Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 2003
or
[ ] Transition report pursuant to 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.
------------------------------------------------------
(Exact 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.)
100 Penn Square East, Philadelphia, PA 19107
---------------------------------------------------
(Address of principal executive offices) (zip code)
(215) 940-4000
--------------
(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 Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [X] YES [ ] NO
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). [X] YES [ ] NO
The number of shares outstanding of the registrant's sole class of
common stock as of October 30, 2003 was 2,946,892 shares.
American Business Financial Services, Inc. and Subsidiaries
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2003 and June 30, 2003.......................................1
Consolidated Statements of Income for the three months ended September 30, 2003 and 2002.....................2
Consolidated Statement of Stockholders' Equity for the three months ended September 30, 2003.................3
Consolidated Statements of Cash Flow for the three months ended September 30, 2003 and 2002..................4
Notes to Consolidated Financial Statements...................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..............34
Item 3. Quantitative and Qualitative Disclosures about Market Risk........................................106
Item 4. Controls and Procedures...........................................................................107
PART II OTHER INFORMATION
Item 1. Legal Proceedings.................................................................................108
Item 2. Changes in Securities and Use of Proceeds.........................................................108
Item 3. Defaults Upon Senior Securities...................................................................108
Item 4. Submission of Matters to a Vote of Security Holders...............................................108
Item 5. Other Information.................................................................................108
Item 6. Exhibits and Reports on Form 8-K..................................................................109
2
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
American Business Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollar amounts in thousands)
September 30, June 30,
2003 2003
------------- -----------
(Unaudited) (Note)
Assets
Cash and cash equivalents $ 27,217 $ 47,475
Loan and lease receivables, net
Available for sale 162,688 271,402
Interest and fees 17,396 15,179
Other 24,681 23,761
Interest-only strips (includes the fair value of
overcollateralization related cash flows of $263,462 and
$279,245 at September 30, 2003 and June 30, 2003) 545,583 598,278
Servicing rights 106,072 119,291
Receivable for sold loans -- 26,734
Prepaid expenses 9,061 3,477
Property and equipment, net 28,314 23,302
Deferred income tax asset 1,042 --
Other assets 28,452 30,452
--------- -----------
Total assets $ 950,506 $ 1,159,351
========= ===========
Liabilities
Subordinated debt $ 687,585 $ 719,540
Warehouse lines and other notes payable 109,410 212,916
Accrued interest payable 43,751 45,448
Accounts payable and accrued expenses 32,725 30,352
Deferred income tax liability -- 17,036
Other liabilities 65,213 91,990
--------- -----------
Total liabilities 938,684 1,117,282
--------- -----------
Stockholders' equity
Preferred stock, par value $.001, authorized, 3,000,000 shares,
issued and outstanding, none -- --
Common stock, par value $.001, authorized, 9,000,000 shares,
issued: 3,653,165 shares (including Treasury shares of 706,273)
at September 30, 2003 and June 30, 2003 4 4
Additional paid-in capital 23,985 23,985
Accumulated other comprehensive income 10,561 14,540
Retained earnings (deficit) (13,164) 13,104
Treasury stock, at cost (8,964) (8,964)
--------- -----------
12,422 42,669
Note receivable (600) (600)
--------- -----------
Total stockholders' equity 11,822 42,069
--------- -----------
Total liabilities and stockholders' equity $ 950,506 $ 1,159,351
========= ===========
Note: The balance sheet at June 30, 2003 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
(dollar amounts in thousands, except per share data)
(unaudited)
Three Months Ended
September 30,
----------------------------------
2003 2002
--------- ---------
Revenues Gain on sale of loans:
Securitizations $ 799 $ 58,011
Whole loan sales 2,921 35
Interest and fees 4,653 4,133
Interest accretion on interest-only strips 11,109 10,747
Servicing income 718 1,537
Other income 1 4
--------- ---------
Total revenues 20,201 74,467
--------- ---------
Expenses
Interest 16,818 17,083
Provision for credit losses 4,156 1,538
Employee related costs 13,852 9,575
Sales and marketing 2,841 6,688
General and administrative 19,215 20,925
Trading (gains) and losses (5,108) 3,440
Securitization assets valuation adjustment 10,795 12,078
--------- ---------
Total expenses 62,569 71,327
--------- ---------
Income (loss) before provision for income taxes (42,368) 3,140
Provision for income tax expense (benefit) (16,100) 1,319
--------- ---------
Net income (loss) $ (26,268) $ 1,821
========= =========
Earnings (loss) per common share:
Basic (8.91) $ 0.64
========= =========
Diluted $ (8.91) $ 0.61
========= =========
Average common shares (in thousands):
Basic 2,947 2,856
========= =========
Diluted 2,947 2,985
========= =========
See accompanying notes to consolidated financial statements.
2
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity
(amounts in thousands)
(unaudited)
Common Stock
----------------------- Accumulated
Number of Additional Other Retained
For the three months ended Shares Paid-In Comprehensive Earnings Treasury
September 30, 2003: Outstanding Amount Capital Income (Deficit) Stock
----------- ------ ---------- ------------- --------- ---------
Balance June 30, 2003 2,947 $ 4 $ 23,985 $ 14,540 $ 13,104 $ (8,964)
Comprehensive income:
Net (loss) -- -- -- -- (26,268) --
Net unrealized loss on
interest-only strips -- -- -- (3,979) -- --
------ ----- -------- -------- -------- --------
Total comprehensive loss -- -- -- (3,979) (26,268) --
------ ----- -------- -------- -------- --------
Balance September 30, 2003 2,947 $ 4 $ 23,985 $ 10,561 $(13,164) $ (8,964)
====== ===== ======== ======== ======== ========
Total
For the three months ended Note Stockholders'
September 30, 2003: Receivable Equity
---------- -------------
Balance June 30, 2003 $ (600) $ 42,069
Comprehensive income:
Net (loss) -- (26,268)
Net unrealized loss on
interest-only strips -- (3,979)
--------- ----------
Total comprehensive loss -- (30,247)
--------- ----------
Balance September 30, 2003 $ (600) $ 11,822
========= ==========
See accompanying notes to consolidated financial statements.
3
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow
(dollar amounts in thousands)
(unaudited)
Three Months Ended
September 30,
----------------------------
2003 2002
----------- ----------
Cash flows from operating activities
Net income (loss) $ (26,268) $ 1,821
Adjustments to reconcile net income to net cash used in operating
activities:
Gain on sales of loans (799) (58,011)
Depreciation and amortization 14,647 11,163
Interest accretion on interest-only strips (10,828) (10,747)
Securitization assets valuation adjustment 10,795 12,078
Provision for credit losses 4,156 1,538
Loans originated for sale (158,284) (386,390)
Proceeds from sale of loans 278,523 382,181
Principal payments on loans and leases 4,169 4,382
(Increase) decrease in accrued interest and fees on loan and lease
receivables (2,217) 724
Required purchase of additional overcollateralization on securitized
loans (7,660) (17,128)
Cash flow from interest-only strips 56,222 33,464
(Increase) decrease in prepaid expenses (5,584) 199
(Decrease) increase in accrued interest payable (1,696) 2,427
Increase in accounts payable and accrued expenses 2,372 5,929
Accrued interest payable reinvested in subordinated debt 9,686 7,863
Decrease in deferred income taxes (16,097) (598)
Increase in loans in process (24,148) (529)
Other, net 1,415 1,106
----------- ----------
Net cash provided by (used in) operating activities 128,404 (8,528)
----------- ----------
Cash flows from investing activities
Purchase of property and equipment, net (6,774) (1,031)
Principal receipts and maturity of investments 11 8
----------- ----------
Net cash used in investing activities (6,763) (1,023)
----------- ----------
4
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow (continued)
(dollar amounts in thousands)
(unaudited)
Three Months Ended
September 30,
----------------------------
2003 2002
----------- ----------
Cash flows from financing activities
Proceeds from issuance of subordinated debt $ 1,576 $ 40,006
Redemptions of subordinated debt (43,217) (33,898)
Net borrowings on revolving lines of credit (77,271) 3,110
Principal payments on lease funding facility -- (931)
Principal payments under capital lease obligations (77) --
Net repayments of other notes payable (26,158) --
Financing costs incurred (314) (233)
Lease incentive receipts 3,562 --
Exercise of non-employee stock options -- 50
Cash dividends paid -- (229)
----------- ----------
Net cash provided by (used in) financing activities (141,899) 7,875
----------- ----------
Net (decrease) increase in cash and cash equivalents (20,258) (1,676)
Cash and cash equivalents at beginning of year 47,475 108,599
----------- ----------
Cash and cash equivalents at end of year $ 27,217 $ 106,923
=========== ==========
Supplemental disclosures:
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ -- $ (1,022)
Increase in warehouse lines and other notes payable $ -- $ 1,022
Cash paid during the period for:
Interest $ 8,828 $ 6,793
Income taxes $ 40 $ 700
See accompanying notes to consolidated financial statements.
5
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 2003
1. Summary of Significant Accounting Policies
Business
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 home equity loans and,
subject to market conditions in the secondary loan market, business purpose
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 one-to-four 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 our products and services. The Company originates loans through a
combination of channels including a national processing center located at its
centralized operating office in Philadelphia, Pennsylvania and a small
processing center in Roseland, New Jersey. The Company's centralized operating
office was located in Bala Cynwyd, Pennsylvania prior to July 7, 2003. Prior to
June 30, 2003, the Company also originated home equity loans through several
retail branch offices. Effective June 30, 2003, the Company no longer originates
home equity loans through retail branch offices. In addition, the Company offers
subordinated debt securities to the public, the proceeds of which are used for
repayment of existing debt, loan originations, operations (including repurchases
of delinquent assets from securitization trusts), investments in systems and
technology and for general corporate purposes including funding our operating
cash requirements and loan over collateralization requirements under the
Company's credit facilities.
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.
Business Conditions
For its ongoing operations, the Company depends upon frequent financings,
including the sale of unsecured subordinated debt securities, borrowings under
warehouse credit facilities or lines of credit and the sale of loans on a whole
loan basis or through publicly underwritten or privately placed securitizations.
If the Company is unable to renew or obtain adequate funding on acceptable terms
through its sale of subordinated debt securities or under a warehouse credit
facility, or other borrowings, the lack of adequate funds would adversely impact
liquidity and reduce profitability or result in losses. If the Company is unable
to sell or securitize its loans, its liquidity would be reduced and it may incur
losses. To the extent that the Company is not successful in maintaining or
replacing existing subordinated debt securities upon maturity, or maintaining
adequate warehouse credit facilities or lines of credit, or securitizing and
selling its loans, it may
6
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
have to limit future loan originations and further restructure its operations.
Limiting loan originations or restructuring operations could impair the
Company's ability to repay subordinated debt at maturity and may result in
losses.
The Company has historically experienced negative cash flow from operations
since 1996 primarily because, in general, its business strategy of selling loans
through securitization has not generated cash flow immediately. For the three
months ended September 30, 2003, the Company experienced positive cash flow from
operations of $128.4 million due to its sales of loans originated in prior
periods that were carried on its balance sheet at June 30, 2003. During the
three months ended September 30, 2003, the Company received cash on whole loan
sales of $245.2 million of loans.
For the three months ended September 30, 2003, the Company recorded a net loss
of $26.3 million. The loss primarily resulted from liquidity issues described
below, which substantially reduced the Company's ability to originate loans and
generate revenues during the first quarter of fiscal 2004, its inability to
complete a securitization of loans during the first quarter of fiscal 2004, and
$10.8 million of pre-tax charges for valuation adjustments on its securitization
assets. For the three months ended September 30, 2003, the Company originated
$124.1 million of loans, which represents a significant reduction as compared to
$370.7 million of loans originated in the same period of the prior fiscal year.
The valuation adjustments reflect the impact of higher than anticipated
prepayments on securitized loans experienced during the first three months of
fiscal 2004 due to the continuing low interest rate environment.
For the fiscal year ended June 30, 2003, the Company recorded a loss of $29.9
million. The loss in fiscal 2003 was primarily due to the Company's inability to
complete a securitization of loans during the fourth quarter of fiscal 2003 and
to $45.2 million of net pre-tax charges for net valuation adjustments recorded
on securitization assets.
Several recent events negatively impacted the Company's short-term liquidity.
Its inability to complete a securitization during the fourth quarter of fiscal
2003 contributed to the loss for fiscal 2003 and adversely impacted the
Company's short-term liquidity position. In addition, further advances under a
non-committed portion of one of the Company's credit facilities were subject to
the discretion of the lender and subsequent to June 30, 2003, no new advances
took place under the non-committed portion. Additionally, on August 20, 2003,
amendments to this credit facility eliminated the non-committed portion of this
facility and reduced the committed portion to $50.0 million and accelerated the
expiration date from November 2003 to September 30, 2003. Also a $300.0 million
mortgage conduit facility with a financial institution that enabled the Company
to sell its loans into an off-balance sheet facility, expired pursuant to its
terms on July 5, 2003. In addition we were unable to borrow under the Company's
$25.0 million warehouse facility after September 30, 2003 and this facility
expired on October 31, 2003.
At June 30, 2003, of the $516.1 million in revolving credit and
7
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
conduit facilities available, $453.4 million was drawn upon. The Company's
revolving credit facilities and mortgage conduit facility had $62.7 million of
unused capacity available at June 30, 2003, which significantly reduced its
ability to fund future loan originations until it sells existing loans, extends
or expands existing credit facilities, or adds new credit facilities. In
addition, the Company was unable to borrow under its $25.0 million warehouse
facility after September 30, 2003 and this facility expired on October 31, 2003.
At September 30, 2003, the Company had $147.0 million in revolving credit
facilities available to the Company, of which $108.6 million was drawn upon. In
addition, the Company's temporary discontinuation of sales of new subordinated
debt for approximately a six week period during the first quarter of fiscal
2004 further impaired its liquidity.
As a result of these liquidity issues, since June 30, 2003, the Company
substantially reduced its loan origination volume. From July 1, 2003 through
September 30, 2003, the Company originated $124.1 million of loans which
represents a significant reduction as compared to originations of $370.7 million
of loans for the same period in fiscal 2003. The Company also experienced a loss
in loan origination employees. The Company's inability to originate loans at
previous levels adversely impacted the relationships its subsidiaries have or
are developing with their brokers and its ability to retain employees. As a
result of the decrease in loan originations and liquidity issues described
above, the Company incurred a loss for the first quarter of fiscal 2004 and
anticipates incurring losses in future periods.
The combination of the Company's current cash position and expected sources of
operating cash over the second and third quarters of fiscal 2004 may not be
sufficient to cover its operating cash requirements, and the Company anticipates
incurring operating losses through at least the third quarter of fiscal 2004. On
October 24, 2003, the Company had cash of approximately $32.4 million and up to
$437.3 million available under its new credit facilities. Advances under these
new credit facilities can only be used to fund loan originations and not for any
other purposes. The Company anticipates that it will need to increase loan
originations to approximately $700.0 million to $800.0 million per quarter to
return to profitable operations. The Company's short-term plan to achieve these
levels of loan originations includes replacing the loan origination employees
recently lost and creating an expanded broker initiative. Beyond the short-term,
the Company expects to increase originations through the application of the
business strategy adjustments discussed below. The Company's ability to achieve
those levels of loan originations could be hampered by a failure to implement
its short-term plans and funding limitations expected during the start up of its
new credit facilities.
For the next three to six months the Company expects to augment its sources of
operating cash with proceeds from the issuance of subordinated debt. In addition
to repaying maturing subordinated notes, proceeds from the issuance of
subordinated debt will be used to fund overcollateralization requirements in
connection with loan originations. Under the terms of the Company's credit
facilities, these credit facilities will advance 75% to 97% of the value of
loans the Company originates. As a result of this limitation, the Company must
fund the difference
8
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
between the loan value and the advances, referred to as the
overcollateralization requirement, from the Company's operating cash and fund
its operating losses.
In light of the loss for the quarter ended September 30, 2003, the Company
requested and obtained waivers for its non-compliance with financial covenants
in its credit facilities and Pooling and Servicing Agreements. See Note 6 for
more detail.
The Company undertook specific remedial actions to address short-term liquidity
concerns including entering into an agreement on June 30, 2003 with an
investment bank to sell up to $700.0 million of mortgage loans, subject to the
satisfactory completion of the purchaser's due diligence review and other
conditions, and soliciting bids and commitments from other participants in the
whole loan sale market. In total, from June 30, 2003 through September 30, 2003,
the Company sold approximately $493.3 million (which includes $222.3 million of
loans sold by the expired mortgage conduit facility) of loans through whole loan
sales. The process of selling loans is continuing. The Company also suspended
paying quarterly dividends on its common stock.
On September 22, 2003, the Company entered into definitive agreements with a
financial institution for a new $200.0 million credit facility for the purpose
of funding loan originations. On October 14, 2003, the Company entered into
definitive agreements with a warehouse lender for a revolving mortgage loan
warehouse credit facility of up to $250.0 million to fund loan originations. See
Note 6 for information regarding the terms of these facilities.
Although the Company obtained two new credit facilities totaling $450.0 million,
it may only use the proceeds of these credit facilities to fund loan
originations and not for any other purpose. Consequently, the Company will have
to generate cash to fund the balance of its business operations from other
sources, such as whole loan sales, additional financings and sales of
subordinated debt.
On October 16, 2003, the Company refinanced through a mortgage warehouse conduit
facility $40.0 million of loans that were previously held in an off-balance
sheet mortgage conduit facility which expired pursuant to its terms in July
2003. The Company also refinanced an additional $133.5 million of mortgage loans
in the new conduit facility which were previously held in other warehouse
facilities, including the $50.0 million warehouse facility which expired on
October 17, 2003. The more favorable advance rate under this conduit facility as
compared to the expired facilities which previously held these loans, along with
loans fully funded with company cash, resulted in the receipt of $17.0 million
in cash. On October 31, 2003, the Company completed a privately-placed
securitization of the $173.5 million of loans, with servicing released, that had
been transferred to this conduit facility. The terms of this conduit facility
provide that it will terminate upon the disposition of the loans held by it.
9
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
To the extent that the Company fails to maintain its credit facilities or obtain
alternative financing on acceptable terms and increase its loan originations, it
may have to sell loans earlier than intended and further restructure its
operations. While the Company currently believes that it will be able to
restructure its operations, if necessary, it can provide no assurances that such
restructuring will enable it to attain profitable operations or repay the
subordinated debt when due.
After the Company recognized its inability to securitize its loans in the fourth
quarter of fiscal 2003, it adjusted its business strategy to emphasize, among
other things, more whole loan sales. The Company intends to continue to evaluate
both public and privately placed securitization transactions, subject to market
conditions.
At September 30, 2003 there were approximately $288.4 million of subordinated
debentures maturing within twelve months. The Company obtains the funds to repay
the subordinated debentures at their maturities by securitizing loans, selling
whole loans and selling additional subordinated debentures. Cash flow from
operations, the issuance of subordinated debentures and lines of credit fund the
Company's cash needs. The Company expects these sources of funds to be
sufficient to meet its cash needs. The Company could, in the future, generate
cash flows by securitizing, selling, or borrowing against its interest-only
strips and selling servicing rights generated in past securitizations.
In the event the Company is unable to offer additional subordinated debentures
for any reason, the Company has developed a contingent financial restructuring
plan including cash flow projections for the next twelve-month period. Based
on the Company's current cash flow projections, the Company anticipates being
able to make all scheduled subordinated debenture maturities and vendor
payments.
The contingent financial restructuring plan is based on actions that the
Company would take, in addition to those indicated in its adjusted business
strategy, to reduce its operating expenses and conserve cash. These actions
would include reducing capital expenditures, selling all loans originated on a
whole loan basis, eliminating or downsizing various lending, overhead and
support groups, and scaling back less profitable businesses. No assurance can
be given that the Company will be able to successfully implement the contingent
financial restructuring plan, if necessary, and repay the subordinated
debentures when due.
10
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
1. Summary of Significant Accounting Policies (continued)
Basis of Financial Statement Presentation
The consolidated financial statements include the accounts of ABFS and its
subsidiaries (all of which are wholly owned). The consolidated financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States of America. All significant intercompany balances
and transactions have been eliminated. In preparing the consolidated financial
statements, management is required to make estimates and assumptions which
affect the reported amounts of assets and liabilities as of the date of the
consolidated financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. These estimates include, among other things, estimated prepayment,
credit loss and discount rates on interest-only strips and servicing rights,
estimated servicing revenues and costs, valuation of real estate owned, the net
recoverable value of interest and fee receivables and determination of the
allowance for credit losses.
Certain prior period financial statement balances have been reclassified to
conform to current period presentation. All outstanding shares, average common
shares, earnings per common share and stock option amounts have been
retroactively adjusted to reflect the effect of a 10% stock dividend declared
August 21, 2002 and amounts reported for June 30, 2001 and 2000 have been
retroactively adjusted to reflect the effect of a 10% stock dividend declared
October 1, 2001.
Recent Accounting Pronouncements
In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest
Entities," referred to as FIN 46 in this document. 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
Entity (SPE) is 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. In October, 2003 the FASB announced
that it was deferring implementation of FIN 46 for all variable interest
entities that were created before February 1, 2003 until the quarter ended
11
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
1. Summary of Significant Accounting Policies (continued)
Recent Accounting Pronouncements (continued)
December 31, 2003. The requirements of Interpretation of FIN 46 apply
immediately to variable interest entities created after January 31, 2003.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities" to clarify
the financial accounting and reporting for derivative instruments and hedging
activities. SFAS No. 149 is intended to improve financial reporting by requiring
comparable accounting methods for similar contracts. SFAS No. 149 is effective
for contracts entered into or modified subsequent to June 30, 2003. The
requirements of SFAS No. 149 do not affect the Company's current accounting for
derivative instruments or hedging activities and therefore will have no effect
on the Company's financial condition or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150
requires an issuer to classify certain financial instruments, such as
mandatorily redeemable shares and obligations to repurchase the issuer's equity
shares, as liabilities. The guidance is effective for financial instruments
entered into or modified subsequent to May 31, 2003, and otherwise is effective
at the beginning of the first interim period after June 15, 2003. The Company
does not have any instruments with such characteristics and does not expect SFAS
No. 150 to have a material impact on the financial condition or results of
operations.
Restricted Cash Balances
The Company held restricted cash balances of $9.4 million and $11.0 million
related to borrower escrow accounts at September 30, 2003 and June 30, 2003,
respectively, and $0.2 million and $6.0 million related to deposits for future
settlement of interest rate swap contracts at September 30, 2003 and June 30,
2003, respectively.
12
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
2. Loan and Lease Receivables
Loan and lease receivables - available for sale were comprised of the following
(in thousands):
September 30, June 30,
2003 2003
----------- ----------
Real estate secured loans (a) $ 164,772 $ 270,096
Leases, net of unearned income of $550 and $668 (b) 3,386 4,154
----------- ----------
168,158 274,250
Less: allowance for credit losses on loan and lease
receivables available for sale 5,470 2,848
----------- ----------
$ 162,688 $ 271,402
=========== ==========
(a) Includes deferred direct loan origination costs of $2.6 million and $6.8
million at September 30, 2003 and June 30, 2003, respectively.
(b) Includes deferred direct lease origination costs of $14 thousand and $28
thousand at September 30, 2003 and June 30, 2003, respectively.
Real estate secured loans have contractual maturities of up to 30 years.
At September 30, 2003 and June 30, 2003, the accrual of interest income was
suspended on real estate secured loans of $11.9 million and $5.4 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $3.7 million and $1.4 million at
September 30, 2003 and June 30, 2003, respectively.
Average balances of non-accrual loans were $9.1 million for the three months
ended September 30, 2003 and $8.6 million for the 2003 fiscal year,
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. Fee
receivables include, among other types of fees, forbearance and deferment
advances. Under deferment and forbearance arrangements, the Company makes
advances to a securitization trust on behalf of a borrower in amounts equal to
the delinquent principal and interest and may pay fees, including taxes,
insurance and other fees on behalf of the borrower. As a result of these
arrangements the Company resets the contractual status of a loan in its managed
portfolio from delinquent to current based upon the borrower's resumption of
making their loan payments. These amounts are carried at their estimated net
recoverable value.
13
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
2. Loan and Lease Receivables (continued)
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. Repurchasing delinquent loans from
securitization trusts benefits the Company by allowing it to limit the level of
delinquencies and losses in the securitization trusts and as a result, the
Company can avoid exceeding specified limits on delinquencies and losses that
trigger a temporary reduction or discontinuation of cash flow from its
interest-only strips until the delinquency or loss triggers are no longer
exceeded. The Company's ability to repurchase these loans does not disqualify it
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 the Company is not required to repurchase any loan and its ability to
repurchase a loan is limited by contract. 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.
3. Interest-Only Strips
The activity for interest-only strip receivables for the three months ended
September 30, 2003 and 2002 were as follows (in thousands):
September 30,
2003 2002
-----------------------
Balance at beginning of period $ 598,278 $ 512,611
Initial recognition of interest-only strips 950 44,126
Cash flow from interest-only strips (56,222) (33,464)
Required purchases of additional overcollateralization 7,660 17,128
Interest accretion 10,828 10,747
Net temporary adjustments to fair value (a) (5,960) 4,792
Other than temporary fair value adjustment (a) (9,951) (12,078)
-----------------------
Balance at end of period $ 545,583 $ 543,862
=======================
(a) Net temporary adjustments to fair value are recorded through other
comprehensive income, which is a component of equity. Other than temporary
adjustments to decrease the fair value of interest-only strips are recorded
through the income statement.
14
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
3. Interest-Only Strips (continued)
Interest-only strips include overcollateralization balances that represent
undivided interests in securitizations maintained to provide credit enhancement
to investors in securitization trusts. At September 30, 2003 and 2002, the fair
value of overcollateralization related cash flows were $263.5 million and $251.0
million, respectively.
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 decreasing 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 the revised assumptions. As a
result, over the last eight quarters the Company has recorded cumulative pre-tax
write downs to its interest-only strips in the aggregate amount of
$138.8 million and pre-tax adjustments to the value of servicing rights of
$13.2 million, for total adjustments of $152.0 million, mainly due to the higher
than expected prepayment experience. Of this amount, $95.9 million was expensed
through the income statement and $56.1 million resulted in a write down through
other comprehensive income, a component of stockholders' equity.
During the three months ended September 30, 2003, the Company recorded total
pre-tax valuation adjustments on its securitization assets of $16.7 million, of
which $10.8 million was charged to the income statement and $5.9 million was
charged to other comprehensive income. The breakout of the total adjustments in
the first three months of fiscal 2004 between interest-only strips and servicing
rights was as follows:
o The Company recorded total pre-tax valuation adjustments on its
interest only-strips of $15.8 million, of which, in accordance
with EITF 99-20, $9.9 million was charged to the income statement
and $5.9 million was charged to other comprehensive income. The
valuation adjustment reflects the impact of higher than
anticipated prepayments on securitized loans experienced in the
first quarter of fiscal 2004 due to the continuing low interest
rate environment.
o The Company recorded total pre-tax valuation adjustments on its
servicing rights of $0.8 million, which was charged to the income
statement. The valuation adjustment reflects the impact of higher
than anticipated prepayments on securitized loans experienced in
the first quarter of fiscal 2004 due to the continuing low
interest rate environment.
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
15
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
3. Interest-Only Strips (continued)
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 its 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 its 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 September 15, 2003 that mortgage refinancings as a
percentage share of total mortgage originations will decline from 71% in the
first quarter of calendar 2003 to 39% in the first quarter of calendar 2004 and
to 25% in the second quarter of calendar 2004. The Mortgage Bankers Association
of America has also projected in its September 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 Company's analysis of these
factors, it 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 its actual experience may have a significant adverse
impact on the value of these assets.
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 2004:
-----------------
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- --------------------------- ---------- --------- -------------
September 30, 2003 $ 16,658 $ 10,795 $ 5,863
16
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
3. Interest-Only Strips (continued)
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
June 30, 2003 13,293 11,879 1,414
--------- -------- --------
Total Fiscal 2003 $ 63,255 $ 45,182 $ 18,073
========= ======== ========
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.
4. Servicing Rights
Activity for the loan and lease servicing rights asset for the three months
ended September 30, 2003 and 2002 were as follows (in thousands):
September 30,
2003 2002
------------------------
Balance at beginning of year $ 119,291 $ 125,288
Initial recognition of servicing rights - 12,193
Amortization (12,375) (8,625)
Write down (844) -
-------------------------
Balance at end of year $ 106,072 $ 128,856
=========================
Servicing rights are valued quarterly by the Company based on the current
estimated fair value of the servicing asset. A review for impairment is
performed by stratifying the serviced loans and leases based on loan type, which
is considered to be the predominant risk characteristic due to their different
prepayment characteristics and fee structures. During the first quarter of
fiscal 2004, we recorded total pre-tax valuation adjustments on our servicing
rights of $0.8 million, which was charged to the income statement.
17
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
5. Other Assets and Other Liabilities
Other assets were comprised of the following (in thousands):
September 30, June 30,
2003 2003
---------- ---------
Goodwill $ 15,121 $ 15,121
Real estate owned 4,566 4,776
Financing costs, debt offerings 3,803 3,984
Due from securitization trusts for
servicing related activities 1,202 1,344
Investments held to maturity 870 881
Other 2,890 4,346
---------- ---------
$ 28,452 $ 30,452
========== =========
Other liabilities were comprised of the following (in thousands):
September 30, June 30,
2003 2003
---------- ---------
Obligation for repurchase of securitized loans $ 29,036 $ 27,954
Unearned lease incentives 13,027 9,465
Commitments to fund closed loans 11,039 35,187
Escrow deposits held 9,386 10,988
Deferred rent incentive 1,314 -
Hedging liabilities, at fair value - 6,335
Periodic advance guarantee 450 650
Trading liabilities, at fair value 157 334
Other 804 1,077
---------- ---------
$ 65,213 $ 91,990
========== =========
See Note 2 for an explanation of the obligation for the repurchase of
securitized loans.
18
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable
Subordinated debt was comprised of the following (in thousands):
September 30, June 30,
2003 2003
---------- ---------
Subordinated debt (a) $ 672,252 $ 702,423
Subordinated debt - money market notes (b) 15,333 17,117
---------- ---------
Total subordinated debt $ 687,585 $ 719,540
========== =========
Warehouse lines and other notes payable were comprised of the following (in
thousands):
September 30, June 30,
2003 2003
---------- ---------
Warehouse and operating revolving line of credit (c) $ 46,626 $ --
Warehouse and operating revolving line of credit (d) -- 30,182
Warehouse revolving line of credit (e) 38,248 136,098
Warehouse revolving line of credit (f) 23,806 19,671
Capitalized leases (g) 730 807
Bank overdraft (h) -- 26,158
---------- ---------
Total warehouse lines and other notes payable $ 109,410 $ 212,916
========== =========
(a) Subordinated debt due October 2003 through October 2013, interest rates
ranging from 3.50% to 13.00%; average rate at September 30, 2003 was 8.89%,
average remaining maturity was 19.9 months, subordinated to all of the
Company's senior indebtedness. The average rate on subordinated debt
including money market notes was 8.78% at September 30, 2003.
(b) Subordinated debt - money market notes due upon demand, interest rate at
4.0%; subordinated to all of the Company's senior indebtedness.
(c) $200.0 million warehouse and operating revolving line of credit with
JPMorgan Chase Bank entered into on September 22, 2003, but limited to
$80.0 million borrowing capacity at September 30, 2003 and contingent upon
the closing of an additional credit facility. Once the additional credit
facility was closed on October 14, 2003, the full $200.0 million became
available. Interest rates on the advances under this facility are based
upon one-month LIBOR plus a margin. Obligations under the facility are
collateralized by pledged loans.
(d) $50.0 million warehouse and operating revolving line of credit with JPMorgan
Chase Bank, collateralized by certain pledged loans, advances to
securitization trusts, real estate owned and certain interest-only strips
which was replaced, for warehouse lending purposes, by the $200.0 million
facility on September 22, 2003. Pursuant to an amendment, this facility
remained in place as an $8.0 million letter of credit facility to secure
lease obligations for corporate office space. The amount of the letter of
credit was $8.0 million at September 30, 2003 and will decrease over the
term of the lease.
19
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
(e) Originally a $200.0 million warehouse line of credit with Credit Suisse
First Boston Mortgage Capital, LLC. $100.0 million of this facility was
continuously committed for the term of the facility while the remaining
$100.0 million of the facility was available at Credit Suisse's discretion.
Subsequent to June 30, 2003, there were no new advances under the
non-committed portion. On August 20, 2003, this credit facility was amended
to reduce the committed portion to $50.0 million (from $100.0 million),
eliminate the non-committed portion and accelerate its expiration date from
November 2003 to September 30, 2003. The expiration date was subsequently
extended to October 17, 2003, but no new advances were permitted under this
facility subsequent to September 30, 2003. This facility was paid down in
full on October 16, 2003. The interest rate on the facility was based on
one-month LIBOR plus a margin. Advances under this facility were
collateralized by pledged loans.
(f) $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. However, we
were not in compliance with the financial covenants in this facility at
September 30, 2003 and as a condition of obtaining a waiver for
non-compliance, the Company was not permitted further advances under this
line. Interest rates on the advances were based on one-month LIBOR plus a
margin. The obligations under this agreement were collateralized by pledged
loans. This facility was paid down in full on October 16, 2003 and it
expired pursuant to its terms on October 31, 2003.
(g) Capitalized leases, maturing through January 2006, imputed interest rate of
8.0%, collateralized by computer equipment.
(h) Overdraft amount on bank accounts paid on the following business day.
Principal payments on subordinated debt, warehouse lines and other notes payable
for the next five years are as follows (in thousands): period ending September
30, 2004 - $397,390; 2005 - $167,464; 2006 - $163,379; 2007 - $27,616; and, 2008
- - $14,043.
At September 30, 2003, warehouse lines and other notes payable were
collateralized by $123.2 million of loan and lease receivables and $1.0 million
of computer equipment.
In addition to the above, the Company had available a $5.0 million operating
line of credit expiring January 2004, fundings to be collateralized by
investments in the 99-A lease securitization trust and Class R and X
certificates of Mortgage Loan Trust 2001-2. This line was unused at September
30, 2003. Until its expiration, the Company also had available a $300.0 million
mortgage conduit facility. This facility expired pursuant to its terms on July
5, 2003. At September 30, 2003, $36.0 million was outstanding under this
facility. The facility provided for the sale of loans into an off-balance sheet
facility with UBS Principal Finance, LLC, an affiliate of UBS Warburg. This
facility was paid down in full on October 16, 2003.
20
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
Interest rates paid on the revolving credit facilities range from London
Inter-Bank Offered Rate ("LIBOR") plus 0.95% to LIBOR plus 1.75%. The
weighted-average interest rate paid on the revolving credit facilities was 2.80%
and 2.24% at September 30, 2003 and June 30, 2003, respectively.
The warehouse credit agreements require that the Company 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 of limits that the Company must meet as a
condition to drawing on a particular line of credit. Pursuant to the terms of
these credit facilities, the failure to comply with the financial covenants
constitutes an event of default and at the option of the lender, entitles the
lender to, among other things, terminate commitments to make future advances to
the Company, declare all or a portion of the loan due and payable, foreclose on
the collateral securing the loan, require servicing payments be made to the
lender or other third party or assume the servicing of the loans securing the
credit facility. An event of default under these credit facilities would result
in defaults pursuant to cross-default provisions of our other agreements,
including but not limited to, other loan agreements, lease agreements and other
agreements. The failure to comply with the terms of these credit facilities or
to obtain the necessary waivers would have a material adverse effect on the
Company's liquidity and capital resources.
As a result of the loss experienced during fiscal 2003, the Company was not in
compliance with the terms of certain financial covenants related to net worth,
consolidated stockholders' equity and the ratio of total liabilities to
consolidated stockholders' equity under two of its principal credit facilities
at June 30, 2003 (one for $50.0 million and the other for $200.0 million, which
was reduced to $50.0 million). The Company has requested and obtained waivers
from these covenant provisions from both lenders. The lender under the
$50.0 million warehouse credit facility has granted the Company a waiver for its
non-compliance with a financial covenant in that credit facility through
September 30, 2003. The Company also entered into an amendment to the
$200.0 million credit facility which provides for the waiver of its
non-compliance with the financial covenants in that facility, the reduction of
the committed portion of this facility from $100.0 million to $50.0 million, the
elimination of the $100.0 million non-committed portion of this credit facility
and the acceleration of the expiration date of this facility from November 2003
to September 30, 2003. The Company entered into subsequent amendments to this
credit facility which extended the expiration date until October 17, 2003. This
facility was paid down in full on October 16, 2003 and expired on October 17,
2003.
In addition, in light of the loss for the first quarter of fiscal 2004, the
Company requested and obtained waivers or amendments to several credit
facilities to address its non-compliance with certain financial covenants as of
September 30, 2003.
21
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
The lender under the $25.0 million credit facility agreed to amend such facility
in light of the Company's non-compliance at September 30, 2003 with the
requirement that its net income not be less than zero for two consecutive
quarters. Pursuant to the revised terms of the Company's agreement with this
lender, no additional advances may be made under this facility after September
30, 2003. This facility was paid down in full on October 16, 2003 and expired
pursuant to its terms on October 31, 2003.
The lender on the new $200.0 million credit facility granted the Company a
waiver of its non-compliance at September 30, 2003 with the minimum net worth
covenant contained in this credit facility. The terms of the new $200.0 million
credit facility, as amended, require, among other things, that the registration
statement registering $295.0 million of subordianted debt be declared effective
by the SEC no later than October 31, 2003 and that the Company have a minimum
net worth of $25.0 million at October 31, 2003 and November 30, 2003. An
identical minimum net worth requirement applies to an $8.0 million letter of
credit facility with the same lender. The lender under the $200.0 million
facility agreed to extend the deadline for the Company's registration statement
to be declared effective by the SEC to November 10, 2003. This lender also
verbally agreed (with written documentation pending) to waive the minimum net
worth requirement at October 31, 2003 under the $200.0 million credit facility
and the $8.0 million letter of credit facility. There can be no assurances that
the Company will be able to obtain this waiver in writing or whether the terms
of the written waiver will impose any conditions on the Company.
Some of the Company's financial covenants in other credit facilities have
minimal flexibility and it cannot say with certainty that it will continue to
comply with the terms of all debt covenants. There can be no assurance as to
whether or in what form a waiver or modification of terms of these agreements
would be granted the Company.
On September 22, 2003, the Company entered into definitive agreements with a
financial institution for a new $200.0 million credit facility for the purpose
of funding its loan originations. Pursuant to the terms of this facility, the
Company is required to, among other things: (i) obtain a written commitment for
another credit facility of at least $200.0 million and close that additional
facility by October 3, 2003 (this condition is satisfied by the closing of the
$250.0 million facility described below); (ii) have a net worth of at least
$28.0 million by September 30, 2003; with quarterly increases of $2.0 million
thereafter; (iii) apply 60% of its net cash flow from operations each quarter to
reduce the outstanding amount of subordinated debt commencing with the quarter
ending March 31, 2004; and (iv) provide a parent company guaranty of 10% of the
outstanding principal amount of loans under the facility. This facility has a
term of 12 months expiring in September 2004 and is secured by the mortgage
loans which are funded by advances under the facility with interest equal to
LIBOR plus a margin. This facility is subject to representations and warranties
and covenants, which are customary for a facility of this type, as well as
amortization events and events of default related to the Company's financial
condition. These provisions require, among other things, the Company's
maintenance of a delinquency ratio for the managed portfolio (which represents
the portfolio of securitized loans and leases we service for others) at the end
of each fiscal quarter of less than 12.0%, its subordinated debt not to exceed
$705.0 million at any time, its ownership of an amount of repurchased loans not
to exceed 1.5% of the managed portfolio and its registration statement
registering $295.0 million of subordinated debt be declared effective by the SEC
no later than October 31, 2003.
22
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
On October 3, 2003, the lender on the new $200.0 million credit facility agreed
to extend the date by which the Company must close an additional credit facility
of at least $200.0 million from October 3, 2003 to October 8, 2003. The Company
subsequently obtained a waiver from this lender which further extended the
required closing date for this additional credit facility to October 14, 2003.
On October 14, 2003, the Company entered into definitive agreements with a
warehouse lender for a revolving mortgage loan warehouse credit facility of up
to $250.0 million to fund loan originations. The $250.0 million facility has a
term of three years with an interest rate on amounts outstanding equal to the
one-month LIBOR plus a margin and the yield maintenance fees (as defined in the
agreements). The Company also agreed to pay fees of $8.9 million upon closing
and approximately $10.3 million annually plus a nonusage fee based on the
difference between the average daily outstanding balance for the current month
and the maximum credit amount under the facility, as well as the lender's
out-of-pocket expenses. Advances under this facility are collateralized by
specified pledged loans and additional credit support was created by granting a
security interest in substantially all of the Company's interest-only strips and
residual interests which the Company contributed to a special purpose entity
organized by it to facilitate this transaction.
This $250.0 million facility contains representations and warranties, events of
default and covenants which are customary for facilities of this type, as well
as our agreement to: (i) restrict the total amount of indebtedness outstanding
under the indenture related to the Company's subordinated debt to $750.0
million or less; (ii) make quarterly reductions commencing in April 2004 of an
amount of subordinated debt pursuant to the formulas set forth in the loan
agreement; (iii) maintain maximum interest rates offered on subordinated debt
securities not to exceed 10 percentage points above comparable rates for FDIC
insured products; and (iv) maintain minimum cash and cash equivalents of not
less than $10.0 million. In addition to events of default which are typical for
this type of facility, an event of default would occur if: (1) the Company is
unable to sell subordinated debt for more than three consecutive weeks or on
more than two occasions in a 12 month period; and (2) certain members of
management are not executive officers and a satisfactory replacement is not
found within 60 days. The definitive agreements grant the lender an option for a
period of 90 days commencing on the first anniversary of entering into the
definitive agreements to increase the credit amount on the $250.0 million
facility to $400.0 million with additional fees and interest payable by the
Company.
On October 16, 2003, the Company refinanced through a mortgage warehouse conduit
facility $40.0 million of loans that were previously held in an off-balance
sheet mortgage conduit facility which expired pursuant to its terms in July
2003. The Company also refinanced an additional $133.5 million of mortgage loans
in the new conduit facility which were previously held in other warehouse
facilities, including the $50.0 million warehouse facility which expired on
October 17, 2003. The more favorable advance rate under this conduit facility as
compared to the expired
23
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
facilities which previously held these loans resulted in the Company's receipt
of $17.0 million in cash. On October 31, 2003, the Company completed a
privately-placed securitization of the $173.5 million of loans, with servicing
released, that had been transferred to this conduit facility. The terms of this
conduit facility provide that it will terminate upon the disposition of loans
held by it.
Under a registration statement declared effective by the SEC on October 3, 2002,
the Company registered $315.0 million of subordinated debt. This registration
statement expired on October 31, 2003. In June 2003, the Company filed a new
registration statement with the SEC to register an additional $295.0 million of
subordinated debt which had not been declared effective by the SEC as of
October 31, 2003.
In the event the Company is unable to offer additional subordinated debentures
for any reason, the Company has developed a contingent financial restructuring
plan including cash flow projections for the next twelve-month period. Based on
the Company's current cash flow projections, the Company anticipates being able
to make all scheduled subordinated debenture maturities and vendor payments.
The contingent financial restructuring plan is based on actions that the
Company would take, in addition to those indicated in its adjusted business
strategy, to reduce its operating expenses and conserve cash. These actions
would include reducing capital expenditures, selling all loans originated on a
whole loan basis, eliminating or downsizing various lending, overhead and
support groups, and scaling back less profitable businesses. No assurance can be
given that the Company will be able to successfully implement the contingent
financial restructuring plan, if necessary, and repay the subordinated
debentures when due.
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.
In September 2002, the Company entered into a series of leases for computer
equipment, which qualify as capital leases. The total principal amount of debt
to be recorded under these leases is $1.0 million. The leases have an imputed
interest rate of 8.0% and mature through January 2006.
The Company paid commitment fees and non-usage fees on warehouse lines and
operating lines of credit of $7.6 million in the three months ended September
30, 2003 and $0.4 million during the fiscal year ended June 30, 2003.
24
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 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 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 case consisted of three purported class action counts and two
individual counts. The plaintiff alleged that the charging of, and the failure
to properly disclose the nature of, a document preparation fee were improper
under applicable state law. In November 2002 the Illinois Federal District Court
dismissed the three class action counts and an agreement in principle was
reached in August 2003 to settle the matter. The terms of the settlement have
been finalized and the action was dismissed on September 23, 2003. The matter
did not have a material effect on our consolidated financial position or results
of operations. 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 and servicing
activities, in addition to the Calvin Hale action 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 its consolidated financial position or results
of operations. However, due to the inherent uncertainty in litigation and
because the ultimate resolution 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 its estimates.
Additionally, court decisions in litigation to which we are not a party may also
affect our lending activities and could subject us to litigation in the future.
For example, in Glukowsky v. Equity One, Inc., (Docket No. A-3202 - 01T3), dated
April 24, 2003, to which we are not a party, 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. This case
has been appealed to the New Jersey Supreme Court which has agreed to hear this
case. We expect that, as a result of the publicity surrounding predatory
lending practices and this recent New Jersey court decision regarding the
Parity Act, we may be subject to other class action suits in the future.
In addition, from time to time, we are involved as plaintiff or defendant in
various other legal proceedings arising in the normal course of our business.
While we cannot predict the ultimate outcome of these various legal proceedings,
management believes that the resolution of these legal actions should not have a
material effect on our financial position, results of operations or liquidity.
25
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
8. Commitments
Lease Agreements
The Company moved its corporate headquarters from Bala Cynwyd, Pennsylvania to
Philadelphia, Pennsylvania on July 7, 2003. The Company leases office space for
its corporate headquarters in Philadelphia, Pennsylvania. The current lease term
expires in June 2014. 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 its 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 provided the Company with reimbursement of a substantial
amount of its costs related to the relocation, subject to certain conditions and
limitations. The Company does not believe 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.
The Company continues to lease some office space in Bala Cynwyd under a
five-year lease expiring in November 2004 at an annual rental of approximately
$0.7 million. The Company performs its loan servicing and collection activities
at this office, but expects to relocate these activities to its Philadelphia
office.
In May 2003, the Company moved its regional processing center to a different
location in Roseland, New Jersey. The Company leases the office space in
Roseland, New Jersey and the nine-year lease expires in January 2012. 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
expenses and cash outlay related to the relocation were not material to the
Company's 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
26
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
8. Commitments
Periodic Advance Guarantees
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 payments to the applicable trust prior to any
distributions to the certificate holders.
The Company adopted Financial Interpretation No. ("FIN") 45 "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" on a prospective basis for guarantees
that are issued or modified after December 31, 2002. Based on the requirements
of this guidance, the Company has recorded a $0.4 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
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.
No derivative financial instruments were utilized for hedging
activities during the three months ended September 30, 2003. The Company
recorded the following gains and losses on the fair value of derivative
financial instruments accounted for as hedges for the three-month periods ended
September 30, 2003 and 2002. Any ineffectiveness related to hedging transactions
during the period was immaterial.
27
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
9. Derivative Financial Instruments (continued)
Hedging Activity (continued)
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
September 30,
2002
------
Offset by gains and losses recorded on
securitizations:
Losses on derivative financial instruments $ (2,839)
Offset by gains and losses recorded on the
fair value of hedged items:
Losses on derivative financial instruments $ (967)
Amount settled in cash - paid --
There were no outstanding derivatives contracts accounted for as hedges
on September 30, 2003. At September 30, 2002, the 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):
Three Months Ended
September 30,
2002
----------------------
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate
swaps $80,000 $ 967
28
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
9. Derivative Financial Instruments (continued)
Trading Activity
The Company recorded the following gains and 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
month periods ended September 30, 2003 and 2002 (in thousands):
Three Months Ended
September 30,
2003 2002
------ ------
Trading Gains/(Losses) on forward starting
interest rate swaps:
Related to loan pipeline $ -- $ (2,517)
Related to whole loan sales $ 5,097 $ --
Amount settled in cash - (paid) $ (1,212) $ --
At September 30, 2003, there were no outstanding derivative financial
instruments utilized to manage interest rate risk on loans in our pipeline or
expected to be sold in whole loan sale transactions. At September 30, 2002,
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):
Three Months Ended
September 30,
2002
---------------------
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate
swaps $ 220,000 $ 2,517
In addition, for the quarter ended September 30, 2003, the Company
recorded a net gain of $11 thousand compared to a net loss of $0.7 million for
the quarter ended September 30, 2002 on an interest rate swap contract which is
not designated as an accounting hedge. This contract was designed to reduce the
exposure to changes in the fair value of certain interest-only strips due to
changes in one-month LIBOR. The loss on the swap contract for the three months
ended September 30, 2002 was due to decreases in the interest rate swap yield
curve during the periods the contract was in place. Included in the $11 thousand
net gain recorded for the three months ended September 30, 2003 were unrealized
gains of $177 thousand representing the net change in the fair value of the
contract during the period and $166 thousand of cash losses paid during the
period. Included in the $0.7 million net loss recorded for the three months
ended September 30, 2002 were unrealized losses of $0.4 million representing the
net change in the fair value of the contract during the prior year period and
$0.3 million of cash losses paid during the prior year period. The cumulative
net unrealized loss of $157 thousand is included as a trading liability in Other
liabilities. Terms of the interest rate swap contract at September 30, 2003 were
as follows (dollars in thousands):
Notional amount $ 29,257
Rate received - Floating (a) 1.20%
Rate paid - Fixed 2.89%
Maturity date April 2004
Unrealized loss $ 157
Sensitivity to 0.1% change in interest rates $ 9
29
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
10. Reconciliation of Basic and Diluted Earnings Per Common Share
Following is a reconciliation of the Company's basic and diluted earnings per
share calculations (in thousands, except per share data):
Three Months Ended
September 30,
-------------------------------
2003 2002
------ ------
Earnings
(a) Net Income (Loss) $ (26,268) $ 1,821
========== ==========
Average Common Shares
(b) Average common shares outstanding 2,947 2,856
Average potentially dilutive shares (i) 129
---------- ----------
(c) Average common and potentially dilutive shares 2,947 2,985
========== ==========
Earnings (Loss) Per Common Share
Basic (a/b) $ (8.91) $ 0.64
Diluted (a/c) $ (8.91) $ 0.61
(i) Anti-dilutive
30
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
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):
Three Months Ended
September 30,
--------------------------------
2003 2002
--------------------------------
Net income
As reported $ (26,268) $ 1,821
Stock based compensation costs,
net of tax effects, determined
under fair value method for all
awards (182) (59)
--------- --------
Pro forma $ (26,450) $ 1,762
========= ========
Earnings per share - basic
As reported $ (8.91) $ 0.64
Pro forma $ (8.94) $ 0.62
Earnings per share - diluted
As reported $ (8.91) $ 0.61
Pro forma $ (8.94) $ 0.59
31
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
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.
Reconciling items represent elimination of inter-segment income and expense
items, and are included to reconcile segment data to the consolidated financial
statements.
32
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2003
12. Segment Information (continued)
Treasury
Three months ended Loan and Reconciling
September 30, 2003: Origination Funding Servicing All Other Items Consolidated
----------- -------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans
Securitizations $ 799 $ - $ - $ - $ - $ 799
Whole loan sales 2,921 - - - - 2,921
Interest income 3,771 7 136 11,109 - 15,023
Non-interest income 605 - 13,219 - (12,366) 1,458
Inter-segment revenues - 18,078 - 4,609 (22,687) -
Operating expenses:
Interest expense 6,723 16,106 (272) 12,339 (18,078) 16,818
Non-interest expense 18,127 1,515 11,296 2,256 - 33,194
Depreciation and amortization 594 16 29 1,123 - 1,762
Securitization assets valuation
adjustments - - - 10,795 - 10,795
Inter-segment expense 16,975 - - - (16,975) -
Income tax expense (benefit) (13,043) 170 875 (4,102) - (16,100)
-------- -------- -------- -------- --------- ---------
Net income (loss) $(21,280) $ 278 $ 1,427 $ (6,693) $ - $ (26,268)
======== ======== ======== ======== ========= =========
Segment assets $216,765 $222,497 $ 96,277 $533,203 $(118,236) $ 950,506
======== ======== ======== ======== ========= =========
Treasury
Three months ended Loan and Reconciling
September 30, 2002: Origination Funding Servicing All Other Items Consolidated
----------- -------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans
Securitizations $ 58,011 $ - $ - $ - $ - $ 58,011
Whole loan sales 35 - - - - 35
Interest income 1,459 169 217 10,747 - 12,592
Non-interest income 2,143 1 10,277 - (8,592) 3,829
Inter-segment revenues - 18,314 - 18,192 (36,506) -
Operating expenses:
Interest expense 5,721 16,819 (36) 12,893 (18,314) 17,083
Non-interest expense 12,289 2,836 9,809 15,521 - 40,455
Depreciation and amortization 848 31 307 525 - 1,711
Securitization assets valuation
adjustments - - - 12,078 - 12,078
Inter-segment expense 26,784 - - - (26,784) -
Income tax expense (benefit) 6,723 (505) 174 (5,073) - 1,319
-------- -------- -------- -------- --------- ---------
Net income (loss) $ 9,283 $ (697) $ 240 $ (7,005) $ - $ 1,821
======== ======== ======== ======== ========= =========
Segment assets $100,400 $204,732 $126,823 $577,653 $ (90,898) $ 918,710
======== ======== ======== ======== ========= =========
33
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, 2003.
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. Through
our principal direct and indirect subsidiaries, we originate, sell and service
home equity, subject to market conditions in the secondary loan market, and
business purpose loans. We also process and purchase home equity loans through
our Bank Alliance Services program.
Our loans primarily consist of fixed interest rate loans secured by
first or second mortgages on one-to-four 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 Philadelphia, Pennsylvania and a small processing center in
Roseland, New Jersey. Our centralized operating office was located in Bala
Cynwyd, Pennsylvania prior to July 7, 2003. Prior to June 30, 2003 we also
originated home equity loans through several retail branch offices. Effective
June 30, 2003, we no longer originate loans through retail branch offices. Our
loan servicing and collection activities are performed at our Bala Cynwyd,
Pennsylvania office, but we expect to relocate these activities to our
Philadelphia office. 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, including funding our operating cash requirements and loan
overcollaterization requirements under our credit facilities.
34
Overview
Current Financial Position and Future Liquidity Issues. On October 24,
2003, we had cash of approximately $32.4 million and up to $437.3 million
available under our new credit facilities described below. We can only use
advances under these new credit facilities to fund loan originations and not for
any other purposes. The combination of our current cash position and expected
sources of operating cash over the second and third quarters of fiscal 2004 may
not be sufficient to cover our operating cash requirements.
For the next three to six months, we intend to augment our sources of
operating cash with proceeds from the issuance of subordinated debt. In addition
to repaying maturing subordinated notes, proceeds from the issuance of
subordinated debt will be used to fund overcollateralization requirements in
connection with our loan originations and fund our operating losses. Under the
terms of our credit facilities, our credit facilities will advance us 75% to 97%
of the value of loans we originate. As a result of this limitation, we must fund
the difference between the loan value and the advances, which we refer to as the
overcollateralization requirement, from our operating cash.
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 continuing operations.
Several recent events negatively impacted our short-term liquidity and
contributed to our losses for fiscal 2003 and the first quarter of fiscal 2004
including our inability to complete our typical publicly underwritten
securitization during the fourth quarter of fiscal 2003. In addition, our
temporary discontinuation of sales of new subordinated debt for approximately a
six week period during the first quarter of fiscal 2004 further impaired our
liquidity.
We incurred operating losses of $29.9 million and $26.3 million for the
year ended June 30, 2003 and the quarter ended September 30, 2003, respectively.
In addition, we anticipate incurring operating losses through at least the third
quarter of fiscal 2004.
As a result of these liquidity issues, since June 30, 2003, we
substantially reduced our loan origination volume. From July 1, 2003 through
September 30, 2003, we originated $124.1 million of loans which represents a
significant reduction as compared to originations of $370.7 million of loans for
the same period in fiscal 2003. As a result of our inability to originate loans
at previous levels, the relationships our subsidiaries have or were developing
with their brokers were adversely impacted and we lost a significant number of
our loan origination employees. We anticipate that we will need to increase our
loan originations to approximately $700.0 million to $800.0 million per quarter
to return to profitable operations. Our short-term plan to achieve these levels
of loan originations includes replacing the loan origination employees we
recently lost and creating an expanded broker initiative described under
"Business -- Business Strategy." Beyond the short-term, we expect to increase
originations through the application of the business strategy adjustments
discussed below. Our ability to achieve those levels of loan originations could
be hampered by our failure to implement
35
our short-term plans and funding limitations expected during the start up of our
new credit facilities. For a detailed discussion of our losses, capital
resources and commitments, see "-- Liquidity and Capital Resources."
Remedial Steps Taken to Address Liquidity Issues. We undertook specific
remedial actions to address short-term liquidity concerns, including entering
into an agreement on June 30, 2003 with an investment bank to sell up to $700.0
million of mortgage loans, subject to the satisfactory completion of the
purchaser's due diligence review and other conditions, and soliciting bids and
commitments from other participants in the whole loan sale market. In total,
from June 30, 2003 through September 30, 2003, we sold approximately $493.3
million (which includes $222.3 million of loans sold by the expired mortgage
conduit facility) of loans through whole loan sales. We are continuing the
process of selling our loans. We also suspended paying quarterly cash dividends
on our common stock.
On September 22, 2003, we entered into definitive agreements with a
financial institution for a new $200.0 million credit facility for the purpose
of funding our loan originations. On October 14, 2003, we entered into
definitive agreements with a warehouse lender for a revolving mortgage loan
warehouse credit facility of up to $250.0 million to fund loan originations. See
"-- Liquidity and Capital Resources -- Credit Facilities" for information
regarding the terms of these facilities and "Risk Factors -- If we are unable to
obtain additional financing, we may not be able to restructure our business to
permit profitable operations or repay our subordinated debt when due."
Although we obtained two new credit facilities totaling $450.0 million,
we may only use the proceeds of these credit facilities to fund loan
originations and not for any other purpose. Consequently, we will have to
generate cash to fund the balance of our business operations from other sources,
such as whole loan sales, additional financings and sales of subordinated debt.
On October 16, 2003, we refinanced through a mortgage warehouse conduit
facility $40.0 million of loans that were previously held in the off-balance
sheet mortgage conduit facility which expired pursuant to its terms in July
2003. We also refinanced an additional $133.5 million of mortgage loans in the
new conduit facility which were previously held in other warehouse facilities,
including the $200.0 million warehouse facility (which had been reduced to $50.0
million) which expired on October 17, 2003 and our $25.0 million warehouse
facility, which expired on October 31, 2003. The more favorable advance rate
under this conduit facility as compared to the expired facilities which
previously held these loans, along with loans fully funded with our cash,
resulted in our receipt of $17.0 million in cash. On October 31, 2003, we
completed a privately-placed securitization of the $173.5 million of loans, with
servicing released, that had been transferred to this conduit facility. The
terms of this conduit facility provide that it will terminate upon the
disposition of the loans in it. See "-- Liquidity and Capital Resources" for
additional information regarding this conduit facility.
To the extent that we fail to maintain our credit facilities or obtain
alternative financing on acceptable terms and increase our loan originations, we
may have to sell loans earlier than intended and further restructure our
operations. While we currently believe that we will be able to restructure our
operations, if necessary, we cannot assure you that such restructuring will
enable us to attain profitable operations or repay the subordinated debt when
due. If we fail to successfully implement our adjusted business strategy, we
36
will be required to consider other alternatives, including raising additional
equity, seeking to convert a portion of our subordinated debt to equity, seeking
protection under federal bankruptcy laws, seeking a strategic investor, or
exploring a sale of the company or some or all of its assets. See "Risk Factors
- -- We depend upon the availability of financing to fund our continuing
operations. Any failure to obtain adequate funding could hurt our ability to
operate profitably and restrict our ability to repay our subordinated debt" and
"-- If we are unable to obtain additional financing, we may be not able to
restructure our business to permit profitable operations or repay our
subordinated debt when due."
Business Strategy Adjustments. Our adjusted business strategy focuses
on a shift from gain-on-sale accounting and the use of securitization
transactions as our primary method of selling loans to a more diversified
strategy which utilizes a combination of whole loan sales and securitizations,
while protecting revenues, controlling costs and improving liquidity. During the
second and third quarters of fiscal 2004, we intend to replace the loan
origination employees we recently lost and create an expanded broker initiative
in order to increase loan originations. See "-- Liquidity and Capital Resources
- -- Business Strategy" for information regarding adjustments to our business
strategy.
If we fail to generate sufficient liquidity through the sales of our
loans, the sale of our subordinated debt, the maintenance of new credit
facilities or a combination of the foregoing, we will have to restrict loan
originations and make additional changes to our business strategy, including
restricting or restructuring our operations which could reduce our profitability
or result in losses and impair our ability to repay the subordinated debt. In
addition, we have historically experienced negative cash flow from operations.
To the extent we fail to successfully implement our adjusted business strategy,
which requires access to capital to originate loans and our ability to
profitably sell these loans, we would continue to experience negative cash flows
from operations which would impair our ability to repay our subordinated debt
and may require us to restructure our operations. See "Risk Factors -- If we are
unable to successfully implement our adjusted business strategy which focuses on
whole loan sales, we may be unable to attain profitable operations which could
impair our ability to repay our subordinated debt."
Credit Facilities, Pooling and Servicing Agreements and Waivers Related
to Financial Covenants. As a result of the loss experienced during fiscal 2003,
we failed to comply with the terms of certain of the financial covenants under
two of our principal credit facilities at June 30, 2003 (one for $50.0 million
and the other for $200.0 million, which was reduced to $50.0 million) and we
requested and obtained waivers of these requirements from our lenders. We
subsequently paid off the $200.0 million credit facility (which had been reduced
to $50.0 million) in the October 16, 2003 refinancing described under
"-- Remedial Steps Taken to Address Liquidity Issues."
We also requested and obtained waivers or amendments to several credit
facilities to address our non-compliance with certain financial covenants and
other requirements as of September 30, 2003 in light of the loss for the first
quarter of fiscal 2004 and our liquidity issues. See "-- Liquidity and Capital
Resources -- Credit Facilities" for additional information regarding the waivers
or amendments obtained.
37
In addition, as a result of our non-compliance at September 30, 2003
with the net worth requirements contained in several of our Pooling and
Servicing Agreements, we requested and obtained waivers of our non-compliance
with these requirements. We received a written waiver from one bond insurer and
a verbal waiver of our non-compliance with a financial covenant (with written
documentation pending) from another bond insurer on several other Pooling and
Servicing Agreements. We cannot assure you that we will be able to obtain this
waiver in writing or whether the terms of the written waiver will impose any
conditions on us. See "Risk Factors -- Our servicing rights may be terminated if
we fail to satisfactorily perform our servicing obligations, or fail to meet
minimum net worth requirements or financial covenants which could hinder our
ability to operate profitably and impair our ability to repay our subordinated
debt."
The terms of our new $200.0 million credit facility, as amended,
require, among other things, that our registration statement registering $295.0
million of subordinated debt be declared effective by the SEC no later than
October 31, 2003 and that we have a minimum net worth of $25.0 million at
October 31, 2003 and November 30, 2003. We obtained a waiver from the lender
under this $200.0 million facility which extends the deadline for our
registration statement to be declared effective by the SEC to November 10, 2003.
This lender also verbally agreed (with written documentation pending) to waive
our required minimum net worth level at October 31, 2003. See "-- Liquidity and
Capital Resources Credit -- Facilities."
Because we anticipate incurring losses through at least the third
quarter of fiscal 2004, we anticipate that we will need to obtain additional
waivers from our lenders and bond insurers as a result of our non-compliance
with financial covenants. We cannot assure you as to whether or in what form we
will obtain these waivers.
Delinquencies; Forbearance and Deferment Arrangements. We experienced
an increase in the total delinquencies in our total managed portfolio to $268.4
million at September 30, 2003 from $229.1 million at June 30, 2003 and $170.8
million at June 30, 2002. Total delinquencies (loans and leases, excluding real
estate owned, with payments past due for more than 30 days) as a percentage of
the total managed portfolio were 9.03% at September 30, 2003 compared to 6.27%
at June 30, 2003 and 5.57% at June 30, 2002.
As the managed portfolio continues to season and if our economy
continues to lag or worsen, the delinquency rate may continue to increase, which
could negatively impact our ability to sell or securitize loans and reduce our
profitability and the funds available to repay our subordinated debt. Continuing
low market interest rates could continue to encourage borrowers to refinance
their loans and increase the levels of loan prepayments we experience which
would negatively impact our delinquency rate.
Delinquencies in our total managed portfolio do not include $222.2
million of previously delinquent loans at September 30, 2003, which are subject
to deferment and forbearance arrangements. Generally, a loan remains current
after we enter into a deferment or forbearance arrangement with the borrower
only if the borrower makes the principal and interest payments as required under
the terms of the original note (exclusive of the delinquent payments advanced or
fees paid by us on borrower's behalf as part of the deferment or forbearance
arrangement) and we do not reflect it as a delinquent loan in our delinquency
statistics. However, if the borrower fails to make principal and interest
payments, we will generally declare the account in default and resume collection
actions.
During the final six months of fiscal 2003, and the first quarter of
fiscal 2004, we experienced a pronounced increase in the number of borrowers
under deferment arrangements than in prior periods. There was approximately
$197.7 million and $222.2 million of cumulative unpaid principal balances under
deferment and forbearance arrangements at June 30, 2003 and September 30, 2003,
respectively, as compared to approximately $138.7 million of cumulative unpaid
principal balance at June 30, 2002. Total cumulative unpaid principal balances
under deferment or forbearance arrangements as a percentage of the total managed
portfolio were 5.41% at June 30, 2003 and 7.47% at September 30, 2003, compared
to 4.52% at June 30, 2002. Additionally, there are loans under deferment and
forbearance arrangements which have returned to delinquent status. At September
30, 2003 there was $39.4 million of cumulative unpaid principal balance under
deferment arrangements and $59.3 million of cumulative unpaid principal balance
under forbearance arrangements that are now reported as delinquent 31 days or
more. See "-- Managed Portfolio Quality -- Deferment and Forbearance
Arrangements."
38
Civil Subpoena from the U.S. Attorney's Office. We received a civil
subpoena, dated May 14, 2003, from the Civil Division of the U.S. Attorney for
the Eastern District of Pennsylvania. The subpoena requests that we provide
certain documents and information with respect to us and our lending
subsidiaries for the period from May 1, 2000 to May 1, 2003: (i) all loan files
in which we entered into a forbearance agreement with a borrower who is in
default; (ii) the servicing, processing, foreclosing, and handling of delinquent
loans and non-performing loans, the carrying, processing and sale of real estate
owned, and forbearance agreements; and (iii) agreements to sell or otherwise
transfer mortgage loans (including, but not limited to, any pooling or
securitization agreements) or to obtain funds to finance the underwriting,
origination or provision of mortgage loans, any transaction in which we sold or
transferred mortgage loans any instance in which we did not service or act as
custodian for a mortgage loan, representations and warranties made in connection
with mortgage loans, secondary market loan sale schedules, and credit loss,
delinquency, default, and foreclosure rates of mortgage loans. We have directed
our attorneys to cooperate fully with this inquiry. To date, we have provided
the U.S. Attorney's Office with an initial set of documents within the scope of
the subpoena. Currently, this inquiry appears to focus on our practices relating
to obtaining forbearance agreements from delinquent borrowers who would
otherwise be subject to foreclosure. Because the inquiry is at a preliminary
stage, we cannot reach any conclusions about the ultimate scope of the inquiry
or the potential liability or financial consequences to us at this time.
To the extent management fails to resolve this matter, the ongoing
review by the U.S. Attorney's Office could limit our ability to engage in
publicly underwritten securitization transactions or otherwise sell or service
our loans. In addition, the U.S. Attorney's inquiry could reduce sales of
subordinated debt upon which we rely to fund our operations and limit our
ability to obtain additional credit facilities, which we need for the
implementation of our business strategy. Furthermore, the U.S. Attorney could
impose sanctions or otherwise restrict our ability to restructure loans, which
could negatively impact our profitability and our ability to repay the
subordinated debt. See "Business -- Regulation."
39
Business Strategy
Our adjusted business strategy focuses on a shift from gain-on-sale
accounting and the use of securitization transactions as our primary method of
selling loans to a more diversified strategy which utilizes a combination of
whole loan sales and securitizations, while protecting revenues, controlling
costs and improving liquidity. In addition, over the next three to six months,
we intend to replace the loan origination employees we recently lost and create
an expanded broker initiative in order to increase loan originations. Our broker
initiative involves significantly increasing the use of loan brokers to increase
loan volume and retaining additional resources in the form of executive
employees to manage the broker program. Our business strategy includes the
following:
Selling substantially all of the loans we originate on at least a
quarterly basis through a combination of securitizations and whole loan
sales. Whole loan sales may be completed on a more frequent basis.
Shifting from a predominantly publicly underwritten securitization
strategy and gain-on-sale business model to a strategy focused on a
combination of whole loan sales and smaller securitization
transactions. Quarterly loan securitization levels will be reduced
significantly from previous levels. Securitizations for the foreseeable
future are expected to be executed as private placements to
institutional investors or publicly underwritten securitizations,
subject to market conditions. Historically, the market for whole loan
sales has provided reliable liquidity for numerous originators as an
alternative to securitization. Whole loan sales provide immediate cash
premiums to us, while securitizations generate cash over time but
generally result in higher gains at the time of sale. We intend to rely
less on gain-on-sale accounting and loan servicing activities for our
revenue and earnings and will rely more on cash premiums earned on
whole loan sales. This strategy is expected to result in relatively
lower earnings levels at current loan origination volumes, but will
increase cash flow, accelerate the timeframe for becoming cash flow
positive and improve our liquidity position. See "--Liquidity and
Capital Resources" for more detail on cash flow.
Broadening our mortgage loan product line and increasing loan
originations. We currently originate primarily fixed-rate loans. Under
our business strategy, we plan to originate adjustable-rate and alt-A
mortgage loans as well as a wide array of fixed-rate mortgage loans in
order to appeal to a broader base of prospective customers and increase
loan originations.
Offering competitive interest rates charged to borrowers on new
products. By offering competitive interest rates charged on new
products, we expect to originate loans with higher credit quality. In
addition, by offering competitive interest rates we expect to appeal to
a wider customer base and substantially reduce our marketing costs,
make more efficient use of marketing leads and increase loan
origination volume.
Reducing origination of the types of loans that are not well received
in the whole loan sale and securitization markets. We intend to reduce
the level of business purpose loans that we will originate, but we will
continue to originate business purpose loans to meet demand in the
whole loan sale and securitization markets. During the first quarter of
fiscal 2004, we did not originate any business purpose loans.
40
Reducing the cost of loan originations. We have implemented plans to:
o eliminate our high cost origination branches;
o reduce the cost to originate in Upland Mortgage by: a)
broadening the product line and offering competitive interest
rates in order to increase origination volume, b) reducing
marketing costs, and c) developing broker relationships;
o reduce the cost to originate in American Business Mortgage
Services, Inc. by increasing volume through a broadening of
the mortgage loan product line and consolidating some of its
operating functions to our centralized operating office in
Philadelphia; and
o reduce the cost to originate in the Bank Alliance Services
program by broadening our product line and increasing the
amount of fees we charge to participating financial
institutions.
Reducing the amount of outstanding subordinated debt. The increase in
cash flow expected under our business strategy is expected to
accelerate a reduction in our reliance on issuing subordinated debt to
meet our liquidity needs and allow us to begin to pay down existing
subordinated debt.
Reducing operating costs. Since June 30, 2003, we reduced our workforce
by approximately 225 employees. With our shift in focus to whole loan
sales, with servicing released, and offering a broader mortgage product
line that we expect will appeal to a wider array of customers, we
currently require a smaller employee base with fewer sales, servicing
and support positions. These workforce reductions represent more than a
20% decrease in staffing levels. In addition, we experienced the loss
of approximately 168 additional employees, a 15% reduction, who have
resigned since June 30, 2003.
Our business strategy is expected to leverage our demonstrated
strengths which include:
o a strong credit culture which consistently originates quality
performing loans;
o long-term broker relationships at American Business Mortgage
Services, Inc.;
o Upland Mortgage brand identity;
o relationships with participating financial institutions in the
Bank Alliance Services program; and
o institutional investors' interest in the bonds issued in our
securitizations.
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 or
sell 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.
41
Legal and Regulatory Considerations
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 reimbursement of fees charged to
borrowers, or will impose fines on us. These changes, if required, could impact
our profitability. These laws and regulations may limit our ability to
securitize loans originated in some 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.
We received a civil subpoena, dated May 14, 2003, from the Civil
Division of the U.S. Attorney for the Eastern District of Pennsylvania. See "--
Overview."
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 on February 13, 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
permitted to charge, including prepayment fees, restricting the terms we are
permitted 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 enact legislation, we are currently
evaluating the potential impact of these legislative initiatives, 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 precludes 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 are required to modify or
eliminate the practice of charging prepayment and other fees in some of the
states where we originate loans. We are continuing to evaluate the impact of the
adoption of the new rule by the Office of Thrift Supervision on our future
lending activities and results of operations. We currently expect that the
percentage of home equity loans containing prepayment fees that we will
originate in the future will decrease to approximately 65% to 70%, from 80% to
85% prior to this rule becoming effective. 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. Although this
New Jersey decision is on appeal to the New Jersey Supreme Court which could
overrule the decision, we are currently evaluating its impact on our future
lending activities in the State of New Jersey and results of operations.
42
We are also subject, from time to time, to private litigation,
including actual and purported class action suits. 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 or otherwise qualified 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,
referred to as GAAP. 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," referred to as SFAS No. 140 in this
document, and "gain-on-sale" accounting to our quarterly loan securitizations.
Gains on sales of loans through securitizations for the three months ended
September 30, 2003 were minimal due to our inability to complete a
securitization of our loans. However, gains on sales of loans through
securitizations for the three months ended September 30, 2002 were 77.9% of
total revenues. Securitization gains represent the difference between the net
proceeds to us, including retained interests in the securitization, and the
allocated cost of loans securitized. The allocated cost of loans securitized is
determined by allocating their net carrying value between the loans, the
interest-only strips and the servicing rights we may retain based upon their
relative fair values. Estimates of the fair values of the interest-only strips
and the servicing rights we may retain are discussed below. We believe the
accounting estimates related to gain on sale are critical accounting estimates
because more than 80% of the securitization gains in fiscal 2003 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.
43
Interest-Only Strips. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 57.4% of our
total assets at September 30, 2003 and 51.6% of our total assets at June 30,
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. We
re-evaluate expected future cash flows from our interest-only strips on a
quarterly basis. We monitor the current assumptions for prepayment and credit
loss rates against actual experience and other economic and market conditions
and we adjust assumptions 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 on issue 99-20, "Recognition
of Interest Income and Impairment on Purchased and Retained Beneficial Interests
in Securitized Financial Assets," referred to as EITF 99-20 in this document,
and SFAS No. 115 "Accounting for Certain Investments in Debt and Equity
Securities," referred to as SFAS No. 115 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.
During the three months ended September 30, 2003, we recorded total
pre-tax valuation adjustments on our interest only-strips of $15.8 million, of
which, in accordance with EITF 99-20, $9.9 million was charged to the income
statement and $5.9 million was charged to other comprehensive income. The
valuation adjustment reflects the impact of higher than anticipated prepayments
on securitized loans experienced in the quarter ended September 30, 2003 due to
the continuing low interest rate environment. 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.
44
Servicing Rights. Servicing rights, which represent the rights to
receive contractual servicing fees from securitization trusts and ancillary fees
from borrowers, net of adequate compensation that would be required by a
substitute servicer, represented 11.1% of our total assets at September 30, 2003
and 10.3% of our total assets at June 30, 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. We monitor the current
assumptions for prepayment and credit loss rates against actual experience and
other economic and market conditions and we adjust assumptions 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.
During the three months ended September 30, 2003, we recorded total
pre-tax valuation adjustments on our servicing rights of $0.8 million, which was
charged to the income statement. The valuation adjustment reflects the impact of
higher than anticipated prepayments on securitized loans experienced in the
first quarter of fiscal 2004 due to the continuing low interest rate
environment. 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 estimated
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 three months ended September 30, 2003, our
valuation analysis indicated that valuation adjustments of $0.8 million were
required for impairment of servicing rights due to higher than expected
prepayment experience. The write down was recorded in the income statement.
Impairment is measured as the excess of carrying value over fair value.
45
Allowance for Loan and Lease Losses. The allowance for loan and lease
losses is maintained primarily to account for loans and leases that are
delinquent and are expected to be ineligible for sale into a future
securitization and for delinquent loans that have been repurchased from
securitization trusts. The allowance is calculated based upon management's
estimate of our ability to collect on outstanding loans and leases based upon a
variety of factors, including, periodic analysis of the available for sale loans
and leases, economic conditions and trends, historical credit loss experience,
borrowers' ability to repay, and collateral considerations. Additions to the
allowance arise from the provision for credit losses charged to operations or
from the recovery of amounts previously charged-off. Loan and lease charge-offs
reduce the allowance. If the actual collection of outstanding loans and leases
is less than we anticipate, further write downs would be required which would
reduce our net income in the period the write down was required.
Development of Critical Accounting Estimates. On a 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 September 30, 2003 with the Audit Committee of our
Board of Directors. In addition, management has reviewed its disclosure of the
estimates discussed 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 impact of changes in critical accounting estimates in the three months
ended September 30, 2003, see "-- 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 amortized 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.
Impact of Changes in Critical Accounting Estimates in Prior Fiscal
Years.
Discount rates. During fiscal 2003, we recorded total pre-tax valuation
adjustments on our securitization assets of $63.3 million, of which $45.2
million was charged to the income statement and $18.1 million was charged to
other comprehensive income. The breakout of the total adjustments in fiscal 2003
between interest-only strips and servicing rights and the amount of the
adjustments related to changes in discount rates were as follows:
46
o We recorded total pre-tax valuation adjustments on our
interest only-strips of $58.0 million, of which $39.9 million
was charged to the income statement and $18.1 million was
charged to other comprehensive income. The valuation
adjustment reflects the impact of higher than anticipated
prepayments on securitized loans experienced in fiscal 2003
due to the low interest rate environment experienced during
fiscal 2003, which has impacted the entire mortgage industry.
The valuation adjustment on interest-only strips for fiscal
2003 was reduced by a $20.9 million favorable valuation impact
as a result of reducing the discount rates applied in valuing
the interest-only strips at June 30, 2003. The amount of the
valuation adjustment charged to the income statement was
reduced by a $10.8 million favorable valuation impact as a
result of reducing the discount rates and the charge to other
comprehensive income was reduced by $10.1 million for the
favorable impact of reducing discount rates. The discount
rates were reduced at June 30, 2003 primarily to reflect the
impact of the sustained decline in market interest rates. The
discount rate on the projected residual cash flows from our
interest-only strips was reduced from 13% to 11% at June 30,
2003. The discount rate used to determine the fair value of
the overcollateralization portion of the cash flows from our
interest-only strips was minimally impacted by the decline in
interest rates and remained at 7% on average. As a result, the
blended rate used to value our interest-only strips, including
the overcollateralization cash flows, was 9% at June 30, 2003.
o We recorded total pre-tax valuation adjustments on our
servicing rights of $5.3 million, which was charged to the
income statement. The valuation adjustment reflects the impact
of higher than anticipated prepayments on securitized loans
experienced in fiscal 2003 due to the low interest rate
environment experienced during fiscal 2003. The valuation
adjustment on servicing rights for fiscal 2003 was reduced by
a $7.1 million favorable valuation impact as a result of
reducing the discount rate applied in valuing the servicing
rights at June 30, 2003. The discount rate was reduced at June
30, 2003 primarily to reflect the impact of the sustained
decline in market interest rates. The discount rate on our
servicing rights was reduced from 11% to 9% at June 30, 2003.
During fiscal 2000, a write down of $12.6 million was recorded on our
interest-only strips, of which $11.2 million was due to a change in the discount
rate used to value our interest-only strips. At June 30, 2000, we increased the
discount rate applicable to the residual portion of our interest-only strips
from 11% to 13%. No changes were made in the discount rate used to determine the
fair value of the overcollateralization portion of the cash flows from our
interest-only strips. The change in the discount rate was considered to be an
other than temporary fair value adjustment and was recorded as expense in fiscal
2000. The factors that led to this other than temporary decline in fair value of
our interest-only strips included:
o sustained increase in market interest rates through the fourth
quarter of fiscal 2000;
o increases in the all-in cost of our mortgage loan trust
investor certificates from September 1998 through June 2000;
o increases in the cost of funding our interest-only strips,
particularly the interest rate paid on subordinated debt; and
o events and conditions in the mortgage lending industry and the
actions by others in that industry.
47
Prepayment rates. During the nine-month period ended October 1998, the
percentage of home equity loans that we originated containing prepayment fees
increased from less than 50% of loans originated to over 85%, a percentage which
has been maintained since that time. Due to this increase in the volume of loans
originated with prepayment fees, we had reduced the initial annual prepayment
rate assumption on business loans and lengthened the initial assumptions used
for the prepayment ramp period on home equity loans from 12 to 18 months
beginning with the 1999-1 mortgage loan securitization through the 2000-1
mortgage loan securitization and to 24 months beginning with the 2000-2 mortgage
loan securitization. Our experience indicated that when a loan has a prepayment
fee provision, fewer borrowers will prepay, and those prepaying will do so more
slowly. Our actual cumulative prepayment experience through March 31, 2000
demonstrated that only 25% of home equity loans having prepayment fees were
actually prepaid by the borrowers, while 47% of home equity loans without
prepayment fees were prepaid. This cumulative historical performance
demonstrates that it was nearly twice as likely that a loan without a prepayment
fee would be prepaid. The effect of these changes in prepayment rate assumptions
increased the gains on securitizations for fiscal 2000.
In the third quarter of fiscal 2001, we evaluated our accumulated
experience with pools of loans that had a high percentage of loans with
prepayment fees. We had begun using a static pool analysis of prepayments,
whereby we analyzed historical prepayments by period, to determine average
prepayments expected by period. For business purpose loans, we found that
prepayments for the first year are generally lower than we had anticipated, peak
at a higher rate than previously anticipated by month 24 and decline by month
40. Home equity loan prepayments generally ramped faster in the first year than
we had anticipated but leveled more slowly over 30 months and to a lower final
rate than we had been using previously. We utilized this information to modify
our loan prepayment rates and ramp periods to better reflect the amount and
timing of expected prepayments. The effect of these changes implemented in the
third quarter of fiscal 2001 was a net reduction in the value of our
interest-only strips of $3.1 million or less than 1% and an insignificant net
impact on securitization gains for fiscal 2001. The effect on the interest-only
strips of this change in assumptions was recorded through an adjustment to
comprehensive income.
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. See"--
Off-Balance Sheet Arrangements -- Securitizations" for discussion of the impacts
of these increases in prepayment rate assumptions.
Credit loss rates. In fiscal 2000, the initial credit loss assumptions
beginning with the 1999-4 mortgage loan securitization were increased as a
result of an increase in the percentage of second mortgage loans originated and
our concerns regarding high levels of real estate values. The average percentage
of first mortgage loans securitized had declined approximately 10% from the
fiscal 1999 securitizations to the fiscal 2000 securitizations. High real estate
values also affected our loss assumptions because in the event of an economic
downturn, the loan-to-value ratios of the loans could be understated. Both of
these factors increased the potential that the underlying real estate collateral
would not be sufficient to satisfy the loan if a foreclosure were required.
Although our percentage of first mortgages has subsequently increased, we
believe real estate values may limit our ability to maintain the credit loss
experience realized in prior securitizations. The effect of these changes in
credit loss assumptions reduced the gains on securitizations in fiscal 2000 by
approximately $1.7 million.
48
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.
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, in part, 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 relevant agreement.
In each securitization, we also may 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 covenants
or 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 and after payment of certain fees and expenses provides 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.
49
We may retain the rights to service the loans we sell through
securitizations. If we retain the servicing rights, 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 on a mortgage loan from our
operating cash can be recovered from the subsequent mortgage loan payments to
the applicable trust prior to any distributions to the certificate holders.
At September 30, 2003 and June 30, 2003, the mortgage securitization
trusts held loans with an aggregate principal balance due of $2.8 billion and
$3.4 billion as assets and owed $2.6 billion and $3.2 billion to third party
investors, respectively. Revenues from the sale of loans to securitization
trusts were $0.8 million, or 4.0% of total revenues for the three months ended
September 30, 2003 and $58.0 million, or 77.9% of total revenues for the three
months ended September 30, 2002. The revenues for the three months ended
September 30, 2002 are net of $1.7 million of expenses for underwriting fees,
legal fees and other expenses associated with securitization transactions during
that period. We have interest-only strips and servicing rights with fair values
of $545.6 million and $106.1 million, respectively at September 30, 2003, which
represent 57.4% of our total assets. Cash flows received from interest-only
strips and servicing rights were $61.6 million for the three months ended
September 30, 2003 and $26.5 million for the three months ended September 30,
2002. These amounts are included in our operating cash flows.
We also used special purpose entities in our sales of loans to a $300.0
million off-balance sheet mortgage conduit facility. Sales into the off-balance
sheet facility involved a two-step transfer that qualified for sale accounting
under SFAS No. 140, similar to the process described above. This facility had a
revolving feature and could be directed by the third party sponsor to dispose of
the loans. Typically, the loans were disposed of by securitizing the loans in a
term securitization. The third party note purchaser also has the right to have
the loans sold in whole loan sale transactions. 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 were treated as sales for financial
reporting purposes. When loans were sold to this facility, we assessed the
likelihood that the sponsor would transfer the loans into a term securitization.
As the sponsor had typically transferred the loans to a term securitization
prior to the fourth quarter of fiscal 2003, the amount of gain on sale we had
recognized for loans sold to this facility was estimated based on the terms we
would obtain in a term securitization rather than the terms of this facility.
For the fourth quarter of fiscal 2003, the likelihood that the facility sponsor
would ultimately transfer the underlying loans to a term securitization was
significantly reduced and the amount of gain recognized for loans sold to this
facility was based on terms expected in a whole loan sale transaction. Our
ability to sell loans into this facility expired pursuant to its terms on July
5, 2003. At June 30, 2003, the off-balance sheet mortgage conduit facility held
loans with principal balances due of $275.6 million as assets and owed $267.5
million to third parties. Through September 30, 2003, $222.3 million of the
loans in the facility at June 30, 2003 were sold in whole loan sales as directed
by the facility sponsor. At September 30, 2003, the off-balance sheet mortgage
conduit facility held loans with principal balances due of $40.5 million as
assets and owed $36.0 million to third parties. This conduit facility was
refinanced in the October 16, 2003 refinancing described under "--Liquidity and
Capital Resources--Credit Facilities."
50
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 in public or private offerings. The
difference between the weighted-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 after payment of certain fees
and expenses and subject to certain conditions 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 may 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.
Declines in securitization pass-through interest rates resulted in
interest rate spreads improving by approximately 235 basis points from the
fourth quarter of fiscal 2000 securitization, to our most recent securitization
in the third quarter of fiscal 2003. Increased interest rate spreads resulted in
increases in the residual cash flow we expect to receive on securitized loans,
the amount we received at the closing of a securitization from the sale of
notional bonds or premiums on investor certificates 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
or that we can complete securitizations in the future. However, in a rising
interest rate environment and under our business strategy we would expect our
ability to originate loans at interest rates that will maintain our most recent
level of securitization gain profitability to become more difficult than during
a stable or falling interest rate environment. 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.
A rising interest rate environment could unfavorably impact our
liquidity and capital resources. Rising interest rates could impact our
short-term liquidity by limiting our ability to sell loans at favorable premiums
in whole loan sales, 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. These effects may be offset to some degree 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.
51
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 eight 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
eight quarters we have recorded cumulative pre-tax write downs to our
interest-only strips in the aggregate amount of $138.8 million and pre-tax
adjustments to the value of servicing rights of $13.2 million, for total
adjustments of $152.0 million, mainly due to our higher than expected prepayment
experience. Of this amount, $95.9 million was expensed through the income
statement and $56.1 million resulted in a write down through other comprehensive
income, a component of stockholders' equity.
During the three months ended September 30, 2003, we recorded total
pre-tax valuation adjustments on our securitization assets of $16.7 million, of
which $10.8 million was charged to the income statement and $5.9 million was
charged to other comprehensive income. The breakout of the total adjustments in
the first three months of fiscal 2004 between interest-only strips and servicing
rights was a follows:
o We recorded total pre-tax valuation adjustments on our
interest only-strips of $15.8 million, of which, in accordance
with EITF 99-20, $9.9 million was charged to the income
statement and $5.9 million was charged to other comprehensive
income. The valuation adjustment reflects the impact of higher
than anticipated prepayments on securitized loans experienced
in the first quarter of fiscal 2004 due to the continuing low
interest rate environment.
o We recorded total pre-tax valuation adjustments on our
servicing rights of $0.8 million, which was charged to the
income statement. The valuation adjustment reflects the impact
of higher than anticipated prepayments on securitized loans
experienced in the first quarter of fiscal 2004 due to the
continuing low interest rate environment.
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 September 15, 2003 that mortgage refinancings as a percentage share of total
mortgage originations will decline from 71% in the first quarter of calendar
2003 to 39% in the first quarter of calendar 2004 and to 25% in the second
quarter of calendar 2004. The Mortgage Bankers Association of America has also
projected in its September 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.
52
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 and EITF 99-20 as they relate to interest-only strips and SFAS No. 140 as it
relates to servicing rights (in thousands):
Fiscal Year 2004:
- -----------------
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- --------------------------- ---------- --------- -------------
September 30, 2003......... $ 16,658 $ 10,795 $ 5,863
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
June 30, 2003.............. 13,293 11,879 1,414
---------- --------- -----------
Total Fiscal 2003.......... $ 63,255 $ 45,182 $ 18,073
========== ========= ===========
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.
53
The following table summarizes the volume of loan securitizations and
whole loan sales for the three months ended September 30, 2003 and 2002 (dollars
in thousands):
Three Months Ended
September 30,
--------------------
Securitizations: 2003 2002
------ ------
Business loans............................... $ 1,207 $ 29,998
Home equity loans............................ 4,245 336,410
-------- ---------
Total........................................ $ 5,452 $ 366,408
======== =========
Gain on sale of loans through
securitization........................... $ 799 $ 58,011
Securitization gains as a percentage of
total revenue............................ 4.0% 77.9%
Whole loan sales............................. $270,979 $ 1,537
Gains on whole loan sales.................... $ 2,921 $ 34
As demonstrated in the fourth quarter of fiscal 2003 and the first
quarter of fiscal 2004, our quarterly revenues and net income will fluctuate in
the future principally as a result of the timing, size and profitability of our
securitizations. The business strategy of selling loans through securitizations
and whole loan sales 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 or whole loan sale is settled, which may not
occur until a subsequent quarter, operating results for a given quarter can
fluctuate significantly. If securitizations or whole loan sales 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 and whole loan sales 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.
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 credit enhancement 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 aggregate principal balance of investor
interests. Overcollateralization requirements are established to provide credit
enhancement for the trust investors.
54
The overcollateralization requirements for a mortgage loan
securitization are different for each securitization and include:
(1) The initial requirement, if any, which is a percentage of the
original unpaid principal balance of loans securitized and is
paid in cash at the time of sale;
(2) The final target, which is a percentage of the original unpaid
principal 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, which is a percentage of the
remaining unpaid principal balance of securitized loans.
During the stepdown period, the overcollateralization amount
is gradually reduced through cash payments to us until the
overcollateralization balance declines to a specific floor.
The stepdown period generally begins at the later of 30 to 36
months after the initial securitization of the loans or when
the remaining balance of securitized loans is less than 50% of
the original balance of securitized loans.
The fair value of our interest-only strips is a combination of the fair
values of our residual cash flows and our overcollateralization cash flows. At
September 30, 2003, investments in interest-only strips totaled $545.6 million,
including the fair value of overcollateralization related cash flows of $263.5
million.
Trigger Management. Repurchasing delinquent loans from securitization
trusts 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.
55
At September 30, 2003, seven of our 25 mortgage securitization trusts
were under a triggering event as a result of delinquencies exceeding specified
levels, losses exceeding specified levels, or both. At June 30, 2003, none of
our 25 mortgage securitization trusts were under a triggering event.
Approximately $3.4 million of excess overcollateralization is being held by the
seven trusts as of September 30, 2003. For the fiscal three months ended
September 30, 2003, we repurchased delinquent loans with an aggregate unpaid
principal balance of $16.3 million from securitization trusts primarily for
trigger management. We cannot predict when the seven trusts currently exceeding
triggers will be below trigger limits and release the excess
overcollateralization. If 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.
The following table summarizes the principal balances of loans and REO
we have repurchased from the mortgage loan securitization trusts during the
first quarter of fiscal 2004 and fiscal years 2003 and 2002. We received $7.6
million, $37.6 million and $19.2 million of proceeds from the liquidation of
repurchased loans and REO for the three months ended September 30, 2003 and for
fiscal years 2003 and 2002, respectively. We carried as assets on our balance
sheet, repurchased loans and REO in the amounts of $14.3 million, $9.6 million
and $9.4 million at September 30, 2003 and June 30, 2003 and 2002, 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, we generally incur a loss on these repurchases. Mortgage loan
securitization trusts are listed only if repurchases have occurred.
56
Summary of Loans and REO Repurchased from Mortgage Loan Securitization Trusts
(dollars in thousands)
2003-1 2001-3 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1 1999-4 1999-3
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Three months ended September 30,
2003:
Business loans................ $ 219 $ -- $ 603 $ -- $ 73 $ -- $ 921 $ 815 $ 644 $ 258
Home equity loans............. -- -- 748 -- 266 560 1,640 2,658 938 598
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Total....................... $ 219 $ -- $1,351 $ -- $ 339 $ 560 $2,561 $3,473 $ 1,582 $ 856
====== ====== ====== ====== ====== ====== ====== ====== ======= ======
% of Original Balance of Loans
Securitized................... 0.05% -- 0.38% -- 0.12% 0.37% 0.85% 1.47% 0.71% 0.39%
Number of loans repurchased... 1 -- 12 -- 6 9 31 52 24 11
Year ended June 30, 2003:
Business loans................ $ -- $ 349 $ -- $ 543 $ 223 $ 144 $2,065 $1,573 $ 2,719 $2,138
Home equity loans................ -- 853 -- 4,522 520 839 4,322 4,783 5,175 3,697
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Total..........................$ -- $1,202 $ -- $5,065 $ 743 $ 983 $6,387 $6,356 $ 7,894 $5,835
====== ====== ====== ====== ====== ====== ====== ====== ======= ======
% of Original Balance of Loans
Securitized................... -- 0.40% -- 1.84% 0.27% 0.66% 2.11% 2.68% 3.56% 2.63%
Number of loans repurchased... -- 11 -- 51 9 11 59 65 97 83
Year ended June 30, 2002:
Business loans................ $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 194 1,006
Home equity loans............. -- -- -- -- -- -- -- 84 944 3,249
------ ------ ------ ------ ------ ------ ------ ------ ------- ------
Total....................... $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 84 $ 1,138 $4,255
====== ====== ====== ====== ====== ====== ====== ====== ======= ======
% of Original Balance of Loans
Securitized................... -- -- -- -- -- -- -- 0.04% 0.51% 1.92%
Number of loans repurchased... -- -- -- -- -- -- -- 2 18 47
(Continued)
1999-2 1999-1 1998-4 1998-3 1998-2 1998-1 1997(a) 1996(a) Total
------ ------ ------ ------ ------ ------ ------ ------ -------
Three months ended September 30,
2003:
Business loans................ $ 608 $ 113 $ 40 $ 18 $ -- $ -- $ 68 $ -- $ 4,380
Home equity loans............. 2,478 951 587 307 -- 62 170 -- 11,963
------ ------ ------ ------ ------ ------ ------ ------ -------
Total....................... $3,086 $1,064 $ 627 $ 325 $ -- $ 62 $ 238 $ -- $16,343
====== ====== ====== ====== ====== ====== ====== ====== =======
% of Original Balance of Loans
Securitized................... 1.40% 0.58% 0.78% 0.16% 0.00% 0.06% 0.14% --
Number of loans repurchased... 36 14 9 4 -- 1 5 -- 215
Year ended June 30, 2003:
Business loans................ $1,977 $1,199 $ 72 $1,455 $ 205 $ 395 $ 744 $ 451 $16,252
Home equity loans............. 3,140 4,432 549 3,211 1,386 610 381 355 38,775
------ ------ ------ ------ ------ ------ ------ ------ -------
Total....................... $5,117 $5,631 $ 621 $4,666 $1,591 $1,005 $1,125 $ 806 $55,027
====== ====== ====== ====== ====== ====== ====== ====== =======
% of Original Balance of Loans
Securitized................... 2.33% 3.04% 0.78% 2.33% 1.33% 0.96% 0.64% 1.30%
Number of loans repurchased... 59 60 7 60 23 13 16 13 637
Year ended June 30, 2002:
Business loans................ $ 341 $ 438 $ 632 $ 260 $ 516 $1,266 $1,912 $ 104 $ 6,669
Home equity loans............. 2,688 2,419 4,649 5,575 1,548 1,770 462 183 23,571
------ ------ ------ ------ ------ ------ ------ ------ -------
Total....................... $3,029 $2,857 $5,281 $5,835 $2,064 $3,036 $2,374 $ 287 $30,240
====== ====== ====== ====== ====== ====== ====== ====== =======
% of Original Balance of Loans
Securitized................... 1.38% 1.54% 6.60% 2.92% 1.72% 2.89% 1.36% 0.46%
Number of loans repurchased... 31 33 58 61 24 37 26 4 341
- ---------------
(a) Amounts represent combined repurchases and percentages for two 1997
securitization pools and two 1996 securitization pools.
57
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 September 30, 2003 balance sheet a liability of $29.0 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.
58
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 September 30, 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.......................... $ 30 $ 26 $ 29 $ 28 $ 24 $ 21 $ 21 $ 25 $ 17 $ 14
Home equity loans....................... 388 294 241 217 161 138 121 126 91 82
------- ------ ------- ------ ------- ------ ------ ------ ------- ------
Total................................... $ 418 $ 320 $ 270 $ 245 $ 185 $ 159 $ 142 $ 151 $ 108 $ 96
======= ====== ======= ====== ======= ====== ====== ====== ======= ======
Weighted-average interest rate on loans
securitized:
Business loans.......................... 15.88% 16.01% 15.97% 16.00% 15.78% 15.79% 15.95% 15.97% 16.03% 16.11%
Home equity loans....................... 9.74% 10.50% 10.84% 10.91% 10.86% 10.71% 11.09% 11.22% 11.44% 11.61%
Total................................... 10.18% 10.95% 11.39% 11.50% 11.50% 11.37% 11.82% 11.99% 12.17% 12.26%
Percentage of first mortgage loans......... 87% 87% 87% 87% 90% 90% 89% 90% 89% 86%
Weighted-average loan-to-value............. 77% 76% 77% 76% 75% 77% 76% 76% 75% 76%
Weighted-average remaining term (months) on
loans securitized...................... 265 257 249 235 228 228 219 215 213 203
Original balance of Trust Certificates..... $ 450 $ 376 $ 370 $ 380 $ 320 $ 322 $ 306 $ 355 $ 275 $ 275
Current balance of Trust Certificates...... $ 408 $ 304 $ 257 $ 231 $ 171 $ 146 $ 130 $ 135 $ 98 $ 84
Weighted-average pass-through interest rate
to Trust Certificate holders(a)........ 5.03% 5.94% 7.09% 7.92% 7.32% 5.35% 5.74% 8.41% 7.91% 7.05%
Highest Trust Certificate pass-through
interest rate.......................... 3.78% 8.61% 6.86% 7.39% 6.51% 5.35% 6.17% 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........... $ 10 $ 16 $ 11 $ 13 $ 14 $ 13 $ 12 $ 16 $ 10 $ 12
Final target reached or anticipated
date to reach........................ 10/2004 3/2004 9/2003 Yes Yes Yes Yes Yes(c) Yes(c) Yes
Stepdown reached or anticipated date to
reach................................ 7/2006 2/2006 10/2005 7/2005 10/2004 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......................... $ 15 $ 11 $ 10 $ 10 $ 8 $ 7 $ 6 $ 7 $ 5 $ 5
- -------------
(a) Rates for securitizations 2001-2 and forward include rates on notional
bonds, or the impact of premiums to loan collateral received on trust
certificates, included in securitization structure. The sale of notional
bonds allows us to receive more cash at the closing of a securitization. See
"-- Three months ended September 30, 2003 Compared to Three months ended
September 30, 2002 -- Gain on Sale of Loans - Securitizations" 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 cannot predict when normal residual cash flow will
resume. See "--Trigger Management" for further detail.
59
Summary of Selected Mortgage Loan Securitization Trust Information (Continued)
Current Balances as of September 30, 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.......................... $ 7 $ 13 $ 10 $ 10 $ 10 $ 10 $ 6 $ 13 $ 9 $ 5
Home equity loans....................... 43 82 59 63 60 61 49 99 18 4
------- ------ ------- ------ ------- ------ ------ ------ ------- ------
Total................................... $ 50 $ 95 $ 69 $ 73 $ 70 $ 71 $ 55 $ 112 $ 27 $ 9
======= ====== ======= ====== ======= ====== ====== ====== ======= ======
Weighted-average interest rate on loans
securitized:
Business loans.......................... 16.07% 16.07% 16.01% 16.08% 15.75% 15.73% 15.96% 15.74% 15.91% 15.89%
Home equity loans....................... 11.44% 11.42% 11.34% 11.03% 10.83% 10.49% 10.65% 10.81% 11.56% 11.06%
Total................................... 12.10% 12.07% 12.04% 11.72% 11.56% 11.26% 11.18% 11.38% 12.96% 13.84%
Percentage of first mortgage loans......... 90% 84% 80% 86% 87% 89% 93% 90% 79% 77%
Weighted-average loan-to-value............. 76% 76% 77% 76% 77% 76% 77% 76% 75% 65%
Weighted-average remaining term (months) on
loans Securitized........................ 202 210 198 196 200 207 205 189 145 105
Original balance of Trust Certificates..... $ 150 $ 300 $ 235 $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61
Current balance of Trust Certificates...... $ 44 $ 84 $ 61 $ 65 $ 62 $ 64 $ 49 $ 100 $ 23 $ 6
Weighted-average pass-through interest rate
to Trust Certificate holders............. 7.61% 7.05% 7.03% 6.84% 6.75% 6.62% 6.56% 6.33% 7.17% 7.67%
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........... $ 6 $ 11 $ 8 $ 8 $ 8 $ 7 $ 6 $ 12 $ 4 $ 3
Final target reached or anticipated
date to reach........................ Yes(b) Yes Yes Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date
to reach............................. 10/2003 Yes Yes Yes Yes(b) Yes Yes(b) Yes(b) 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......................... $ 2 $ 4 $ 3 $ 3 $ 3 $ 2 $ 2 $ 2 $ 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 the final target has been reached, this trust is exceeding
delinquency limits, and the trust is retaining additional
overcollateralization. We cannot predict when normal residual cash flow will
resume. 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.
60
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.
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.
At September 30, 2003, we applied a discount rate of 11% to the
estimated residual cash flows. In determining the discount rate that we apply to
residual cash flows, we follow what we believe to be the practice of other
companies in the non-conforming mortgage industry. That is, to determine the
discount rate by adding an interest rate spread to the all-in cost of
securitizations to account for the risks involved in securitization assets. 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. Trustee fees and surety fees,
where applicable, generally range from 19 to 22 basis points combined. From
industry experience comparisons and our evaluation of the risks inherent in our
securitization assets, we have determined an interest rate spread, which is
added to the all-in cost of our mortgage loan securitization trusts' investor
certificates. From June 30, 2000 through March 31, 2003, we had applied a
discount rate of 13% to residual cash flows. On June 30, 2003, we reduced that
discount rate to 11% based on the following factors:
o We have experienced a period of sustained decreases in market
interest rates. Interest rates on three and five-year term US
Treasury securities have been on the decline since mid-2000.
Three-year rates have declined approximately 475 basis points and
five-year rates have declined approximately 375 basis points.
o The interest rates on the bonds issued in our securitizations over
this same timeframe also have experienced a sustained period of
decline. The highest trust certificate pass-through interest rate
has declined 426 basis points, from 8.04% in the 2000-2
securitization to 3.78% in the 2003-1 securitization.
o The weighted average interest rate on loans securitized has
declined from a high of 12.01% in the 2000-3 securitization to
10.23% in the 2003-1 securitization.
o Market factors and the economy favor the continuation of low
interest rates for the foreseeable future.
o Economic analysis of interest rates and data currently being
released support declining mortgage refinancings even though
predicting the continuation of low interest rates for the
foreseeable future.
o The interest rates paid on recently issued subordinated debt,
which is used to fund our interest-only strips, has declined from
a high of 11.85% in February 2001 to a current rate of 7.49% in
June 2003.
61
However, because the discount rate is applied to projected cash flows,
which consider expected prepayments and losses, the discount rate assumption was
not evaluated in isolation. These risks involved in our securitization assets
were considered in establishing a discount rate. The impact of this reduction in
discount rate from 13% to 11% was to increase the valuation of our interest-only
strips by $17.6 million at June 30, 2003. The 11% 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 historically 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 At origination, approximately 90% to 95% of securitized business
purpose loans have prepayment fees and approximately 80% to 85% of
securitized home equity loans have prepayment fees. Currently in
our managed portfolio, approximately 50% to 55% of securitized
business purpose loans have prepayment fees and approximately 60%
to 65% 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.
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% on overcollateralization cash flows. At June 30,
2003 we reduced the minimum discount rate to 5.0% to reflect the sustained
decline in interest rates. This reduction in the minimum discount rate impacted
the valuation of three securitizations and increased the June 30, 2003 and
September 30, 2003 valuation of our interest-only strips by $3.3 million. At
June 30, 2003 and September 30, 2003, the average discount rate applied to
projected overcollateralization cash flows was 7%. This discount rate is lower
than the discount rate applied to residual cash flows because 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.
Overcollateralization represents our investment in the excess of the aggregate
principal balance of loans in a securitized pool over the aggregate principal
balance of trust certificates.
62
The blended discount rate used to value the interest-only strips,
including the overcollateralization cash flows, was 9% at September 30, 2003 and
June 30, 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 seven quarters, our actual
prepayment experience was generally higher, most significantly on home equity
loans, than our historical averages for prepayments. See "-- Off-Balance Sheet
Arrangements -- 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.
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.
63
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.............................$ 2,765,929
Balance sheet carrying value of retained interests (a).....$ 651,656
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............................... $ 27,927 $ 53,423
Credit loss rate............................... 4,987 9,974
Floating interest rate certificates (a)........ 790 1,524
Discount rate.................................. 18,103 35,318
- ---------------
(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.
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."
64
The following tables provide information regarding the initial and
current assumptions applied in determining the fair values of mortgage loan
related interest-only strips and servicing rights for each securitization trust.
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at September 30, 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....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Interest-only strip overcollateralization
discount rate:
Initial valuation....................... 7% 9% 7% 7% 7% 7% 7% 7% 6% 7%
Current valuation....................... 5% 9% 7% 7% 7% 5% 6% 7% 6% 7%
Servicing rights discount rate:
Initial valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation....................... 9% 9% 9% 9% 9% 9% 9% 9% 9% 9%
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........................ 9% 11% 13% 16% 18% 20% 22% 21% 18% 15%
Home equity loans..................... 27% 36% 39% 39% 39% 39% 42% 46% 47% 36%
Current prepayment experience (c):
Business loans........................ 13% 15% 19% 20% 23% 23% 12% 13% 31% 31%
Home equity loans..................... 12% 25% 38% 46% 44% 46% 41% 44% 40% 37%
Annual credit loss rates:
Initial assumption...................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Current assumption...................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.50% 0.40%
Actual experience....................... -- -- 0.04% 0.05% 0.10% 0.17% 0.26% 0.18% 0.46% 0.38%
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.
65
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at September 30, 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....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Interest-only strip overcollateralization
discount rate:
Initial valuation....................... 8% 8% 8% 8% 7% 7% 7% 7% 7% 8%
Current valuation....................... 8% 8% 8% 8% 7% 7% 7% 7% 7% 8%
Servicing rights discount rate:
Initial valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%
Current valuation....................... 9% 9% 9% 9% 9% 9% 9% 9% 9% 9%
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% 15% 10%
Home equity loans..................... 22% 22% 22% 22% 22% 22% 22% 23% 22% 20%
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........................ 12% 31% 25% 20% 18% 28% 25% 17% 15% 10%
Home equity loans..................... 33% 42% 42% 31% 32% 36% 29% 36% 22% 20%
Current prepayment experience (c):
Business loans........................ 22% 31% 27% 31% 17% 28% 18% 18% 19% 6%
Home equity loans..................... 36% 45% 41% 31% 34% 38% 30% 36% 32% 23%
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...................... 0.50% 0.45% 0.65% 0.70% 0.65% 0.35% 0.55% 0.60% 0.40% 0.45%
Actual experience....................... 0.43% 0.43% 0.62% 0.65% 0.60% 0.38% 0.49% 0.55% 0.35% 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. 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
66
Servicing Rights. As the holder of servicing rights on securitized
loans, we are entitled to receive annual contractual servicing fees of 50 basis
points (70 basis points in the case of the 2000-4 securitization) 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 funds 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, we evaluate capitalized servicing rights for impairment, which
is measured as the excess of unamortized cost over fair value. See
"--Application of Critical Accounting Policies -- Servicing Rights" for a
discussion of the $0.8 million write down of servicing rights recorded in the
first quarter of fiscal 2004 and "--Application of Critical Accounting Policies
- -- Impact of Changes in Critical Accounting Estimates in Prior Fiscal Years" for
a discussion of the $5.3 million write down of servicing rights recorded in
fiscal 2003.
From June 2000 to March 2003, the discount rate applied in determining
the fair value of servicing rights was 11% which is 200 basis points lower than
the 13% discount rate applied to value residual cash flows from interest-only
strips during that period. On June 30, 2003, we reduced the discount rate on
servicing rights cash flows to 9%. We used the same 9% discount rate to value
servicing rights at September 30, 2003. In determining the discount rate applied
to calculate the present value of cash flows from servicing rights, management
has subtracted a factor from the discount rate used to value residual cash flows
from interest-only strips to provide for the lower risks inherent in servicing
assets. Unlike the interest-only strips, the servicing asset is not exposed to
credit losses. Additionally, the distribution of the contractual servicing fee
cash flow from the securitization trusts is senior to both the trusts' investor
certificates and our interest-only strips. This priority of cash flow reduces
the risks associated with servicing rights and thereby supports a lower discount
rate than the rate applied to residual cash flows from interest-only strips.
Cash flows related to ancillary servicing fees, such as prepayment fees, late
fees, and non-sufficient fund fees are retained directly by us.
The impact of the June 30, 2003 reduction in discount rate from 11% to
9% was to increase the valuation of our servicing rights by $7.1 million at June
30, 2003. This favorable impact was offset by a decrease of $12.4 million mainly
due to prepayment experience in fiscal 2003.
Servicing rights can be terminated under certain circumstances, such as
our failure to make required servicer payments, defined changes of 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.
67
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.
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. See "-- Off-Balance Sheet Arrangements --
Securitizations" for information on the volume of whole loan sales and premiums
recorded for the three months ended September 30, 2003 and 2002. Loans reported
as sold on a whole loan basis were generally loans that we originated
specifically for a whole loan sale and exclude impaired loans, which may be
liquidated by selling the loan with servicing released. However, see "--Business
Strategy" for detail on our adjustment in business strategy from originating
loans predominantly for publicly underwritten securitizations, to originating
loans for a combination of whole loan sales and smaller securitizations. Also,
see "Business -- Whole Loan Sales."
Results of Operations
Summary
For the first three months of fiscal 2004, we recorded a net loss of
$26.3 million. The loss primarily resulted from liquidity issues which
substantially reduced our ability to originate loans and generate revenues
during the first quarter of fiscal 2004, our inability to complete a
securitization of loans during the quarter ended September 30, 2003, and $10.8
million of pre-tax charges for valuation adjustments on our securitization
assets charged to the income statement. Loan origination volume decreased to
$124.1 million for the quarter ended September 30, 2003, compared to origination
volume of $370.7 million for the same period in fiscal 2003, due to our
previously discussed short term liquidity issues. While we originated loans at a
substantially reduced level during the first quarter, our expense base for the
quarter would have supported greater origination volume.
68
During the quarter ended September 30, 2003, we recorded total pre-tax
adjustments on our securitization assets of $16.7 million, of which $10.8
million was reflected as an expense on the income statement and $5.9 was
reflected as an adjustment to other comprehensive income, a component of
stockholders' equity. These write downs of our interest-only strips and
servicing rights, which we refer to as our securitization assets, primarily
reflect the impact of higher than anticipated prepayments on securitized loans
experienced in fiscal 2004 due to the continuing low interest rate environment.
As a result of the $26.3 million loss and the $5.9 million pre-tax reduction to
other comprehensive income during the quarter ended September 30, 2003, total
stockholders' equity was reduced to $11.8 million at September 30, 2003. For the
same period in fiscal 2003, we recorded total pre-tax valuation adjustments of
$16.7 million, of which $12.1 million was reflected as an expense on the income
statement and $4.6 was reflected as an adjustment to other comprehensive income.
The loss per common share for the first three months of fiscal 2004 was
$8.91 per share on average common shares of 2,947,000 compared to diluted net
income per share of $.61 per share on average common shares of 2,985,000 for the
first three months of fiscal 2003. A dividend of $0.08 per share was paid for
the first three months of fiscal 2003. No dividend was paid in the first three
months of fiscal 2004. The common dividend payout ratio based on diluted
earnings per share was 13.1% for the first three months of fiscal 2003.
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, we adjusted all
outstanding common shares, earnings per common share, average common share and
stock option amounts presented in this document 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 during the three
months ended September 30, 2003 and 2002 (in thousands):
Three Months Ended
September 30,
------------------------------
2003 2002
---------- ----------
Business purpose loans....... $ -- $ 28,863
Home equity loans............ 124,052 341,852
--------- ---------
$ 124,052 $ 370,715
========= =========
69
During the first quarter of fiscal 2004, our subsidiary, American
Business Credit, Inc., did not originate any business purpose loans. For the
three months ended September 30, 2002, American Business Credit, Inc. originated
$28.9 million of business purpose loans. Our previously discussed liquidity
issues have substantially reduced our ability to originate business purpose
loans during the first quarter of fiscal 2004. In addition, due to less
favorable response for our business purpose loans in the whole loan sale market,
pursuant to our adjusted business strategy, we plan to continue to originate
business purpose loans, but at lower volumes, to meet demand in the whole loan
sale and securitization markets. See "-- Business Strategy".
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, decreased $217.8
million, or 63.7%, for the three months ended September 30, 2003, to $124.1
million from $341.9 million for the three months ended September 30, 2002.
Liquidity issues have reduced our ability to originate home equity loans.
American Business Mortgage Services, Inc. home equity loan originations for the
three months ended September 30, 2003 decreased by $129.2 million, or 92.8%,
from the prior year period. We no longer originate loans through retail
branches, which resulted in a decrease in loan originations of $44.2 million, or
98.6%, from the prior year period. The Bank Alliance Services program's loan
originations for the three months ended September 30, 2003 increased $1.4
million, or 3.4%, over the comparable prior year period. Based on our business
strategy, which emphasizes whole loan sales and smaller privately-placed
securitizations and reducing costs, effective June 30, 2003 we no longer
originate loans through our retail branches, which were a high cost origination
channel, and plan to increase our focus on broker and Bank Alliance Services'
origination sources. Our home equity loan origination subsidiaries will continue
to focus on increasing efficiencies and productivity gains by refining marketing
techniques and integrating technological improvements into the loan origination
process as we work through our liquidity issues. In addition, we will focus on
developing broker relationships, a lower cost source of originations, in
executing our new business strategy in the future.
Summary Financial Results
(dollars in thousands, except per share data)
Three Months Ended
September 30, Percentage
------------------- Increase/
2003 2002 Decrease
---------- -------- --------
Total revenues.................... $ 20,201 $ 74,467 (72.9)%
Total expenses.................... $ 62,569 $ 71,327 (12.3)%
Net income (loss)................. $ (26,268) $ 1,821
Return on average assets.......... (9.88)% 0.80%
Return on average equity.......... (386.77)% 10.14%
Earnings (loss) per share:
Basic..................... $ (8.91) $ 0.64
Diluted................... $ (8.91) $ 0.61
Dividends declared per share...... $ -- $ 0.08
Total Revenues. For the first quarter of fiscal 2004, total revenues
decreased $54.3 million, or 72.9%, to $20.2 million from $74.5 million for the
first quarter of fiscal 2003. Our limited amount of funding capacity due to the
expiration of the mortgage conduit pursuant to its terms, our inability to
borrow under certain credit facilities due to our non-compliance with several
lending covenants and our inability to complete a securitization in the first
quarter of fiscal 2004 accounted for this decrease in total revenues.
70
Gain on Sale of Loans - Securitizations. For the first quarter of
fiscal 2004, gains of $0.8 million were recorded on the securitization of $5.5
million of loans. This was a decrease of $57.2 million, or 98.6% below gains of
$58.0 million recorded on securitizations of $366.4 million of loans for the
first quarter of fiscal 2003.
The decrease in securitization gains for the three months ended
September 30, 2003 was due to our inability to complete a securitization of
loans during the quarter. The $0.8 million gain recorded in the three months
ended September 30, 2003 resulted from the sale of $5.5 million of loans into an
off-balance sheet facility before its expiration on July 5, 2003 and additional
gains from our residual interests in the $35.0 million of loans remaining in the
off-balance sheet facility from June 30, 2003.
Gain on Sale of Loans - Whole Loan Sales. Gains on whole loan sales
increased $2.9 million, to $2.9 million for the three months ended September 30,
2003 from $35 thousand for the three months ended September 30, 2002. The volume
of whole loan sales increased $269.4 million, to $271.0 million for the three
months ended September 30, 2003 from $1.5 million for the three months ended
September 30, 2002. The increase in the volume of whole loan sales for the three
months ended September 30, 2003 resulted from management's decision to adjust
its business strategy to emphasize more whole loan sales. See "-- Business
Strategy" and "-- Liquidity and Capital Resources" for further detail.
Interest and Fees. For the three months ended September 30, 2003,
interest and fee income increased $0.5 million, or 12.6%, to $4.7 million
compared to $4.1 million in the same period of fiscal 2003. Interest and fee
income consists primarily of interest income earned on loans available for sale,
interest income on invested cash and other ancillary fees collected in
connection with loan and lease originations.
During the three months ended September 30, 2003, total interest income
increased $2.1 million, or 112.1%, to $3.9 million from $1.8 million for the
three months ended September 30, 2002. Loan interest income increased $2.3
million from the three months ended September 30, 2002 as a result of our
carrying a higher average loan balance during the first three months of fiscal
2004 as compared to fiscal 2003. This increase was offset by a decrease of $0.2
million of investment interest income due to lower interest rates earned on
invested cash balances caused by general decreases in market interest rates.
Other fees decreased $1.5 million for fiscal 2004 compared to the same
periods in fiscal 2003. The decrease was mainly due to the decrease in fees from
loan originations, which resulted from liquidity issues that substantially
reduced our ability to originate loans. Our 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 $11.1
million was earned in the three months ended September 30, 2003 compared to
$10.7 million in the three months ended September 30, 2002. The increase
reflects the growth in the balance of our interest-only strips of $1.7 million,
or 0.3%, to $545.6 million at September 30, 2003 from $543.9 million at
September 30, 2002. In addition, cash flows from interest-only strips for the
three months ended September 30, 2003 totaled $56.2 million, an increase of
$22.8 million, or 68.0%, from the three months ended September 30, 2002 due to
the larger size of our more recent securitizations and additional
securitizations reaching final target overcollateralization levels and stepdown
overcollateralization levels.
71
Servicing Income. Servicing income is comprised of contractual and
ancillary fees collected on securitized loans serviced for others, less
amortization of the servicing rights assets that are recorded at the time loans
are securitized. Ancillary fees include prepayment fees, late fees and other
servicing fee compensation. For the three months ended September 30, 2003,
servicing income decreased $0.8 million, or 53.3%, to $0.7 million from $1.5
million for the three months ended September 30, 2002. Because loan prepayment
levels in the first quarter of fiscal 2004 increased from the first quarter of
fiscal 2003, the amortization of servicing rights has also increased.
Amortization is recognized in proportion to contractual and ancillary fees
collected. Therefore the collection of additional prepayment fees in the first
quarter of fiscal 2004 has resulted in higher levels of amortization.
The following table summarizes the components of servicing income for
the three months ended September 30, 2003 and 2002 (in thousands):
Three Months Ended
September 30,
---------------------------
2003 2002
----------- -----------
Contractual and ancillary fees................... $ 13,093 $ 10,162
Amortization of servicing rights................. (12,375) (8,625)
----------- ---------
Net servicing income............................. $ 718 $ 1,537
=========== =========
Total Expenses. Total expenses decreased $8.8 million, or 12.3%, to
$62.6 million for the three months ended September 30, 2003 compared to $71.3
million for the three months ended September 30, 2002. As described in more
detail below, this decrease was mainly a result of decreases in trading loss
activity, general and administrative expenses, sales and marketing expenses, and
securitization assets valuation adjustments during the three months ended
September 30, 2003, partially offset by increases in employee related costs and
provision for loan losses.
Interest Expense. During the first quarter of fiscal 2004, interest
expense decreased $0.3 million, or 1.6%, to $16.8 million compared to $17.1
million for the first quarter of fiscal 2003. Average subordinated debt
outstanding during the three months ended September 30, 2003 was $704.7 million
compared to $662.3 million during the three months ended September 30, 2002.
Average interest rates paid on subordinated debt outstanding decreased to 8.75%
during the three months ended September 30, 2003 from 9.71% during the three
months ended September 30, 2002.
Rates offered on subordinated debt were reduced beginning in the fourth
quarter of fiscal 2001 and have continued downward through the fourth quarter of
fiscal 2003 in response to decreases in market interest rates as well as
declining cash needs during that period. The weighted-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 June 2003 of 7.49%. The weighted-average interest rate on
subordinated debt issued during the month of September 2003 was 8.41%, an
increase that reflects a general rise in market interest rates and our financial
condition. Our ability to maintain the rates offered on our subordinated debt,
or limit increases in rates offered, depends on our financial condition,
liquidity, future results of operations, market interest rates and competitive
factors, among other circumstances.
72
The average outstanding balances under warehouse lines of credit were
$131.9 million during the three months ended September 30, 2003, compared to
$24.1 million during the three months ended September 30, 2002. The increase in
the average balance on warehouse lines was due to a higher volume of loans held
on balance sheet during the period. Interest rates paid on warehouse lines are
generally based on one-month LIBOR plus an interest rate spread ranging from
0.95% to 1.75%. One-month LIBOR has decreased from approximately 1.8% at
September 30, 2002 to 1.12% at September 30, 2003.
Provision for Credit Losses. The provision for credit losses on loans
and leases available for sale increased $2.6 million, or 170.2%, to $4.2 million
for the three months ended September 30, 2003 from $1.5 million for the three
months ended September 30, 2002. A related allowance for loan losses on
repurchased loans is included in our provision for credit losses in the period
of repurchase. See "-- Off-Balance Sheet Arrangements -- Securitizations" and
"-- Off-Balance Sheet Arrangements -- Trigger Management" for further discussion
of repurchases from securitization trusts. Non-accrual loans were $11.9 million
at September 30, 2003, compared to $5.4 million at June 30, 2003 and $7.1
million at September 30, 2002. See "-- Managed Portfolio Quality" for further
detail.
The allowance for credit losses was $5.5 million, or 3.3% of loans and
leases available for sale at September 30, 2003 compared to $2.8 million, or
1.0% of loans and leases available for sale at June 30, 2003 and $3.2 million,
or 5.0% of loans and leases available for sale at September 30, 2002. The
allowance for credit losses increased due to the increase of the non-accrual
loan balance being carried on our balance sheet at September 30, 2003. The
allowance for credit losses as a percentage of gross receivables decreased from
September 30, 2002 due to the increase in the balance of loans available for
sale. 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, particularly if economic conditions deteriorate.
The following table summarizes changes in the allowance for credit
losses for the three months ended September 30, 2003 and 2002 (in thousands):
Three Months Ended
September 30,
-----------------------
2003 2002
--------- --------
Balance at beginning of period.................. $ 2,848 $ 3,705
Provision for credit losses...................... 4,156 1,538
(Charge-offs) recoveries, net.................... (1,534) (2,059)
-------- --------
Balance at end of period......................... $ 5,470 $ 3,184
======== ========
The following tables summarize the changes in the allowance for credit
losses by loan and lease type (in thousands):
Business Home
Purpose Equity Equipment
Three Months Ended September 30, 2003: Loans Loans Leases Total
- -------------------------------------- ---------- -------- ---------- --------
Balance at beginning of period........... $ 593 $ 2,085 $ 170 $ 2,848
Provision for credit losses.............. 1,111 3,075 (30) 4,156
(Charge-offs) recoveries, net............ (349) (1,183) (2) (1,534)
-------- -------- -------- --------
Balance at end of period................. $ 1,355 $ 3,977 $ 138 $ 5,470
======== ======== ======== ========
73
Business Home
Purpose Equity Equipment
Three Months Ended September 30, 2002: Loans Loans Leases Total
- -------------------------------------- ---------- -------- ---------- --------
Balance at beginning of period........... $ 1,388 $ 1,998 $ 319 $ 3,705
Provision for credit losses.............. 71 1,293 174 1,538
(Charge-offs) recoveries, net............ (528) (1,314) (217) (2,059)
-------- -------- -------- --------
Balance at end of period................. $ 931 $ 1,977 $ 276 $ 3,184
======== ======== ======== ========
The following table summarizes net charge-off experience by loan type
for the three months ended September 30, 2003, and 2002 (in thousands):
Three months ended
September 30,
---------------------------
2003 2002
-------- -------
Business purpose loans.................. $ 349 $ 528
Home equity loans....................... 1,183 1,314
Equipment leases........................ 2 217
-------- -------
Total................................... $ 1,534 $ 2,059
======= =======
Employee Related Costs. For the three months ended September 30, 2003,
employee related costs increased $4.3 million, or 44.7%, to $13.9 million from
$9.6 million in the prior year. The increase in employee related costs for the
three months ended September 30, 2003 was primarily attributable to a decrease
in the amount of expenses deferred under SFAS No. 91 due to the reduction in
loan originations and the inability to defer loan origination costs under SFAS
No. 91. Total employees at September 30, 2003 were 855 compared to 1,017 at
September 30, 2002. At October 31, 2003, total employees were 726. Since June
30, 2003, our workforce has decreased by approximately 393 employees. With our
business strategy's focus on whole loan sales and offering a broader mortgage
product line that we expect will appeal to a wider array of customers, we
currently require a smaller employee base with fewer sales, servicing and
support positions, and we reduced our workforce by approximately 225 employees.
In addition, we experienced the loss of approximately 168 additional employees
who have resigned since June 30, 2003. These workforce reductions and
resignations represent a 35% decrease in staffing levels from June 30, 2003. The
decrease in SFAS No. 91 cost deferrals totaled $7.9 million. Decreases in loan
origination commissions and bonuses partially offset the effect of reduced SFAS
No. 91 cost deferrals.
Sales and Marketing Expenses. For the three months ended September 30,
2003, sales and marketing expenses decreased $3.8 million, or 57.5%, to $2.8
million from $6.7 million for the three months ended September 30, 2002. The
increase was primarily due to decreases in expenses for direct mail advertising
and broker commissions for home equity and business loan originations as well as
decreases in newspaper advertisements for subordinated debt. We expect to be
able to streamline our sales and marketing costs in the future by offering a
wider array of loan products and targeting segments that we believe will enable
us to increase our loan origination conversion rates. By increasing our
conversion rates, we expect to be able to lower our overall sales and marketing
costs per dollar originated. See "-- Business Strategy" for further discussion.
Trading (Gains) and Losses. During the three months ended September 30,
2003, we recognized trading gains of $5.1 million on interest rate swaps. This
compares to trading losses of $3.4 million for the three months ended September
30, 2002. For more detail on our trading activity, see "-- Interest Rate Risk
Management -- Strategies for Use of Derivative Financial Instruments."
General and Administrative Expenses. For the three months ended
September 30, 2003, general and administrative expenses decreased $1.7 million,
or 8.2%, to $19.2 million from $20.9 million for the three months ended
September 30, 2002. This decrease was primarily attributable to a decrease of
$0.6 million in costs associated with servicing and collecting our total managed
portfolio including expenses associated with REO and delinquent loans, and a
$1.1 million decrease in costs associated with customer retention incentives.
74
Securitization Assets Valuation Adjustment. During the three months ended
September 30, 2003, we recorded total pre-tax valuation adjustments on our
securitization assets of $16.7 million, of which $10.8 million was reflected as
an expense on the income statement and $5.9 million was reflected as an
adjustment to other comprehensive income. The breakout of the total adjustments
in the first three months of fiscal 2004 between interest-only strips and
servicing rights was as follows:
o We recorded total pre-tax valuation adjustments on our
interest only-strips of $15.8 million, of which, in accordance
with EITF 99-20, $9.9 million was reflected as an expense on
the income statement and $5.9 million was reflected as an
adjustment to other comprehensive income. The valuation
adjustment reflects the impact of higher than anticipated
prepayments on securitized loans experienced in the first
quarter of fiscal 2004 due to the continuing low interest
rate environment.
o We recorded total pre-tax valuation adjustments on our
servicing rights of $0.8 million, which was reflected as an
expense on the income statement. The valuation adjustment
reflects the impact of higher than anticipated prepayments
on securitized loans experienced in the first quarter
of fiscal 2004 due to the continuing low interest rate
environment.
During the three months ended September 30, 2002, we recorded total
pre-tax valuation adjustments on our securitization assets of $16.7 million, of
which $12.1 million was reflected as an expense on the income statement and
$4.6 million was reflected as an adjustment to other comprehensive income.
See "-- Off-Balance Sheet Arrangements -- Securitizations" for further detail
of these adjustments.
75
Balance Sheet Information
Balance Sheet Data
(Dollars in thousands, except per share data)
September 30, June 30,
2003 2003
------------- -----------
Cash and cash equivalents....................... $ 27,217 $ 47,475
Loan and lease receivables, net:
Available for sale........................... 162,688 271,402
Interest and fees............................ 17,396 15,179
Other........................................ 24,681 23,761
Interest-only strips............................ 545,583 598,278
Servicing rights................................ 106,072 119,291
Receivable for sold loans....................... - 26,734
Total assets.................................... 950,506 1,159,351
Subordinated debt............................... 687,585 719,540
Warehouse lines and other notes payable......... 109,410 212,916
Accrued interest payable........................ 43,751 45,448
Deferred income taxes........................... - 17,036
Total liabilities............................... 938,684 1,117,282
Total stockholders' equity...................... 11,822 42,069
Book value per common share..................... $ 4.01 $ 14.28
Total assets decreased $208.8 million, or 18.0%, to $950.5 million at
September 30, 2003 from $1,159.4 million at June 30, 2003 primarily due to
decreases in cash and cash equivalents, loan and lease receivables available for
sale, interest-only strips and receivable for sold loans.
Cash and cash equivalents decreased due to liquidity issues which
substantially reduced our ability to originate loans for sale, our inability to
complete a securitization during the quarter ended September 30, 2003 and a
reduction in the issuance of subordinated debt.
Loan and lease receivables - Available for sale decreased $108.7
million, or 40.1% due to whole loan sales coupled with a reduction in loan
originations caused by our liquidity issues.
76
Activity of our interest-only strips for the three months ended
September 30, 2003 and 2002 was as follows (in thousands):
Three Months Ended
September 30,
-------------------------
2003 2002
----------- ----------
Balance at beginning of period......................... $ 598,278 $ 512,611
Initial recognition of interest-only strips............ 950 44,126
Cash flow from interest-only strips.................... (56,222) (33,464)
Required purchases of additional overcollateralization. 7,660 17,128
Interest accretion..................................... 10,828 10,747
Net temporary adjustments to fair value (a)............ (5,960) 4,792
Other than temporary adjustments to fair value (a)..... (9,951) (12,078)
--------- ---------
Balance at end of period............................... $ 545,583 $ 543,862
========= =========
(a) Net temporary adjustments to fair value are recorded through other
comprehensive income, which is a component of equity. Other than
temporary adjustments to decrease the fair value of interest-only
strips are recorded through the income statement.
The following table summarizes our purchases of overcollateralization
by securitization trust for the three months ended September 30, 2003 and the
fiscal years ended June 30, 2003 and 2002. Purchases of overcollateralization
represent amounts of residual cash flows from interest-only strips retained by
the securitization trusts to establish required overcollateralization levels in
the trust. Overcollateralization represents our investment in the excess of the
aggregate principal balance of loans in a securitized pool over the aggregate
principal balance of trust certificates. See "-- Off-Balance Sheet Arrangements
- -- Securitizations" for a discussion of overcollateralization requirements.
Summary of Mortgage Loan Securitization Overcollateralization Purchases
(in thousands)
2003-1 2002-4 2002-3 2001-2 Other(a) Total
------ ------ ------ ------ -------- -----
Three Months Ended
September 30, 2003:
Required purchases of
additional
overcollateralization........... $ 4,662 $ 3,820 $ 1,978 $ 250 $(4,032) $6,678
======= ======= ======= ======= ======= ======
(a) includes the recovery of $4.2 million of overcollateralization from an
off-balance sheet mortgage conduit facility.
2003-1 2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 Other Total
------ ------ ------ ------ ------ ------ ------ ------ ----- -----
Year Ended June 30, 2003:
Initial overcollateralization.... $ -- $ 3,800 $ -- $ -- $ -- $ -- $ -- $ -- $ 6,841 $ 10,641
Required purchases of
additional
overcollateralization.......... 4,807 8,728 10,972 13,300 10,586 12,522 7,645 3,007 1,686 73,253
------ ------- ------- ------- ------- ------- ------ ------ ------- -------
Total........................ $4,807 $12,528 $10,972 $13,300 $10,586 $12,522 $7,645 $3,007 $8,527 $83,894
====== ======= ======= ======= ======= ======= ====== ====== ======= =======
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
======= ====== ======= ======= ======= ====== ====== ======= ======= ======= =======
77
Servicing rights decreased $13.2 million, or 11.1%, to $106.1 million
at September 30, 2003 from $119.3 million at June 30, 2003, primarily due to our
inability to complete a securitization in the first current quarter of fiscal
2004, amortization of servicing rights and a $0.8 million write down of the
servicing asset mainly due to the impact of higher than expected prepayment
experience.
The receivable for sold loans of $26.7 million at June 30, 2003
resulted from a whole loan sale transaction which closed on June 30, 2003, but
settled in cash on July 1, 2003.
Total liabilities decreased $178.6 million, or 16.0%, to $938.7 million
at September 30, 2003 from $1,117.3 million at June 30, 2003 primarily due to
decreases in warehouse lines and other notes payable, subordinated debt
outstanding, deferred income taxes and other liabilities. The decrease in
warehouse lines and other notes payable was due to our inability to renew or
replace expiring facilities during the quarter ended September 30, 2003. Other
liabilities decreased $26.8 million, or 29.1%, to $65.2 million from $92.0
million due mainly to a $24.1 million decrease in the loan funding liability
related to decreased loan originations.
During the three months ended September 30, 2003, subordinated debt
decreased $32.0 million, or 4.4%, to $687.6 million due to the temporary
discontinuation of the sale of new subordinated debentures. See "-- Liquidity
and Capital Resources" for further information regarding outstanding debt.
Our deferred income tax position changed from a liability of $17.0
million at June 30, 2003 to an asset of $1.0 million at September 30, 2003. This
change from a liability position is the result of the federal and state tax
benefits of $16.2 million recorded on our first quarter pre-tax loss, which will
be realized against anticipated future years' state and federal taxable income.
In addition, a federal benefit of $2.1 million was recognized on the portion of
the valuation adjustment on our interest-only strips which was recorded through
other comprehensive income. These benefits were partially offset by a refund of
a $0.2 million overpayment on our June 30, 2002 federal tax return.
78
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 Forbearance Arrangements" for the amounts of previously delinquent
loans subject to these deferment and forbearance arrangements which are not
included in this table if borrowers are current on principal and interest
payments as required under the terms of the original note (exclusive of
delinquent payments advanced or fees paid by us on the borrower's behalf as part
of the deferment or forbearance arrangement) (dollars in thousands):
September 2003 June 30, 2003 March 31, 2003
----------------------- --------------------- --------------------
Delinquency by Type Amount % Amount % Amount %
- ------------------- ------------ ------ ---------- ------ ------------ ------
Business Purpose Loans
Total managed portfolio............. $ 364,970 $ 393,098 $ 392,228
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 5,761 1.57% $ 4,849 1.23% $ 5,526 1.41%
61-90 days...................... 6,129 1.68 4,623 1.18 2,718 0.69
Over 90 days.................... 42,831 11.74 38,466 9.79 35,286 9.00
---------- ------ ----------- ----- ----------- -----
Total delinquencies............. $ 54,721 14.99% $ 47,938 12.20% $ 43,530 11.10%
=========== ====== =========== ===== =========== =====
REO................................. $ 4,491 $ 5,744 $ 4,506
=========== =========== ===========
Home Equity Loans
Total managed portfolio............. $ 2,601,125 $ 3,249,501 $ 3,073,392
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 53,514 2.06% $ 48,332 1.49% $ 47,809 1.56%
61-90 days...................... 36,729 1.41 24,158 0.74 23,261 0.76
Over 90 days.................... 122,997 4.73 108,243 3.33 104,939 3.41
------------ ------ ----------- ----- ----------- -----
Total delinquencies............. $ 213,240 8.20% $ 180,733 5.56% $ 176,009 5.73%
=========== ====== =========== ===== =========== =====
REO................................. $ 21,561 $ 22,256 $ 30,704
=========== =========== ===========
Equipment Leases
Total managed portfolio............. $ 5,705 $ 8,475 $ 12,185
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 248 4.34% $ 162 1.91% $ 379 3.11%
61-90 days...................... 40 0.70 83 0.98 89 0.73
Over 90 days.................... 200 3.51 154 1.82 85 0.70
----------- ------ ----------- ----- ----------- -----
Total delinquencies............. $ 488 8.55% $ 399 4.71% $ 553 4.54%
=========== ====== =========== ===== =========== =====
Combined
- --------
Total managed portfolio............. $ 2,971,800 $ 3,651,074 $ 3,477,805
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 59,523 2.00% $ 53,343 1.46% $ 53,714 1.55%
61-90 days...................... 42,898 1.44 28,864 0.79 26,068 0.75
Over 90 days.................... 166,028 5.59 146,863 4.02 140,310 4.03
----------- ------ ----------- ----- ----------- -----
Total delinquencies............. $ 268,449 9.03% $ 229,070 6.27% $ 220,092 6.33%
=========== ====== =========== ===== =========== =====
REO................................. $ 26,052 0.88% $ 28,000 0.77% $ 35,210 1.01%
=========== ====== =========== ===== =========== =====
Losses experienced during the
period(a)(b) :
Loans........................... $ 8,100 0.97% $ 7,390 0.83% $ 8,405 0.99%
====== ===== =====
Leases.......................... 1 0.06% 55 2.14% 176 4.82%
----------- ====== ----------- ===== ----------- =====
Total managed portfolio......... $ 8,101 0.97% $ 7,445 0.84% $ 8,581 1.01%
=========== ====== =========== ===== =========== =====
(Continued on next page)
79
Managed Portfolio Quality (continued)
(a) Percentage based on annualized losses and average managed portfolio.
(b) Losses recorded on our books were $3.5 million ($1.5 million from
charge-offs through the provision for loan losses and $2.0 million for
write downs of real estate owned) and losses absorbed by loan
securitization trusts were $4.6 million for the three months ended
September 30, 2003. Losses recorded on our books were $4.2 million
($0.9 million from charge-offs through the provision for loan losses
and $3.3 million for write downs of real estate owned) and losses
absorbed by loan securitization trusts were $3.3 million for the three
months ended June 30, 2003. 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 include
losses for loans we hold as available for sale or real estate owned and
loans repurchased from securitization trusts.
The following table summarizes key delinquency statistics related to
loans, leases and REO recorded on our balance sheet and their related percentage
of our available for sale portfolio (dollars in thousands):
September 30, June 30, March 31,
2003 2003 2003
--------------------------------------------------
Delinquent loans and leases on balance sheet (a) $ 11,825 $ 5,412 $ 5,992
% of on balance sheet loan and lease receivables 7.21% 2.04% 11.7%
Loans and leases in non-accrual status on
balance sheet (b)........................... $ 11,941 $ 5,358 $ 5,905
% of on balance sheet loan and lease receivables 7.28% 2.02% 11.5%
Allowance for losses on available for sale loans
and leases................................ $ 5,470 $ 2,848 $ 1,953
% of available for sale loans and leases........ 3.3% 1.0% 3.6%
Real estate owned on balance sheet.............. $ 4,566 $ 4,776 $ 6,348
- -----------
(a) Delinquent loans and leases are included in total delinquencies in the
previously presented "Managed Portfolio Quality" table. Included in total
delinquencies are loans in non-accrual status of $10.7 million, $5.0
million, and $5.6 million at September 30, 2003, June 30, 2003, March 31,
2003.
(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. 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. To assist borrowers, we may agree to enter into a
deferment or forbearance arrangement. Prevailing economic conditions, which
affect the borrower's ability to make their regular payments, may also have an
impact on the value of the real estate or other collateral securing the loans,
resulting in a change to the loan-to-value ratios. We may take these conditions
into account when we evaluate a borrower's request for assistance for relief
from their financial hardship.
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 of other collateral, as applicable) if reasonably possible. We
review and regularly revise these policies and procedures in order to enhance
their effectiveness in achieving these goals. We permit exceptions to the
policies and practices from time to time based on individual borrowers'
situations.
80
In a deferment arrangement, we make advances to a securitization trust
on behalf of the borrower in amounts equal to the delinquent loan payments,
which include principal and interest. Additionally, we may pay taxes, insurance
and other fees on behalf of the borrower. Based on our review of the borrower's
current financial circumstances, the borrower must repay the advances and other
payments and fees we make on the borrower's behalf either at the termination of
the loan or on a monthly payment plan. Borrowers must provide a written
explanation of their hardship, which generally requests relief from their loan
payments. We review the borrower's current financial situation and based upon
this review, we may create a payment plan for the borrower which allows the
borrower to pay past due amounts over a period from 12 to 42 months, but not
beyond the maturity date of the loan, in addition to making regular monthly loan
payments. Each deferment arrangement must be approved by two of our managers.
Deferment arrangements which defer two or more past due payments must also be
approved by a senior vice president.
Principal guidelines currently applicable to the deferment process are:
(i) the borrower may have up to six payments deferred during the life of the
loan; (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 payments on the
loan and twelve months must have passed since the last deferment in order to
qualify for a new deferment arrangement. Any deferment arrangement which
includes an exception to our guidelines must be approved by the senior vice
president of collections and an executive vice president. If the deferment
arrangement is approved, a collector contacts the borrower regarding the
approval and the revised payment terms.
For borrowers who are two or more payments delinquent, we will consider
using a forbearance arrangement if permitted under applicable state law. In a
forbearance arrangement, we make advances to a securitization trust on behalf of
the borrower in amounts equal to the delinquent loan payments, which include
principal and interest. Additionally, we may pay taxes, insurance and other fees
on behalf of the borrower. We assess the borrower's current financial situation
and based upon this assessment, we may create a payment plan for the borrower
which generally allows the borrower to pay past due amounts over a longer period
than a typical deferment arrangement, but not beyond the maturity date of the
loan. We typically structure a forbearance arrangement to require the borrower
to make payments of principal and interest equivalent to the original loan terms
plus additional monthly payments, which in the aggregate represent the amount
that we advanced to the securitization trust and other fees paid by us on behalf
of the borrower. We currently require the borrower to provide written
documentation outlining their financial hardship, and we offer these
arrangements to borrowers who we believe have the ability to remit
post-forbearance principal and interest payments in addition to the amounts
advanced or paid by us. As part of the written forbearance agreement, the
borrower must execute a deed in lieu of foreclosure. If the borrower
subsequently defaults before repaying the amount due under the forbearance
agreement in full and becomes 60 days delinquent on principal and interest
payments, we may elect to record the deed after providing proper notification to
the borrower and a reasonable period of time to cure. Recording the deed in lieu
of foreclosure gives us immediate legal title to the property without the need
for further legal action.
Principal guidelines currently applicable to the forbearance process
are: (i) the subject loan should be at least six months old; (ii) the loan
should be a minimum of three payments delinquent; and (iii) each forbearance
arrangement must be approved by a manager, the senior vice president of
collections and the senior vice president of asset allocation. Forbearance
arrangements which defer ten or more past due payments, involve advances or
other payments of more than $25,000 or include an exception to our guidelines
must also be approved by an executive vice president.
81
For delinquent borrowers with business purpose loans, we may enter into
written forbearance agreements pursuant to which we do not obtain a deed in lieu
of foreclosure. These arrangements typically allow the borrower to pay past due
amounts over a period of 12-36 months, but not beyond the maturity date of the
loan, and generally require the borrower to make a payment at the time of
entering into the forbearance agreement.
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 any of these arrangements depends upon one or more of the following
factors: our assessment of the individual borrower's current financial situation
and reasons for the delinquency, a valuation of the real estate securing the
loan and our view of prevailing economic conditions. Because deferment 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 attempt to tailor the type and terms of the arrangement we use to the
borrower's circumstances, and we prefer to use deferment over forbearance
arrangements, if possible.
As a result of these arrangements, we reset the contractual status of a
loan in our managed portfolio from delinquent to current based upon the
borrower's resumption of making their loan payments. Generally, a loan remains
current after a deferment or forbearance arrangement with the borrower only if
the borrower makes the principal and interest payments as required under the
terms of the original note (exclusive of delinquent payments advanced or fees
paid by us on the borrower's behalf as part of the deferment or forbearance
arrangement), and we do not reflect it as a delinquent loan in our delinquency
statistics. However, if the borrower fails to make principal and interest
payments, the account will generally be declared in default and collection
actions resumed.
82
The following table presents, as of the end of our last six quarters,
information regarding loans under deferment and forbearance arrangements, which
are reported as current loans if borrowers are current on principal and interest
payments as required under the terms of the original note (exclusive of
delinquent payments advanced or fees paid by us on the borrower's behalf as part
of the deferment or forbearance arrangement) and thus not included in
delinquencies in the delinquency table. (dollars in thousands):
Cumulative Unpaid Principal Balance
------------------------------------------------
% of
Under Under Managed
Deferment Forbearance Total(a) Portfolio
------------- ------------- ------------- -----------
June 30, 2002................. $ 64,958 $ 73,705 $138,663 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................ 85,205 84,751 169,956 4.89
June 30, 2003................. 110,487 87,199 197,686 5.41
September 30, 2003............ 141,547 80,467 222,014 7.47
- ----------
(a) Included in cumulative unpaid principal balance are loans with
arrangements that were entered into longer than twelve months ago. At
September 30, 2003, there was $26.4 million of cumulative unpaid
principal balance under deferment arrangements and $25.5 million of
cumulative unpaid principal balance under forbearance arrangements that
were entered into prior to October 2002.
Additionally, there are loans under deferment and forbearance
arrangements which have returned to delinquent status. At September 30, 2003
there was $39.4 million of cumulative unpaid principal balance under deferment
arrangements and $59.3 million of cumulative unpaid principal balance under
forbearance arrangements that are now reported as delinquent 31 days or more.
Over the previous nine months, we experienced a pronounced increase in
the number of borrowers under deferment arrangements 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 attempt to actively manage the loan accounts under deferment
arrangements 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 each quarter
of fiscal 2003 and the first quarter of fiscal 2004 (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 44,019 1.32
March 31, 2003................ 37,117 28,051 65,168 1.87
June 30, 2003................. 44,840 18,064 62,904 1.72
September 30, 2003............ 58,419 15,955 74,374 2.50
83
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 $268.4 million at September 30, 2003 compared to $209.9 million
at September 30, 2002. Total delinquencies as a percentage of the total managed
portfolio were 9.03% at September 30, 2003 compared to 6.56% at September 30,
2002. The increase in delinquencies and delinquency percentages in fiscal 2004
and 2003 were mainly due to the impact on our borrowers of continued uncertain
economic conditions, which may include the reduction in other sources of credit
to our borrowers and the seasoning of the managed portfolio. These factors have
resulted in a significant increase in the usage of deferment and forbearance
activities. In addition, the delinquency percentage has increased due to
increased prepayment rates resulting from refinancing activities. Refinancing is
not typically available to delinquent borrowers, and therefore the remaining
portfolio is experiencing a higher delinquency rate. A decrease in amount of new
loans generated also contributed to the increase in the delinquency percentage
in fiscal 2004 from 2003. As the managed portfolio continues to season, and if
our economy continues to lag or worsen, the delinquency rate may continue to
increase. Delinquent loans and leases held as available for sale on our balance
sheet increased from $5.4 million at June 30, 2003 to $11.8 million at September
30, 2003.
Real estate owned. Total REO, comprising foreclosed properties and
deeds acquired in lieu of foreclosure, decreased to $26.0 million, or 0.88% of
the total managed portfolio at September 30, 2003 compared to $32.4 million, or
1.01% at September 30, 2002. The decrease in the volume of REO was mainly due to
processes we have implemented to decrease the cycle time in the disposition of
REO properties. Part of this strategy includes bulk sales of REO properties.
Reducing the time properties are carried reduces carrying costs for interest on
funding the cost of the property, legal fees, taxes, insurance and maintenance
related to these properties. As our portfolio seasons and if our economy
continues to lag or worsen, the REO balance may increase. REO held by us on our
balance sheet decreased from $4.8 million at June 30, 2003 to $4.6 million at
September 30, 2003.
Loss experience. During the three months ended September 30, 2003, we
experienced net loan and lease charge-offs in the total managed portfolio of
$8.1 million or 0.97% on an annualized basis. During the three months ended
September 30, 2002, we experienced net loan and lease charge-offs in the total
managed portfolio of $8.1 million, or 1.03% of the total managed portfolio.
During the three months ended June 30, 2003, we experienced net loan and lease
charge-offs in the total managed portfolio of $7.4 million, or 0.84% of the
average total managed portfolio. Principal loss severity experience on
delinquent loans generally has ranged from 15% to 35% of principal and loss
severity experience on REO generally has ranged from 25% to 40% of principal.
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 experienced an increase in recent
periods and their increases have exceeded the rate of increase of many other
types of investments in the current economy. If in the future this trend
reverses and real estate values begin to decline our loss severity could
increase.
84
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, 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. Profitability and financial performance is
also sensitive to the impact of changes in interest rates on the fair value of
loans which are expected to be sold in whole loan sales. A substantial and
sustained increase in market interest rates could adversely affect our ability
to originate and purchase loans and maintain our profitability. The overall
objective of our interest rate risk management strategy is to mitigate the
effects of changing interest rates on profitability and the fair value of
interest rate sensitive balances (primarily loans available for sale,
interest-only strips, servicing rights and subordinated debt). We would address
this challenge by carefully monitoring our product pricing, the actions of our
competition and market trends and the use of hedging strategies in order to
continue to originate loans in as profitable a manner as possible.
A component of our interest rate risk exposure relates to changes in
the fair value of certain interest-only strips due to changes in one-month
LIBOR. The structure of certain securitization trusts includes a floating
interest rate certificate, which pays interest based on one-month LIBOR plus an
interest rate spread. Floating interest rate certificates in a securitization
expose us to gains or losses due to changes in the fair value of the
interest-only strip from changes in the floating interest rate paid to the
certificate holders.
A rising interest rate environment could unfavorably impact our
liquidity and capital resources. Rising interest rates could impact our
short-term liquidity by limiting our ability to sell loans at favorable premiums
in whole loan sales, 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-term and short-term liquidity.
85
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 September 30, 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)............................. $150,023 $ 974 $ 412 $ 197 $ 223 $ 10,859 $162,688 $ 169,472
Interest-only strips.................. 122,184 115,409 105,900 87,631 68,339 244,316 743,779 545,583
Servicing rights...................... 33,208 25,979 20,308 15,877 12,414 39,630 147,416 106,072
Investments held to maturity.......... 249 352 269 -- -- -- 870 908
Rate Sensitive Liabilities:
Fixed interest rate borrowings........ $288,385 $167,107 $163,331 $27,615 $14,043 $ 27,104 $687,585 $684,830
Average interest rate................. 8.01% 9.12% 9.33% 9.59% 9.84% 11.98% 8.89%
Variable interest rate borrowings..... $109,410 $ -- $ -- $ -- $ -- $ -- $109,410 $109,410
Average interest rate................. 2.68% -- -- -- -- -- 2.68%
____________________________
(a) For purposes of this table, all loans and leases which qualify for
securitization or whole loan sale 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 or whole loan sale.
Loans Available for Sale. Gain on sale of loans may be unfavorably
impacted to the extent we hold loans with fixed interest rates prior to their
sale. See "-- Business Strategy" for a discussion of our intent to add
adjustable rate mortgage loans to our loan product line.
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 future 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.
A significant variable affecting the gain on sale of fixed interest
rate loans sold in whole loan sale transactions is the change in market interest
rates between the date the loan was originated at a fixed rate of interest and
the date the loan was sold in a whole loan sale. If market interest rates
required by investors increase prior to sale of the loans, the premium expected
on sale of the loans would be reduced. This factor could have a material adverse
effect on our future results of operations and financial condition.
86
Interest-Only Strips and Servicing Rights. A portion of the
certificates issued to investors by certain securitization trusts are floating
interest rate certificates based on one-month LIBOR plus an interest rate
spread. The fair value of the excess cash flow we will receive from these trusts
would be affected by any changes in interest rates paid on the floating interest
rate certificates. At September 30, 2003, $109.1 million of debt issued by loan
securitization trusts was floating interest rate certificates based on one-month
LIBOR, representing 4.3% of total debt issued by loan securitization trusts. In
accordance with accounting principles generally accepted in the United States of
America, the changes in fair value are generally recognized as part of net
adjustments to other comprehensive income, which is a component of retained
earnings. As of September 30, 2003, the interest rate sensitivity for $29.2
million of floating interest rate certificates issued by securitization trusts
is managed with an interest rate swap contract effectively fixing our cost for
this debt. See "-- Strategies for Use of Derivative Financial Instruments" for
further detail. In addition, the interest rate sensitivity for $63.0 million of
floating interest rate certificates issued from the 2003-1 Trust is managed by
an interest rate cap which was entered into by the Trust at the inception of the
securitization. This interest rate cap limits the one-month LIBOR to a maximum
rate of 4.0% and was structured to automatically unwind as the floating interest
rate certificates pay down.
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. When originally recorded, approximately 90-95% of business
loans and 80-85% of home equity loans in the total managed portfolio were
subject to prepayment fees. Currently, approximately 50-55% of business loans
and 60-65% 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. We perform revaluations of our interest-only strips and servicing
rights on a quarterly basis. As part of the revaluation process, we monitor the
assumptions used for prepayment rates against actual experience, economic
conditions and other factors and we adjust the assumptions, 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 September 30, 2003 approximately $399.2 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.
87
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, we utilize derivative financial instruments in an
attempt to mitigate the effect of changes in interest rates between the date
loans are originated at fixed interest rates and the date the fixed interest
rate pass-through certificates to be issued by a securitization trust are priced
or the date the terms and pricing for a whole loan sale are fixed. Generally,
the period between loan origination and pricing of the pass-through interest
rate or whole loan sale 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.
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 or whole loan sale. Cash flow related to hedging
activities is reported as it occurs. The effectiveness of our hedge
relationships is continuously monitored. If highly effective correlation did not
exist, the related gain or loss on the hedged item would no longer be recognized
as an adjustment to income.
Related to Loans Expected to Be Sold Through Securitizations. At the
time the derivative contracts are executed, they 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 matching the maturities of
the pass-through certificates. We may hedge potential interest rate changes in
interest rate swap yield curves with forward starting 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.
No derivative financial instruments were utilized for hedging
activities during the three months ended September 30, 2003. We recorded the
following gains and losses on the fair value of derivative financial instruments
accounted for as hedges for the three months ended September 30, 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):
88
Three Months Ended
September 30,
2002
-------------------
Offset by gains and losses recorded on
securitizations:
Losses on derivative financial instruments .... $(2,839)
Offset by gains and losses recorded on the
fair value of hedged items:
Losses on derivative financial instruments .... $ (967)
Amount settled in cash - paid ................. --
There were no outstanding derivative contracts accounted for as hedges
on September 30, 2003. At September 30, 2002, the 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):
Three Months Ended
September 30,
----------------------
2002
----------------------
Notional Unrealized
Amount Loss
--------- ----------
Forward starting interest rate
swaps ................................................. $ 80,000 $ 967
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 SFAS No. 133, "Accounting for Derivative Financial Instruments
and Hedging Activities," and therefore were accounted for as trading assets or
liabilities.
Related to Loans Expected to be Sold Through Securitizations. During
the three months ended September 30, 2002, we used interests 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
derivative contracts were used to manage interest rate risk on loans in our
pipeline, we recorded losses on forward starting interest rate swap contracts
during the three months ended September 30, 2002. The losses are summarized in
the table below.
Related to Loans Expected to Be Sold Through Whole Loan Sale
Transactions. The $170.0 million notional amount of forward starting interest
rate swap contracts carried over from a disqualified hedging relationship
occurring in the fourth quarter were utilized to manage the effect of changes in
market interest rates on the fair value of fixed-rate mortgage loans that were
sold in whole loan sale transactions during the three months ended September 30,
2003. We had elected not to designate these derivative contracts as an
accounting hedge.
89
We recorded the following gains and losses on the fair value of
derivative financial instruments classified as trading for the three months
ended September 30, 2003 and 2002. There were no derivative contracts classified
as trading for the quarter ended September 30, 2002 except those noted below to
manage the exposure to changes in the fair value of certain interest-only strips
due to changes in one-month LIBOR. (in thousands):
Three Months Ended
September 30,
----------------------
2003 2002
------- ------
Trading Gains/(Losses) on forward starting
interest rate swaps:
Related to loan pipeline..................... $ -- $(2,517)
Related to whole loan sales.................. $ 5,097 $ --
Amount settled in cash - (paid).............. $(1,212) $ --
At September 30, 2003 there were no outstanding derivative financial
instruments utilized to manage interest rate risk on loans in our pipeline or
expected to be sold in whole loan sale transactions. At September 30, 2002,
outstanding forward starting interest rate swap contracts used to manage
interest rate risk on loans in our pipeline and associated unrealized losses
recorded as liabilities on the balance sheet were as follows (in thousands):
Three Months Ended
September 30,
2002
----------------------
Notional Unrealized
Amount Loss
---------- ----------
Forward starting interest rate
swaps ................................................ $220,000 $ 2,517
Related to Interest-only Strips. For the quarter ended September 30,
2003 we recorded a net gain of $11 thousand compared to a net loss of $0.7
million for the quarter ended September 30, 2002, on an interest rate swap
contract which is not designated as an accounting hedge. This contract was
designed to reduce the exposure to changes in the fair value of certain
interest-only strips due to changes in one-month LIBOR. Included in the $11
thousand net gain recorded for the three months ended September 30, 2003 were
unrealized gains of $177 thousand representing the net change in the fair value
of the contract during the period and $166 thousand of cash losses paid during
the period. Included in the $0.7 million net loss recorded for the three months
ended September 30, 2002 were unrealized losses of $0.4 million representing the
net change in the fair value of the contract during the prior year period and
$0.3 million of cash losses paid during the prior year period. The cumulative
net unrealized loss of $157 thousand is included as a trading liability in Other
Liabilities. Terms of the interest rate swap contract at September 30, 2003 were
as follows (dollars in thousands):
Notional amount.......................... $ 29,257
Rate received - Floating (a)............. 1.20%
Rate paid - Fixed........................ 2.89%
Maturity date............................ April 2004
Unrealized loss.......................... $ 157
Sensitivity to 0.1% change in interest rates.... $ 9
____________________________
(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 September 30, 2003, we held
no derivative financial instruments in a cumulative gain position.
In the future, we may expand the types of derivative financial
instruments we use to hedge interest rate risk to include other types of
derivative contracts. However, an effective interest rate risk management
strategy is complex and no such strategy can completely insulate us from
interest rate changes. Poorly designed strategies or improperly executed
transactions may increase rather than mitigate risk. Hedging involves
transaction and other costs that could increase as the period covered by the
hedging protection increases. Although it is expected that such costs would be
offset by income realized from securitizations in that period or in future
periods, we may be prevented from effectively hedging fixed interest rate loans
held for sale without reducing income in current or future periods. In addition,
while Eurodollar rates, interest rate swap yield curves and the pass-through
interest rate of securitizations are generally strongly correlated, this
correlation has not held in periods of financial market disruptions (e.g., the
so-called Russian Crisis in the later part of 1998).
90
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 mix of loan sales through securitization shifts to whole loan
sales, 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).
Initially, we finance our loans under two secured credit facilities.
These credit facilities are generally revolving lines of credit, which we have
with a financial institution and a warehouse lender 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.
For the first three months of fiscal 2004, we recorded a net loss of
$26.3 million. The loss primarily resulted from liquidity issues described
below, which substantially reduced our ability to originate loans and generate
revenues during the first quarter of fiscal 2004, our inability to complete a
securitization of loans during the first quarter of fiscal 2004, and $10.8
million of pre-tax charges for valuation adjustments on our securitization
assets.
In fiscal 2003, we recorded a net loss of $29.9 million. The loss in
fiscal 2003 was due in part to our inability to complete our typical quarterly
securitization of loans during the fourth quarter of our fiscal year. Also
contributing to the loss was $45.2 million of net pre-tax charges for valuation
adjustments recorded on our securitization assets during the 2003 fiscal year.
See "-- Securitizations" for more detail on the valuation adjustments.
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
short-term liquidity was negatively impacted by several recent events. Our
inability to complete our typical publicly underwritten securitization during
the fourth quarter of fiscal 2003 contributed to our loss for fiscal 2003 and
adversely impacted our short-term liquidity position. In addition, further
advances under a non-committed portion of one of our credit facilities were
subject to the discretion of the lender and subsequent to June 30, 2003, there
were no new advances under the non-committed portion. Additionally, on August
20, 2003, this credit facility was amended to, among other things, eliminate the
non-committed portion, reduce the amount available to $50.0 million and
accelerated the expiration date from November 2002 to September 30, 2003. We
also had a $300.0 million mortgage conduit facility with a financial institution
that enabled us to sell our loans into an off-balance sheet facility, which
expired pursuant to its terms on July 5, 2003. In addition we were unable to
borrow under our $25.0 million warehouse facility after September 30, 2003 and
this $25.0 million facility expired on October 31, 2003. In addition, our
temporary discontinuation of sales of new subordinated debt for approximately a
six week period during the first quarter of fiscal 2004 further impaired our
liquidity.
At June 30, 2003, of the $516.1 million in revolving credit and conduit
facilities available to us, $453.4 million was drawn upon. Our revolving credit
facilities and mortgage conduit facility had $62.7 million of unused capacity
available at June 30, 2003, which significantly reduced our ability to fund
future loan originations until we sell existing loans, extend or expand existing
credit facilities, or add new credit facilities. At September 30, 2003, we had
$147.0 million in revolving credit facilities available to us, of which $108.6
million was drawn upon.
91
As a result of these liquidity issues, since June 30, 2003, we
substantially reduced our loan origination volume. For the three months ended
September 30, 2003, we originated $124.1 million of loans which represents a
significant reduction as compared to originations of $370.7 million of loans for
the same period in fiscal 2003. We also experienced a loss in loan origination
employees. Our inability to originate loans at previous levels adversely
impacted the relationships our subsidiaries have or are developing with their
brokers and our ability to retain employees. As a result of the decrease in loan
originations and liquidity issues described above, we incurred a loss for the
first quarter of fiscal 2004 and we anticipate incurring losses in future
periods at least through the third quarter of fiscal 2004. In light of the loss
for the quarter ended September 30, 2003, we requested and obtained waivers for
our non-compliance with financial covenants in our credit facilities and Pooling
and Servicing Agreements. See "-- Overview -- Credit Facilities, Pooling and
Servicing Agreements and Waivers Related to Financial Covenants." Further, we
can provide no assurances that we will be able to sell our loans, maintain
existing facilities or expand or obtain new credit facilities, if necessary. If
we are unable to maintain existing financing, we may not be able to restructure
our business to permit profitable operations or repay our subordinated debt when
due. Even if we are able to maintain adequate financing, our inability to
originate and sell our loans could hinder our ability to operate profitably in
the future and repay our subordinated debt when due.
We undertook specific remedial actions to address short-term liquidity
concerns including entering into an agreement on June 30, 2003 with an
investment bank to sell up to $700.0 million of mortgage loans, subject to the
satisfactory completion of the purchaser's due diligence review and other
conditions, and soliciting bids and commitments from other participants in the
whole loan sale market. In total, from June 30, 2003 through September 30, 2003,
we sold approximately $493.3 million (which includes $222.3 million of loans
sold by the expired mortgage conduit facility) of loans through whole loan
sales. We are continuing the process of selling our loans. We also suspended
paying quarterly cash dividends on our common stock.
We also entered into an amendment to the $200.0 million credit facility
which provides for the waiver of our non-compliance with the financial covenants
in that facility, the reduction of the committed portion of this facility from
$100.0 million to $50.0 million, the elimination of the $100.0 million
non-committed portion of this credit facility and the acceleration of the
expiration date of this facility from November 2003 to September 30, 2003. We
entered into subsequent amendments to this credit facility which extended the
expiration date until October 17, 2003. The loans held in this facility were
transferred to the refinanced mortgage conduit described below.
As a result of the loss experienced during fiscal 2003, we failed to
comply with the terms of certain of the financial covenants under two of our
principal credit facilities (one for $50.0 million and the other for $200.0
million, which had been reduced to $50.0 million) and we requested and obtained
waivers of these requirements from our lenders. See "-- Credit Facilities."
On September 22, 2003, we entered into definitive agreements with a
financial institution for a new $200.0 million credit facility for the purpose
of funding our loan originations. On October 14, 2003, we entered into
definitive agreements with a warehouse lender for a revolving mortgage loan
warehouse credit facility of up to $250.0 million to fund loan originations. See
"-- Credit Facilities" for information regarding the terms of these facilities
and "Risk Factors -- If we are unable to obtain additional financing, we may not
be able to restructure our business to permit profitable operations or repay our
subordinated debt when due."
92
Although we obtained two new credit facilities totaling $450.0 million,
the proceeds of these credit facilities may only be used to fund loan
originations and may not be used for any other purpose. Consequently, we will
have to generate cash to fund the balance of our business operations from other
sources, such as whole loan sales, additional financings and sales of
subordinated debt.
On October 16, 2003, we refinanced through a mortgage warehouse conduit
facility $40.0 million of loans that were previously held in an off-balance
sheet mortgage conduit facility which expired pursuant to its terms in July
2003. We also refinanced an additional $133.5 million of mortgage loans in the
new conduit facility which were previously held in other warehouse facilities,
including the $50.0 million warehouse facility which expired on October 17,
2003. The more favorable advance rate under this conduit facility as compared to
the expired facilities, which previously held these loans, along with loans
fully funded with our cash, resulted in our receipt of $17.0 million in cash. On
October 31, 2003, we completed a privately-placed securitization of the $173.5
million of loans, with servicing released, that had been transferred to this
conduit facility. The terms of this conduit facility provide that it will
terminate upon the disposition of the loans held by it.
We requested and obtained waivers or amendments to several credit
facilities to address our non-compliance with certain financial covenants as of
September 30, 2003 in light of the loss for the first quarter of fiscal 2004 and
our inability to obtain a second credit facility totaling at least $200.0
million by October 8, 2003. See "-- Credit Facilities" for additional
information regarding the waivers or amendments obtained. As a result of our
future anticipated loss and any noncompliance with other financial covenants, we
anticipate that we will also need to obtain additional waivers in future periods
from our lenders but we cannot give you any assurances as to whether or in what
form these waivers will be granted.
In addition, as a result of our non-compliance at September 30, 2003
with the net worth requirements contained in several of our Pooling and
Servicing Agreements, we requested and obtained waivers of our non-compliance
with these requirements. Pursuant to the terms of the amended agreements with
one bond insurer and the trustee, the net worth maintenance requirement was
waived for the term of the agreement and we were appointed as servicer for 120
days commencing October 1, 2003. The bond insurer may determine to reappoint us
a servicer for successive 120 day periods if we qualify to act as servicer, as
determined by the bond insurer, in its sole discretion. If we do not re-qualify,
we can be replaced as servicer. We received a verbal waiver of our
non-compliance with a financial covenant (with written documentation pending)
from another bond insurer on several other Pooling and Servicing Agreements. No
assurance can be given that we will be able to obtain this waiver in writing or
whether any conditions will be imposed on us in connection with the written
waiver.
93
The following table summarizes our short and long-term capital
resources and obligations as of September 30, 2003. For capital resources, the
table presents projected and scheduled principal cash flows expected to be
available to meet our contractual obligations. For those timeframes where a
shortfall in capital resources exists, we anticipate that these shortfalls will
be funded through a combination of cash from whole loan sales of future loan
originations and the issuance of subordinated debt. The terms of our credit
facilities provide that we may only use the funds available under the credit
facilities to originate loans.
----------------------------------------------------------------
Less than 1 to 3 4 to 5 More than
1 year years years 5 years Total
----------------------------------------------------------------
(In thousands)
Capital Resources from:
Cash .......................................... $ 27,217 $ -- $ -- $ -- $ 27,217
Loans ......................................... 150,023 1,386 420 10,859 162,688
Interest-only strips .......................... 122,184 221,309 155,970 244,316 743,779
Servicing rights .............................. 33,208 46,287 28,291 39,630 147,416
Investments ................................... 249 621 -- -- 870
------- ------- ------- ------- ----------
332,881 269,603 184,681 294,805 1,081,970
------- ------- ------- ------- ----------
Contractual Obligations (a)
Subordinated debt ............................. 288,383 330,439 41,659 27,104 687,585
Accrued interest-subordinated debt (b)......... 18,515 18,601 2,629 3,842 43,587
Warehouse and operating lines of
credit (c) .................................. 108,680 -- -- -- 108,680
Capitalized lease (d) ......................... 326 404 -- -- 730
Operating leases (e) .......................... 2,519 10,316 8,622 32,131 53,588
Services and equipment (f) .................... 4,033 -- -- -- 4,033
------- ------- ------- ------- ----------
422,456 359,760 52,910 63,077 898,203
------- ------- ------- ------- ----------
Excess (Shortfall) ................................. $(89,575) $(90,157) $131,771 $231,728 $ 183,767
======== ======== ======== ======== ==========
(a) See "--Contractual Obligations."
(b) This table reflects interest payment terms elected by subordinated debt
holders as of September 30, 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.
(c) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(d) Amounts include principal and interest.
(e) Amounts include lease for office space.
(f) 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 portion 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 may
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 "-- Securitizations" and "-- Securitizations -- Trigger Management" for more
information on how the servicing of securitized loans affects 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. We expect these sources of funds to be
sufficient to meet our 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.
94
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 successfully implement our business strategy and on the following items:
o manage the mixture of whole loan sales and securitization
transactions to maximize cash flow and economic value;
o manage levels of securitizations to maximize cash flows received at
closing and subsequently from interest-only strips and servicing
rights;
o maintain 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 identify and invest in technology and other efficiencies
to reduce per unit costs in our loan origination and servicing
process; and
o control overall expense levels.
Historically, our cash flow from operations has been negatively
impacted by a number of factors. Growth of our loan originations negatively
impacts our cash flow from operations because we incur the cash expenses of the
origination, but generally do not recover the cash outflow from these
origination 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 could negatively impact our cash flow, is an increase in market interest
rates. If market interest rates increase, the premiums we would be paid on whole
loan sales could be reduced and the interest rates that investors will demand on
the certificates issued in future securitizations will increase. The increase in
interest rates paid to investors reduces the cash we will receive from
interest-only strips created in future securitizations. 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 three months ended September 30, 2003
was a positive $128.4 million compared to a negative $8.5 million for the first
quarter of fiscal 2002. The positive cash flow from operations for the three
months ended September 30, 2003 was due to our sales of loans originated in
prior periods that were carried on our balance sheet at June 30, 2003.
Additionally, cash flow from our interest-only strips in the first quarter of
fiscal 2004 increased $21.8 million, or 65.1%, compared to the first quarter of
fiscal 2003.
The amount of cash we receive as gains on whole loan sales, and the
amount of cash we receive and the amount of overcollateralization we are
required to fund at the closing of our securitizations are 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 to fluctuate
in the foreseeable future, our goal is to reduce our negative cash flow from
operations from historical levels. We believe that if our projections based on
our business strategy prove accurate, our cash flow from operations will
continue to be positive. However, negative cash flow from operations may
continue in fiscal 2004 due to the nature of our operations and the timing to
implement our business strategy. We generally expect the level of cash flow from
operations to fluctuate.
95
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.
Contractual obligations. Following is a summary of future payments
required on our contractual obligations as of September 30, 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................. $687,585 $288,383 $330,439 $ 41,659 $ 27,104
Accrued interest - subordinated
debt (a) ...................... 43,587 18,515 18,601 2,629 3,842
Warehouse and operating lines
of credit (b).................. 108,680 108,680 -- -- --
Capitalized lease (c)............. 730 326 404 -- --
Operating leases (d).............. 53,588 2,519 10,316 8,622 32,131
Services and equipment (e)........ 4,033 4,033 -- -- --
-------- -------- -------- ---------- --------
Total obligations................. $898,203 $422,456 $359,760 $ 52,910 $ 63,077
======== ======== ======== ======== ========
(a) This table reflects interest payment terms elected by subordinated debt
holders as of September 30, 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) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(c) Amounts include principal and interest.
(d) Amounts include lease for office space.
(e) 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 portion of these payments.
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. Under the
terms of these facilities, approximately 75% to 97% of our loan originations may
be funded with borrowings under the credit facilities and the remaining amounts,
our overcollateralization requirements, must come from our operating capital.
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 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.
96
The following is a description of the warehouse and operating lines of
credit facilities, which were available to us at September 30, 2003 (in
thousands):
Facility Amount Amount
Amount Utilized Available
--------- --------- ---------
Revolving credit facilities:
Warehouse and operating revolving line of credit, expiring
September 2004 (a)....................................... $ 80,000 $ 46,626 $ 33,374
Warehouse revolving line of credit, expired October 2003 (b) 50,000 38,248 --
Warehouse revolving line of credit, expired October 2003 (c) 25,000 23,806 --
Operating revolving line of credit, expiring January 2004 (d) 5,000 -- 5,000
-------- -------- --------
Total revolving credit facilities............................. 160,000 108,680 38,374
Other facilities:
Capitalized leases, maturing January 2006 (e) ............. 730 730 --
-------- -------- --------
Total credit facilities....................................... $160,730 $109,410 $ 38,374
======== ======== ========
____________________________
(a) $200.0 million warehouse and operating credit facility with JPMorgan Chase
Bank entered into on September 22, 2003, but limited to $80.0 million
borrowing capacity at September 30, 2003 and contingent upon the closing
of an additional credit facility. Once the additional credit facility was
closed on October 14, 2003, the full $200.0 million became available.
Interest rates on the advances under this facility are based upon
one-month LIBOR plus a margin. Obligations under the facility are
collateralized by pledged loans.
Additionally, we have a letter of credit facility with JPMorgan Chase Bank
to secure lease obligations for corporate office space. The amount of the
letter of credit was $8.0 million at September 30, 2003 and will decrease
over the term of the lease.
(b) Originally a $200.0 million warehouse line of credit with Credit Suisse
First Boston Mortgage Capital, LLC. $100.0 million of this facility was
continuously committed for the term of the facility while the remaining
$100.0 million of the facility was available at Credit Suisse's
discretion. Subsequent to June 30, 2003, there were no new advances under
the non-committed portion. On August 20, 2003, this credit facility was
amended to reduce the committed portion to $50.0 million (from $100.0
million), eliminate the non-committed portion and accelerate its
expiration date from November 2003 to September 30, 2003. The expiration
date was subsequently extended to October 17, 2003, but no new advances
were permitted under this facility subsequent to September 30, 2003. This
facility was paid down in full on October 16, 2003. The interest rate on
the facility was based on one-month LIBOR plus a margin. Advances under
this facility were collateralized by pledged loans.
(c) $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. However, we
were not in compliance with the financial covenants in this facility at
September 30, 2003 and as a condition of obtaining a waiver for
non-compliance, we were not permitted further advances under this line.
Interest rates on the advances were based on one-month LIBOR plus a
margin. The obligations under this agreement were collateralized by
pledged loans. This facility was paid down in full on October 16, 2003 and
it expired pursuant to its terms on October 31, 2003.
(d) $5.0 million revolving line of credit facility from Firstrust Savings
Bank. The obligations under this facility are collateralized by the cash
flows from our investments in the ABFS 99-A lease securitization trust and
Class R and X certificates of the ABFS Mortgage Loan Trust 2001-2. The
interest rate on the advances from this facility is one-month LIBOR plus a
margin.
(e) Capitalized leases, imputed interest rate of 8.0%, collateralized by
computer equipment.
97
Until its expiration, we also had available to us a $300.0 million
mortgage conduit facility. This facility expired pursuant to its terms on July
5, 2003. At September 30, 2003, $36.0 million was outstanding under this
facility. The facility provided for the sale of loans into an off-balance sheet
facility. This facility was refinanced on October 16, 2003. See "-- Overview --
Remedial Steps Taken to Address Liquidity and Issues" and "-- Application of
Critical Accounting Policies" for further discussion of the off-balance sheet
features of this facility.
On September 22, 2003, we entered into definitive agreements with a
financial institution for a new $200.0 million credit facility for the purpose
of funding our loan originations. Pursuant to the terms of this facility, we are
required to, among other things: (i) obtain a written commitment for another
credit facility of at least $200.0 million and close that additional facility by
October 3, 2003 (this condition was satisfied by the closing of the facility
totaling $250.0 million described below); (ii) have a net worth of at least
$28.0 million by September 30, 2003; with quarterly increases of $2.0 million
thereafter; (iii) apply 60% of our net cash flow from operations each quarter to
reduce the outstanding amount of subordinated debt commencing with the quarter
ending March 31, 2004; and (iv) provide a parent company guaranty of 10% of the
outstanding principal amount of loans under the facility. Prior to the closing
of the second facility, our borrowing capacity on this $200.0 million credit
facility is limited to $80.0 million. This facility has a term of 12 months
expiring in September 2004 and is secured by the mortgage loans which are funded
by advances under the facility with interest equal to LIBOR plus a margin. This
facility is subject to representations and warranties and covenants, which are
customary for a facility of this type, as well as amortization events and events
of default related to our financial condition. These provisions require, among
other things, our maintenance of a delinquency ratio for the managed portfolio
at the end of each fiscal quarter of less than 12.0%, our subordinated debt not
to exceed $705.0 million at any time, our ownership of an amount of repurchased
loans not to exceed 1.5% of the managed portfolio and our registration statement
registering $295.0 million of subordinated debt be declared effective by the SEC
no later than October 31, 2003.
On October 3, 2003, the lender on the new $200.0 million credit
facility agreed to extend the date by which we must close an additional credit
facility of at least $200.0 million from October 3, 2003 to October 8, 2003. We
subsequently obtained a waiver from this lender which extended this required
closing date for obtaining the additional credit facility to October 14, 2003.
On October 14, 2003, we entered into definitive agreements with a
warehouse lender for a revolving mortgage loan warehouse credit facility of up
to $250.0 million to fund loan originations. The $250.0 million facility has a
term of three years with an interest rate on amounts outstanding equal to the
one-month LIBOR plus a margin and the yield maintenance fees (as defined in the
agreements). We also agreed to pay fees of $8.9 million upon closing and
approximately $10.3 million annually plus a nonusage fee based on the difference
between the average daily outstanding balance for the current month and the
maximum credit amount under the facility, as well as the lender's out-of-pocket
expenses. Advances under this facility are collateralized by specified pledged
loans and additional credit support was created by granting a security interest
in substantially all of our interest-only strips and residual interests which we
contributed to a special purpose entity organized by us to facilitate this
transaction.
98
This $250.0 million facility contains representations and warranties,
events of default and covenants which are customary for facilities of this type,
as well as our agreement to: (i) restrict the total amount of indebtedness
outstanding under the indenture related to our subordinated debt to $750.0
million or less; (ii) make quarterly reductions commencing in April 2004 of an
amount of subordinated debt pursuant to the formulas set forth in the loan
agreement; (iii) maintain maximum interest rates offered on subordinated debt
securities not to exceed 10 percentage points above comparable rates for FDIC
insured products; and (iv) maintain minimum cash and cash equivalents of not
less than $10.0 million. In addition to events of default which are typical for
this type of facility, an event of default would occur if: (1) we are unable to
sell subordinated debt for more than three consecutive weeks or on more than two
occasions in a 12 month period; and (2) certain members of management are not
executive officers and a satisfactory replacement is not found within 60 days.
The definitive agreements grant the lender an option for a period of 90 days
commencing on the first anniversary of entering into the definitive agreements
to increase the credit amount on the $250.0 million facility to $400.0 million
with additional fees and interest payable by us.
Although we obtained two new credit facilities totaling $450.0 million,
the proceeds of these credit facilities may only be used to fund loan
originations and may not be used for any other purpose. Consequently, we will
have to generate cash to fund the balance of our business operations from other
sources, such as whole loan sales, additional financings and sales of
subordinated debt.
On October 16, 2003, we refinanced through a mortgage warehouse conduit
facility $40.0 million of loans that were previously held in an off-balance
sheet mortgage conduit facility which expired pursuant to its terms in July
2003. We also refinanced an additional $133.0 million of mortgage loans in the
new conduit facility which were previously held in other warehouse facilities,
including the $50.0 million warehouse facility which expired on October 17,
2003. The more favorable advance rate under this conduit facility as compared to
the expired facilities which previously held these loans, along with loans
funded with our cash, resulted in our receipt of $17.0 million in cash. On
October 31, 2003, we completed a privately-placed securitization of the $173.5
million of loans, with servicing released, that had been transferred to this
conduit facility. The terms of this conduit facility provide that it will
terminate upon the disposition of the loans held by it.
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 of limits that we must meet as a condition to
drawing on a particular line of credit. Pursuant to the terms of these credit
facilities, the failure to comply with the financial covenants constitutes an
event of default and at the option of the lender, entitles the lender to, among
other things, terminate commitments to make future advances to us, declare all
or a portion of the loan due and payable, foreclose on the collateral securing
the loan, require servicing payments be made to the lender or other third party
or assume the servicing of the loans securing the credit facility. An event of
default under these credit facilities would result in defaults pursuant to
cross-default provisions of our other agreements, including but not limited to,
other loan agreements, lease agreements and other agreements. The failure to
comply with the terms of these credit facilities or to obtain the necessary
waivers would have a material adverse effect on our liquidity and capital
resources.
99
As a result of the loss experienced during fiscal 2003, we were not in
compliance with the terms of certain financial covenants related to net worth,
consolidated stockholders' equity and the ratio of total liabilities to
consolidated stockholders' equity under two of our principal credit facilities
(one for $50.0 million and the other for $200.0 million, of which $100.0 million
was non-committed). We have requested and obtained waivers from these covenant
provisions from both lenders. The lender under the $50.0 million warehouse
credit facility has granted us a waiver for our non-compliance with a financial
covenant in that credit facility through September 30, 2003. We also entered
into an amendment to the $200.0 million credit facility which provides for the
waiver of our non-compliance with the financial covenants in that facility, the
reduction of the committed portion of this facility from $100.0 million to $50.0
million, the elimination of the $100.0 million non-committed portion of this
credit facility and the acceleration of the expiration date of this facility
from November 2003 to September 30, 2003. We entered into subsequent amendments
to this credit facility which extended the expiration date until October 17,
2003. The loans held in this facility were transferred to the refinanced
mortgage conduit described above.
In addition, in light of the loss for the first quarter of fiscal 2004,
we requested and obtained waivers or amendments to several credit facilities to
address our non-compliance with certain financial covenants as of September 30,
2003.
The lender under the $25.0 million credit facility agreed to amend such
facility in light of our non-compliance at September 30, 2003 with the
requirement that our net income not be less than zero for two consecutive
quarters. Pursuant to the revised terms of our agreement with this lender, no
additional advances may be made under this facility after September 30, 2003.
This facility was paid down in full on October 16, 2003 and expired pursuant to
its terms on October 31, 2003.
The terms of our new $200.0 million credit facility, as amended,
require, among other things, that our registration statement registering $295.0
million of subordinated debt be declared effective by the SEC no later than
October 31, 2003 and that we have a minimum net worth of $25.0 million at
October 31, 2003 and November 30, 2003. An identical minimum net worth
requirement applies to an $8.0 million letter of credit facility with the same
lender. The lender under the $200.0 million facility agreed to extend the
deadline for our registration statement to be declared effective by the SEC to
November 10, 2003. This lender also verbally agreed (with written documentation
pending) to waive the minimum net worth requirement at October 31, 2003 under
the $200.0 million credit facility and the $8.0 million letter of credit
facility. We cannot assure you that we will be able to obtain this waiver in
writing or whether the terms of the written waiver will impose any conditions on
us.
Because we anticipate incurring a loss through at least the third
quarter of fiscal 2004 and as a result of any non-compliance with other
financial covenants, we anticipate that we will need to obtain additional
waivers from our lenders and bond insurers. We cannot assure you as to whether
or in what form a waiver or modification of these agreements would be granted to
us.
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 have elected to
utilize proceeds from the issuance of subordinated debt to fund loans instead of
using our warehouse credit facilities, depending on our determination of
liquidity needs. During the first quarter of fiscal 2004, subordinated debt
decreased by $32.0 million compared to an increase of $14.0 million in the first
quarter of fiscal 2003. The reduction in the level of subordinated debt sold was
a result of our temporary discontinuation of sales of new subordinated debt for
a portion of the first quarter of fiscal 2004.
100
We registered $315.0 million of subordinated debt under a registration
statement, which was declared effective by the SEC on October 3, 2002. Of the
$315.0 million, $80 million of this debt was unsold as of September 30, 2003.
This registration expired on October 31, 2003. In June 2003, we filed a new
registration statement with the SEC to register an additional $295.0 million of
subordinated debt which had not been declared effective by the SEC as of
October 31, 2003.
In the event we are unable to offer additional subordinated debentures
for any reason, we have developed a contingent financial restructuring plan
including cash flow projections for the next twelve-month period. Based on our
current cash flow projections, we anticipate being able to make all scheduled
subordinated debt maturities and vendor payments.
The contingent financial restructuring plan is based on actions that we
would take, in addition to those indicated in our adjusted business strategy, to
reduce our operating expenses and conserve cash. These actions would include
reducing capital expenditures, selling all loans originated on a whole loan
basis, eliminating or downsizing various lending, overhead and support groups,
and scaling back less profitable businesses. No assurance can be given that we
will be able to successfully implement the contingent financial restructuring
plan, if necessary, and repay the subordinated debentures when due.
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. To the extent that we fail to
maintain our credit facilities or obtain alternative financing on acceptable
terms and increase our loan originations, we may have to sell loans earlier than
intended and further restructure our operations, which could further hinder our
ability to repay the subordinated debt when due.
The weighted-average interest rate on subordinated debt we issued in
the month of September 2003 was 8.41%, compared to debt issued in the month of
June 2003, which had a weighted-average interest rate of 7.49%. Debt issued at
our peak rate, which was in February 2001, was at a rate of 11.85%. Our ability
to maintain the rates offered on subordinated debt, or limit increases in rates
offered, depends on our financial condition, liquidity, future results of
operations, market interest rates and competitive factors among other
circumstances. The weighted average remaining maturity of our subordinated debt
at September 2003 was 19.9 months compared to 19.5 months at June 2003.
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 may also
retain the right to service the loans. Residual cash from the loans after
required principal and interest payments are made to the investors provides 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.
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.
101
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.
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 each
of Warren E. Palitz and Jeffrey S. Steinberg as newly appointed members of our
Board of Directors.
We employ members of the immediate family of two of our executive
officers (one of whom is also a director) in various executive and other
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 received a commission from the landlord of the new corporate office space
which we believe to be consistent with market and industry standards.
Additionally, as part of our agreement with Lanard & Axilbund, Inc., they have
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.
102
Reconciliation of Non-GAAP Financial Measures
This document contains non-GAAP financial measures. For purposes of the
SEC's 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 are included in the most directly comparable
measure calculated and presented in accordance with GAAP in our statement of
income, balance sheet or statement of cash flows (or equivalent statement); 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 accounting principles
generally accepted 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 GAAP financial measure.
We present managed portfolio and managed real estate owned, referred to
as REO, information. Management believes these measures enhance the users'
overall understanding of our 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 our
financial performance as a result of our retained interests in the securitized
loans. Retained interests include interest-only strips and servicing rights. In
addition, because the servicing and collection of our 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 our
on-balance sheet loan and lease receivables, certain of our resources, such as
personnel and technology, are allocated based on their pro rata relationship to
the total managed portfolio and total managed REO. The following tables
reconcile the managed portfolio measures presented in "-- Managed Portfolio
Quality" and "Selected Financial Information." (dollars in thousands):
September 30, 2003: Delinquencies
----------------------------------------------------------------------
Amount %
----------------------------------
On-balance sheet loan and lease
receivables.................. $ 164,108 $ 11,825 7.21%
Securitized loan and lease
receivables..................... 2,807,692 256,624 9.14%
---------- --------
Total Managed Portfolio........... $2,971,800 $268,449 9.03%
========== ========
On-balance sheet REO.............. $ 4,566
Securitized REO................... 21,486
----------
Total Managed REO................. $ 26,052
==========
103
June 30, 2003: Delinquencies
------------------------------------------------------------------------
Amount %
-------------------------
On-balance sheet loan and lease
receivables.................. $ 265,764 $ 5,412 2.04%
Securitized loan and lease
receivables..................... 3,385,310 223,658 6.61%
---------- --------
Total Managed Portfolio........... $3,651,074 $229,070 6.27%
========== ========
On-balance sheet REO.............. $ 4,776
Securitized REO.................... 23,224
----------
Total Managed REO................. $ 28,000
==========
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
==========
Office Facilities
We presently lease office space for our corporate headquarters in
Philadelphia, Pennsylvania. Our corporate headquarters was located in Bala
Cynwyd, Pennsylvania prior to July 7, 2003. The lease for the Bala Cynwyd
facility has expired. The current lease term for the Philadelphia facility
expires in June 2014. 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 our 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.
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 $8.0 million and declines over time
to $4.0 million. The letter of credit is currently issued by JPMorgan Chase Bank
under our $8.0 million facility with JPMorgan Chase Bank.
We continue to lease some office space in Bala Cynwyd under a five-year
lease expiring in November 2004 at an annual rental of approximately $0.7
million. We perform loan servicing and collection activities at this office, but
expect to relocate these activities to our Philadelphia office.
104
In May 2003, we moved our regional processing center to a different
location in Roseland, New Jersey. We also lease the office space in Roseland,
New Jersey and the nine-year lease expires in January 2012. 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 expenses
and cash outlay related to the relocation were not material to our operations.
Recent Accounting Pronouncements
In January 2003, the FASB issued FIN 46 "Consolidation of Variable
Interest Entities," referred to as FIN 46 in this document. 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
Entity (SPE) is 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. In October, 2003 the FASB announced
that it was deferring implementation of FIN 46 for all variable Interest
Entities that were created before February 1, 2003 until the quarter ended
December 31, 2003. The requirements of Interpretation of FIN 46 apply
immediately to variable interest entities created after January 31, 2003.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," referred to as SFAS No.
149 in this document. SFAS No. 149 amends SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities" to clarify the financial
accounting and reporting for derivative instruments and hedging activities. SFAS
No. 149 is intended to improve financial reporting by requiring comparable
accounting methods for similar contracts. SFAS No. 149 is effective for
contracts entered into or modified subsequent to June 30, 2003. The requirements
of SFAS No. 149 do not affect the Company's current accounting for derivative
instruments or hedging activities and therefore will have no effect on the
Company's financial condition or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity,"
referred to as SFAS No. 150 in this document SFAS No. 150 requires an issuer to
classify certain financial instruments, such as mandatorily redeemable shares
and obligations to repurchase the issuer's equity shares, as liabilities. The
guidance is effective for financial instruments entered into or modified
subsequent to May 31, 2003, and otherwise is effective at the beginning of the
first interim period after June 15, 2003. The Company does not have any
instruments with such characteristics and does not expect SFAS No. 150 to have a
material impact on the financial condition or results of operations.
105
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."
106
Item 4. Controls and Procedures
The Company, under the supervision and with the participation of its
management, including its principal executive officer and principal financial
officer, evaluated the effectiveness of the design and operation of its
disclosure controls and procedures as of the end of the period covered by this
report. Based on this evaluation, the principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures are effective in reaching a reasonable level of assurance that
information required to be disclosed by the Company in the reports that it files
or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time period specified in the Securities and
Exchange Commission's rules and forms.
The principal executive officer and principal financial officer also
conducted an evaluation of internal control over financial reporting ("Internal
Control") to determine whether any changes in Internal Controls occurred during
the quarter that have materially affected or which are reasonably likely to
materially affect Internal Controls. Based on that evaluation, there has been no
such change during the quarter covered by this report.
A control system, no matter how well conceived and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Further, the design of a control system must reflect the
fact that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in all
control systems, no evaluation of controls can provide absolute assurance that
all control issues and instances of fraud, if any, within the Company have been
detected. Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be detected. The
Company conducts periodic evaluations to enhance, where necessary, its
procedures and controls.
107
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 case consisted of three purported class action counts and two
individual counts. The plaintiff alleged that the charging of, and the failure
to properly disclose the nature of, a document preparation fee were improper
under applicable state law. In November 2002 the Illinois Federal District Court
dismissed the three class action counts and an agreement in principle was
reached in August 2003 to settle the matter. The terms of the settlement have
been finalized and the action was dismissed on September 23, 2003. The matter
did not have a material effect on our consolidated financial position or results
of operations. 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 and servicing
activities, in addition to the Calvin Hale action 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 resolution 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.
Additionally, court decisions in litigation to which we are not a party
may also affect our lending activities and could subject us to litigation in the
future. For example, in Glukowsky v. Equity One, Inc., (Docket No. A-3202 -
01T3), dated April 24, 2003, to which we are not a party, 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. This case
has been appealed to the New Jersey Supreme Court which has agreed to hear this
case. We expect that, as a result of the publicity surrounding predatory lending
practices and this recent New Jersey court decision regarding the Parity Act, we
may be subject to other class action suits in the future.
In addition, from time to time, we are involved as plaintiff or
defendant in various other legal proceedings arising in the normal course of our
business. While we cannot predict the ultimate outcome of these various legal
proceedings, management believes that the resolution of these legal actions
should not have a material effect on our financial position, results of
operations or liquidity.
We received a civil subpoena dated May 14, 2003, from the Civil
Division of the U.S. Attorney for the Eastern District of Pennsylvania. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Overview."
Item 2. Changes in Securities and Use of Proceeds - 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
108
Exhibits
Exhibit
Number Description
- ----------------- -------------------------------------------------------------
Item 6. Exhibits and Reports on Form 8-K
10.1 Letter, dated August 21, 2003 from JPMorgan Chase Bank to American
Business Credit, Inc., HomeAmerican Credit, Inc., American Business
Mortgage Services, Tiger Relocation Company, ABFS Residual 2002, Inc.
and American Business Financial Services, Inc. regarding waiver of
financial covenant in 3/02 Senior Secured Credit Agreement dated as of
March 15, 2002. (Incorporated by reference to Exhibit 10.1 of the
Registrant's Current Report on Form 8-K filed on September 25, 2003).
10.2 Waiver and Amendment Number Two to the Master Repurchase Agreement
between Credit Suisse First Boston Mortgage Capital LLC and ABFS Repo
2001, Inc. dated August 20, 2003 and Letter dated as of August 20, 2003
from Credit Suisse First Boston Mortgage Capital LLC to ABFS Repo 2001,
Inc. (Incorporated by reference to Exhibit 10.2 of the Registrant's
Current Report on Form 8-K filed on September 25, 2003).
10.3 Sale and Servicing Agreement, dated September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., ABFS Mortgage Loan
Warehouse Trust 2003-1, American Business Credit, Inc., American
Business Financial Services, Inc. and JPMorgan Chase Bank.
(Incorporated by reference to Exhibit 10.3 of the Registrant's Current
Report on Form 8-K filed on September 25, 2003).
10.4 Indenture, dated September 22, 2003 between ABFS Mortgage Loan
Warehouse Trust 2003-1 and JPMorgan Chase Bank, as Indenture Trustee,
with Appendix I, Defined Terms. (Incorporated by reference to Exhibit
10.4 of the Registrant's Current Report on Form 8-K filed on September
25, 2003).
10.5 Trust Agreement, dated as of September 22, 2003, by and between ABFS
Bala Pointe, Inc., as Depositor and Wilmington Trust Company, as Owner
Trustee. (Incorporated by reference to Exhibit 10.5 of the Registrant's
Current Report on Form 8-K filed on September 25, 2003).
10.6 ABFS Mortgage Loan Warehouse Trust 2003-1 Secured Notes Series 2003-1
Purchase Agreement. (Incorporated by reference to Exhibit 10.6 of the
Registrant's Current Report on Form 8-K filed on September 25, 2003).
10.7 Commitment letter dated September 22, 2003 addressed to American
Business Financial Services Inc. from Chrysalis Warehouse Funding, LLC.
(Incorporated by reference to Exhibit 10.7 of the Registrant's Current
Report on Form 8-K filed on September 25, 2003).
10.8 Fee letter dated September 22, 2003 addressed to American Business
Financial Services, Inc. and Chrysalis Warehouse Funding, LLC from
Clearwing Capital, LLC. (Incorporated by reference to Exhibit 10.8 of
the Registrant's Current Report on Form 8-K filed on September 25,
2003).
10.9 9/03 Amendment to Senior Secured Credit Agreement dated as of September
22, 2003 among American Business Credit, Inc. and certain affiliates
and JPMorgan Chase Bank and other vendor parties thereto. (Incorporated
by reference to Exhibit 10.9 of the Registrant's Current Report on Form
8-K filed on September 25, 2003).
109
10.10 Extension of the Expiration Date, dated September 30, 2003, under the
Master Repurchase Agreement between Credit Suisse First Boston Mortgage
Capital LLC and ABFS Repo 2001, Inc. from Credit Suisse First Boston
Mortgage Capital LLC to ABFS Repo 2001, Inc. (Incorporated by reference
to Exhibit 10.10 of the Registrant's Current Report on Form 8-K filed
on October 16, 2003).
10.11 First Amendment to First Amended and Restated Warehousing Credit and
Security Agreement, dated September 30, 2003, between American Business
Credit, Inc., American Business Mortgage Services, Inc. and
HomeAmerican Credit, Inc. and Residential Funding Corporation.
(Incorporated by reference to Exhibit 10.12 of the Registrant's Current
Report on Form 8-K filed on October 16, 2003).
10.12 Waiver, dated September 30, 2003, to Indenture, dated September 22,
2003, between ABFS Mortgage Loan Warehouse Trust 2003-1 and JP Morgan
Chase Bank, as Indenture Trustee. (Incorporated by reference to Exhibit
10.13 of the Registrant's Current Report on Form 8-K filed on October
16, 2003).
10.13 Term-to-Term Servicing Agreement, Waiver and Consent, dated as of
September 30, 2003, between American Business Credit, Inc., MBIA
Insurance Corporation as Note Insurer and JP Morgan Chase Bank as
Trustee. (Incorporated by reference to Exhibit 10.14 of the
Registrant's Current Report on Form 8-K filed on October 16, 2003).
10.14 Mortgage Loan Purchase and Interim Servicing Agreement, dated July 22,
2003, among DLJ Mortgage Capital, Inc., American Business Credit, Inc.,
HomeAmerican Credit, Inc. d/b/a Upland Mortgage and American Business
Mortgage Services, Inc. (Incorporated by reference to Exhibit 10.107 of
the 2003 Form 10-K).
10.15 Waiver to Indenture, dated September 22, 2003, between ABFS Mortgage
Loan Warehouse Trust 2003-1 and JPMorgan Chase Bank, as Indenture
Trustee.
31.1 Chief Executive Officer's Certificate
31.2 Chief Financial Officer's Certificate
32.1 Certification pursuant to Section 906 of the Sarbanes Oxley Act of
2002.
Reports on Form 8-K -
The following current reports on Form 8-K were filed or furnished to the SEC
during the quarter ended September 30, 2003 or thereafter:
July 18, 2003 - (Item 5) regarding anticipated loss on results of
operations for the fiscal year ended June 30, 2003.
September 23, 2003 - regarding press release dated Tuesday, September 23,
2003 announcing loss on results of operations for the fiscal
year ended June 30, 2003.
September 25, 2003 - (Item 5) regarding short term liquidity and remedial
steps taken in light of loss on results of operations for the
fiscal year ended June 30, 2003.
October 16, 2003 - (Item 5) announcing a definitive agreement to enter into a
$250 million credit facility to fund loan originations.
October 24, 2003 - (Item 5) announcing refinancing through a mortgage
conduit facility $40.0 million of loans that were previously
held in an off-balance sheet mortgage conduit facility and the
refinancing of an additional $133.0 million of mortgage loans
previously held in other warehouse facilities.
110
SIGNATURE
Pursuant to the requirements of the Securities and Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
DATE: November 5, 2003 By: /s/ Albert W. Mandia
------------------------------------
Albert W. Mandia
Executive Vice President and Chief Financial
Officer
EXHIBIT INDEX
Exhibit
Number Description
- ------------------------------------------------------------------------------
10.1 Letter, dated August 21, 2003 from JPMorgan Chase Bank to American
Business Credit, Inc., HomeAmerican Credit, Inc., American Business
Mortgage Services, Tiger Relocation Company, ABFS Residual 2002, Inc.
and American Business Financial Services, Inc. regarding waiver of
financial covenant in 3/02 Senior Secured Credit Agreement dated as of
March 15, 2002. (Incorporated by reference to Exhibit 10.1 of the
Registrant's Current Report on Form 8-K filed on September 25, 2003).
10.2 Waiver and Amendment Number Two to the Master Repurchase Agreement
between Credit Suisse First Boston Mortgage Capital LLC and ABFS Repo
2001, Inc. dated August 20, 2003 and Letter dated as of August 20, 2003
from Credit Suisse First Boston Mortgage Capital LLC to ABFS Repo 2001,
Inc. (Incorporated by reference to Exhibit 10.2 of the Registrant's
Current Report on Form 8-K filed on September 25, 2003).
10.3 Sale and Servicing Agreement, dated September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., ABFS Mortgage Loan
Warehouse Trust 2003-1, American Business Credit, Inc., American
Business Financial Services, Inc. and JPMorgan Chase Bank.
(Incorporated by reference to Exhibit 10.3 of the Registrant's Current
Report on Form 8-K filed on September 25, 2003).
10.4 Indenture, dated September 22, 2003 between ABFS Mortgage Loan
Warehouse Trust 2003-1 and JPMorgan Chase Bank, as Indenture Trustee,
with Appendix I, Defined Terms. (Incorporated by reference to Exhibit
10.4 of the Registrant's Current Report on Form 8-K filed on September
25, 2003).
10.5 Trust Agreement, dated as of September 22, 2003, by and between ABFS
Bala Pointe, Inc., as Depositor and Wilmington Trust Company, as Owner
Trustee. (Incorporated by reference to Exhibit 10.5 of the Registrant's
Current Report on Form 8-K filed on September 25, 2003).
10.6 ABFS Mortgage Loan Warehouse Trust 2003-1 Secured Notes Series 2003-1
Purchase Agreement. (Incorporated by reference to Exhibit 10.6 of the
Registrant's Current Report on Form 8-K filed on September 25, 2003).
10.7 Commitment letter dated September 22, 2003 addressed to American
Business Financial Services Inc. from Chrysalis Warehouse Funding, LLC.
(Incorporated by reference to Exhibit 10.7 of the Registrant's Current
Report on Form 8-K filed on September 25, 2003).
10.8 Fee letter dated September 22, 2003 addressed to American Business
Financial Services, Inc. and Chrysalis Warehouse Funding, LLC from
Clearwing Capital, LLC. (Incorporated by reference to Exhibit 10.8 of
the Registrant's Current Report on Form 8-K filed on September 25,
2003).
10.9 9/03 Amendment to Senior Secured Credit Agreement dated as of September
22, 2003 among American Business Credit, Inc. and certain affiliates
and JPMorgan Chase Bank and other vendor parties thereto. (Incorporated
by reference to Exhibit 10.9 of the Registrant's Current Report on Form
8-K filed on September 25, 2003).
10.10 Extension of the Expiration Date, dated September 30, 2003, under the
Master Repurchase Agreement between Credit Suisse First Boston Mortgage
Capital LLC and ABFS Repo 2001, Inc. from Credit Suisse First Boston
Mortgage Capital LLC to ABFS Repo 2001, Inc. (Incorporated by reference
to Exhibit 10.10 of the Registrant's Current Report on Form 8-K filed
on October 16, 2003).
10.11 First Amendment to First Amended and Restated Warehousing Credit and
Security Agreement, dated September 30, 2003, between American Business
Credit, Inc., American Business Mortgage Services, Inc. and
HomeAmerican Credit, Inc. and Residential Funding Corporation.
(Incorporated by reference to Exhibit 10.12 of the Registrant's Current
Report on Form 8-K filed on October 16, 2003).
10.12 Waiver, dated September 30, 2003, to Indenture, dated September 22,
2003, between ABFS Mortgage Loan Warehouse Trust 2003-1 and JP Morgan
Chase Bank, as Indenture Trustee. (Incorporated by reference to Exhibit
10.13 of the Registrant's Current Report on Form 8-K filed on October
16, 2003).
10.13 Term-to-Term Servicing Agreement, Waiver and Consent, dated as of
September 30, 2003, between American Business Credit, Inc., MBIA
Insurance Corporation as Note Insurer and JP Morgan Chase Bank as
Trustee. (Incorporated by reference to Exhibit 10.14 of the
Registrant's Current Report on Form 8-K filed on October 16, 2003).
10.14 Mortgage Loan Purchase and Interim Servicing Agreement, dated July 22,
2003, among DLJ Mortgage Capital, Inc., American Business Credit, Inc.,
HomeAmerican Credit, Inc. d/b/a Upland Mortgage and American Business
Mortgage Services, Inc. (Incorporated by reference to Exhibit 10.107 of
the 2003 Form 10-K).
10.15 Waiver to Indenture, dated September 22, 2003, between ABFS Mortgage
Loan Warehouse Trust 2003-1 and JPMorgan Chase Bank, as Indenture
Trustee.
31.1 Chief Executive Officer's Certificate
31.2 Chief Financial Officer's Certificate
32.1 Certification pursuant to Section 906 of the Sarbanes Oxley Act of
2002.