The types of off-balance sheet arrangements we use include special
purpose entities for the securitization of loans, obligations we incur as the
servicer of securitized loans and other contractual obligations such as
operating leases for corporate office space. See "-- Liquidity and Capital
Resources" for additional information regarding our off-balance sheet
contractual obligations.
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 of
its balance sheet by selling them to a special purpose entity. We sell our loans
into off-balance sheet facilities to generate the cash to pay off revolving
credit facilities and to generate revenue through securitization gains. 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.
28
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. The trust is a distinct legal entity,
independent from us. By transferring title of the loans to the trust, we isolate
those assets from our assets. Finally, the trust issues certificates to
investors to raise the cash purchase price for the loans we have sold. Cash from
the sale of certificates to third party investors is returned to us in exchange
for our loan receivables and we use this cash to repay any 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. We have no
additional obligations to the off-balance sheet facilities other than those
required as servicer of the loans and for breach of warranty obligations. We are
not required to make any additional investments in the trusts. Under current
accounting rules, the trusts do not qualify for consolidation in our financial
statements. The trusts carry the loan collateral as assets and the certificates
issued to investors as liabilities. 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. We expect 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.
We retain the rights to service the loans we sell through
securitizations. 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. If the funds available from the
collection account are insufficient to make the required interest advances, then
we are required to make the advance from our operating cash. The advances made
from a trust's collection account, 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 our balance sheet. However, any advances we
make from our operating cash can be recovered from the subsequent month's
mortgage loan payments to the applicable trust prior to any distributions to the
certificate holders.
At March 31, 2003 and June 30, 2002, the mortgage securitization trusts
held loans with an aggregate principal balance due of $3.4 billion and $2.9
billion as assets and owed $3.2 billion and $2.8 billion to third party
investors, respectively. Revenues from the sale of loans to securitization
trusts were $170.4 million, or 77.2% of total revenues for the nine months ended
March 31, 2003 and $129.1 million, or 73.3% of total revenues for the nine
months ended March 31, 2002. These amounts are net of $5.1 million of expenses
for underwriting fees, legal fees and other expenses associated with
securitization transactions during the periods. We have interest-only strips and
servicing rights with fair values of $609.9 million and $132.9 million,
respectively at March 31, 2003, which represent 76.3% of our total assets. Cash
flows received from interest-only strips and servicing rights were $140.1
million for the nine months ended March 31, 2003. These amounts are included in
our operating cash flows.
29
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 third party sponsor to dispose of
the loans. Typically the loans are disposed of by securitizing the loans in a
term securitization. The third party note purchaser also has the right to have
the loans sold. Under this off-balance sheet facility 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 assess 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 March 31, 2003, the off-balance sheet mortgage conduit facility
held loans with principal balances due of $29.4 million as assets and owed $29.5
million to third parties.
Securitizations
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. These certificates, which are senior in right to our
interest-only strips in the trusts, are sold to public or private offerings. 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. The interest rate spread is distributed from the trust to us and is the
basis of the value of our interest-only strips. In addition, when we securitize
our loans we retain the right to service the loans for a fee, which is the basis
for 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.
Since fiscal 2000, declines in securitization pass-through interest
rates resulted in interest rate spreads improving by approximately 235 basis
points at March 31, 2003 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. No assurances can be made that market interest rates will 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
during the period 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 by only 71 basis points. We would seek
to 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 "-- Strategies for Use of Derivative
Financial Instruments" for a discussion of our hedging strategies.
30
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. These effects may be
offset by the positive effect of a decline in prepayment activity that we would
expect in a rising interest rate environment. See "-- Liquidity and Capital
Resources" for a discussion of both long and short-term liquidity.
Conversely, a declining interest rate environment could unfavorably
impact the valuation 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 and may require
increases in assumptions for prepayments for future periods.
After a two-year period during which management's estimates required no
valuation adjustments to our interest-only strips and servicing rights,
declining interest rates and high prepayment rates over the last six quarters
have required revisions to management's estimates of the value of these retained
interests. Beginning in the second quarter of fiscal 2002 and on a quarterly
basis thereafter, we increased the prepayment rate assumptions used to value our
securitization assets, thereby decreasing the fair value of these assets.
However, because our prepayment rates as well as those throughout the mortgage
industry continued to remain at higher than expected levels due to continuous
declines in interest rates during this period to 40-year lows, our prepayment
experience exceeded even our revised assumptions. As a result, over the last six
quarters we have recorded cumulative write downs to our interest-only strips in
the aggregate amount of $89.5 million and an adjustment to the value of
servicing rights of $4.5 million, for total adjustments of $94.0 million mainly
due to our higher than expected prepayment experience. Of this amount, $55.3
million was expensed through the income statement and $38.7 million resulted in
a write down through other comprehensive income, a component of stockholders'
equity.
During the first nine months of fiscal 2003, write downs of $50.0
million were recorded on our securitization assets, including $45.5 million on
interest-only strips and $4.5 million servicing rights. Within the $50.0 million
write down was a charge of $58.3 million mainly due to increases in prepayment
experience, offset by $8.3 million of favorable fair value adjustments in the
second quarter.
The long duration of historically low interest rates has given
borrowers an extended opportunity to engage in mortgage refinancing activities
which resulted in elevated prepayment experience. The persistence of
historically low interest rate levels, unprecedented in the last 40 years, has
made the forecasting of prepayment levels in future fiscal periods difficult. We
had assumed that the decline in interest rates had stopped and a rise in
interest rates would occur in the near term. Consistent with this view, we had
utilized derivative financial instruments to manage interest rate risk exposure
on our loan production and loan pipeline to protect the fair value of these
fixed rate items against potential increases in market interest rates. Based on
current economic conditions and published mortgage industry surveys including
the Mortgage Bankers Association's Refinance Indexes available at the time of
our quarterly revaluation of our interest-only strips and servicing rights, 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. The Mortgage Bankers Association of America has forecast as
of April 8, 2003 that mortgage refinancings as a percentage share of total
mortgage originations will decline from 71% in the first quarter to 33% in the
fourth quarter of calendar 2003. The Mortgage Bankers Association of America has
also projected in its April 2003 economic forecast that the 10-year treasury
rate (which generally affects mortgage rates) will increase over the next three
quarters. As a result of our analysis of these factors, 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 securitization
assets and our actual experience may have a significant adverse impact on the
value of these assets.
31
The following tables detail the pre-tax write downs of the
securitization assets by quarter and details the impact to the income statement
and to other comprehensive income in accordance with the provisions of SFAS No.
115 "Accounting for Certain Investments in Debt and Equity Securities" and EITF
99-20 as they relate to interest-only strips and SFAS No. 140 "Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities"
as it relates to servicing rights (in thousands):
Fiscal Year 2003:
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- ----------------------------------------- ---------- --------- -------------
September 30, 2002....................... $ 16,739 $ 12,078 $ 4,661
December 31, 2002........................ 16,346 10,568 5,778
March 31, 2003........................... 16,877 10,657 6,220
--------- -------- --------
Total Fiscal 2003........................ $ 49,962 $ 33,303 $ 16,659
========= ======== ========
Fiscal Year 2002:
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
========= ======== ========
Note: The impacts of prepayments on our securitization assets in the quarter
ended September 30, 2001 were not significant.
32
The following table summarizes the volume of loan securitizations and
whole loan sales for the three months and nine months ended March 31, 2003 and
2002 (dollars in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
--------------------------- ---------------------------
Securitizations: 2003 2002 2003 2002
----------- ----------- ----------- ------------
Business loans................................. $ 33,748 $ 34,423 $ 93,267 $ 93,709
Home equity loans.............................. 369,881 306,411 1,083,676 879,434
----------- ----------- ----------- ------------
Total....................................... $ 403,629 $ 340,834 $ 1,176,943 $ 973,143
=========== =========== =========== ============
Gain on sale of loans through securitization.. $ 54,504 $ 49,220 $ 170,394 $ 129,139
Securitization gains as a percentage of total
Revenue...................................... 75.9% 75.2% 77.2% 73.3%
Whole loan sales............................... $ 702 $ 12,220 $ 2,239 $ 55,943
(Discount) premiums on whole loan sales........ $ (3) $ 540 $ 29 $ 2,374
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 material 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, credit
quality of the managed portfolio of loans or potential changes to the legal and
accounting principles underlying securitization transactions. 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.
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. In most of our
securitizations, 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 are different for each securitization and 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;
33
(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 overcollateralization 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 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
March 31, 2003, investments in interest-only strips totaled $609.9 million,
including the fair value of overcollateralization related cash flows of $290.6
million.
Trigger Management. Repurchasing loans benefits us by allowing us to
limit the level of delinquencies and losses in the securitization trusts and as
a result, we can avoid exceeding specified limits on delinquencies and losses
that trigger a temporary reduction or discontinuation of cash flow from our
interest-only strips until the delinquency or loss triggers are no longer
exceeded. We have the right, but are not obligated, to repurchase a limited
amount of delinquent loans from securitization trusts. In addition, we elect to
repurchase loans in situations requiring more flexibility for the administration
and collection of these loans. 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 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.
At March 31, 2003, three of our 25 mortgage securitization trusts were
under a triggering event, a decrease from seven at December 31, 2002. See the
"Summary of Selected Mortgage Loan Securitization Trust Information" for details
of trusts under triggering events. As a result, these three trusts are retaining
all or a portion of the cash flow that would normally be available to us had
delinquencies or losses not exceeded specified limits in these trusts. We have a
plan to manage the repurchase of delinquent loans in order to more effectively
limit delinquencies and losses in the trusts and recover the cash flow held in
trusts where triggers have been exceeded, as well as to avoid exceeding trigger
limits in the other securitization trusts. The goal of this plan is to maximize
net cash receipts by eliminating reductions or discontinuations of cash flow
from our interest-only strips. For the nine months ended March 31, 2003, we
repurchased $42.5 million in principal of delinquent loans from securitization
trusts primarily for trigger management. We expect that the three trusts
currently exceeding triggers will again be below trigger limits within the next
two months. During that period, we anticipate that approximately $4.4 million of
excess overcollateralization now being held by the three trusts will be reduced
and cash flow from the related interest-only strips will resume at normal
levels. If, however, delinquencies increase and we cannot cure the delinquency
or liquidate the loans in the mortgage securitization trusts without exceeding
loss triggers, the levels of repurchases required to manage triggers may
increase. Our ability to continue to manage triggers in our securitization
trusts in the future is affected by our availability of cash from operations or
through the sale of subordinated debt to fund these repurchases. Additionally,
our repurchase activity increases prepayments which may result in unfavorable
prepayment experience. See "-- Securitizations" for more detail of the effect
prepayments have on our financial statements. Also see "Managed Portfolio
Quality -- Delinquent Loans and Leases" for further discussion of the impact of
delinquencies.
34
The following table summarizes the principal balances of loans and REO
we have repurchased from the mortgage loan securitization trusts for the nine
months ended March 31, 2003 and fiscal years 2002 and 2001. We received $27.4
million of proceeds from the liquidation of repurchased loans and REO for the
nine months ended March 31, 2003 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 $11.4 million, $9.4 million and
$4.8 million at March 31, 2003 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. Because the contractual outstanding balance is typically greater than the
fair value, the Company generally incurs a loss on these repurchases. Mortgage
loan securitization trusts are listed only if repurchases have occurred.
35
Summary of Loans and REO Repurchased from Mortgage Loan Securitization Trusts
(dollars in thousands)
2001-3 2001-1 2000-4 2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 1999-1
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Nine months ended March 31, 2003:
Business loans................. $ 349 $ 267 $ 223 $ 145 $1,086 $1,410 $2,371 $1,963 $ 1,807 $1,200
Home equity loans.............. 853 2,236 276 839 1,453 3,170 4,224 3,574 2,336 4,272
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Total........................ $1,202 $2,503 $ 499 $ 984 $2,539 $4,580 $6,595 $5,537 $ 4,143 $5,472
====== ====== ====== ====== ====== ====== ====== ====== ======= ======
Number of loans repurchased.... 11 27 6 11 26 42 79 79 47 58
Year ended June 30, 2002:
Business loans................. $ -- $ -- $ -- $ -- $ -- $ -- $ 194 $1,006 $ 341 $ 438
Home equity loans.............. -- -- -- -- -- 84 944 3,249 2,688 2,419
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Total........................ $ -- $ -- $ -- $ -- $ -- $ 84 $1,138 $4,255 $ 3,029 $2,857
====== ====== ====== ====== ====== ====== ====== ====== ======= ======
Number of loans repurchased.... -- -- -- -- -- 2 18 47 31 33
Year ended June 30, 2001:
Business loans................. $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ --
Home equity loans.............. -- -- -- 88 330 -- -- -- -- --
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Total....................... $ -- $ -- $ -- $ 88 $ 330 $ -- $ -- $ -- $ -- $ --
====== ====== ====== ====== ====== ====== ====== ====== ======= ======
Number of loans repurchased.... -- -- -- 1 2 -- -- -- -- --
(Continued) 1998-4 1998-3 1998-2 1998-1 1997-2 1997-1 1996-2 1996-1 Total
------ ------ ------ ------ ------ ------ ------ ------ -------
Nine months ended March 31, 2003:
Business loans................. $ -- $1,455 $ 206 $ 147 $ -- $ 714 $ 313 $ 138 $13,794
Home equity loans.............. 549 2,828 1,205 381 -- 157 355 -- 28,708
------ ------ ------ ------ ------ ------ ------ ------ -------
Total........................ $ 549 $4,283 $1,411 $ 528 $ -- $ 871 $ 668 $ 138 $42,502
====== ====== ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased.... 6 53 20 8 -- 12 12 1 498
Year ended June 30, 2002:
Business loans................. $ 632 $ 260 $ 516 $1,266 $1,729 $ 183 $ -- $ 104 $ 6,669
Home equity loans.............. 4,649 5,575 1,548 1,770 223 239 60 123 23,571
------ ------ ------ ------ ------ ------ ------ ------ -------
Total........................ $5,281 $5,835 $2,064 $3,036 $1,952 $ 422 $ 60 $ 227 $30,240
====== ====== ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased.... 58 61 24 37 18 8 1 3 341
Year ended June 30, 2001:
Business loans................. $ 173 $ 803 $ 215 $ 428 $2,252 $ -- $ 380 $ 250 $ 4,501
Home equity loans.............. 1,310 3,886 1,284 1,686 1,764 -- 92 109 10,549
------ ------ ------ ------ ------ ------ ------ ------ -------
Total....................... $1,483 $4,689 $1,499 $2,114 $4,016 $ -- $ 472 $ 359 $15,050
====== ====== ====== ====== ====== ====== ====== ====== =======
Number of loans repurchased.... 10 48 13 31 37 -- 8 4 154
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 No. 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 March 31, 2003 balance sheet a liability of $25.0 million for
the repurchase of loans subject to these removal of accounts provisions. A
corresponding asset for the loans, at the lower of their cost basis or fair
value, has also been recorded.
36
Mortgage Loan Securitization Trust Information. The following tables
provide information regarding the nature and principal balances of mortgage
loans securitized in each trust, the securities issued by each trust, and the
overcollateralization requirements of each trust.
Summary of Selected Mortgage Loan Securitization Trust Information
Current Balances as of March 31, 2003
(dollars in millions)
2003-1 2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Original balance of loans securitized:
Business loans.....................$ 33 $ 30 $ 34 $ 34 $ 32 $ 29 $ 31 $ 35 $ 29 $ 27
Home equity loans.................. 417 350 336 346 288 287 269 320 246 248
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total..............................$ 450 $ 380 $ 370 $ 380 $ 320 $ 316 $ 300 $ 355 $ 275 $ 275
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
Current balance of loans securitized:
Business loans.....................$ 33 $ 29 $ 32 $ 32 $ 28 $ 24 $ 23 $ 27 $ 21 $ 17
Home equity loans.................. 416 343 311 296 220 189 158 169 117 103
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total..............................$ 449 $ 372 $ 343 $ 328 $ 248 $ 213 $ 181 $ 196 $ 138 $ 120
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
Weighted-average interest rate on loans
securitized:
Business loans.....................15.85% 16.01% 15.91% 16.01% 15.84% 15.81% 15.94% 15.94% 16.05% 16.07%
Home equity loans.................. 9.78% 10.55% 10.87% 10.94% 10.84% 10.71% 11.10% 11.23% 11.43% 11.61%
Total..............................10.23% 10.98% 11.35% 11.42% 11.42% 11.29% 11.72% 11.88% 12.13% 12.23%
Percentage of first mortgage loans.... 86% 85% 86% 85% 90% 89% 88% 89% 89% 85%
Weighted-average loan-to-value........ 77% 77% 77% 77% 76% 77% 76% 76% 75% 76%
Weighted-average remaining term
(months) on loans securitized....... 270 262 257 245 238 237 227 225 222 212
Original balance of Trust
Certificates........................$ 450 $ 376 $ 370 $ 380 $ 320 $ 322 $ 306 $ 355 $ 275 $ 275
Current balance of Trust
Certificates........................$ 449 $ 364 $ 336 $ 317 $ 234 $ 201 $ 169 $ 180 $ 126 $ 108
Weighted-average pass-through
interest rate to Trust Certificate
holders(a).......................... 4.69% 5.82% 6.79% 7.25% 6.11% 5.35% 5.72% 7.92% 7.52% 7.05%
Highest Trust Certificate pass-through
interest rate..................... 3.78% 8.61% 6.86% 7.39% 6.51% 5.35% 6.14% 6.99% 6.28% 7.05%
Overcollateralization requirements:
Required percentages:
Initial............................. -- 1.00% -- -- -- -- -- -- -- --
Final target........................ 5.50% 5.75% 3.50% 3.50% 4.50% 4.25% 4.00% 4.40% 4.10% 4.50%
Stepdown overcollateralization......11.00% 11.50% 7.00% 7.00% 9.00% 8.50% 8.00% 8.80% 8.20% 9.00%
Required dollar amounts:
Initial............................. -- $ 4 -- -- -- -- -- -- -- --
Final target........................$ 25 $ 22 $ 13 $ 13 $ 14 $ 13 $ 12 $ 16 $ 11 $ 12
Current status:
Overcollateralization amount........ -- $ 8 $ 7 $ 10 $ 14 $ 11 $ 12 $ 16 $ 12 $ 12
Final target reached or
anticipated date to reach.........9/2004 3/2004 10/2003 8/2003 Yes 7/2003 Yes Yes Yes (c) Yes
Stepdown reached or anticipated
date to reach....................10/2006 7/2006 1/2006 8/2005 1/2005 7/2004 4/2004 1/2004 10/2003 1/2004
Annual surety wrap fee................ 0.20% (b) (b) (b) 0.21% 0.20% 0.20% 0.20% 0.20% 0.21%
Servicing rights:
Original balance....................$ 16 $ 14 $ 13 $ 15 $ 13 $ 13 $ 12 $ 15 $ 11 $ 14
Current balance.....................$ 16 $ 14 $ 12 $ 13 $ 10 $ 8 $ 7 $ 8 $ 6 $ 6
- ----------------------------
(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 "-- Nine Months Ended
March 31, 2003 Compared to Nine Months Ended March 31, 2002 -- Gain on Sale
of Loans" for further description of the notional bonds.
(b) Credit enhancement was provided through a senior / subordinate certificate
structure.
(c) Although the final target has been reached, this trust is exceeding
delinquency limits, and the trust is retaining additional
overcollateralization. We expect normal residual cash flow to resume within
two months. See "-- Trigger Management" for further detail.
37
Summary of Selected Mortgage Loan Securitization Trust Information (Continued)
Current Balances as of March 31, 2003
(dollars in millions)
2000-3 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.....................$ 16 $ 28 $ 25 $ 25 $ 28 $ 30 $ 16 $ 57 $ 45 $ 29
Home equity loans.................. 134 275 212 197 194 190 169 448 130 33
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total..............................$ 150 $ 303 $ 237 $ 222 $ 222 $ 220 $ 185 $ 505 $ 175 $ 62
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
Current balance of loans securitized:
Business loans.....................$ 9 $ 16 $ 13 $ 12 $ 11 $ 12 $ 6 $ 15 $ 11 $ 5
Home equity loans.................. 55 110 80 78 74 79 60 124 23 5
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total..............................$ 64 $ 126 $ 93 $ 90 $ 85 $ 91 $ 66 $ 139 $ 34 $ 10
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
Weighted-average interest rate on loans
securitized:
Business loans.....................16.06% 16.06% 16.02% 16.06% 15.79% 15.68% 15.96% 15.95% 15.91% 15.89%
Home equity loans..................11.43% 11.42% 11.36% 11.06% 10.84% 10.44% 10.65% 10.78% 11.54% 11.00%
Total..............................12.07% 12.02% 12.00% 11.73% 11.50% 11.15% 11.14% 11.35% 12.89% 13.66%
Percentage of first mortgage loans.... 88% 81% 81% 85% 86% 89% 92% 90% 76% 74%
Weighted-average loan-to-value........ 77% 77% 77% 76% 77% 76% 77% 77% 74% 66%
Weighted-average remaining term
(months) on loans securitized....... 210 219 208 204 207 216 210 195 153 112
Original balance of Trust
Certificates........................$ 150 $ 300 $ 235 $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61
Current balance of Trust
Certificates........................$ 56 $ 108 $ 82 $ 78 $ 76 $ 80 $ 60 $ 125 $ 29 $ 7
Weighted-average pass-through
interest rate to Trust Certificate
holders............................. 7.61% 7.07% 7.11% 6.86% 6.77% 6.61% 6.56% 6.29% 7.17% 7.68%
Highest Trust Certificate pass-through
interest rate....................... 7.61% 8.04% 7.93% 7.68% 7.49% 7.13% 6.58% 6.86% 7.53% 7.95%
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........................ 4.75% 5.95% 5.95% 5.50% 5.00% 5.00% 5.00% 5.10% 7.43% 8.94%
Stepdown overcollateralization...... 9.50% 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........................$ 7 $ 18 $ 14 $ 12 $ 11 $ 11 $ 9 $ 26 $ 13 $ 6
Current status:
Overcollateralization amount........$ 7 $ 18 $ 11 $ 12 $ 9 $ 11 $ 6 $ 14 $ 5 $ 3
Final target reached or
anticipated date to reach......... Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated
date to reach....................10/2003 7/2003 Yes Yes (b) Yes Yes (b) Yes Yes Yes Yes
Annual surety wrap fee................ 0.21% 0.21% 0.19% 0.21% 0.21% 0.19% 0.19% 0.22% 0.26% 0.18%
Servicing rights:
Original balance...................$ 7 $ 14 $ 10 $ 10 $ 10 $ 10 $ 8 $ 18 $ 7 $ 4
Current balance....................$ 3 $ 5 $ 4 $ 3 $ 3 $ 3 $ 2 $ 5 $ 1 $ 1
- ----------------------------
(a) Amounts represent combined balances and weighted-average percentages for
four 1998 securitization pools, two 1997 securitization pools and two 1996
securitization pools.
(b) Although stepdown date has been reached, these trusts are temporarily
ineligible to reduce excess overcollateralization levels due to their
exceeding delinquency or loss limits. We expect normal cash flow from
overcollateralization to resume within two months. See "-- Trigger
Management" for further detail.
Discounted Cash Flow Analysis. 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
appropriate. 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.
38
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, in total, range from 19 to 22 basis
points. 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 interest rates, 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, 23% B
credits, 14% C credits, and 3% D credits. In addition, our
historical loss experience is below what is experienced by others
in the non-conforming mortgage industry.
Although market interest rates have declined from fiscal years 2001
through the third 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.
39
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 March 31, 2003, 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 unpaid
principal 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. See "--
Trigger Management" for further detail of trusts that have not stepped down 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 March 31, 2003.
Prepayment rates. The assumptions we use to estimate future prepayment
rates are regularly compared to actual prepayment experience of the individual
securitization pools 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, for the past six quarters, our actual
prepayment experience was generally higher, most significantly on home equity
loans, than our historical averages for prepayments. See "-- Securitizations"
for further detail of our recent prepayment experience.
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 the impact
these efforts will have on our future prepayment experience.
40
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 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. See "Interest Rate Risk Management -- Strategies for Use of
Derivative Financial Instruments" for further detail of our management of the
risk of changes in interest rates paid on floating interest rate certificates.
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 thousands):
Securitized collateral balance...........................$ 3,417,041
Balance sheet carrying value of retained interests (a)...$ 742,816
Weighted-average collateral life (in years).............. 4.0
- ----------------------------
(a) Amount includes interest-only strips and servicing rights.
Sensitivity of assumptions used to determine the fair value of retained
interests (dollars in thousands):
Impact of
Adverse Change
--------------------------------
10% Change 20% Change
--------------- ---------------
Prepayment speed........................... $ 30,456 $ 55,684
Credit loss rate........................... 5,151 10,302
Floating interest rate certificates (a).... 1,005 1,910
Discount rate.............................. 24,248 47,072
- ----------------------------
(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
incorporating the effect of rate caps where applicable to the individual
deals.
41
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."
42
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 March 31, 2003
2003-1 2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Interest-only strip residual discount rate:
Initial valuation....................... 13% 13% 13% 13% 13% 13% 13% 13% 13% 13%
Current valuation....................... 13% 13% 13% 13% 13% 13% 13% 13% 13% 13%
Interest-only strip overcollateralization
discount rate........................... 7% 9% 7% 7% 7% 7% 7% 7% 6% 7%
Servicing rights discount rate:
Initial valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Prepayment rates:
Initial assumption (a):
Expected Constant Prepayment Rate (CPR):
Business loans........................ 11% 11% 11% 11% 11% 11% 11% 11% 11% 10%
Home equity loans..................... 22% 22% 22% 22% 22% 22% 22% 22% 22% 24%
Ramp period (months):
Business loans........................ 27 27 27 27 27 27 24 24 24 24
Home equity loans..................... 30 30 30 30 30 30 30 30 30 24
Current assumptions (b):
Expected Constant Prepayment Rate (CPR):
Business loans ....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Home equity loans .................... 22% 22% 22% 22% 22% 22% 22% 22% 22% 22%
Ramp period (months):
Business loans........................ 27 27 27 27 27 27 27 27 27 27
Home equity loans..................... 30 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% 22%
Home equity loans..................... 2% 9% 20% 28% 30% 30% 30% 30% 32% 36%
Current prepayment experience (c):
Business loans........................ -- -- 5% 8% 9% 19% 19% 11% 14% 27%
Home equity loans..................... -- -- 10% 21% 25% 36% 40% 38% 28% 35%
Annual credit loss rates:
Initial assumption...................... 0.40% 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% 0.40%
Actual experience....................... -- -- -- 0.02% 0.02% 0.06% 0.23% 0.12% 0.26% 0.25%
Servicing fees:
Contractual fees........................ 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.70%
Ancillary fees.......................... 1.25% 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 ramps to an expected peak rate over 27 months
then declines to the final expected CPR by month 40. The home equity loan
prepayment ramp begins at 2% in month one and ramps to an expected rate over
30 months.
(b) Current assumptions for business loans are the estimated expected
weighted-average prepayment rates over the securitization's estimated
remaining life. The majority of 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. Generally, trusts for
both business and home equity loans that are out of the ramping period are
based on historical averages.
(c) Current experience is a six-month historical average.
43
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at March 31, 2003 (Continued)
2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998(d) 1997(d) 1996(d)
------ ------ ------ ------ ------ ------ ------ ------ ------ -------
Interest-only strip residual discount rate:
Initial valuation....................... 13% 13% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation....................... 13% 13% 13% 13% 13% 13% 13% 13% 13% 13%
Interest-only strip overcollateralization 8% 8% 8% 8% 7% 7% 7% 7% 7% 8%
discount rate...........................
Servicing rights discount rate:
Initial valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Prepayment rates:
Initial assumption (a):
Expected Constant Prepayment Rate (CPR):
Business loans ....................... 10% 10% 10% 10% 10% 10% 10% 13% 13% 13%
Home equity loans..................... 24% 24% 24% 24% 24% 24% 24% 24% 24% 24%
Ramp period (months):
Business loans........................ 24 24 24 24 24 24 24 24 24 24
Home equity loans..................... 24 24 18 18 18 18 18 12 12 12
Current assumptions (b):
Expected Constant Prepayment Rate (CPR):
Business loans ....................... 11% 11% 11% 11% 10% 10% 10% 10% 22% 14%
Home equity loans..................... 22% 22% 22% 22% 22% 22% 22% 23% 25% 25%
Ramp period (months):
Business loans........................ 27 Na Na Na Na Na Na Na Na Na
Home equity loans..................... 30 30 Na Na Na Na Na Na Na Na
CPR adjusted to reflect ramp:
Business loans........................ 19% 16% 13% 32% 30% 26% 20% 28% 22% 14%
Home equity loans..................... 22% 22% 22% 29% 32% 27% 26% 27% 25% 25%
Current prepayment experience (c):
Business loans........................ 33% 23% 29% 32% 30% 26% 20% 28% 22% 10%
Home equity loans..................... 33% 33% 36% 29% 32% 27% 26% 27% 18% 12%
Annual credit loss rates:
Initial assumption...................... 0.40% 0.40% 0.40% 0.30% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
Current assumption...................... 0.40% 0.40% 0.65% 0.60% 0.55% 0.35% 0.53% 0.60% 0.40% 0.45%
Actual experience....................... 0.39% 0.37% 0.61% 0.59% 0.54% 0.35% 0.51% 0.57% 0.37% 0.42%
Servicing fees:
Contractual fees........................ 0.50% 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% 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 ramps to an expected peak rate over 27 months
then declines to the final expected CPR by month 40. The home equity loan
prepayment ramp begins at 2% in month one and ramps to an expected rate over
30 months.
(b) Current assumptions for business loans are the estimated expected
weighted-average prepayment rates over the securitization's estimated
remaining life. The majority of 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. Generally, trusts for
both business and home equity loans that are out of the ramping period are
based on historical averages.
(c) Current experience is a six-month historical average.
(d) Amounts represent weighted-average percentages for four 1998 securitization
pools, two 1997 securitization pools and two 1996 securitization pools.
Na = not applicable
44
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 a trust's
collection account until these funds are distributed from a 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.
On a quarterly basis, capitalized servicing rights are evaluated for impairment,
which is measured as the excess of unamortized cost over fair value.
Servicing rights can be terminated under certain circumstances, such as
our failure to make required servicer payments, defined change in control and
reaching specified loss levels on underlying mortgage pools.
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, we believe the
prepayment experience on our managed portfolio is more stable than the mortgage
market in general. We believe this stability has favorably impacted our ability
to value the future cash flows from our servicing rights and interest-only
strips because it increased the predictability of future cash flows. However,
for the past six quarters, our prepayment experience has exceeded our
expectations for prepayments on our managed portfolio and as a result we have
written down the value of our securitization assets. See "-- Off-Balance Sheet
Arrangements -- Securitizations" for further detail of the effects prepayments
that were above our expectations have had on the value of our securitization
assets.
45
Whole Loan Sales
We also sell loans with servicing released, which we refer 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 "-- Off Balance Sheet Arrangements -- Securitizations" for information on
the volume of whole loan sales and premiums recorded for the nine months ended
March 31, 2003 and 2002. Loans reported as sold on a whole loan basis are
generally loans that were originated specifically for a whole loan sale and
exclude impaired loans, which may be liquidated by selling the loan with
servicing released.
RESULTS OF OPERATIONS
Overview
For the third quarter of fiscal 2003, net income decreased $1.5
million, or 87.5%, to $0.2 million compared to $1.8 million in the third quarter
of fiscal 2002. Diluted earnings per common share were $0.06 on average common
shares of 3,103,000 compared to $0.55 per share on average common shares of
3,034,000 for the third quarter of fiscal 2002. Dividends of $0.08 and $0.07 per
share were paid for the quarters ended March 31, 2003 and 2002, respectively.
The common dividend payout ratio based on diluted earnings per share was 133.3%
for the third quarter of fiscal 2003 compared to 13.3% for the third quarter of
fiscal 2002.
Increases in the gain on sale and interest accretion on the
interest-only strips recorded during the third quarter of fiscal 2003 were
offset by increases in general and administrative expenses and a higher
valuation adjustment on securitization assets recorded during the third quarter
ended March 31, 2003 compared to the third quarter of fiscal 2002.
For the nine months ended March 31, 2003, net income decreased $1.4
million, or 25.5%, to $4.2 million compared to $5.6 million for the same period
in fiscal 2002. Diluted earnings per common share decreased to $1.36 on average
common shares of 3,043,000 compared to $1.74 per share on average common shares
of 3,202,000 for the nine months ended March 31, 2002. Dividends of $0.24 and
$0.21 per share were paid for the nine months ended March 31, 2003 and 2002,
respectively. The common dividend payout ratio based on diluted earnings per
share was 17.6% for the first nine months ended March 31, 2003 compared to 12.1%
for the first nine months ended March 31, 2002.
Increases in the gain on sale recorded during the first nine months of
fiscal 2003 were partially offset by increases in general and administrative
expenses, employee related expenses and a $33.3 million valuation adjustment on
securitization assets recorded during the nine-month period ended March 31,
2003. See below for further discussion of gain on sale, general and
administrative expenses, other expenses and the securitization assets 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 at that time 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 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 $0.20 and $0.35 for the nine months ended March 31, 2003
and 2002. We currently have no plans to continue to repurchase additional shares
or extend the repurchase program.
46
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 in this document have been adjusted to reflect the effect of
this stock dividend.
In December 2002, the Company's shareholders approved an increase in
the number of shares of authorized preferred stock from 1.0 million shares to
3.0 million shares. The preferred shares may be used to raise equity capital,
redeem outstanding debt or acquire other companies, although no such
acquisitions are currently contemplated. 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 Nine Months Ended
March 31, March 31,
--------------------------- ---------------------------
2003 2002 2003 2002
--------- --------- ---------- ----------
Business purpose loans....... $ 32,119 $ 37,143 $ 93,170 $ 99,035
Home equity loans............ 371,554 291,631 1,084,170 907,594
--------- --------- ---------- ----------
$ 403,673 $ 328,774 $1,177,340 $1,006,629
========= ========= ========== ==========
Loan originations for our subsidiary, American Business Credit, Inc.,
which offers business purpose loans secured by real estate, decreased $5.9
million, or 5.9%, for the nine months ended March 31, 2003, to $93.2 million
from $99.0 million for the nine months ended March 31, 2002. Current economic
conditions have had an adverse impact on smaller businesses and our ability to
find qualified borrowers has become more difficult. In order to increase
business purpose loan originations while maintaining our underwriting standards
for business purpose loans, 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.
47
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 Services program, increased $176.6
million, or 19.5%, for the nine months ended March 31, 2003, to $1.1 billion
from $907.6 million for the nine months ended March 31, 2002. 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. Expansion in the
central and western portions of the United States is also planned to potentially
increase loan origination volume. 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. As a result of these efforts, as well as the favorable
environment for originating home equity loans due to low interest rates,
American Business Mortgage Services, Inc. loan originations for the nine months
ended March 31, 2003 increased by $92.0 million, or 26.3%, over the prior year
period. In addition, the historically low interest rate environment and
productivity gains in our Upland Mortgage branch operations have resulted in an
increase in loan originations of $39.6 million, or 47.1%, over the prior year
period. The remaining increase in originations is primarily attributable to our
Upland Mortgage direct retail originations. If interest rates remain level or
increase, our ability to make home equity loans may become more difficult and
may result in increased costs to originate loans as a result of increasing
advertising or geographic expansion or result in a lower volume of loan
originations.
Summary Financial Results
(dollars in thousands, except per share data)
Three Months Ended Nine Months Ended
March 31, March 31,
------------------------- Percentage ------------------------- Percentage
2003 2002 Increase/(Decrease) 2003 2002 Increase/(Decrease)
-------- -------- ------------------ --------- --------- -------------------
Total revenues.............. $ 71,766 $ 65,435 9.7% $ 220,851 $ 176,141 25.4%
Total expenses.............. 71,737 62,399 15.0% 214,043 166,533 28.5%
Net income.................. 221 1,761 (87.5)% 4,153 5,573 (25.5)%
Return on average equity.... 1.17% 10.75% 7.47% 11.20%
Return on average assets.... 0.09% 0.82% 0.60% 0.90%
Earnings per share:
Basic..................... $0.07 $0.58 (87.9)% $1.43 $ 1.88 (23.9)%
Diluted................... $0.06 $0.55 (89.1)% $1.36 $ 1.74 (21.8)%
Dividends declared per
share..................... $0.08 $0.07 14.3% $0.24 $ 0.21 14.3%
Total Revenues. For the third quarter of fiscal 2003, total revenues
increased $6.3 million, or 9.7%, to $71.8 million from $65.4 million for fiscal
2002. For the first nine months of fiscal 2003, total revenues increased $44.7
million, or 25.4%, to $220.9 million from $176.1 million for the first nine
months of fiscal 2002. Growth in total revenues for both periods was 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 third quarter of fiscal 2003, gains of
$54.5 million were recorded on the securitization of $403.6 million of loans.
This represents an increase of $5.3 million, or 10.7%, over gains of $49.2
million recorded on securitizations of $340.8 million of loans for the third
quarter of fiscal 2002. For the nine months ended March 31, 2003, gains of
$170.4 million were recorded on the securitization of $1.2 billion of loans.
This was an increase of $41.3 million, or 31.9% over gains of $129.1 million
recorded on securitizations of $1.0 billion of loans for the nine months ended
March 31, 2002.
48
The increase in securitization gains for the three and nine months
ended March 31, 2003 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 14.5% for
the nine months ended March 31, 2003 from 13.3% on loans securitized for the
nine months ended March 31, 2002. Increases in interest rate spreads increase
residual cash flows to us and the amount of cash we receive at the closing of a
securitization from notional bonds or premiums on the sale of trust
certificates. Increases in the cash received at the closing of a securitization
and residual cash results in increases in the gains we recognize on the sale of
loans into securitizations. See "-- Off-Balance Sheet Arrangements --
Securitizations" for further detail of how securitization gains are calculated.
The increase in interest rate spread for the nine months ended March
31, 2003 compared to the nine months ended March 31, 2002 resulted from
decreases in pass-through interest rates on investor certificates issued by
securitization trusts. For loans securitized during the nine months ended March
31, 2003, the weighted average loan interest rate was 10.82%, a 4.9% decrease
from 11.38% on loans securitized during the nine months ended March 31, 2002.
However, the weighted average interest rate on trust certificates issued in
mortgage loan securitizations during the nine months ended March 31, 2003 was
4.47%, a 19.7% decrease from 5.57% during the nine months ended March 31, 2002.
The resulting net improvement in interest rate spread was approximately 54 basis
points.
Also contributing to the increase in the securitization gain
percentages for the nine months ended March 31, 2003, 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 nine months ended March 31, 2003 we received additional cash at the closing
of our securitizations, due to these modified structures, of $30.2 million
compared to $19.4 million for the first nine months of fiscal 2002.
Securitization gains and cash received at the closing of securitizations were
partially offset by initial overcollateralization requirements of $3.8 million
in fiscal 2003. There was no initial overcollateralization requirement in fiscal
2002.
The Office of Thrift Supervision has adopted a rule effective in July
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.
49
Interest and Fees. For the third quarter of fiscal 2003, interest and
fee income decreased $0.6 million, or 11.9%, to $4.7 million compared to $5.3
million for the third quarter of fiscal 2002. For the nine months ended March
31, 2003, interest and fee income decreased $3.3 million, or 19.9%, to $13.4
million compared to $16.8 million in the same period 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 third quarter of fiscal 2003, interest income increased $0.3
million, or 11.2%, to $2.7 million from $2.4 million for the third quarter of
fiscal 2002. This is primarily caused by the increased loans held on our balance
sheet prior to securitization in the comparable periods due to higher levels of
loan originations during the period. During the nine months ended March 31,
2002, interest income decreased $0.6 million, or 8.7%, to $6.8 million from $7.5
million for the nine months ended March 31, 2002. The year to date 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 $2.3 million, to $29 thousand
for the nine months ended March 31, 2003 from $2.4 million for the nine months
ended March 31, 2002. The volume of whole loan sales decreased 96.0%, to $2.2
million for the nine months ended March 31, 2003 from $55.9 million for the nine
months ended March 31, 2002. The decrease in the volume of whole loan sales for
the nine months ended March 31, 2003 resulted from management's decision to
securitize additional loans as the securitization market's experience during the
past year was more favorable than the whole loan sale market.
Other fees decreased $0.4 million for the third quarter and nine months
of fiscal 2003 compared to the same periods in fiscal 2002. The decrease is
mainly due to a decrease in leasing income, which resulted from 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.
Interest Accretion on Interest-Only Strips. Interest accretion of $12.1
million and $34.4 million were earned in the three and nine months ended March
31, 2003 compared to $9.5 million and $25.9 million in the three and nine months
ended March 31, 2002. The increase reflects the growth in the balance of our
interest-only strips of $119.7 million, or 24.4%, to $609.9 million at March 31,
2003 from $490.1 million at March 31, 2002. In addition, cash flows from
interest-only strips for the nine months ended March 31, 2003 totaled $109.8
million, an increase of $39.1 million, or 55.3%, from the nine months ended
March 31, 2002 due to the larger size of our more recent securitizations and
additional securitizations reaching final target overcollateralization levels
and stepdown 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 March 31, 2003, servicing income decreased $0.8
million, or 62.1%, to $0.5 million from $1.3 million for the three months ended
March 31, 2002. For the nine months ended March 31, 2003, servicing income
decreased $1.5 million, or 36.7%, to $2.7 million from $4.2 million for the nine
months ended March 31, 2002.
50
The following table summarizes the components of servicing income for
the three and nine months ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
------------------------ ----------------------
2003 2002 2003 2002
-------- -------- -------- ---------
Contractual and ancillary fees...............$ 11,232 $ 9,150 $ 32,682 $ 25,830
Amortization of servicing rights............. (10,746) (7,868) (30,015) (21,614)
-------- -------- -------- ---------
$ 486 $ 1,282 $ 2,667 $ 4,216
======== ======== ======== =========
Because loan prepayment levels in fiscal 2003 increased from fiscal
2002, the amortization of servicing rights has also increased. Amortization is
recognized in proportion to servicing income. Therefore the collection of
additional prepayment fees in fiscal 2003 has resulted in higher levels of
amortization.
Total Expenses. Total expenses increased $9.3 million, or 15.0%, to
$71.7 million for the three months ended March 31, 2003 compared to $62.4
million for the three months ended March 31, 2002. Total expenses increased
$47.5 million, or 28.5%, to $214.0 million for the nine months ended March 31,
2003 compared to $166.5 million for the nine months ended March 31, 2002. As
described in more detail below, this increase was mainly a result of increases
in securitization asset valuation adjustments recorded during the nine months
ended March 31, 2003, increases in employee related costs and increases in
general and administrative expenses.
Interest Expense. For the third quarter of fiscal 2003, interest
expense decreased $0.4 million, or 2.1%, to $16.8 million from $17.2 million for
the third quarter of fiscal 2002. Average subordinated debt outstanding during
the three months ended March 31, 2003 was $704.3 million compared to $628.9
million during the three months ended March 31, 2002. The effect of the increase
in outstanding debt was offset by a decrease in the average interest rates paid
on subordinated debt. Average interest rates paid on subordinated debt
outstanding decreased to 9.09% during the three months ended March 31, 2003 from
10.50% during the three months ended March 31, 2002.
During the first nine months of fiscal 2003, interest expense decreased
$0.4 million, or 0.8%, to $51.1 million compared to $51.5 million for the nine
months ended March 31, 2002. Average subordinated debt outstanding during the
nine months ended March 31, 2003 was $684.2 million compared to $603.2 million
during the nine months ended March 31, 2002. Average interest rates paid on
subordinated debt outstanding decreased to 9.42% during the nine months ended
March 31, 2003 from 10.80% during the nine months ended March 31, 2002.
Rates offered on subordinated debt were reduced beginning in the fourth
quarter of fiscal 2001 and have continued downward through the third quarter of
fiscal 2003 in response to decreases in market interest rates as well as our
lower cash needs. The average interest rate of subordinated debt issued at its
peak rate, which was the month of February 2001, was 11.85% compared to the
average interest rate of subordinated debt issued in the month of March 2003 of
7.78%. As the higher rate notes mature, we expect the average interest rate paid
on subordinated debt to decline provided that market rates do not significantly
increase.
51
The average outstanding balances under warehouse lines of credit were
$51.4 million during the three months ended March 31, 2003, compared to $22.3
million during the three months ended March 31, 2002. The average outstanding
balances under warehouse lines of credit were $42.3 million during the nine
months ended March 31, 2003, compared to $26.7 million during the nine months
ended March 31, 2002. The increases in the average balances on warehouse lines
were due to a higher volume of loans originated and lower average cash balances
available for loan funding during the periods. 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
1.9% at March 31, 2002 to 1.3% at March 31, 2003.
Provision for Credit Losses. The provision for credit losses on
available for sale loans and leases was $1.7 million for both the three months
ended March 31, 2003 and March 31, 2002. The provision for credit losses on
available for sale loans and leases for the nine months ended March 31, 2003
increased $0.3 million, or 5.8%, to $4.7 million, compared to $4.4 million for
the nine months ended March 31, 2002. The increase in the provision for credit
losses for the nine-month period was primarily due to increases in the average
balance of loans in non-accrual status, which were generally repurchased from
securitization trusts. The related allowance for loan losses on these
repurchased loans is included in our provision for credit losses in the period
of repurchase. See "Off-Balance Sheet Arrangements -- Securitizations -- Trigger
Management" for further discussion of repurchases from securitization trusts.
Non-accrual loans were $5.9 million and $8.8 million at March 31, 2003 and 2002,
respectively. See "-- Managed Portfolio Quality" for further detail.
The allowance for credit losses was $2.0 million, or 3.6% of gross
receivables at March 31, 2003 compared to $3.7 million, or 6.6% of gross
receivables at June 30, 2002 and $3.3 million, or 5.1% of gross receivables at
March 31, 2002. The allowance for credit losses as a percentage of gross
receivables decreased from June 30, 2002 and March 31, 2002 due to the decrease
of the non-accrual loan balance being carried on the Company's books at March
31, 2003. Although we maintain an allowance for credit losses at the level we
consider adequate to provide for potential losses, there can be no assurances
that actual losses will not exceed the estimated amounts or that an additional
provision will not be required.
52
The following table summarizes changes in the allowance for credit
losses for the three and nine months ended March 31, 2003 and 2002 (in
thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
------------------------ -------------------------
2003 2002 2003 2002
------------ ----------- ------------ ------------
Balance at beginning of period...............$ 3,581 $ 2,878 $ 3,705 $ 2,480
Provision for credit losses.................. 1,718 1,728 4,692 4,434
(Charge-offs) recoveries, net................ (3,346) (1,309) (6,444) (3,617)
----------- ---------- ----------- ------------
$ 1,953 $ 3,297 $ 1,953 $ 3,297
=========== ========== =========== ============
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 March 31, 2003: Loans Loans Leases Total
- ---------------------------------- -------- ------- --------- -------
Balance at beginning of period........... $ 1,387 $ 1,898 $ 296 $ 3,581
Provision for credit losses.............. 229 1,392 97 1,718
(Charge-offs) recoveries, net............ (1,016) (2,153) (177) (3,346)
-------- -------- ------- -------
Balance at end of period................. $ 600 $ 1,137 $ 216 $ 1,953
======== ======== ======= =======
Business Home
Purpose Equity Equipment
Nine Months Ended March 31, 2003: Loans Loans Leases Total
- --------------------------------- -------- ------- --------- -------
Balance at beginning of period........... $ 1,388 $ 1,998 $ 319 $ 3,705
Provision for credit losses.............. 1,079 3,257 356 4,692
(Charge-offs) recoveries, net............ (1,867) (4,118) (459) (6,444)
-------- -------- ------- -------
Balance at end of period................. $ 600 $ 1,137 $ 216 $ 1,953
======== ======== ======= =======
Business Home
Purpose Equity Equipment
Three Months Ended March 31, 2002: Loans Loans Leases Total
- ---------------------------------- -------- ------- --------- -------
Balance at beginning of period........... $ 801 $ 1,739 $ 338 $ 2,878
Provision for credit losses.............. 242 823 663 1,728
(Charge-offs) recoveries, net............ (140) (493) (676) (1,309)
-------- -------- ------- -------
Balance at end of period................. $ 903 $ 2,069 $ 325 $ 3,297
======== ======== ======= =======
Business Home
Purpose Equity Equipment
Nine Months Ended March 31, 2002: Loans Loans Leases Total
- --------------------------------- -------- ------- --------- -------
Balance at beginning of period........... $ 591 $ 1,473 $ 416 $ 2,480
Provision for credit losses.............. 1,134 2,368 932 4,434
(Charge-offs) recoveries, net............ (822) (1,772) (1,023) (3,617)
-------- -------- ------- -------
Balance at end of period................. $ 903 $ 2,069 $ 325 $ 3,297
======== ======== ======= =======
The increase in charge-offs for the first nine-month period of fiscal
2003 compared to the same nine-month period of fiscal 2002 was due to increases
in the liquidation of loans repurchased from securitization trusts.
53
Employee Related Costs. For the third quarter of fiscal 2003, employee
related costs decreased $0.1 million, or 0.5%, to $9.4 million from $9.5 million
in the third quarter of fiscal 2002. For the nine months ended March 31, 2003,
employee related costs increased $4.0 million, or 15.5%, to $30.0 million from
$26.0 million in the prior year. Total employees at March 31, 2003 were 1,093
compared to 968 at March 31, 2002. Increases in payroll and benefits expenses
for the increased number of employees were offset in the third quarter of fiscal
2003 compared to the third quarter of fiscal 2002 by reductions of management
bonus accruals due to the overall financial performance of the Company in the
third quarter of fiscal 2003. The increase in employee related costs in fiscal
2003 for the nine-month comparative period was primarily attributable to
additions of personnel to originate, service and collect loans. The remaining
increase was attributable to annual salary increases as well as increases in the
costs of providing insurance benefits to employees.
Sales and Marketing Expenses. For the third quarter of fiscal 2003,
sales and marketing expenses increased $0.5 million, or 7.2%, to $7.0 million
from $6.5 million for the third quarter of fiscal 2002. For the nine months
ended March 31, 2003, sales and marketing expenses increased $1.2 million, or
6.3%, to $20.1 million from $18.9 million for the nine months ended March 31,
2002. These increases were primarily due to increases in expenses for direct
mail advertising for home equity and business loan originations offset by
decreases in newspaper advertisements for subordinated debt.
General and Administrative Expenses. For the third quarter of fiscal
2003, general and administrative expenses increased $7.3 million, or 39.0%, to
$26.2 million from $18.8 million for the third quarter of fiscal 2002 mainly due
to increases of $3.6 million in costs associated with servicing and collecting
our larger total managed portfolio, $2.9 million in costs associated with
customer retention incentives to help mitigate loan prepayments and $1.3 million
in losses on interest rate swaps. For the nine months ended March 31, 2003,
general and administrative expenses increased $22.3 million, or 42.4%, to $74.9
million from $52.6 million for the nine months ended March 31, 2002. This
increase for the nine months ended March 31, 2003 compared to the same period in
fiscal 2002 was primarily attributable to increases of approximately $12.8
million in costs associated with servicing and collecting our larger total
managed portfolio including expenses associated with REO and delinquent loans,
$6.8 million increase in costs associated with customer retention incentives in
addition to increases of $5.6 million in losses on interest rate swaps. We
expect general and administrative expenses to continue to increase as the size
of our managed portfolio increases.
Securitization Assets Valuation Adjustment. During the three months
ended March 31, 2003, a write down through the Statement of Income of $10.7
million was recorded on our securitization assets compared to $8.7 million
during the third quarter of fiscal 2002. Of the adjustments, $8.8 million and
$8.7 million were write downs of our interest-only strips in fiscal 2003 and
2002, respectively. The remaining $1.9 million in fiscal 2003 was a write down
of our servicing rights. These adjustments reflect 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 as they relate to
interest-only strips and SFAS No. 140 as it relates to servicing rights. During
the nine months ended March 31, 2003, write downs through the Statement of
Income of $33.3 million were recorded compared to $13.2 million for the same
period in fiscal 2002. Of these adjustments, $28.8 million and $13.2 million
were write downs of our interest-only strips in fiscal 2003 and 2002,
respectively. The remaining $4.5 million in fiscal 2003 was a write down of our
servicing rights. See "-- Off-Balance Sheet Arrangements -- Securitizations" for
further detail of these adjustments.
54
Provision for Income Taxes. For the nine months ended March 31, 2003,
the provision for income taxes decreased $1.4 million as a result of a $2.8
million decline in pre-tax income and a reduction in our effective tax rate from
42% to 39%. The change in the effective tax rate was made due to an anticipated
decrease in any future interest costs on federal tax deficiencies. In the third
quarter of fiscal 2003, we recorded a tax benefit of $0.2 million as the
cumulative effect of the change in the effective tax rate for fiscal 2003 was
recorded in the third quarter.
BALANCE SHEET INFORMATION
Balance Sheet Data:
See "-- Reconciliation of Non-GAAP Financial Measures" for a reconciliation of
the below four ratios to the most directly comparable financial measure prepared
in accordance with GAAP. (Dollars in thousands, except per share data)
March 31, June 30,
2003 2002
-------- ---------
Cash and cash equivalents................ $ 87,232 $ 108,599
Loan and lease receivables, net:
Available for sale.................... 52,651 52,622
Interest and fees..................... 14,154 12,292
Other................................. 21,254 9,028
Interest-only strips..................... 609,891 512,611
Servicing rights......................... 132,925 125,288
Receivable for sold loans................ -- 5,055
Total assets............................. 972,939 876,375
Subordinated debt........................ 710,218 655,720
Warehouse lines and other notes payable.. 6,782 8,486
Accrued interest payable................. 45,513 43,069
Deferred income taxes.................... 38,898 35,124
Total liabilities........................ 895,712 806,997
Total stockholders' equity............... 77,227 69,378
Book value per common share.............. $ 26.31 $ 24.40
Total liabilities to tangible equity(c).. 14.4x 14.9x
Adjusted debt to tangible equity (a)(c).. 12.4x 12.2x
Subordinated debt to tangible equity(c).. 11.4x 12.1x
Interest-only strips to adjusted
tangible equity (b)(c)................ 4.6x 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 $96.6 million, or 11.0%, to $972.9 million at
March 31, 2003 from $876.4 million at June 30, 2002 primarily due to increases
in interest-only strips, servicing rights and loan and lease receivables -
Other, offset by a decrease in cash and cash equivalents.
55
Cash and cash equivalents decreased mainly due to higher levels of loan
receivables funded with cash and cash paid on settlements of hedging activities
during the period as well as a planned leveling in the issuance of subordinated
debt during the nine-month period.
Loan and lease receivables - Other increased $12.2 million or 135.4%
due to increases in delinquent loans eligible for repurchase from securitization
trusts. See Note 2 of the Consolidated Financial Statements for an explanation
of these loan receivables.
Activity of our interest-only strips for the nine months ended March
31, 2003 and 2002 were as follows (in thousands):
Nine Months Ended
March 31,
------------------------
2003 2002
--------- ---------
Balance at beginning of period............................ $ 512,611 $ 398,519
Initial recognition of interest-only strips, including
initial overcollateralization of $3.8 million and $0.... 141,511 112,869
Cash flow from interest-only strips....................... (109,849) (70,729)
Required purchases of additional overcollateralization.... 53,496 35,468
Interest accretion........................................ 34,361 25,920
Termination of lease securitization (a)................... (1,741) --
Net temporary adjustments to fair value (b)............... 8,286 1,253
Other than temporary adjustments to fair value (b)........ (28,784) (13,153)
--------- ---------
Balance at end of period.................................. $ 609,891 $ 490,147
========= =========
- -----------------
(a) Reflects release of lease collateral from a lease securitization trust which
was terminated in accordance with the trust documents after the full payout
of trust note certificates. Lease receivables of $1.6 million were recorded
on our balance sheet as a result of the termination.
(b) 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 nine months ended March 31, 2003, and the years ended June 30,
2002 and 2001. See "-- Off-Balance Sheet Arrangements -- Securitizations" for a
discussion of overcollateralization requirements.
56
Summary of Mortgage Loan Securitization Overcollateralization Purchases
(in thousands)
2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 Other Total
------ ------ ------ ------ ------ ------ ------ ----- -----
Nine months ended March 31, 2003:
Initial overcollateralization.... $3,800 $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 3,800
Required purchases of additional
overcollateralization.......... 4,300 7,263 10,241 10,586 10,525 7,645 3,007 (71) $53,496
------ ------ ------- ------- ------- ------ ------ ------ -------
Total............................ $8,100 $7,263 $10,241 $10,586 $10,525 $7,645 $3,007 $ (71) 57,296
====== ====== ======= ======= ======= ====== ====== ====== =======
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 $7.6 million, or 6.1%, to $132.9 million at
March 31, 2003 from $125.3 million at June 30, 2002, due to the securitization
of $1.2 billion of loans during the nine months ended March 31, 2003, partially
offset by amortization of the servicing asset for fees collected during the same
period and a $4.5 million write down of the servicing asset mainly due to the
impact of higher than expected prepayment experience.
Total liabilities increased $88.7 million, or 11.0%, to $895.7 million
from $807.0 million at June 30, 2002 primarily due to increases in subordinated
debt outstanding, increases in accounts payable and accrued expenses and
increases in obligations to repurchase securitized loans recorded in other
liabilities. See Note 2 of the Consolidated Financial Statements for further
detail of this obligation. Accounts payable and accrued expenses increased $7.6
million, or 55.4%, primarily due to accruals for costs associated with customer
retention incentives to help mitigate loan repayments and liabilities to
securitization trust collection accounts for periodic interest advances.
During the nine months ended March 31, 2003, subordinated debt
increased $54.5 million, or 8.3%, to $710.2 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 $28.2 million of the increase
in subordinated debt was due to the reinvestment of accrued interest on the
subordinated debt at maturity. Subordinated debt was 11.4 times tangible equity
at March 31, 2003, compared to 12.1 times as of June 30, 2002. See "-- Liquidity
and Capital Resources" for further information regarding outstanding debt.
57
Managed Portfolio Quality
The following table provides data concerning delinquency experience,
real estate owned and loss experience for the managed loan and lease portfolio.
See "-- Reconciliation of Non-GAAP Financial Measures" for a reconciliation of
total managed portfolio and managed REO measures to our balance sheet. See
"-- Deferment and Forebearance Arrangements" for the amounts of loans whose
contractual status have been reset to current as a result of these arrangements.
(Dollars in thousands):
March 31, 2003 December 31, 2002 September 30, 2002
------------------------ -------------------- ---------------------
Delinquency by Type Amount % Amount % Amount %
-------------- ------- ------------- ------ ------------- -------
Business Purpose Loans
Total managed portfolio............. $ 392,228 $ 385,139 $ 369,148
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 5,526 1.41% $ 3,966 1.03% $ 3,852 1.04%
61-90 days...................... 2,718 0.69 4,040 1.05 4,025 1.09
Over 90 days.................... 35,286 9.00 35,708 9.27 34,467 9.34
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 43,530 11.10% $ 43,714 11.35% $ 42,344 11.47%
============ ===== =========== ===== =========== =====
Managed REO......................... $ 4,506 $ 6,021 $ 8,267
============ =========== ===========
Home Equity Loans
Total managed portfolio............. $ 3,073,392 $ 2,933,492 $ 2,806,490
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 47,809 1.56% $ 46,746 1.59% $ 50,578 1.80%
61-90 days...................... 23,261 0.76 29,610 1.01 26,065 0.93
Over 90 days.................... 104,939 3.41 100,044 3.41 89,971 3.21
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 176,009 5.73% $ 176,400 6.01% $ 166,614 5.94%
============ ===== =========== ===== =========== =====
Managed REO......................... $ 30,704 $ 28,403 $ 24,167
============ =========== ===========
Equipment Leases
Total managed portfolio............. $ 12,185 $ 16,907 $ 22,523
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 379 3.11% $ 359 2.12% $ 338 1.50%
61-90 days...................... 89 0.73 46 0.27 181 0.80
Over 90 days.................... 85 0.70 358 2.12 389 1.73
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 553 4.54% $ 763 4.51% $ 908 4.03%
============ ===== =========== ===== =========== =====
Combined
Total managed portfolio............. $ 3,477,805 $ 3,335,538 $ 3,198,161
============ =========== ===========
Period of delinquency:
31-60 days...................... $ 53,714 1.55% $ 51,071 1.53% $ 54,768 1.71%
61-90 days...................... 26,068 0.75 33,696 1.01 30,271 0.95
Over 90 days.................... 140,310 4.03 136,110 4.08 124,827 3.90
------------ ----- ----------- ----- ----------- -----
Total delinquencies............. $ 220,092 6.33% $ 220,877 6.62% $ 209,866 6.56%
============ ===== =========== ===== =========== =====
Managed REO......................... $ 35,210 1.01% $ 34,424 1.03% $ 32,434 1.01%
============ ===== =========== ===== =========== =====
Losses experienced during the three
month period(a)(b):
Loans........................... $ 8,405 0.99% $ 5,849 0.72% $ 7,863 1.01%
===== ===== =====
Leases.......................... 176 4.82% 65 1.33% 201 3.13%
------------ ===== ----------- ===== ----------- =====
Total managed portfolio......... $ 8,581 1.01% $ 5,914 0.72% $ 8,064 1.03%
============ ===== =========== ===== =========== =====
(a) Percentage based on annualized losses and average managed portfolio.
(b) Losses recorded on our books were $6.1 million ($3.1 million from
charge-offs through the provision for loan losses and $3.0 million for write
downs of real estate owned) and losses absorbed by loan securitization trusts
were $2.5 million for the three months ended March 31, 2003. Losses recorded on
our books were $2.4 million ($0.9 million from charge-offs through the provision
for loan losses and $1.5 million for write downs of real estate owned) and
losses absorbed by loan securitization trusts were $3.5 million for the three
months ended December 31, 2002. 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 include losses for loans we hold as available
for sale or real estate owned and loans repurchased from securitization trusts.
58
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):
March 31, December 31, September 30,
2003 2002 2002
------------ ------------ ------------
Delinquencies held as available for sale (a)..... $ 5,992 $ 9,494 $ 6,658
11.7% 16.2% 11.5%
Available for sale loans and leases in
non-accrual status (b)........................ $ 5,905 $ 9,886 $ 6,991
11.5% 16.9% 12.1%
Allowance for losses on available for sale
loans and leases............................. $ 1,953 $ 3,581 $ 3,184
3.6% 5.8% 5.7%
Real estate owned on balance sheet............... $ 6,348 $ 7,215 $ 3,784
- ----------------------------
(a) Included in total delinquencies are loans in non-accrual status of $5.6
million, $8.6 million and $6.2 million at March 31, 2003, December 31, 2002
and September 30, 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.
Deferment and Forbearance Arrangements. Our policies and practices
regarding deferment and forbearance arrangements, like all of our collections
policies and practices, are designed to manage customer relationships, maximize
collections and avoid foreclosure or repossession if reasonably possible. From
time to time, borrowers are confronted with events, usually involving hardship
circumstances or temporary financial setbacks that adversely affect their
ability to continue payments on their loan for some period of time. To assist
borrowers during a hardship period, we may agree to enter into a deferment or
forbearance arrangement. When economic conditions, such as those that exist at
the present time, cause the value of the real estate securing our loans to rise,
thereby lowering loan-to-value ratios, we are able to be more accommodating to
borrowers who request a deferment or forbearance arrangement as relief from
their temporary financial hardship.
These arrangements permit us to reset the contractual status of a loan
in our managed portfolio from delinquent to current based upon evidence, which
in our judgment indicates a significant potential for eventual resumption of
contractual payments.
In a deferment arrangement, which is initiated solely at the request of
the borrower, we make advances to a securitization trust on behalf of the
borrower in amounts equal to the delinquent loan payments. The borrower must
repay the advances either at the termination of the loan or on a monthly payment
plan. Borrowers must provide written documentation outlining their hardship and
requesting deferment. Other principal guidelines applicable to the deferment
process are: (i) the borrower may have up to six payments deferred during the
life of the loan and must have a history demonstrating the ability to repay in
post-deferment periods; (ii) no more than three payments may be deferred during
a twelve-month period; and (iii) the borrower must have made a minimum of six
timely payments on the loan and twelve months must have passed since the last
deferment in order to qualify for a new deferment request.
In a forbearance arrangement, which also is initiated solely at the
request of a borrower, we also make advances to a securitization trust on behalf
of the borrower in amounts equal to the delinquent loan payments and we also
advance any unpaid taxes, insurance premiums or similar assessments. The
borrower must repay the advances in addition to their regular monthly payment
until the advances are paid in full and the borrower must exhibit the ability to
remit post-forbearance payments in a timely manner. A forbearance is part of a
formal agreement in which the borrower must execute a deed in lieu of
foreclosure, subject to exceptions based on local laws and regulations and
individual borrower circumstances. We retain the unrecorded deed in safekeeping
until such time as the entire advance amount is repaid. If the borrower
subsequently defaults before repaying the advances in full, we have the option
to record the deed after providing proper notification to the borrower and a
reasonable period of time to cure. The recording of the deed allows us to
proceed with a deed in lieu of foreclosure action, which is typically less
complex and less costly than a foreclosure action. Other principal guidelines
applicable to the forbearance process are: (i) the subject loan must be at least
nine months old; (ii) the loan must be a minimum of two payments delinquent and
it is preferred that the deferment option be exhausted prior to the initiation
of a forbearance process; and (iii) the borrower must not have excessive liens
against the real estate collateralizing the loan.
59
We do not enter into a deferment or forbearance arrangement based
solely on the fact that a loan meets the criteria for one of the arrangements.
Our use of the arrangements depends upon a new credit decision, our view of
prevailing economic conditions and an individual's circumstances, which vary
from borrower to borrower. Because deferral and forbearance arrangements are
account management tools which help us to manage customer relationships,
maximize collection opportunities and increase the value of our account
relationships, the application of these tools generally is subject to constantly
shifting complexities and variations in the marketplace. We continually review
and assess the policies and practices to make sure they are in alignment with
the goals we have set for them. We modify or permit exceptions to the policies
and practices from time to time and from one reporting period to another.
In most cases, a loan is considered current if the borrower immediately
begins payment under the terms of the deferment or forbearance arrangement and
we do not reflect it as a delinquent loan in our delinquency statistics,
although if the agreed terms are not adhered to by the borrower, the account
status may be reversed and collection actions resumed.
The following table presents information regarding loans under
deferment and forbearance arrangements, which are reported as current loans and
thus not included in delinquencies as of the end of our last four quarters
(dollars in thousands):
Cumulative Unpaid Principal Balance
---------------------------------------------
% of
Under Under Managed
Deferment Forbearance Total Portfolio
----------- ------------- ---------- ------------
June 30, 2002........................... $64,958 $73,705 $138,662 4.52%
September 30, 2002...................... 67,282 76,649 143,931 4.50
December 31, 2002....................... 70,028 81,585 151,613 4.55
March 31, 2003(a)....................... 85,205 84,751 169,955 4.89
- ----------------------
(a) Included in cumulative unpaid principal balance are loans with arrangements
that were entered into longer than twelve months ago. At March 31, 2003,
there was $35.5 million of cumulative unpaid principal balance under
deferment arrangements and $30.2 million of cumulative unpaid principal
balance under forbearance arrangements that were entered into prior to
April 2002.
Additionally, there are loans under deferment and forbearance
arrangements which return to delinquent status. At March 31, 2003 there was
$22.6 million of cumulative unpaid principal balance under deferment
arrangements and $48.8 million of cumulative unpaid principal balance under
forbearance arrangements that are reported as delinquent 31 days or more.
During the quarter ended March 31, 2003 we experienced a pronounced
increase in the number of borrowers requesting a deferment or forbearance
arrangement and in light of the weakened economic environment we made use of
deferment arrangements to a greater degree than in prior periods. We currently
expect this condition to be temporary and will actively attempt to manage the
loan accounts under deferment arrangement to maximize our chances for full
recovery of the borrowed amount while still accommodating borrower needs during
their period of hardship.
The following table presents the amount of unpaid principal balance of
loans that entered into a deferment or forbearance arrangement in the first
three quarters of fiscal 2003 (dollars in thousands):
Unpaid Principal Balance Impacted by
Arrangements
---------------------------------------------
% of
Under Under Managed
Quarter Ended: Deferment Forbearance Total Portfolio
----------- ------------- ---------- ------------
September 30, 2002...................... $11,619 $23,564 $35,183 1.10%
December 31, 2002....................... 17,015 27,004 44,018 1.32
March 31, 2003.......................... 37,117 28,051 65,168 1.87
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 $220.1 million at March 31, 2003 compared to $220.9 million and
$209.9 million at December 31, 2002 and September 30, 2002, respectively. Total
delinquencies as a percentage of the total managed portfolio were 6.33% at March
31, 2003 compared to 6.62% and 6.56% at December 31, 2002 and September 30,
2002, respectively. Delinquencies at June 30, 2002 were $170.8 million or 5.57%
of the managed portfolio. Although delinquencies at March 31, 2003 have
declined, increases in percentages in fiscal 2003 from fiscal 2002 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. These factors have also resulted in a
significant increase in the usage of deferment and forbearance arrangements,
which impact the aging status of loans for purposes of delinquency reporting
described above. In addition, the delinquency percentage had 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 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 slightly from
$5.9 million at June 30, 2002 to $6.0 million at March 31, 2003. Compared to
December 31, 2002 and September 30, 2002 delinquencies decreased primarily due
to liquidations through sales of loans repurchased from our mortgage
securitization trusts. See "Results of Operations -- Provision for Credit
Losses" for further detail of the impact of delinquencies.
60
Real estate owned. Total REO, comprising foreclosed properties and
deeds acquired in lieu of foreclosure, increased to $35.2 million, or 1.01%, of
the total managed portfolio at March 31, 2003 compared to $34.4 million, or
1.03% and $32.4 million, or 1.01%, at December 31, 2002 and September 30, 2002,
respectively. REO at June 30, 2002 was $34.0 million, or 1.11%. As our portfolio
seasons and if economic conditions continue to lag or worsen, REO as a
percentage of the portfolio may increase. Although the disposition of REO is
affected by court processes, seasonality of the real estate market and other
factors beyond our control, management has been making a concerted effort to
reduce the time a loan remains in seriously delinquent status until the sale of
an REO property. This effort includes 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. We believe
the results of this effort are evident in the fact that REO as a percentage of
the managed portfolio has remained level. REO held by us on our balance sheet
increased from $3.8 million at June 30, 2002 to $6.3 million at March 31, 2003
primarily due to repurchases of foreclosed loans from our mortgage
securitization trusts.
Loss experience. During the third quarter of fiscal 2003, we
experienced net loan and lease charge-offs in our total managed portfolio of
$8.6 million. On an annualized basis, during the third quarter of fiscal 2003,
net loan and lease charge-offs were 1.01% of the total managed portfolio. For
the three months ended December 31, 2003, net loan and lease charge-offs in our
total managed portfolio were $5.9 million, or 0.72% of the average total managed
portfolio. For the three months ended September 30, 2002, net loan and lease
charge-offs in our total managed portfolio were $8.1 million, or 1.03% of the
average total managed portfolio. Principal loss severity experience on
delinquent loans generally has ranged from 10% to 30% of principal and loss
severity experience on REO generally has ranged from 25% to 40% of principal. 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. See "-- Summary of Loans and REO Repurchased from
Mortgage Loan Securitization Trusts" for further detail of loan repurchase
activity. See "-- Off-Balance Sheet Arrangements -- 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 rates could increase.
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.
61
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.
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 "-- Off-Balance Sheet Arrangements -- 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 March 31, 2003
------------------------------------------------------------------------------
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).$ 46,986 $ 73 $ 80 $ 88 $ 97 $ 5,327 $ 52,651 $ 53,265
Interest-only strips.................... 127,407 130,263 125,011 109,418 90,043 317,028 899,170 609,891
Servicing rights........................ 42,754 33,970 26,764 20,948 16,402 53,101 193,939 132,925
Investments held to maturity............ 215 253 424 - - - 892 935
Rate Sensitive Liabilities:
Fixed interest rate borrowings..........$365,866 $146,685 $130,361 $ 27,097 $ 14,685 $ 26,406 $711,100 $710,051
Average interest rate................... 9.32% 9.19% 9.34% 9.84% 9.88% 11.32% 9.82%
Variable interest rate borrowings.......$ 5,862 $ 3 $ 30 $ - $ 5 $ - $ 5,900 $ 5,900
Average interest rate................... 2.80% 3.08% 3.08% 3.08% 3.08% 3.08% 2.80%
- ----------------------------
(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.
62
Loans Available for Sale. Gain on sale of loans may be unfavorably
impacted to the extent we hold fixed interest rate available for sale mortgage
loans 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 March 31, 2003, $142.1 million of debt issued by loan
securitization trusts was floating interest rate certificates based on one-month
LIBOR, representing 4.4% 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 March 31, 2003, the interest rate sensitivity for $60.8 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. In addition, the interest rate sensitivity for $63.0 million of floating
interest rate certificates issued from the 2003-1 Trust is managed using an
interest rate cap which limits the one-month LIBOR to a maximum rate of 4%. See
"-- Strategies for Use of Derivative Financial Instruments" for further detail.
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 performed on a
quarterly basis. As part of the revaluation process, assumptions used for
prepayment rates are monitored against actual experience, economic conditions
and other factors and adjusted if warranted. See "-- Off-Balance Sheet
Arrangements -- 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 March 31, 2003 approximately $345.2 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 on
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.
63
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 interest rate swaps,
Eurodollar futures, forward treasury sales 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 is based on
quoted market prices. The fair value of the items hedged is 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.
64
We recorded the following gains and losses on the fair value of
derivative financial instruments accounted for as hedges for the three and
nine-month periods ended March 31, 2003 and 2002. 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 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
--------------------------- ---------------------------
2003 2002 2003 2002
--------- ----------- --------- -----------
Offset by gains and losses recorded on
securitizations:
Losses on derivative financial instruments... $ (2,071) $ (135) $ (3,806) $ (4,923)
Offset by gains and losses recorded on the
fair value of hedged items:
Losses on derivative financial instruments... (16) -- (3,070) --
Amount settled in cash - paid................ (2,619) (135) (5,041) (4,923)
At March 31, 2003 outstanding forward starting interest rate swap
contracts accounted for as hedges and unrealized losses recorded as liabilities
on the balance sheet were as follows (in thousands):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate
swaps............................. $47,497 $ 2,809
The sensitivity of forward starting interest rate swap contracts held
as hedges as of March 31, 2003 to a 0.1% change in market interest rates is $0.1
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 and nine months ended March 31, 2003, 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, we recorded the
following losses on forward starting interest rate swap contracts, which were
used to manage interest rate risk on loans in our pipeline and were therefore
classified as trading for the three and nine-month periods ended March 31, 2003
and 2002 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
---------------------------- --------------------------
2003 2002 2003 2002
------------ ----------- ----------- -----------
Trading losses on forward starting interest
rate swaps............................... $ (784) $ -- $ (3,708) $ --
Amount settled in cash - paid.............. -- -- (2,671) --
65
At March 31, 2003 outstanding forward starting interest rate swap
contracts used to manage interest rate risk on loans in the Company's pipeline
and associated unrealized losses recorded as liabilities on the balance sheet
were as follows (in thousands):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate
swaps........................... $72,503 $ 22
The sensitivity of the forward starting interest rate swap contracts
held as trading as of March 31, 2003 to a 0.1% change in market interest rates
is $0.3 million.
In addition, for the three and nine-month periods ended March 31, 2003,
respectively, the Company recorded losses of $0.1 million and $1.1 million on an
interest rate swap contract which is not designated as an accounting hedge, and
gains of $0.5 million for the three and nine-month periods ended March 31, 2002.
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 losses recognized during the
nine-month period, $0.3 million were unrealized losses representing the net
change in the fair value of the contract during the period and $0.8 million were
cash losses. The cumulative net unrealized loss of $0.5 million is included as a
trading liability in Other liabilities at March 31, 2003.
Terms of the interest rate swap agreement at March 31, 2003 were as
follows (dollars in thousands):
Notional amount.................................$ 66,412
Rate received - Floating (a)..................... 1.34%
Rate paid - Fixed................................ 2.89%
Maturity date....................................April 2004
Unrealized loss.................................$ 755
Sensitivity to 0.1% change in interest rates....$ 30
- ------------------
(a) Rate represents the spot rate for one-month LIBOR paid on the securitized
floating interest rate certificate at the end of the period.
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 March 31, 2003, we held no
derivative financial instruments in a gain position.
66
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).
67
Following is a summary of future payments required on our contractual
obligations as of March 31, 2003 (in thousands):
Payments Due by Period
-----------------------------------------------------------------------
Less than 1 to 3 4 to 5 More than
Contractual Obligations Total 1 year years years 5 years
- ---------------------------------- ----------- ----------- ----------- --------- ----------
Subordinated debt ................ $710,218 $364,984 $277,046 $ 41,782 $ 26,406
Accrued interest - subordinated
debt (a) ...................... 45,450 23,776 15,923 2,240 3,511
Warehouse and operating lines
of credit ..................... 5,900 5,900 -- -- --
Capitalized lease (b) ............ 882 311 571 -- --
Operating leases (c) ............. 55,406 2,104 9,422 10,499 33,381
Services and equipment (d) ....... 10,542 10,542 -- -- --
-------- -------- -------- -------- --------
Total obligations ................ $828,398 $407,617 $302,962 $ 54,521 $ 63,298
======== ======== ======== ======== ========
(a) This table reflects interest payment terms elected by subordinated debt
holders as of March 31, 2003. 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.
(c) Amounts include lease for office space assuming a July 1, 2003 start date.
Actual start date is dependent upon various factors and may be different
from assumed date.
(d) Amounts related to the relocation of our corporate headquarters. The
provisions of the lease, local and state grants will provide us with
reimbursement of a substantial amount of these payments.
The following discussion of liquidity and capital resources should be
read in conjunction with the discussion contained in "Application of Critical
Accounting Policies."
When loans are sold through a securitization, we retain the rights to
service the loans. Servicing loans obligates us to advance interest payments for
delinquent loans under certain circumstances and allows us to repurchase a
limited amount of delinquent loans from securitization trusts. See "Off-Balance
Sheet Arrangements" and "Off-Balance Sheet Arrangements -- Securitizations --
Trigger Management" for more information on how the servicing of securitized
loans effects requirements on our capital resources and cash flow.
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 be certain 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.
68
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.
Cash flow from operations for the nine months ended March 31, 2003 was
a negative $41.5 million compared to negative $21.0 million for the first nine
months of fiscal 2002. Negative cash flow from operations increased $20.5
million, or 97.8%, for the nine months ended March 31, 2003 from the nine months
ended March 31, 2002 mainly due to increases in the repurchases of securitized
loans to avoid delinquency triggers, the funding of $3.8 million in initial
overcollateralization from the proceeds of our December 2002 securitization and
$2.8 million for the settlement of derivative contracts. Increases in the
proceeds from our securitizations from the sale of notional bonds and increases
in the cash flow from interest-only strips in the first nine months of fiscal
2003 were offset by increases in operating expenses, mainly general and
administrative expenses to service and collect the larger managed portfolio.
Negative cash flow from operations was $0.2 million for the third
quarter of fiscal 2003, compared to negative cash flow from operations of $32.8
million the second quarter of fiscal 2003, a decrease of $32.5 million. This
decrease was mainly due to the receipt of $13.8 million of proceeds during the
third quarter from the liquidation of impaired loans and REO that we had
repurchased from securitization trusts in prior periods. Also contributing was a
$5.1 million increase in the amount of cash we received at the closing of our
third quarter securitization resulting from a $1.3 million increase in the
proceeds from the sale of notional bonds over the second quarter and reduced
initial overcollateralization from the second quarter when we were required to
fund $3.8 million of overcollateralization from the proceeds of that quarter's
securitization. The amount of cash that we received in the third quarter's
securitization was also higher because the larger size of that securitization
required us to reduce the amount of securitizable loans available for sale on
our balance sheet by approximately $8.3 million. The amount of cash we receive
and the amount of overcollateralization we are required to fund at the closing
of our securitizations is dependent upon a number of factors including market
factors over which we have no control. Although we expect negative cash flow
from operations to continue and fluctuate in the foreseeable future, our goal is
to continue to reduce our negative cash flow from operations from historical
levels. We believe that if our business projections prove accurate, our cash
flow from operations will become positive. However, negative cash flow from
operations in the current fiscal year may continue to 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.
69
As was previously discussed, during the six quarters ended March 31,
2003, 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 initial
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.
Other factors could negatively affect our cash flow and liquidity such
as increases in mortgage interest rates legislation or other economic conditions
which may make our ability to originate loans more difficult. As a result, our
costs to originate loans could increase or our volume of loan originations could
decrease.
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.
70
The following is a description of the warehouse and operating lines of
credit and mortgage conduit facilities, which were available to us at March 31,
2003 (in thousands):
Amount Amount
Facility Utilized On- Utilized Off-
Amount Balance Sheet Balance Sheet
------ ------------- -------------
Revolving credit and conduit facilities:
Mortgage conduit facility, expiring July 2003 (a)................... $300,000 $ Na $29,528
Warehouse revolving line of credit, expiring November 2003 (b) ..... 200,000 -- Na
Warehouse and operating revolving line of credit, expiring
December 2003 (c)................................................. 50,000 5,862 Na
Warehouse revolving line of credit, expiring October 2003 (d) ...... 25,000 -- Na
Operating revolving line of credit, expiring January 2004 (e) ...... 1,200 -- Na
-------- ------- -------
Total revolving credit facilities...................................... 576,200 5,862 29,528
Other facilities:
Commercial paper conduit for lease production, maturity
matches underlying leases (f)..................................... 199 38 161
Capitalized leases, maturing January 2006 (g) ...................... 882 882 Na
-------- ------- -------
Total credit facilities................................................ $577,281 $ 6,782 $29,689
======== ======= =======
- ----------------------------
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 this facility is continuously
committed for the term of the facility while the remaining $100.0 million
of the facility is 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.
(c) $50.0 million warehouse and operating credit facility which includes a
sublimit for a letter of credit to secure lease obligations for corporate
office space with JPMorgan Chase Bank. Interest rates on the advances under
this facility are based upon one-month LIBOR plus a margin. The amount of
the letter of credit was $8.0 million at March 31, 2003 and will vary over
the term of the lease. 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, 1998-1 and 1998-3.
(d) $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.
(e) $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.
(f) 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.
(g) 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 a particular line of credit. At March 31, 2003, 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.
71
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 nine months ended March 31, 2003, subordinated debt increased
by $54.5 million, net of redemptions compared to an increase of $102.8 million
in the first nine months 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 $315.0 million of subordinated debt under a registration
statement, which was declared effective by the Securities and Exchange
Commission on October 3, 2002. Of the $315.0 million, $187.5 million of this
debt was available for future issuance as of March 31, 2003.
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 19.1% of the
$388.8 million of subordinated debt and accrued interest maturities due within
one year. Unrestricted cash balances were $74.4 million at March 31, 2003,
compared to $99.6 million at June 30, 2002 and $122.9 million at March 31, 2002.
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
March 2003 was 7.27%, compared to debt issued in March 2002, which had a
weighted-average interest rate of 7.85%. 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 at March 2003 was
18 months compared to 17 months at March 2002.
Sales into special purpose entities and off-balance sheet facilities.
We rely significantly on access to the asset-backed securities market through
securitizations to provide permanent funding of our loan production. 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. See "-- Off-Balance Sheet Arrangements" for further detail
of our securitization activity and effect of securitizations on our liquidity
and capital resources.
72
Other liquidity considerations. In December 2002, our shareholders
approved an amendment to our Certificate of Incorporation to increase the number
of shares of authorized preferred stock from 1.0 million shares to 3.0 million
shares. The preferred shares may be used to raise equity capital, redeem
outstanding debt or acquire other companies, although no such acquisitions are
currently contemplated. 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.
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.
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 hedge our loan portfolio effectively
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. Additionally, under the
Soldiers' and Sailors' Civil Relief Act of 1940, members of all branches of the
military on active duty, including draftees and reservists in military service
and state national guard called to federal duty are entitled to have interest
rates reduced and capped at 6% per annum, on obligations (including mortgage
loans) incurred prior to the commencement of military service for the duration
of military service and may be entitled to other forms of relief from mortgage
obligations. To date, compliance with the Act has not had a material effect on
our business.
73
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 2,500 shares (3,025 shares after the
effect of stock dividends) of our common stock to Richard Kaufman, our director,
as a result of services rendered in connection with our stock repurchases.
In February 2003, we awarded 2,000 shares of our common stock to both
Warren E. Palitz and Jeffrey S. Steinberg, respectively, as newly appointed
members of our Board of Directors.
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.
In fiscal 2003, Lanard & Axilbund, Inc., a real estate brokerage and
management firm in which our Director, Mr. Sussman, was a partner and is now
Chairman Emeritus, acted as our agent in connection with the lease of our new
corporate office space. As a result of this transaction, Lanard & Axilbund, Inc.
has, and will receive, when our lease begins, a commission from the owner of the
building where we will be leasing office space. We believe that the commission
to be received by Lanard & Axilbund, Inc. as a result of this transaction is
consistent with market and industry standards. Additionally, as part of our
agreement with Lanard & Axilbund, Inc., they reimbursed us for some of our costs
related to finding new office space including some of our expenses related to
legal services, feasibility studies and space design. An additional
reimbursement payment will be made to us when our lease begins.
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.
74
RECONCILIATION OF NON-GAAP FINANCIAL MEASURES
This quarterly report contains non-GAAP financial measures. For
purposes of the Securities and Exchange Commission Regulation G, a non-GAAP
financial measure is a numerical measure of a registrant's historical or future
financial performance, financial position or cash flow that excludes amounts, or
is subject to adjustments that have the effect of excluding amounts, that were
included in the most directly comparable measure calculated and presented in
accordance with GAAP in the statement of income, balance sheet or statement of
cash flows (or equivalent statement) of the Company; or includes amounts, or is
subject to adjustments that have the effect of including amounts, that are
excluded from the most directly comparable measure so calculated and presented.
In this regard, GAAP refers to generally accepted accounting principles in the
United States of America. Pursuant to the requirements of Regulation G,
following is a reconciliation of the non-GAAP financial measures to the most
directly comparable financial measure.
The Company presents certain financial ratios to measure balance sheet
leverage relationships that include or exclude items from GAAP based financial
ratios consistent with common industry practices. Additionally, some ratios are
adjusted in order to isolate secured items such as secured debt or
overcollateralization, which is secured by loan principal in securitization
trusts, from unsecured items. Management believes these measures enhance the
users' overall understanding of the Company's current financial performance and
prospects for the future and that these measures help in understanding the risk
characteristics of certain significant balance sheet amounts and how their
proportions to equity changes over time. The following tables reconcile the
ratios presented in "Balance Sheet Information -- Balance Sheet Data" to GAAP
basis measures (dollars in thousands):
Total liabilities to tangible
equity: March 31, 2003 June 30, 2002
-------------- -------------
Total liabilities ................. $ 895,712 $ 806,997
Equity ............................ 77,227 69,378
Less: Goodwill .................... (15,121) (15,121)
--------- ---------
Tangible equity ............... $ 62,106 $ 54,257
========= =========
Total liabilities to tangible
equity.......................... 14.4x 14.9x
========= =========
Liabilities/equity ................ 11.6x 11.6x
========= =========
75
Adjusted debt to tangible
equity: March 31, 2003 June 30, 2002
-------------- -------------
Total liabilities................. $ 895,712 $ 806,997
Less: Cash........................ (87,232) (108,599)
Less: Warehouse lines............. (6,782) (8,486)
Less: Loans in process............ (31,750) (29,866)
--------- ----------
769,948 660,046
Equity............................ 77,227 69,378
Less: Goodwill.................... (15,121) (15,121)
--------- ----------
Tangible equity............... $ 62,106 $ 54,257
========= ==========
Adjusted debt to tangible
equity......................... 12.4x 12.2x
========= ==========
Liabilities/equity................ 11.6x 11.6x
========= ==========
Subordinated debt to tangible
equity: March 31, 2003 June 30, 2002
-------------- -------------
Subordinated debt................. $ 710,218 $ 655,720
Equity............................ 77,227 69,378
Less: Goodwill.................... (15,121) (15,121)
--------- ----------
Tangible equity............... $ 62,106 $ 54,257
========= ==========
Subordinated debt to tangible
equity......................... 11.4x 12.1x
========= ==========
Liabilities/equity................ 11.6x 11.6x
========= ==========
Interest-only strips to
adjusted tangible equity: March 31, 2003 June 30, 2002
-------------- -------------
Interest-only strips.............. $ 609,891 $ 512,611
Less: Overcollateralization....... (201,258) (160,079)
--------- ----------
408,633 352,532
Equity............................ 77,227 69,378
Less: Goodwill.................... (15,121) (15,121)
--------- ----------
Tangible equity............... 62,106 54,257
Plus: Subordinated debt with
remaining maturity >5 years..... 26,406 27,629
--------- ----------
$ 88,512 $ 81,886
========= ==========
Interest-only strips to adjusted
tangible equity................ 4.6x 4.3x
========= =========
Interest-only strips/equity....... 7.9x 7.4x
========= =========
76
The Company presents Managed Portfolio and Managed REO information.
Management believes these measures enhance the users' overall understanding of
the Company's current financial performance and prospects for the future because
the volume and credit characteristics of off-balance sheet securitized loan and
lease receivables have a significant effect on the financial performance of the
Company as a result of the Company's retained interests in the securitized
loans. Retained interests included interest-only strips and servicing rights. In
addition, because the servicing and collection of the Company's off-balance
sheet securitized loan and lease receivables are performed in the same manner
and according to the same standards as the servicing and collection of its
on-balance sheet loan and lease receivables, certain Company resources, such as
personnel and technology, are allocated based on the total Managed Portfolio and
total Managed REO. The following tables reconcile the managed portfolio measures
presented in "Managed Portfolio Quality." (Dollars in thousands):
March 31, 2003: Delinquencies
- --------------------------------------------------------------------------
Amount %
-----------------------
On-balance sheet loan and lease
receivables...................... $ 51,347 $ 5,992 11.67%
Securitized loan and lease
receivables...................... 3,426,458 214,100 6.25%
---------- -------- -------
Total Managed Portfolio........... $3,477,805 $220,092 6.33%
========== ======== =======
On-balance sheet REO.............. $ 6,348
Securitized REO................... 28,862
----------
Total Managed REO................. $ 35,210
==========
December 31, 2002: Delinquencies
- --------------------------------------------------------------------------
Amount %
-----------------------
On-balance sheet loan and lease
receivables...................... $ 58,582 $ 9,494 16.21%
Securitized loan and lease
receivables...................... 3,276,956 211,383 6.45%
---------- -------- -------
Total Managed Portfolio........... $3,335,538 $220,877 6.62%
========== ======== =======
On-balance sheet REO.............. $ 7,215
Securitized REO................... 27,209
----------
Total Managed REO................. $ 34,424
==========
September 30, 2002: Delinquencies
- --------------------------------------------------------------------------
Amount %
-----------------------
On-balance sheet loan and lease
receivables...................... $ 57,884 $ 6,658 11.50%
Securitized loan and lease
receivables...................... 3,140,277 203,208 6.47%
---------- -------- -------
Total Managed Portfolio........... $3,198,161 $209,866 6.56%
========== ======== =======
On-balance sheet REO.............. $ 4,508
Securitized REO................... 27,926
----------
Total Managed REO................. $ 32,434
==========
77
June 30, 2002: Delinquencies
- -----------------------------------------------------------------------------
Amount %
---------------------
On-balance sheet loan and lease
receivables..................... $ 56,625 $ 5,918 10.45%
Securitized loan and lease
receivables..................... 3,009,564 164,855 5.48%
---------- --------- -------
Total Managed Portfolio.......... $3,066,189 $170,773 5.57%
========== ========= =======
On-balance sheet REO............. $ 3,784
Securitized REO.................. 30,261
----------
Total Managed REO................ $ 34,045
==========
RECENT ACCOUNTING PRONOUNCEMENTS
Set forth below are 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 November 2002, the Financial Accounting Standards Board ("FASB")
issued Financial Interpretation No. ("FIN") 45 "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." FIN 45 standardizes practices related to the
recognition of a liability for the fair value of a guarantor's obligation. The
rule requires companies to record a liability for the fair value of its
guarantee to provide or stand ready to provide services, cash or other assets.
The rule applies to contracts that require a guarantor to make payments based on
an underlying factor such as change in market value of an asset, collection of
the scheduled contractual cash flows from individual financial assets held by a
special purpose entity, non-performance of a third party, for indemnification
agreements, or for guarantees of the indebtedness of others among other things.
The provisions of FIN 45 are effective on a prospective basis for guarantees
that are issued or modified after December 31, 2002. The disclosure requirements
were effective for statements of annual or interim periods ending after December
15, 2002.
Based on the requirements of this guidance for the quarter ended March
31, 2003, we have recorded a $0.7 million liability in conjunction with the sale
of mortgage loans to the ABFS 2003-1 securitization trust which occurred in
March 2003. This liability represents the fair value of periodic interest
advances that we, as servicer of the securitized loans, are obligated to pay on
behalf of delinquent loans in the trust. Recording of this liability reduces the
gain on sale recorded for the securitization. We would expect to record a
similar liability for each subsequent securitization, which generally occurs on
a quarterly basis. The amount of the liability that will be recorded is
dependent mainly on the volume of loans we securitize, the expected performance
of those loans and the interest rate of the loans. In the quarter ended March
31, 2003, the adoption of FIN 45 reduced net income by approximately $0.3
million and diluted earnings per share by $0.11. See Note 8 of the Consolidated
Financial Statements for further detail of this obligation.
78
In December 2002, the FASB issued SFAS No. 148 "Accounting for
Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS
No. 123 "Accounting for Stock-Based Compensation." SFAS No. 148 provides
alternative methods of transition for a voluntary change to the fair value
method of accounting for stock-based compensation and requires pro forma
disclosures of the effect on net income and earnings per share had the fair
value method been used to be included in annual and interim reports and
disclosure of the effect of the method used if the accounting method was
changed, among other things. SFAS No. 148 is effective for annual reports of
fiscal years beginning after December 15, 2002 and interim reports for periods
beginning after December 15, 2002. We plan to continue using the intrinsic value
method of accounting for stock-based compensation and therefore the new rule
will have no effect on our financial condition or results of operations. We
adopted the new standard related to disclosure in the interim period beginning
January 1, 2003. See Note 11 of the Consolidated Financial Statements for
further detail of the adoption of this rule.
In April 2003, the FASB began reconsidering the current alternatives
for accounting for stock-based compensation. We cannot predict whether the
guidance will change our current accounting for stock-based compensation, or
what effect, if any, changes may have on our current financial condition or
results of operations.
In January 2003, the FASB issued FIN 46 "Consolidation of Variable
Interest Entities." FIN 46 provides guidance on the identification of variable
interest entities that are subject to consolidation requirements by a business
enterprise. A variable interest entity subject to consolidation requirements is
an entity that does not have sufficient equity at risk to finance its operations
without additional support from third parties and the equity investors in the
entity lack certain characteristics of a controlling financial interest as
defined in the guidance. Special purpose entities ("SPEs") are one type of
entity, which under certain circumstances may qualify as a variable interest
entity. Although we use unconsolidated SPEs extensively in our loan
securitization activities, the guidance will not affect our current
consolidation policies for SPEs as the guidance 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. FIN 46 will therefore have no effect on
our financial condition or results of operations and would not be expected to
affect it in the future. In March 2003, the FASB announced that it is
reconsidering the permitted activities of a qualifying SPE. We cannot predict
whether the guidance will change or what effect, if any, changes may have on our
current consolidation policies for SPEs.
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. 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.
In December 2002, we entered into a new lease for office space for the
relocation of our corporate headquarters into Philadelphia, Pennsylvania. The
eleven-year operating lease is expected to commence in fiscal 2004. The terms of
the rental agreement require increased payments annually for the term of the
lease with average minimum annual rental payments of $4.2 million. We have
entered into contracts, or may engage parties in the future, related to the
relocation of our corporate headquarters such as contracts for building
improvements to the leased space, office furniture and equipment and moving
services. The provisions of the lease and local and state grants will provide us
with reimbursement of a substantial amount of the costs related to the
relocation, subject to certain conditions and limitations. We do not believe our
unreimbursed expenses or unreimbursed cash outlay related to the relocation will
be material to our operations.
79
The lease requires us to maintain a letter of credit in favor of the
landlord to secure our obligations to the landlord throughout the term of the
lease. The amount of the letter of credit is currently $8.0 million and declines
over time to $4.0 million. The letter of credit is currently issued by JPMorgan
Chase under our current lending facility with JPMorgan Chase.
In March 2003, we entered into a new lease agreement for office space
in Roseland, New Jersey for the relocation of the our regional processing center
presently located in Roseland, New Jersey. The nine-year lease is expected to
commence in May 2003. The terms of the rental agreement require increased
payments periodically for the term of the lease with average minimum annual
rental payments of $0.8 million. The provisions of the lease require the
landlord to assume the costs to ready the premises for occupancy, subject to
certain conditions and limitations. We do not believe that our expenses or cash
outlay related to the relocation will be material to our operations.
80
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 site 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. This web site is only intended to be an inactive
textual reference.
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 or our internal
controls and procedures for financial reporting ("Internal Controls") will
prevent all error and all fraud. A control system, no matter how well conceived
and operated, can provide only reasonable, but not absolute assurance that the
objectives of a control system are met. Further, any control system reflects
limitations on resources, and the benefits of a control system must be
considered relative to its 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 a control. As design of a control system is also based upon certain
assumptions about the likelihood of future events, there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions; 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 may not be detected.
81
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 accordance 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.
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.
The Hale case consists of five separate counts - three purported class
action counts and two individual counts. On November 22, 2002 the Illinois
Federal District Court granted Upland Mortgage's motion to dismiss the three
class action counts, but a judgment erroneously dismissing all five counts of
the case was entered in the docket. The plaintiff appealed the dismissal to the
United States Court of Appeals for the Seventh Circuit but, on February 14,
2003, the Court of Appeals dismissed the appeal for lack of jurisdiction, on the
grounds that the judgment entered by the Illinois Federal District Court was
erroneous and did not constitute a final disposition of all counts of the case.
Action on the two remaining individual counts in the Illinois Federal District
Court has resumed and discovery has been scheduled.
82
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 because
the ultimate resolutions of these proceedings are influenced by factors outside
of our control, our estimated liability under these proceedings may change or
actual results may differ from our estimates. We expect that, as a result of the
publicity surrounding predatory lending practices and a recent New Jersey court
decision regarding the Federal Parity Act and state laws which preclude the
imposition of prepayment and other fees, we may be subject to other class action
suits in the future. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations - General" for more detail.
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
Item 5. Other Information - None
Item 6. Exhibits and Reports on Form 8-K
Exhibits
Exhibit
Number Description
-------- -----------------------------------------------------------------------------------------------
10.1 Amendment No. 3 of Letter of Credit Agreement with JPMorgan Chase
10.2 Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business Financial Services,
Inc., Lessee for 105 Eisenhower Parkway, Roseland, New Jersey
10.3 First Amendment to Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business
Financial Services, Inc., Lessee.
99.1 Chief Executive Officer's Certificate
99.2 Chief Financial Officer's Certificate
Reports on Form 8-K - None
83
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: May 14, 2003 By: Albert W. Mandia
------------ -----------------------------
Albert W. Mandia
Executive Vice President and
Chief Financial Officer
84
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
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: May 14, 2003 Anthony J. Santilli
---------------------------------------------
Anthony J. Santilli
Chairman, President, Chief Executive Officer,
Chief Operating Officer, and Director
(principal executive officer)
85
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;
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: May 14, 2003 Albert W. Mandia
------------------------------
Albert W. Mandia
Executive Vice President and
Chief Financial Officer
(principal financial officer)
86
EXHIBIT INDEX
Exhibit
Number Description
------- -----------------------------------------------------------------------------------------------
10.1 Amendment No. 3 of Letter of Credit Agreement with JPMorgan Chase
10.2 Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business Financial Services,
Inc., Lessee for 105 Eisenhower Parkway, Roseland, New Jersey
10.3 First Amendment to Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business
Financial Services, Inc., Lessee.
99.1 Chief Executive Officer's Certificate
99.2 Chief Financial Officer's Certificate
86