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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 December 31, 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). [ ] YES [X] NO
The number of shares outstanding of the registrant's sole class of
common stock as of February 3, 2003 was 3,146,892 shares.
American Business Financial Services, Inc. and Subsidiaries
INDEX
Page
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PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of December 31, 2003 and June 30, 2003.........................................1
Consolidated Statements of Income for the three and six months ended December 31, 2003 and
2002......................................................................................................2
Consolidated Statement of Stockholders' Equity for the six months ended December 31, 2003.....................3
Consolidated Statements of Cash Flow for the six months ended December 31, 2003 and 2002......................4
Notes to Consolidated Financial Statements....................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...............36
Item 3. Quantitative and Qualitative Disclosures about Market Risk.........................................110
Item 4. Controls and Procedures............................................................................111
PART II OTHER INFORMATION
Item 1. Legal Proceedings..................................................................................112
Item 2. Changes in Securities and Use of Proceeds .........................................................113
Item 3. Defaults Upon Senior Securities....................................................................114
Item 4. Submission of Matters to a Vote of Security Holders ...............................................115
Item 5. Other Information..................................................................................115
Item 6. Exhibits and Reports on Form 8-K...................................................................116
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
American Business Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollar amounts in thousands)
December 31, June 30,
2003 2003
----------- ------------
Assets (Unaudited) (Note)
Cash and cash equivalents $ 29,620 $ 47,475
Loan and lease receivables, net
Available for sale 115,792 271,402
Interest and fees 19,822 15,179
Other 30,636 23,761
Interest-only strips (includes the fair value of over-collateralization
related cash flows of $251,445 at December 31, 2003 and $279,245 at
June 30, 2003) 533,677 598,278
Servicing rights 94,086 119,291
Receivable for sold loans -- 26,734
Prepaid expenses 17,147 3,477
Property and equipment, net 26,974 23,302
Deferred income tax asset 16,442 --
Other assets 27,210 30,452
----------- ------------
Total assets $ 911,406 $ 1,159,351
=========== ============
Liabilities and Stockholders' Equity
Liabilities
Subordinated debentures $ 629,674 $ 719,540
Senior collateralized subordinated notes 34,459 --
Warehouse lines and other notes payable 87,940 212,916
Accrued interest payable 39,323 45,448
Accounts payable and other accrued expenses 28,567 30,352
Deferred income tax liability -- 17,036
Other liabilities 65,837 91,990
----------- ------------
Total liabilities 885,800 1,117,282
----------- ------------
Stockholders' Equity
Preferred stock, par value $.001, liquidation preference of $1.00 per share
plus accrued and unpaid dividends to the date of liquidation, authorized
shares, 203,000,000 at December 31, 2003 and 3,000,000 at June 30, 2003;
Issued: 39,095,109 shares of Series A at December 31, 2003 39 --
Common stock, par value $.001, authorized shares, 209,000,000 at December 31,
2003 and 9,000,000 at June 30, 2003; Issued: 3,653,165 shares at December
31, 2003 and June 30, 2003 (including treasury shares of 506,273 at
December 31, 2003 and 706,273 at June 30, 2003) 4 4
Additional paid-in capital 61,150 23,985
Accumulated other comprehensive income 10,285 14,540
Unearned compensation (860) --
Retained earnings (deficit) (37,986) 13,104
Treasury stock, at cost (6,426) (8,964)
----------- ------------
26,206 42,669
Note receivable (600) (600)
----------- ------------
Total stockholders' equity 25,606 42,069
----------- ------------
Total liabilities and stockholders' equity $ 911,406 $ 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 Six Months Ended
December 31, December 31,
------------------------------ ---------------------------
2003 2002 2003 2002
------------- ----------- ---------- -----------
Revenues
Gain on sale of loans:
Securitizations $ 14,308 $ 57,879 $ 15,107 $ 115,890
Whole loan sales 78 (2) 2,999 33
Interest and fees 2,167 4,595 6,820 8,728
Interest accretion on interest-only strips 10,228 11,500 21,337 22,247
Servicing income 1,809 644 2,527 2,181
Other income 1 2 2 6
------------- ----------- ---------- -----------
Total revenues 28,591 74,618 48,792 149,085
------------- ----------- ---------- -----------
Expenses
Interest 16,650 17,150 33,468 34,233
Provision for credit losses 3,814 1,436 7,970 2,974
Employee related costs 11,799 10,972 25,651 20,547
Sales and marketing 3,093 6,485 5,934 13,173
Trading (gains) and losses 38 1,035 (5,070) 4,475
General and administrative 21,265 23,333 40,480 44,258
Securitization assets valuation adjustment 11,968 10,568 22,763 22,646
------------- ----------- ---------- -----------
Total expenses 68,627 70,979 131,196 142,306
------------- ----------- ---------- -----------
Income (Loss) Before Provision for Income Taxes
(Benefit) (40,036) 3,639 (82,404) 6,779
Provision for income taxes (benefit) (15,214) 1,528 (31,314) 2,847
------------- ----------- ---------- -----------
Net Income (Loss) $ (24,822) $ 2,111 $ (51,090) $ 3,932
============= =========== ========== ===========
Earnings (loss) per common share:
Basic $ (8.35) $ 0.72 $ (17.26) $ 1.36
============= =========== ========== ===========
Diluted $ (8.35) $ 0.69 $ (17.26) $ 1.30
============= =========== ========== ===========
Average common shares:
Basic 2,973 2,932 2,960 2,894
============= =========== ========== ===========
Diluted 2,973 3,044 2,960 3,014
============= =========== ========== ===========
See accompanying notes to consolidated financial statements.
2
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity
For the six months ended December 31, 2003
(amounts in thousands)
(unaudited)
Preferred Stock Common Stock
-------------------- ------------------- Accumulated
Number of Number of Additional Other Retained
Shares Shares Paid-In Comprehensive Unearned Earnings
Outstanding Amount Outstanding Amount Capital Income Compensation (Deficit)
----------- ------ ----------- ------ ---------- ------------- ------------ -----------
Balance June 30, 2003 -- $ -- 2,947 $ 4 $ 23,985 $ 14,540 $ -- $ 13,104
Issuance of preferred stock 39,095 39 -- -- 38,843 -- -- --
Issuance of restricted
common stock -- -- 200 -- (1,678) -- (860) --
Comprehensive income:
Net loss -- -- -- -- -- -- -- (51,090)
Net unrealized loss
on interest-only
strips -- -- -- -- -- (4,255) -- --
------ ---- ------ ----- -------- -------- ------ ---------
Total comprehensive loss -- -- -- -- -- (4,255) -- (51,090)
------ ---- ------ ----- -------- -------- ------ ---------
Balance December 31, 2003 39,095 $ 39 3,147 $ 4 $ 61,150 $ 10,285 $ (860) $ (37,986)
====== ==== ====== ===== ======== ======== ====== =========
Total
Treasury Note Stockholders'
Stock Receivable Equity
-------- ---------- ------------
Balance June 30, 2003 $ (8,964) $ (600) $ 42,069
Issuance of preferred stock -- -- 38,882
Issuance of restricted
common stock 2,538 -- --
Comprehensive income:
Net loss -- -- (51,090)
Net unrealized loss
on interest-only
strips -- -- (4,255)
-------- ------- ---------
Total comprehensive loss -- -- (55,345)
-------- ------- ---------
Balance December 31, 2003 $ (6,426) $ (600) $ 25,606
======== ======= =========
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)
Six Months Ended
December 31,
---------------------------------
2003 2002
------------ -----------
Cash flows from operating activities
Net income (loss) $ (51,090) $ 3,932
Adjustments to reconcile net income to net cash used in operating
activities:
Gain on sales of loans (15,107) (115,890)
Depreciation and amortization 27,500 24,336
Interest accretion on interest-only strips (21,057) (22,247)
Securitization assets valuation adjustment 22,763 22,646
Provision for credit losses 7,970 2,974
Loans originated for sale (276,574) (806,144)
Proceeds from sale of loans 431,166 796,441
Principal payments on loans and leases 11,165 7,051
Increase in accrued interest and fees on loan and lease receivables (4,643) (735)
Purchase of initial overcollateralization on securitized loans -- (3,800)
Required purchase of additional overcollateralization on securitized
loans (12,801) (37,680)
Cash flow from interest-only strips 97,170 72,858
(Increase) decrease in prepaid expenses (13,670) 316
(Decrease) increase in accrued interest payable (6,475) 3,709
(Decrease) increase in accounts payable and accrued expenses (1,785) 5,223
Accrued interest payable reinvested in subordinated debentures 21,285 16,911
Decrease in deferred income taxes (32,663) (785)
Decrease in loans in process (27,560) (6,941)
(Payments) receipts on derivative financial instruments (2,161) 2,087
Other, net (3,911) (5,553)
------------ -----------
Net cash provided by (used in) operating activities 149,522 (41,291)
------------ -----------
Cash flows from investing activities
Purchase of property and equipment, net (7,298) (1,527)
Principal receipts and maturity of investments 21 16
------------ -----------
Net cash used in investing activities (7,277) (1,511)
------------ -----------
4
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow (continued)
(dollar amounts in thousands)
(unaudited)
Six Months Ended
December 31,
---------------------------------
2003 2002
------------ -----------
Cash flows from financing activities
Proceeds from issuance of subordinated debentures $ 82,446 $ 89,793
Redemptions of subordinated debentures (119,693) (69,929)
Net borrowings on revolving lines of credit (99,137) 3,164
Principal payments on lease funding facility -- (1,575)
Principal payments under capital lease obligations (156) (65)
Net repayments of other notes payable (26,158) --
Financing costs incurred (964) (605)
Lease incentive receipts 3,562 (2)
Exercise of non-employee stock options -- 50
Cash dividends paid -- (464)
------------ -----------
Net cash provided by (used in) financing activities (160,100) 20,367
------------ -----------
Net decrease in cash and cash equivalents (17,855) (22,435)
Cash and cash equivalents at beginning of year 47,475 108,599
------------ -----------
Cash and cash equivalents at end of year $ 29,620 $ 86,164
============ ===========
Supplemental disclosures:
Noncash transactions recorded in the acquisition of a mortgage
broker business:
Increase in warehouse lines and other notes payable $ 475 $ --
Increase in accounts payable and other accrued expenses $ 107 $ --
Increase in other assets $ 582 $ --
Noncash transactions recorded for conversion of subordinated
debentures into preferred stock and senior collateralized
subordinated notes:
Decrease in subordinated debentures $ 73,554 $ --
Increase in senior collateralized subordinated notes $ 34,459 $ --
Increase in preferred stock $ 39 $ --
Increase in additional paid-in capital $ 39,056 $ --
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ -- $ (1,006)
Increase in warehouse lines and other notes payable $ -- $ 1,006
Cash paid during the period for:
Interest $ 16,970 $ 13,614
Income taxes $ 58 $ 734
See accompanying notes to consolidated financial statements.
5
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 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. Recent expansion has positioned the Company to increase its operations
in the western portion of the United States, especially California. The Company
originates, sells and services home equity loans through its principal direct
and indirect subsidiaries. The Company also processes and purchases home equity
loans from other financial institutions through the Bank Alliance Services
program. The Company services business purpose loans which it had originated and
sold in prior periods. To the extent the Company obtains a credit facility to
fund business purpose loans, the Company may originate and sell business purpose
loans in future periods.
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 its 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, a small processing
center in Roseland, New Jersey and a recently acquired broker operation in West
Hills, California. 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
debentures 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 and funding loan
overcollateralization requirements under the Company's credit facilities),
investments in systems and technology and for general corporate purposes.
Business Conditions
General. For its ongoing operations, the Company depends upon frequent
financings, including the sale of unsecured subordinated debentures, borrowings
under warehouse credit facilities or lines of credit and also on 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 debentures or under a
warehouse credit facility, or other borrowings, the lack of adequate funds would
adversely impact liquidity and reduce profitability or result in continued
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 debentures upon
maturity, or maintaining adequate warehouse credit facilities or lines of
credit, or securitizing and selling its loans, it may 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 debentures at maturity and may result in continued losses.
6
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
The Company has historically experienced negative cash flow from operations
since 1996 primarily because, in general, its business strategy of selling loans
through securitizations has not generated cash flow immediately. For the six
months ended December 31, 2003, the Company experienced positive cash flow from
operations of $149.5 million due to whole loan sales of its loans originated in
prior periods that were carried on its balance sheet at June 30, 2003. During
the six months ended December 31, 2003, the Company received cash on whole loan
sales of $253.2 million of loans.
For the six months ended December 31, 2003, the Company recorded a net loss of
$51.1 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 six months of fiscal 2004, its inability to
complete a securitization of loans during the first quarter of fiscal 2004, and
$22.8 million of pre-tax charges for valuation adjustments on its securitization
assets. The valuation adjustments reflect the impact of higher than anticipated
prepayments on securitized loans experienced during the first six months of
fiscal 2004 due to the continuing low interest rate environment. For the six
months ended December 31, 2003, the Company originated $227.1 million of loans,
which represents a significant reduction as compared to $773.7 million of loans
originated in the same period of the prior fiscal year.
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.
Short-term Liquidity. Several recent events and issues since the fourth quarter
of fiscal 2003 have negatively impacted the Company's short-term liquidity.
First, the Company's inability to complete a securitization during the fourth
quarter of fiscal 2003 adversely impacted its short-term liquidity position and
contributed to the loss for fiscal 2003. At June 30, 2003, of the $516.1 million
in revolving credit and conduit facilities then 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 sold
existing loans, extended or expanded existing credit facilities, or added new
credit facilities.
Second, the Company's ability to borrow under credit facilities to finance new
loan originations was limited for most of the first six months of fiscal 2004.
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, 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
7
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
July 5, 2003. 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.
Third, the Company's temporary discontinuation of sales of new subordinated
debentures 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's loan
origination volume was substantially reduced. From July 1, 2003 through December
31, 2003, the Company originated $227.1 million of loans, which represents a
significant reduction as compared to originations of $773.7 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 two quarters 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 third and fourth quarters of fiscal 2004 may not be
sufficient to cover its operating cash requirements, and the Company anticipates
incurring operating losses through the fourth quarter of fiscal 2004. On
December 31, 2003, the Company had unrestricted cash of approximately $14.7
million and up to $363.2 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
depending upon the size of its future quarterly securitizations, 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 increasing the use of loan brokers
referred to as the Company's broker initiative. On December 24, 2003, the
Company acquired a broker operation with 35 employees located in California that
operates primarily on the west coast of the United States for the purpose of
expanding its capacity to originate loans through its broker channel, primarily
in the state of California.
Beyond the short-term, the Company expects to increase originations through the
application of the business strategy adjustments discussed in "Managements
Discussion and Analysis of Financial Condition and Results of Operations --
Business Strategy." 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, which are discussed below.
For the next three to six months the Company expects to augment its sources of
operating cash with proceeds from the issuance of subordinated debentures. In
addition to repaying maturing subordinated debentures, proceeds from the
issuance of subordinated debentures will be used to fund overcollateralization
requirements in connection with loan originations and fund the Company's
operating losses. 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
between the loan value and the advances, referred to as the
overcollateralization requirement, from the Company's operating cash.
8
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
1. Summary of Significant Accounting Policies (continued)
Business Conditions (continued)
In light of the losses during the quarters ended September 30, 2003 and December
31, 2003, the Company requested and obtained waivers for its non-compliance with
financial covenants in its credit facility agreements and servicing agreements.
See Note 7 for more detail.
Remedial Actions to Address Short-term Liquidity. 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 December 31, 2003, the Company sold approximately
$501.2 million of loans (which includes $222.3 million of loans sold by the
expired mortgage conduit facility) 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 7 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 debentures.
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 expired
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 provided for the termination upon the disposition of these loans.
On December 1, 2003, the Company mailed an Offer to Exchange (the "Exchange
Offer") to holders of its subordinated debentures issued prior to April 1, 2003
("eligible debentures"). The Exchange Offer permitted holders of eligible
debentures to exchange their eligible debentures for 10% Series A convertible
preferred stock ("Series A Preferred Stock") of the Company or for an equal
combination of Series A Preferred Stock and senior collateralized subordinated
notes of the Company. In the first closing of the Exchange Offer held December
31, 2003, the Company exchanged $73.6 million of eligible debentures for 39.1
million shares of Series A Preferred Stock and $34.5 million of senior
collateralized subordinated notes. On December 31, 2003, the Company also
extended the expiration date of the Exchange Offer to February 6, 2004. As a
result of the second closing of the Exchange Offer on February 6, 2004, the
Company exchanged an additional $41.9 million of eligible debentures for 22.0
million shares of Series A Preferred Stock and $19.9 million of senior
collateralized subordinated notes.
9
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 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
subordinated debentures 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.
Subordinated Debentures and Senior Collateralized Subordinated Notes. At
December 31, 2003 there were approximately $285.6 million of subordinated
debentures and $5.2 million of senior collateralized subordinated notes,
maturing within twelve months. The Company obtains the funds to repay the
subordinated debentures and senior collateralized subordinated notes at their
maturities by securitizing loans, selling loans on a whole loan basis and
selling additional subordinated debentures. Cash flow from operations, the sale
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, although the Company's ability to
utilize the interest-only strips in this fashion could be restricted in whole or
in part by the terms of the Company's $250.0 million warehouse credit facility
and senior collateralized subordinated notes, both of which are collateralized
by the interest-only strips at the present time. See Note 4 for more detail.
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 subordinated debentures when due.
10
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
1. Summary of Significant Accounting Policies (continued)
Basis of Financial Statement Presentation
The accompanying unaudited 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 for
interim financial information and pursuant to rules and regulations of the
Securities and Exchange Commission. Accordingly, they do not include all the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring accruals
and the elimination of intercompany balances) considered necessary for a fair
presentation have been included. Operating results for the six-month period
ended December 31, 2003 are not necessarily indicative of financial results that
may be expected for the full year ended June 30, 2004. These unaudited
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in the Company's
Annual Report on Form 10-K for the fiscal year ended June 30, 2003.
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.
At the Company's annual meeting of shareholders held on December 31, 2003, the
Company's shareholders approved three proposals to enable the Company to
consummate the Exchange Offer: a proposal to increase the number of authorized
shares of common stock from 9.0 million to 209.0 million, a proposal to increase
the number of authorized shares of preferred stock from 3.0 million to 203.0
million, and a proposal to authorize the Company to issue the Series A Preferred
Stock in connection with the Company's exchange offer and the common stock
issuable upon the conversion of the Series A Preferred Stock.
Certain prior period financial statement balances have been reclassified to
conform to current period presentation.
Stock Option
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 Six Months Ended
December 31, December 31,
------------------------------------ --------------------------------
2003 2002 2003 2002
------------------------------------ --------------------------------
Net income (loss), as reported $ (24,822) $ 2,111 $ (51,090) $ 3,932
Stock based compensation costs, net of
tax effects determined under fair
value method for all awards 136 (60) 189 (119)
------------------------------------ --------------------------------
Pro forma $ (24,686) $ 2,051 $ (50,901) $ 3,813
==================================== ================================
Earnings (loss) per share - basic
As reported $ (8.35) $ 0.72 $ (17.26) $ 1.36
Pro forma $ (8.35) $ 0.70 $ (17.26) $ 1.32
Earnings (loss) per share - diluted
As reported $ (8.35) $ 0.69 $ (17.26) $ 1.30
Pro forma $ (8.35) $ 0.67 $ (17.26) $ 1.27
Restricted Cash Balances
The Company held restricted cash balances of $8.1 million at December 31, 2003
collateralizing a letter of credit facility, $6.1 million and $11.0 million
related to borrower escrow accounts at December 31, 2003 and June 30, 2003,
respectively, and $0.7 million and $6.0 million related to deposits for future
settlement of derivative financial instruments at December 31, 2003 and June 30,
2003, respectively.
11
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
1. Summary of Significant Accounting Policies (continued)
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB") issued
Financial Interpretation No. ("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 Statement of Financial Accounting Standards ("SFAS")
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities," referred to as SFAS No. 140 in this document,
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,
results of operations or cash flows 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, results of operations or cash flows.
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
an impact on the financial condition, results of operations or cash flows.
12
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
2. Acquisition
On December 24, 2003, the Company acquired a broker operation with 35 employees
located in California that operates primarily on the west coast of the United
States for the purpose of expanding its capacity to originate loans through its
broker channel, especially in the state of California. Assets acquired in this
transaction, mostly fixed assets, were not material. The purchase price was
comprised of issuing a $475 thousand convertible non-negotiable promissory note
to the seller and assuming $107 thousand of liabilities. As a result of this
transaction, the Company increased its goodwill by $582 thousand.
The convertible non-negotiable promissory note bears interest at 6% per annum
and matures June 30, 2005. At any time on or after December 24, 2004 and before
January 31, 2005, the holder of the note has the option to convert the note into
the number of shares of common stock determined by dividing the outstanding
principal amount of the note and accrued interest, if any, by $5.00, subject to
adjustment for any changes in the capitalization of the Company affecting its
common stock.
3. Loan and Lease Receivables
Loan and lease receivables - available for sale were comprised of the following
(in thousands):
December 31, June 30,
2003 2003
---------- ---------
Real estate secured loans (a) $ 114,882 $ 270,096
Leases, net of unearned income of $843 and $550 (b) 4,095 4,154
---------- ---------
118,977 274,250
Less: allowance for credit losses on loan and lease
receivables available for sale 3,185 2,848
---------- ---------
$ 115,792 $ 271,402
========== =========
(a) Includes deferred direct loan origination costs of $1.2 million and $6.8
million at December 31, 2003 and June 30, 2003, respectively.
(b) Includes deferred direct lease origination costs of $0 and $28 thousand at
December 31, 2003 and June 30, 2003, respectively.
Real estate secured loans have contractual maturities of up to 30 years.
13
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
3. Loan and Lease Receivables (continued)
At December 31, 2003 and June 30, 2003, the accrual of interest income was
suspended on real estate secured loans of $6.9 million and $5.4 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $2.4 million and $1.4 million at
December 31, 2003 and June 30, 2003, respectively.
Average balances of non-accrual loans were $5.2 million for the six months ended
December 31, 2003 and $8.6 million for the 2003 fiscal year.
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.
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. On January 22, 2004, the Company
executed an agreement to sell its interests in the remaining lease portfolio.
The terms of the agreement included a cash sale price of approximately $4.8
million in exchange for the Company's lease portfolio balance as of December 31,
2003. Additionally, the Company will continue to service the portfolio until the
February 20, 2004 servicing transfer date under the agreement. The Company
received cash from this sale in January 2004.
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.
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 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 (see Note 6). A corresponding receivable is
recorded at the lower of the loans' cost basis or fair value.
14
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
4. Interest-Only Strips
The activity for interest-only strip receivables for the six months ended
December 31, 2003 and 2002 were as follows (in thousands):
December 31,
2003 2002
--------------------------
Balance at beginning of period $ 598,278 $ 512,611
Initial recognition of interest-only strips 25,523 94,182
Cash flow from interest-only strips (97,170) (72,858)
Required purchases of additional overcollateralization 12,801 37,680
Interest accretion 21,057 22,247
Termination of lease securitization (a) (1,759) (1,741)
Net temporary adjustments to fair value (b) (5,070) 7,485
Other than temporary fair value adjustment (b) (19,983) (20,002)
----------- ----------
Balance at end of period $ 533,677 $ 579,604
=========== ==========
(a) Reflects release of lease collateral from lease securitization trusts which
were terminated in accordance with the trust documents after the full payout
of trust note certificates. Lease receivables of $1.8 million and $1.6
million, respectively, were recorded on the balance sheet at
December 31, 2003 and 2002 as a result of the terminations.
(b) Net temporary adjustments to fair value are recorded through other
comprehensive income, which is a component of equity. Other than temporary
adjustments to decrease the fair value of interest-only strips are recorded
through the income statement.
Interest-only strips include overcollateralization balances that represent
undivided interests in securitizations maintained to provide credit enhancement
to investors in securitization trusts. At December 31, 2003 and 2002, the fair
value of overcollateralization related cash flows were $251.4 million and $270.3
million, respectively.
The Company's interest-only strips secure certain obligations under its $250.0
million credit facility with a warehouse lender. These obligations include an
amount not to exceed 10% of the outstanding principal balance under this
facility and the obligations for fees payable under this facility. Assuming the
entire $250.0 million available under this credit facility were utilized, the
maximum amount secured by the interest-only strips would be approximately $60.0
million.
Interest-only strips also secure 150% of the original principal amount of the
Company's senior collateralized subordinated notes. At December 31, 2003, $51.7
million of the Company's interest-only strips were securing the senior
collateralized subordinated notes.
15
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
4. Interest-Only Strips (continued)
Beginning in the second quarter of fiscal 2002 and on a quarterly basis
thereafter, the Company increased the prepayment rate assumptions used to value
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
continuing low interest rates during this period, the Company's prepayment
experience exceeded even our revised assumptions. As a result, over the last
nine quarters the Company has recorded cumulative pre-tax write downs to its
interest-only strips in the aggregate amount of $160.0 million and pre-tax
adjustments to the value of servicing rights of $15.2 million, for total
adjustments of $175.2 million, mainly due to the higher than expected prepayment
experience. Of this amount, $113.1 million was expensed through the income
statement and $62.1 million resulted in a write down through other comprehensive
income, a component of stockholders' equity.
During the same period, the Company reduced the discount rates it applies to
value its securitization assets, resulting in favorable valuation impacts of
$29.3 million on its interest-only strips and $7.1 million on its servicing
rights. Of this amount, $23.1 million offset the adjustments expensed through
the income statement and $13.3 million offset write downs through other
comprehensive income. The discount rates were reduced primarily to reflect the
impact of the sustained decline in market interest rates.
The long duration of historically low interest rates has given borrowers an
extended opportunity to engage in mortgage refinancing activities which resulted
in elevated prepayment experience. The persistence of historically low interest
rate levels, unprecedented in the last 40 years, has made the forecasting of
prepayment levels in future fiscal periods difficult. The Company had assumed
that the decline in interest rates had stopped and a rise in interest rates
would occur in the near term. Consistent with this view, the Company had
utilized derivative financial instruments to manage interest rate risk exposure
on 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 December 17, 2003 that mortgage refinancings as a
percentage share of total mortgage originations will decline from 68% in the
second quarter of calendar 2003 to 25% in the second quarter of calendar 2004.
The Mortgage Bankers Association of America has also projected in its December
2003 economic forecast that the 10-year treasury rate (which generally affects
mortgage rates) will increase slightly 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 our 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 securitization
assets and its actual experience may have a significant adverse impact on the
value of these assets.
16
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
4. Interest-Only Strips (continued)
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 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
December 31, 2003 14,724 11,968 2,756
--------- -------- --------
Total Fiscal 2004 $ 31,382 $ 22,763 $ 8,619
========= ======== ========
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.
During the six months ended December 31, 2003, the Company recorded gross
pre-tax valuation adjustments on its securitization assets primarily related to
prepayment experience of $39.8 million, of which $28.0 million was charged to
the income statement and $11.8 million was charged to other comprehensive
income. The valuation adjustment on interest-only strips for the six months
ended December 31, 2003 was offset by an $8.4 million favorable impact of
reducing the discount rate applied to value the residual cash flows from
interest-only strips on December 31, 2003. Of this amount, $5.2
17
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
4. Interest-Only Strips (continued)
million offset the portion of the adjustment expensed through the income
statement and $3.2 million offset the portion of the adjustment charged to other
comprehensive income. The breakout of the total adjustments in the six months
ended December 31, 2003 between interest-only strips and servicing rights was as
follows:
o The Company recorded gross pre-tax valuation adjustments on its
interest only-strips of $37.0 million, of which $25.2 million was
charged to the income statement and $11.8 million was charged to
other comprehensive income. The gross valuation adjustment primarily
reflects the impact of higher than anticipated prepayments on
securitized loans experienced in the first six months of fiscal 2004
due to the continuing low interest rate environment. The valuation
adjustment on interest-only strips for the six months ended December
31, 2003 was offset by an $8.4 million favorable impact of reducing
the discount rate applied to value the residual cash flows from
interest-only strips on December 31, 2003. Of this amount, $5.2
million offset the portion of the adjustment expensed through the
income statement and $3.2 million offset the portion of the
adjustment charged to other comprehensive income. The discount rate
was reduced to 10% on December 31, 2003 from 11% on September 30,
2003 and June 30, 2003 primarily to reflect the impact of the
sustained decline in market interest rates.
o The Company recorded total pre-tax valuation adjustments on its
servicing rights of $2.8 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 six months of fiscal 2004 due to the continuing low interest
rate environment.
5. Servicing Rights
Activity for the loan and lease servicing rights asset for the six months ended
December 31, 2003 and 2002 were as follows (in thousands):
December 31,
2003 2002
----------------------------
Balance at beginning of year $ 119,291 $ 125,288
Initial recognition of servicing rights -- 27,248
Amortization (22,425) (19,269)
Write down (2,780) (2,644)
----------- ----------
Balance at end of period $ 94,086 $ 130,623
=========== ==========
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 two quarters of
fiscal 2004, we recorded total pre-tax valuation adjustments on our servicing
rights of $2.8 million, which was charged to the income statement.
18
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
6. Other Assets and Other Liabilities
Other assets were comprised of the following (in thousands):
December 31, June 30,
2003 2003
---------- --------
Goodwill $ 15,703 $ 15,121
Financing costs, debt offerings 3,528 3,984
Real estate owned 3,077 4,776
Due from securitization trusts for
servicing related activities 1,048 1,344
Investments held to maturity 860 881
Other 2,994 4,346
--------- --------
$ 27,210 $ 30,452
========= ========
Other liabilities were comprised of the following (in thousands):
December 31, June 30,
2003 2003
---------- --------
Obligation for repurchase of securitized loans $ 36,042 $ 27,954
Unearned lease incentives 12,438 9,465
Commitments to fund closed loans 7,627 35,187
Escrow deposits held 6,082 10,988
Deferred rent incentive 2,514 --
Hedging liabilities, at fair value -- 6,335
Periodic advance guarantee 171 650
Trading liabilities, at fair value 48 334
Other 915 1,077
--------- --------
$ 65,837 $ 91,990
========= ========
See Note 3 for an explanation of the obligation for the repurchase of
securitized loans.
19
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable
Subordinated debentures was comprised of the following (in thousands):
December 31, June 30,
2003 2003
---------- --------
Subordinated debentures (a) $ 615,790 $702,423
Subordinated debentures - money market notes (b) 13,884 17,117
--------- --------
Total subordinated debentures $ 629,674 $719,540
========= ========
Senior collateralized subordinated notes were comprised of the following (in
thousands):
December 31, June 30,
2003 2003
---------- --------
Senior collateralized subordinated notes (c) $ 34,459 $ --
========= ========
Warehouse lines and other notes payable were comprised of the following (in
thousands):
December 31, June 30,
2003 2003
---------- --------
Warehouse revolving line of credit (d) $ 8,010 $ --
Warehouse revolving line of credit (e) 78,804 --
Warehouse and operating revolving line of credit (f) -- 30,182
Warehouse revolving line of credit (g) -- 136,098
Warehouse revolving line of credit (h) -- 19,671
Capitalized leases (i) 651 807
Convertible promissory note (j) 475 --
Bank overdraft (k) -- 26,158
--------- --------
Total warehouse lines and other notes payable $ 87,940 $212,916
========= ========
(a) Subordinated debentures due January 2004 through January 2014, interest
rates ranging from 3.75% to 13.00%; average rate at December 31, 2003 was
9.16%, average remaining maturity was 17.7 months, subordinated to all of
the Company's senior indebtedness. The average rate on subordinated
debentures including money market notes was 9.07% at December 31, 2003.
(b) Subordinated debentures - money market notes due upon demand, interest rate
at 4.88%; subordinated to all of the Company's senior indebtedness.
20
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable (continued)
(c) Senior collateralized subordinated notes due December 2004 through January
2014, interest rates ranging from 5.40% to 13.00%; average rate at December
31, 2003 was 9.53%, average remaining maturity was 24.7 months. The senior
collateralized subordinated notes are secured by a security interest in
certain cash flows originating from interest-only strips of the Company's
subsidiaries held by ABFS Warehouse Trust 2003-1 with an aggregate value of
at least an amount equal to 150% of the outstanding principal balance of
the senior collateralized subordinated notes; provided that, such
collateral coverage may not fall below 100% of the outstanding principal
balance of the senior collateralized subordinated notes, as determined by
the Company on any quarterly balance sheet date. In the event of
liquidation, to the extent the collateral securing the senior
collateralized subordinated notes is not sufficient to repay these notes,
the deficiency portion of the senior collateralized subordinated notes will
rank junior in right of payment behind the Company's senior indebtedness
and all of its other existing and future senior debt and debt of its
subsidiaries and equally in right of payment with the subordinated
debentures, and any future subordinated debentures issued by the Company
and other unsecured debt. Senior collateralized subordinated notes were
issued in connection with the December 1, 2003 Exchange Offer. At December
31, 2003, $51.7 million of the Company's interest-only strips were
collateralizing the senior collateralized subordinated notes.
(d) $200.0 million warehouse revolving line of credit with JPMorgan Chase Bank
entered into on September 22, 2003 and expiring September 2004. 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.
(e) $250.0 million warehouse revolving line of credit with Chrysalis Warehouse
Funding, LLC, entered into on October 14, 2003 and expiring October 2006.
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 and certain interest-only strips.
(f) Originally a $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 December 31, 2003, was collateralized
by cash and will decrease over the term of the lease.
(g) 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.
(h) Previously a $25.0 million warehouse line of credit facility from
Residential Funding Corporation. Under this warehouse facility, advances
could be obtained, subject to specific conditions described in the
agreements. 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.
(i) Capitalized leases, maturing through January 2006, imputed interest rate of
8.0%, collateralized by computer equipment.
(j) Convertible non-negotiable promissory note issued December 24, 2003 in the
acquisition of certain assets and operations of a mortgage broker business.
The note bears interest at 6% per annum and matures June 30, 2005. At any
time on or after December 24, 2004 and before January 31, 2005, the holder
of the note has the option to convert the note into the number of shares of
common stock determined by dividing the outstanding principal amount of the
note and accrued interest, if any, by $5.00, subject to adjustment for any
changes in the capitalization of the Company affecting its common stock.
(k) Overdraft amount on bank accounts paid on the following business day.
21
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable (continued)
At December 31, 2003, warehouse lines and other notes payable were
collateralized by $91.2 million of loan and lease receivables and $1.0 million
of computer equipment.
In addition to the above, the Company had available to it 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 December 31,
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.
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.
On October 16, 2003, the Company refinanced through another mortgage warehouse
conduit facility $40.0 million of loans that were previously held in the above
off-balance sheet mortgage conduit facility. 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 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 the loans held by it.
Interest rates paid on the revolving credit facilities range from London
Inter-Bank Offered Rate ("LIBOR") plus 2.00% to LIBOR plus 2.50%. The
weighted-average interest rate paid on the revolving credit facilities was 3.57%
and 2.24% at December 31, 2003 and June 30, 2003, respectively.
Principal payments on subordinated debentures, senior collateralized
subordinated notes, warehouse lines and other notes payable for the next five
years are as follows (in thousands): twelve month period ending December 31,
2004 - $377,958; 2005 - $196,869; 2006 - $126,030; 2007 - $18,116; and, 2008 -
$11,778.
In September 2002, the Company entered into a series of leases for computer
equipment, which qualify as capital leases. The original principal amount of
debt recorded under these leases was $1.0 million. The leases have an imputed
interest rate of 8.0% and mature through January 2006.
Financial and Other Covenants
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
22
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable (continued)
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 requested and obtained waivers from
these covenant provisions from both lenders. The lender under the $50.0 million
warehouse credit facility granted the Company a waiver for its non-compliance
with a financial covenant in that credit facility through December 31, 2003 and
converted this facility to an $8.0 million letter of credit facility. This $50.0
million facility was replaced by the new $200.0 million facility described below
and the principal amount that remains on this facility is the $8.0 million
letter of credit which secures the lease on the Company's principal executive
office. The Company also entered into an amendment to the $200.0 million credit
facility which provided 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 losses during the first and second quarters of
fiscal 2004, the Company requested and obtained waivers or amendments to several
credit facilities to address its non-compliance with certain financial
covenants.
The terms of the Company's new $200.0 million credit facility, as amended,
required, among other things, that our registration statement registering $295.0
million of subordinated debentures 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 the $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. The Company's registration statement was declared effective
on November 7, 2003. This lender also waived the minimum net worth requirement
at October 31, 2003, November 30, 2003 and also December 31, 2003 under the
$200.0 million credit facility and the $8.0 million letter of credit facility.
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.
23
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable (continued)
On September 22, 2003, the Company entered into definitive agreements with JP
Morgan Chase Bank 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 was 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 debentures 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 debentures 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 debentures 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 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 extended this required
closing date for obtaining the 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 debentures to $750.0
million or less; (ii) make quarterly reductions commencing in April 2004 of an
amount of subordinated debentures pursuant to the formulas set forth in the loan
agreement; (iii) maintain maximum interest rates offered on subordinated
debentures securities not to exceed 10 percentage points above comparable rates
for
24
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable (continued)
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 debentures 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.
Subordinated Debentures and Senior Collateralized Subordinated Notes
Under a registration statement declared effective by the SEC on November 7,
2003, the Company registered $295.0 million of subordinated debentures. Of the
$295.0 million, $252.9 million of debt from this registration statement was
available for future issuance as of December 31, 2003.
On December 1, 2003, the Company mailed an Exchange Offer to holders of its
eligible debentures. Holders of such eligible debentures had the ability to
exchange their notes for (i) equal amounts of senior collateralized subordinated
notes and shares of the Series A Preferred Stock; and/or (ii) dollar-for-dollar
for shares of Series A Preferred Stock. Senior collateralized subordinated notes
issued in the exchange have interest rates equal to 10 basis points above the
eligible debentures tendered. Senior collateralized subordinated notes with
maturities of 12 months were issued in exchange for subordinated debentures
tendered with maturities of less than 12 months, while subordinated debentures
with maturities greater than 36 months were exchanged for senior collateralized
subordinated notes with the same maturity or reduced to 36 months. All other
senior collateralized subordinated notes issued in the exchange have maturities
equal to the eligible debentures tendered. The senior collateralized
subordinated notes are secured by a security interest in certain cash flows
originating from interest-only strips of the Company's subsidiaries held by ABFS
Warehouse Trust 2003-1 with an aggregate value of at least an amount equal to
150% of the outstanding principal balance of the senior collateralized
subordinated notes; provided that, such collateral coverage may not fall below
100% of the outstanding principal balance of the senior collateralized
subordinated notes, as determined by the Company on any quarterly balance sheet
date. In the event of liquidation, to the extent the collateral securing the
senior collateralized subordinated notes is not sufficient to repay these notes,
the deficiency portion of the senior collateralized subordinated notes will rank
junior in right of payment behind the Company's senior indebtedness and all of
the Company's other existing and future senior debt and debt of our subsidiaries
and equally in right of payment with the subordinated debentures, and any future
subordinated debentures issued by the Company and other unsecured debt.
Pursuant to the terms of the Exchange Offer, in the first closing of the
Exchange Offer on December 31, 2003, the Company exchanged $73.6 million of
outstanding subordinated debentures for 39.1 million shares of Series A
Preferred Stock and $34.5 million of senior collateralized subordinated notes.
On December 31, 2003, the Company also extended the expiration date of the
Exchange Offer to February 6, 2004. As a result of the second closing of the
Exchange Offer on February 6, 2004, the Company exchanged an additional $41.9
million of eligible debentures for 22.0 million shares of Series A Preferred
Stock and $19.9 million of senior collateralized subordinated notes.
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 payments for maturities of subordinated debentures, senior
collateralized subordinated notes and vendor payments.
25
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
7. Subordinated Debentures, Senior Collateralized Subordinated Notes and
Warehouse Lines and Other Notes Payable (continued)
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 debentures 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 debentures 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 debentures.
Facility Fees
The Company paid commitment fees and non-usage fees on warehouse lines and
operating lines of credit of $12.1 million and $18.8 million in the three and
six months ended December 31, 2003 and $0.4 million during the fiscal year ended
June 30, 2003.
8. Stockholders' Equity
Exchange Offer
On December 1, 2003, the Company mailed an Exchange Offer to holders of its
eligible debentures. Holders of such eligible debentures had the ability to
exchange their notes for (i) equal amounts of senior collateralized subordinated
notes and shares of Series A Preferred Stock; and/or (ii) dollar-for-dollar for
shares of Series A Preferred Stock. See Note 7 for a description of the terms of
the senior collateralized subordinated notes.
Pursuant to the terms of the Exchange Offer, in the first closing of the
Exchange Offer on December 31,
26
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
8. Stockholders' Equity (continued)
2003, the Company exchanged $73.6 million of outstanding subordinated debentures
for 39.1 million shares of Series A Preferred Stock and $34.5 million of senior
collateralized subordinated notes. On December 31, 2003, the Company also
extended the expiration date of the Exchange Offer to February 6, 2004. As a
result of the second closing of the Exchange Offer on February 6, 2004, the
Company exchanged an additional $41.9 million of eligible debentures for 22.0
million shares of Series A Preferred Stock and $19.9 million of senior
collateralized subordinated notes.
Terms of the Series A Preferred Stock
General. The Series A Preferred Stock has a par value of $.001 per share and may
be redeemed at the Company's option at a price equal to the liquidation value
plus accrued and unpaid dividends after the second anniversary of the issuance
date.
Liquidation Preference. Upon any voluntary or involuntary liquidation, the
holders of the Series A Preferred Stock will be entitled to receive a
liquidation preference of $1.00 per share, plus accrued and unpaid dividends to
the date of liquidation. Based on the shares of Series A Preferred Stock
outstanding on December 31, 2003, the liquidation value equals $39.1 million.
Dividend Payments. Monthly dividend payments will be $.0083 per share of Series
A Preferred Stock (equivalent to $.10 per share annually or 10% annually of the
liquidation value). Payment of dividends on the Series A Preferred Stock is
subject to compliance with applicable Delaware state law. Based on the shares of
Series A Preferred Stock outstanding on December 31, 2003, the annual dividend
requirement equals $3.9 million.
Conversion into Shares of Common Stock. On or after the second anniversary of
the issuance date (or on or after the one year anniversary of the issuance date
if no dividends are paid on the Series A Preferred Stock), each share of the
Series A Preferred Stock is convertible at the option of the holder into a
number of shares of the Company's common stock determined by dividing: (A) $1.00
plus an amount equal to accrued but unpaid dividends (if the conversion date is
prior to the second anniversary of the issuance date because the Series A
Preferred Stock has become convertible due to a failure to pay dividends), $1.20
plus an amount equal to accrued but unpaid dividends (if the conversion date is
prior to the third anniversary of the issuance date but on or after the second
anniversary of the issuance date) or $1.30 plus an amount equal to accrued but
unpaid dividends (if the conversion date is on or after the third anniversary of
the issuance date) by (B) the market value of a share of the Company's common
stock (which figure shall not be less than $5.00 per share regardless of the
actual market value on the conversion date). Based on the $5.00 per share market
value floor and if each share of Series A Preferred Stock issued at the December
31, 2003 and February 6, 2004 closings converted on the anniversary dates listed
below, the number of shares of the Company's common stock which would be issued
upon conversion follows (shares in thousands):
December 31, 2003 Closing February 6, 2004 Closing
------------------------------------ -----------------------------------
Convertible Convertible
Number of into Number of Number of into Number
Preferred Common Preferred of Common
Shares Shares Shares Shares
---------------- ---------------- ---------------- ------------
Second anniversary date 39,095 9,382 22,015 5,284
Third anniversary date 39,095 10,165 22,015 5,724
As described above, the conversion ratio of the Series A Preferred Stock
increases during the first three years after its issuance, which provides the
holders of the Series A Preferred Stock with a discount on the shares of common
stock that will be issued upon conversion. This discount, which is referred to
as a beneficial conversion feature, was valued at $4.6 million on December 31,
2003. The value of the beneficial conversion feature equals the excess of the
intrinsic value of the shares of common stock that will be issued upon
conversion of the Series A Preferred Stock, over the value of the Series A
Preferred Stock on the date it was issued. The $4.6 million will be amortized to
the income statement over the three-year period that the holders of the Series A
Preferred Stock earn the discount as additional non-cash dividends on the Series
A Preferred Stock.
27
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
8. Stockholders' Equity (continued)
Restricted Shares Granted
The Company entered into an employment agreement dated December 24, 2003 with an
experienced industry professional who will direct the wholesale business for the
Company. The employment agreement provided for this executive to receive an
award of 200,000 restricted shares of the Company's common stock. The vesting of
these restricted shares is subject to the executive achieving performance
targets for the wholesale business. The restricted shares were issued from the
Company's treasury stock with an average cost of $12.69 per share. The market
price of the Company's common stock on December 31, 2003 was $4.30 per common
share and was used to record unearned compensation on the restricted shares.
Unearned compensation will be adjusted as the Company's common stock price
changes and will be expensed over the vesting period of the restricted stock.
9. 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.
28
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
9. Legal Proceedings (continued)
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.
10. 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.
In connection with the acquisition of the California mortgage broker operation,
the Company assumed the obligations under a lease for approximately 3,700 square
feet of space in West Hills, California. The remaining term of the lease is 2
3/4 years, expiring September 30, 2006 at an annual rental of approximately $0.1
million.
29
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
10. Commitments (continued)
Periodic Advance Guarantees
As the servicer of securitized loans, the Company is obligated to advance
interest payments for delinquent loans if we deem that the advances will
ultimately be recoverable. These advances can first be made out of funds
available in a trust's collection account. If the funds available from the
trust's collection account are insufficient to make the required interest
advances, then the Company is required to make the advance from its operating
cash. The advances made from a trust's collection account, if not recovered from
the borrower or proceeds from the liquidation of the loan, require reimbursement
from the Company. However, the Company can recover any advances the Company
makes from its operating cash from the subsequent month's mortgage loan 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 $0.2 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.
30
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
11. Derivative Financial Instruments
Hedging Activity
A primary market risk exposure that the Company faces is interest rate risk.
Interest rate risk occurs due to potential changes in interest rates between the
date fixed rate loans are originated and the date of securitization. The Company
may, from time to time, utilize hedging strategies to mitigate the effect of
changes in interest rates between the date loans are originated and the date the
fixed rate pass-through certificates to be issued by a securitization trust are
priced, a period typically less than 90 days.
The Company recorded the following gains and losses on the fair value of
derivative financial instruments accounted for as hedges for the three and
six-month periods ended December 31, 2003 and 2002. Any ineffectiveness related
to hedging transactions during the period was immaterial. Ineffectiveness is a
measure of the difference in the change in fair value of the derivative
financial instrument as compared to the change in the fair value of the item
hedged (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
------------------------- ----------------------
2003 2002 2003 2002
----------- ----------- ---------- ----------
Offset by losses and gains recorded on
securitizations:
Gains (losses) on derivative financial
instruments $ -- $ 1,104 $ -- $ (1,735)
Offset by losses and gains recorded on the
fair value of hedged items:
Gains (losses) on derivative financial
instruments (648) (2,087) (648) (3,054)
Amount settled in cash - received (paid) (692) (2,422) (692) (2,422)
At December 31, 2003 and 2002, outstanding Eurodollar futures contracts and
forward starting interest rate swap contracts accounted for as hedges and the
related unrealized gains (losses) recorded as assets (liabilities) on the
balance sheet were as follows (in thousands):
December 31, 2003 December 31, 2002
----------------------------- -----------------------------
Notional Unrealized Notional Unrealized
Amount Gain Amount (Loss)
------------- ------------- ------------ --------------
Eurodollar futures contracts $ 50,000 $ 44 -- --
Forward starting interest rate swaps -- -- $ 84,370 $ (2,087)
31
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
11. Derivative Financial Instruments (continued)
Trading Activity
The Company recorded the following gains and losses on forward starting interest
rate swap contracts classified as trading for the three and six-month periods
ended December 31, 2003 and 2002 (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
------------------------- ----------------------
2003 2002 2003 2002
----------- ----------- ---------- ----------
Trading Gains/(Losses) on forward starting
interest rate swaps:
Related to loan pipeline $ -- $ (407) $ -- $ (2,924)
Related to whole loan sales -- -- 5,097 --
Amount settled in cash - (paid) -- (2,671) (1,212) (2,671)
At December 31, 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 December 31, 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):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate swaps $10,630 $ 263
The Company has an interest rate swap contract, which is not designated as an
accounting hedge, designed to reduce the exposure to changes in the fair value
of certain interest-only strips due to changes in one-month LIBOR. Unrealized
gains and losses on the interest rate swap contract are due to changes in the
interest rate swap yield curve during the periods the contract is in place. Net
gains and losses on this interest rate swap contract include the amount of cash
settlement with the contract counter party each period. Net gains and losses on
this interest rate swap contract for the three and six-month periods ended
December 31, 2003 and 2002 were as follows (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
------------------------- ----------------------
2003 2002 2003 2002
----------- ----------- ---------- ----------
Unrealized gain (loss) on interest rate
swap contract $ 109 $ (417) $ 286 $ (295)
Cash interest received (paid) on
interest rate swap contract (91) (270) (257) (540)
-------- -------- ------- -------
Net gain (loss) on interest rate swap
contract $ 18 $ (687) $ 29 $ (835)
======== ======== ======= =======
32
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
11. Derivative Financial Instruments (continued)
The cumulative net unrealized loss of $48 thousand at December 31, 2003 is
included as a trading liability in Other liabilities. Terms of the interest rate
swap contract at December 31, 2003 were as follows (dollars in thousands):
Notional amount $ 14,887
Rate received - Floating (a) 1.20%
Rate paid - Fixed 2.89%
Maturity date April 2004
Unrealized loss $ 48
Sensitivity to 0.1% change in interest rates $ 2
- -------------------
(a) Rate represents the spot rate for one-month LIBOR paid on the securitized
floating interest rate certificate at the end of the period.
12. 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 Six Months Ended
December 31, December 31,
--------------------------- --------------------------
2003 2002 2003 2002
------------ ----------- ------------ ----------
Earnings
(a) Net Income $ (24,822) $ 2,111 $ (51,090) $ 3,932
========== ========== =========== =========
Average Common Shares
(b) Average common shares outstanding 2,973 2,932 2,960 2,894
Average potentially dilutive shares (i) 112 (ii) 120
---------- ---------- ---------- ---------
(c) Average common and potentially
dilutive shares 2,973 3,044 2,960 3,014
========== ========== =========== =========
Earnings Per Common Share
Basic (a/b) $ (8.35) $ 0.72 $ (17.26) $ 1.36
Diluted (a/c) $ (8.35) $ 0.69 $ (17.26) $ 1.30
(i) 104 shares anti-dilutive for the period
(ii) 81 shares anti-dilutive for the period
33
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
13. Segment Information
The Company has three operating segments: Loan Origination, Servicing and
Treasury and Funding.
The Loan Origination segment originates home equity loans typically to
credit-impaired borrowers and loans secured by one-to-four family residential
real estate and business purpose loans secured by real estate and other business
assets.
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 debentures
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.
34
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2003
13. Segment Information (continued)
Six months ended Loan Treasury Reconciling
December 31, 2003: Origination and Funding Servicing All Other Items Consolidated
----------- ----------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans:
Securitizations $ 15,107 $ -- $ -- $ -- $ -- $ 15,107
Whole loan sales 2,999 -- -- -- -- 2,999
Interest income 4,960 15 271 21,354 -- 26,600
Non-interest income 1,240 -- 25,236 -- (22,390) 4,086
Inter-segment revenues -- 34,105 -- 16,705 (50,810) --
Operating expenses:
Interest expense 12,121 32,264 (565) 23,753 (34,105) 33,468
Non-interest expense 35,610 3,623 19,717 12,388 -- 71,338
Depreciation and amortization 1,174 32 503 1,918 -- 3,627
Securitization assets valuation
adjustments -- -- -- 22,763 -- 22,763
Inter-segment expense 39,095 -- -- -- (39,095) --
Income tax expense (benefit) (24,204) (684) 2,224 (8,650) -- (31,314)
-------- -------- -------- -------- ---------- -----------
Net income (loss) $(39,490) $ (1,115) $ 3,628 $(14,113) $ -- $ (51,090)
======== ======== ======== ======== ========== ===========
Segment assets $179,918 $239,396 $ 84,170 $534,032 $ (126,110) $ 911,406
======== ======== ======== ======== ========== ===========
Six months ended Loan Treasury Reconciling
December 31, 2002: Origination and Funding Servicing All Other Items Consolidated
----------- ----------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans:
Securitizations $115,890 $ -- $ -- $ -- $ -- $ 115,890
Whole loan sales 33 -- -- -- -- 33
Interest income 3,454 267 416 22,247 -- 26,384
Non-interest income 4,359 1 21,654 -- (19,236) 6,778
Inter-segment revenues -- 37,041 -- 38,409 (75,450) --
Operating expenses:
Interest expense 11,526 33,578 (92) 26,262 (37,041) 34,233
Non-interest expense 24,135 5,069 19,476 33,301 -- 81,981
Depreciation and amortization 1,691 58 604 1,093 -- 3,446
Securitization assets valuation
adjustment -- -- -- 22,646 -- 22,646
Inter-segment expense 57,645 -- -- -- (57,645) --
Income tax expense (credit) 12,070 (586) 874 (9,511) -- 2,847
-------- -------- -------- -------- ---------- -----------
Net income (loss) $ 16,669 $ (810) $ 1,208 $(13,135) $ -- $ 3,932
======== ======== ======== ======== ========== ===========
Segment assets $103,663 $186,629 $128,376 $616,287 $ (93,262) $ 941,693
======== ======== ======== ======== ========== ===========
35
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.
Overview
General. We are a diversified financial services organization operating
predominantly in the eastern and central portions of the United States. Recent
expansion has positioned us to significantly increase our operations in the
western portion of the United States, especially California. (See "-- Business
Strategy Adjustments" for details of our acquisition of a broker operation
located in California.) Through our principal direct and indirect subsidiaries,
we originate, sell and service home equity and, subject to market conditions in
the secondary loan market, business purpose loans. We also process and purchase
home equity loans through our Bank Alliance Services program. Additionally, we
service business purpose loans, which we had originated and sold in prior
periods. To the extent we obtain a credit facility to fund business purpose
loans, we may originate and sell business purpose loans in future periods.
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, a small processing center in Roseland, New
Jersey and a recently acquired broker operation in West Hills, California. 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 debentures 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 and funding our loan
overcollateralization requirements under our credit facilities), investments in
systems and technology and for general corporate purposes.
36
Current Financial Position and Future Liquidity Issues. On February 3,
2004, we had cash of approximately $37.7 million (including unrestricted cash of
$20.6 million) and up to $308.6 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 third and fourth 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 debentures. In
addition to repaying maturing subordinated debentures, proceeds from the
issuance of subordinated debentures 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 six months of fiscal
2004, including our inability to complete our typical publicly underwritten
securitization during the fourth quarter of fiscal 2003 and the first quarter of
fiscal 2004 and our inability to draw down upon and the expiration of several
credit facilities. In addition, our temporary discontinuation of sales of new
subordinated debentures 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 $51.1 million for the
fiscal year ended June 30, 2003 and the first six months of fiscal 2004,
respectively. In addition, we anticipate incurring operating losses through the
fourth quarter of fiscal 2004.
For the second quarter of fiscal 2004, we recorded a net loss of $24.8
million. The loss primarily resulted from liquidity issues we have experienced
in recent quarters, which substantially reduced our loan origination volume and
our ability to generate revenues, and a net $12.0 million pre-tax valuation
adjustment on our securitization assets which was charged to the income
statement. Additionally, operating expense levels that would support greater
loan origination volume also contributed to the loss for the second quarter of
fiscal 2004.
During the second quarter of fiscal 2004, we recorded gross pre-tax
valuation adjustments on our securitization assets primarily related to
prepayment experience of $23.1 million, of which $17.2 million was charged to
the income statement and $5.9 million was charged to other comprehensive income.
Our securitization assets are comprised of interest-only strips and servicing
rights. The valuation adjustment on interest-only strips related to prepayment
experience for the six months ended December 31, 2003 was offset by an $8.4
million favorable impact of reducing the discount rate applied to value the
residual cash flows from interest-only strips on December 31, 2003 from 11.0% to
10.0%. Of this amount, $5.2 million offset the portion of the adjustment
expensed through the income statement and $3.2 million offset the portion of the
adjustment charged to other comprehensive income. The write-down of
securitization assets primarily reflects the impact of higher than anticipated
prepayments on securitized loans due to the continuing low interest rate
environment.
For the first six months of fiscal 2004, we recorded a net loss of
$51.1 million. The loss primarily resulted from liquidity issues we have
experienced in recent quarters, which substantially reduced our loan origination
volume and our ability to generate revenues, and net pre-tax valuation
adjustment of $22.8 million on our securitization assets which were charged to
the income statement. Additionally, operating expense levels that would support
greater loan origination volume also contributed to the loss for the first six
months of fiscal 2004. During the first six months of fiscal 2004, we recorded
gross pre-tax valuation adjustments on its securitization assets primarily
related to prepayment experience of $39.8 million, of which $28.0 million was
charged to the income statement and $11.8 million was charged to other
comprehensive income. The valuation adjustment on interest-only strips related
to prepayment experience for the first six months of fiscal 2004 was offset by
an $8.4 million favorable impact of reducing the discount rate applied to value
the residual cash flows from interest-only strips on December 31, 2003 from
11.0% to 10.0%. Of this amount, $5.2 million offset the portion of the
adjustment expensed through the income statement and $3.2 million offset the
portion of the adjustment charged to other comprehensive income. The write-down
of securitization assets primarily reflects the impact of higher than
anticipated prepayments on securitized loans due to the continuing low interest
rate environment.
As a result of these liquidity issues, since June 30, 2003, our loan
origination volume was substantially reduced. From July 1, 2003 through December
31, 2003, we originated $227.1 million of loans which represents a significant
reduction as compared to originations of $773.7 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 also lost a significant number of
our loan origination employees. We anticipate that depending upon the size of
our future quarterly securitizations, 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
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 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."
37
At December 31, 2003, we had total indebtedness of approximately $752.1
million, comprised of amounts outstanding under our credit facilities, senior
collateralized subordinated notes, capitalized leases and subordinated
debentures. The following table compares our secured and senior debt obligations
and unsecured subordinated debenture obligations at December 31, 2003 to assets
which are available to repay those obligations and gives effect to tenders of
subordinated debentures accepted by us on December 31, 2003 as a result of our
December 1, 2003 Offer to Exchange, referred to as the Exchange Offer in this
document (in thousands):
Secured and Unsecured
Senior Debt Subordinated
Obligations Debentures Total Debt
----------------- ----------------- -------------
Outstanding debt obligations (a)(f)..... $ 122,399 (b) $ 629,674 $ 752,073
=========== =========== ===========
Assets available to repay debt:
Cash................................ $ -- $ 14,759 $ 14,759 (c)
Loans............................... 91,208 (d) 24,584 115,792
Interest-only strips................ 110,289 (a)(b) 423,388 533,677 (e)
Servicing rights.................... -- 94,086 94,086 (e)
----------- ----------- -----------
Total assets available.............. $ 201,497 $ 556,817 $ 758,314
=========== =========== ===========
(a) Includes the impact of the exchange of $73.6 million of subordinated
debentures (unsecured subordinated debentures) for $34.5 million of senior
collateralized subordinated notes (secured and senior debt obligations) and
39.1 million shares of Series A Preferred Stock on December 31, 2003. At
December 31, 2003, $51.7 million of our interest-only strips were
collateralizing the senior collateralized subordinated notes at 150% of the
outstanding amount of the senior collateralized subordinated notes.
(b) Security interests under the terms of the $250.0 million credit facility are
included in this table. This $250.0 million credit facility is secured by
loans when funded under this facility. In addition, interest-only strips
secure obligations in an amount not to exceed 10% of the outstanding
principal balance under this facility and the obligations due under the fee
letter related to this facility. Assuming the entire $250.0 million
available under this credit facility were utilized, the maximum amount
secured by the interest-only strips would be approximately $58.6 million.
This amount is included as an allocation of our interest-only strips to the
secured and senior debt obligations column.
(c) The amount of cash reflected in this table excludes restricted cash balances
of $14.9 million at December 31, 2003.
(d) Reflects the amount of loans specifically pledged as collateral against our
advances under our credit facilities.
(e) Reflects the fair value of our interest-only strips and servicing rights at
December 31, 2003.
(f) The Exchange Offer was extended through February 6, 2004. The pro forma
effects on the above table of the February 6, 2004 exchange of an additional
$41.9 million of subordinated debentures (unsecured subordinated debentures)
for $19.9 million of senior collateralized subordinated notes (secured
obligations) and 22.0 million shares of Series A Preferred Stock are
summarized below. At February 6, 2004, $29.8 million of our interest-only
strips were collateralizing these new senior collateralized subordinated
notes. Including the senior collateralized subordinated notes issued on
December 31, 2003, $81.5 million of our interest-only strips are
collateralizing senior collateralized subordinated notes.
Secured and Unsecured
Senior Debt Subordinated Total
Obligations Debentures Debt
--------------- ---------- --------
Outstanding debt obligations -
historical................................ $122,399 $629,674 $752,073
Pro forma effect of the Exchange Offer
extension to February 6, 2004............. 19,874 (41,890) (22,016)
-------- -------- --------
Pro forma outstanding debt
obligations.............................. $142,273 $587,784 $730,057
======== ======== ========
Total assets available to repay debt -
historical............................. .. $201,497 $556,817 $758,314
Pro forma effect of Exchange Offer
extension to February 6, 2004............. 29,811 (29,811) -
-------- -------- --------
Pro forma assets available.............. $231,308 $527,006 $758,314
======== ======== ========
38
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 December 31, 2003, we sold approximately $501.2
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.
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
debentures.
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 loans held by it. See "-- Liquidity and Capital Resources" for
additional information regarding this conduit facility.
On December 1, 2003, we mailed an Offer to Exchange, referred to as the
Exchange Offer in this document, to holders of our subordinated debentures
issued prior to April 1, 2003. Holders of such subordinated debentures had the
ability to exchange their notes for (i) equal amounts of senior collateralized
subordinated notes and shares of 10% Series A convertible preferred stock,
referred to as Series A Preferred Stock in this document; and/or (ii)
dollar-for-dollar for shares of Series A Preferred Stock. Senior collateralized
subordinated notes issued in the exchange have interest rates equal to 10 basis
points above the subordinated debentures tendered. Senior collateralized
subordinated notes with maturities of 12 months were issued in exchange for
subordinated debentures tendered with maturities of less than 12 months, while
subordinated debentures with maturities greater than 36 months were exchanged
for senior collateralized subordinated notes with the same maturity or reduced
to 36 months. All other senior collateralized subordinated notes issued in the
exchange have maturities equal to the subordinated debentures tendered. The
senior collateralized subordinated notes are secured by a security interest in
certain cash flows originating from interest-only strips of our subsidiaries
held by ABFS Warehouse Trust 2003-1 with an aggregate value of at least an
amount equal to 150% of the outstanding principal balance of the senior
collateralized subordinated notes; provided that, such collateral coverage may
not fall below 100% of the outstanding principal balance of the senior
collateralized subordinated notes, as determined by us on any quarterly balance
sheet date. In the event of liquidation, to the extent the collateral securing
the senior collateralized subordinated notes is not sufficient to repay these
notes, the deficiency portion of the senior collateralized subordinated notes
will rank junior in right of payment behind our senior indebtedness and all of
our other existing and future senior debt and debt of our subsidiaries and
equally in right of payment with the subordinated debentures, and any future
subordinated debentures issued by us and other unsecured debt. At December 31,
2003, $51.7 million of our interest-only strips were collateralizing the senior
collateralized subordinated notes.
39
Pursuant to the terms of the Exchange Offer, in the first closing of
the Exchange Offer on December 31, 2003, we exchanged $73.6 million of
outstanding subordinated debentures for 39.1 million shares of Series A
Preferred Stock and $34.5 million of senior collateralized subordinated notes.
On December 31, 2003, we also extended the expiration date of the Exchange Offer
to February 6, 2004. As a result of the second closing of the Exchange Offer on
February 6, 2004, we exchanged an additional $41.9 million of eligible
debentures for 22.0 million shares of Series A Preferred Stock and $19.9 million
of senior collateralized subordinated notes.
On January 22, 2004, we executed an agreement to sell our interests in
the remaining lease portfolio. The terms of the agreement included a cash sale
price of approximately $4.8 million in exchange for our lease portfolio balance
as of December 31, 2003. Additionally, we will continue to service the portfolio
until the February 20, 2004 servicing transfer date under the agreement. We
received cash from this sale in January 2004.
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 debentures
when due. If we fail to successfully implement our adjusted business strategy,
we will be required to consider other alternatives, including raising additional
equity, seeking to convert an additional portion of our subordinated debentures
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.
Business Strategy Adjustments. Our adjusted business strategy focuses
on shifting 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. This shift
will be more pronounced as our loan origination levels increase. Short-term, we
intend to replace the loan origination employees we recently lost and create an
expanded broker initiative in order to increase loan originations. On December
24, 2003, the Company acquired a broker operation that operates primarily on the
west coast of the United States. The operation acquired has 35 employees located
in California and is expected to contribute to the Company's loan origination
volume from its broker channel, especially in the state of California. Assets
acquired in this transaction, mostly fixed assets, were not material. The
purchase price was comprised of issuing a $475 thousand convertible
non-negotiable promissory note to the sellers and assuming $107 thousand of
liabilities. Beyond the short-term, we expect to increase loan originations
through the application of adjustments to our business strategy. See " --
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 debentures, 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 debentures.
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 debentures and may require us to restructure our operations.
Credit Facilities, 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."
40
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, October 31, 2003, November 30, 2003
and December 31, 2003 in light of the losses during the first and second
quarters of fiscal 2004 and our liquidity issues. See "-- Liquidity and Capital
Resources -- Credit Facilities" for additional information regarding the waivers
or amendments obtained.
In addition, as a result of our non-compliance at September 30, 2003
with the net worth requirements contained in several of our 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.
The terms of our new $200.0 million credit facility, as amended,
require our compliance with various financial and other covenants. We requested
and obtained waivers from the lender for our non-compliance with certain
covenants under this $200.0 million facility. See "-- Liquidity and Capital
Resources -- Credit Facilities."
Because we anticipate incurring losses through the fourth 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 $272.2
million at December 31, 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 10.93% at December 31, 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 debentures.
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 $228.4
million of previously delinquent loans at December 31, 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.
41
During the final six months of fiscal 2003 and the first two quarters
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 $228.4 million of cumulative unpaid principal balance under
deferment and forbearance arrangements at June 30, 2003 and December 31, 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 9.17% at December 31, 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 December
31, 2003, there was $53.8 million of cumulative unpaid principal balance under
deferment arrangements and $58.7 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."
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 requested 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, including: (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.
On December 22, 2003, we entered into a Joint Agreement with the Civil
Division of the U. S. Attorney's Office for the Eastern District of Pennsylvania
which ends the inquiry by the U.S. Attorney focused on our forbearance policy
initiated pursuant to the civil subpoena dated May 14, 2003.
In response to the inquiry and as part of the Joint Agreement, we have
adopted a revised forbearance policy, which became effective on November 19,
2003. Under this policy, we will no longer require a borrower to execute a deed
in lieu of foreclosure as a condition to entering into a forbearance agreement
with us where the real estate securing the loan is the borrower's primary
residence. Under the Joint Agreement, we have also agreed to return to existing
borrowers any executed but unrecorded deeds in lieu of foreclosure obtained
under our former forbearance policy.
We also agreed to contribute a total of $80,000 to one or more U.S.
Department of Housing and Urban Development (HUD) approved housing counseling
organizations within the next 13 months. We have the right to designate the
recipient organization(s) and will provide the U.S. Attorney's Office with the
name(s) of the recipient(s). Each recipient must provide housing counseling in
the states in which we originate mortgage loans.
Under our revised forbearance policy, eligible borrowers will be sent a
letter, along with our standard form forbearance agreement encouraging them to:
read the forbearance agreement; seek the advice of an attorney or other advisor
prior to signing the forbearance agreement; and contact our consumer advocate by
calling a toll-free number with questions. The Joint Agreement requires that for
18 months following its execution, we will notify the U.S. Attorney's Office of
any material changes we propose to make to our forbearance policy, form of
forbearance agreement (or cover letter) and that no changes to these documents
shall be effective until at least 30 days after this notification. The U.S.
Attorney reserves the right to re-institute its inquiry if we do not comply with
our revised forbearance policy, fail to provide the 30 days notice described
above, or disregard the concerns of the U.S. Attorney's Office, after providing
such notice. The Joint Agreement also requires that we provide the U.S. Attorney
with two independently prepared reports confirming our compliance with our
revised forbearance policy (including the standard form of forbearance agreement
and cover letter) and internal company training for collections department
employees described below. These reports are to be submitted to the U.S.
Attorney's Office at 9 and 18 months after the execution of the Joint Agreement.
42
We also agreed to implement a formal training session regarding our
revised forbearance policy for all of our collections department employees, at
which such employees will be directed to inform borrowers that they can obtain
assistance from housing and credit counseling organizations and how to find such
organizations in their area. We agreed to monitor compliance with our
forbearance policy and take appropriate disciplinary action against those
employees who do not comply with this policy.
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. In December 2003, we hired an
experienced industry professional who will direct the wholesale business and
acquired a broker operation with 35 employees located in California. Our
business strategy includes the following:
o 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.
o 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 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.
o 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.
o 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.
43
o 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 depending on our ability to
obtain a credit facility to fund business purpose loans. During the
first two quarters of fiscal 2004, we did not originate any business
purpose loans.
o Reducing the cost of loan originations. We have implemented plans to:
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 our broker channel, including
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 would charge to new participating financial
institutions.
o Reducing the amount of outstanding subordinated debentures. The
increase in cash flow expected under our business strategy is expected
to accelerate a reduction in our reliance on issuing subordinated
debentures to meet our liquidity needs and allow us to begin to pay
down existing subordinated debentures.
o Reducing operating costs. Since June 30, 2003, we reduced our workforce
by approximately 250 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
22% decrease in staffing levels. In addition, we experienced the
attrition of approximately 157 additional employees, a 14% reduction,
who have resigned since June 30, 2003.
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.
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.
44
We received a civil subpoena, dated May 14, 2003, from the Civil
Division of the U.S. Attorney for the Eastern District of Pennsylvania. This
inquiry was ended on December 22, 2003. See "-- Overview."
On January 21, 2004, January 28, 2004 and February 12, 2004, three
purported class action lawsuits were filed against us and our director and Chief
Executive Officer, Anthony Santilli, and our Chief Financial Officer, Albert
Mandia, in the United States District Court for the Eastern District of
Pennsylvania. The first two suits also name former director, Richard Kaufman, as
a defendant. The complaints are captioned: Richard Weisinger v. American
Business Financial Services, Inc., et. al., Civil Action No. 04-265; Sean Ruane
v. American Business Financial Services, Inc., Civil Action No. 04-400, and
Operative Plasterers' and Cement Masons' International Employees' Trust Fund,
et.al v. American Business Financial Services, Inc., et. al., Civil Action No.
04-CV-617. The lawsuits were brought on behalf of all purchasers of our common
stock between for the class period January 27, 2000 and June 25, 2003 with
respect to the first two suits filed. The class period related to the third suit
is January 27, 2000 through June 12, 2003.
The first two lawsuits allege that we and the named directors and
officers violated Sections 10(b) and 20(a) of the Securities Exchange Act of
1934. These lawsuits allege that, among other things, during the applicable
class period, our forbearance and foreclosure practices enabled us to, among
other things, allegedly inflate our financial results. These two lawsuits appear
to relate to the same subject matter as the Form 8-K we filed on June 13, 2003
disclosing a subpoena from the Civil Division of the U.S. Attorney's Office into
our forbearance and foreclosure practices. The U.S. Attorney's inquiry was
subsequently concluded in December 2003. See "- Overview - Subpoena from U.S.
Attorney's Office." These two lawsuits seek unspecified compensatory damages,
costs and expenses related to bringing the action, and other unspecified relief.
The third lawsuit alleges that the defendants issued false and
misleading financial statements in violation of GAAP, the Securities Exchange
Act of 1934 and SEC rules by entering into forbearance agreements with
borrowers, understating default and foreclosure rates and failing to properly
adjust prepayment assumptions to hide the impact on net income. This lawsuit
seeks unspecified damages, interest, costs and expenses of the litigation, and
injunctive or other relief.
Procedurally, these lawsuits are in a very preliminary stage and no
class has been certified in any of the actions. We do not expect that we will be
required to file a response to the lawsuits for several months. We believe that
we have several defenses to the claims raised by these lawsuits and intend to
vigorously defend the lawsuits. Due to the inherent uncertainties in litigation
and because the ultimate resolution of these proceedings are influenced by
factors outside our control, we are currently unable to predict the ultimate
outcome of this litigation or its impact on our financial position or results of
operations.
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.
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.
45
Application of Critical Accounting Estimates
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
December 31, 2003 were 50.0% of total revenues compared to 77.6% for the three
months ended December 31, 2002. The decline in the percentage of total revenues
comprised of securitization gains resulted from the reduction in loans
originated during the first six months of fiscal 2004. 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.
Interest-Only Strips. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 58.6% of our
total assets at December 31, 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.
46
During the six months ended December 31, 2003, we recorded total
pre-tax valuation adjustments on our interest only-strips of $28.6 million, of
which, in accordance with EITF 99-20, $20.0 million was charged to the income
statement and $8.6 million was charged to other comprehensive income. The
valuation adjustment reflects the impact of higher than anticipated prepayments
on securitized loans experienced during the six months ended December 31, 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.
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 10.3% of our total assets at December 31, 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 six months ended December 31, 2003, we recorded total
pre-tax valuation adjustments on our servicing rights of $2.8 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 six months 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.
47
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 six months ended December 31, 2003, our
valuation analysis indicated that valuation adjustments of $2.8 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.
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 December 31, 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 six months
ended December 31, 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 certain governmental grant agreements, which
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.
48
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:
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
reductions in discount rates are discussed in more detail
below.
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.
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 had 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 had declined approximately 475 basis points
and five-year rates have declined approximately 375 basis
points over that period.
o The interest rates on the bonds issued in our securitizations
over that same timeframe also had experienced a sustained
period of decline. The trust certificate pass-through interest
rate had declined 395 basis points, from 8.04% in the 2000-2
securitization to 4.09% in the 2003-1 securitization.
o The weighted average interest rate on loans securitized had
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 favored the continuation of low
interest rates for the foreseeable future.
o Economic analysis of interest rates and data released at the
time of the June 30, 2003 evaluation supported declining
mortgage refinancings even though predicting the continuation
of low interest rates for the foreseeable future.
49
o The interest rates paid on subordinated debentures issued,
which is used to fund our interest-only strips, had declined
from a high of 11.85% in February 2001 to a rate of 7.49% in
June 2003.
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.
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 valuation
of our interest-only strips by $3.3 million.
The blended rate used to value our interest-only strips at June 30,
2003 was 9%.
From June 2000 to March 2003, the discount rate applied in determining
the fair value of servicing rights was 11%, which was 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%. 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.
Prepayment rates. 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.
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.
50
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 do not service the loans in the 2003-2 securitization, our most recent
securitization, which closed in October 2003. 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 debentures and our operating cash needs.
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 December 31, 2003 and June 30, 2003, the mortgage securitization
trusts held loans with an aggregate principal balance due of $2.5 billion and
$3.4 billion as assets and owed $2.3 billion and $3.2 billion to third party
investors, respectively. Revenues from the sale of loans to securitization
trusts were $15.1 million, or 31.0% of total revenues for the six months ended
December 31, 2003 and $115.1 million, or 77.7% of total revenues for the six
months ended December 31, 2002. The revenues for the six months ended December
31, 2003 and December 31, 2002 are net of $2.2 million and $3.2 million,
respectively, 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 $533.7 million and
$94.1 million, respectively at December 31, 2003, which combined represent 68.9%
of our total assets. Cash flows received from interest-only strips and servicing
rights were $109.3 million for the six months ended December 31, 2003 and $56.6
million for the six months ended December 31, 2002. These amounts are included
in our operating cash flows.
51
We also used special purpose entities in our sales of loans to a $300.0
million off-balance sheet mortgage conduit facility that was available to us
until July 5, 2003. 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 which were 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."
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.
52
Declines in market interest rates have resulted in reductions in the
levels of securitization pass-through interest rates leading to an improvement
in interest rate spreads by approximately 245 basis points from the fourth
quarter of fiscal 2000 securitization, to our most recent securitization in the
second quarter of fiscal 2004. Increased interest rate spreads resulted in
increases in the residual cash flow we expect to receive on securitized loans,
the amount of cash 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.
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 nine 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
nine quarters we have recorded cumulative pre-tax write downs to our
interest-only strips in the aggregate amount of $160.0 million and pre-tax
adjustments to the value of servicing rights of $15.2 million, for total
adjustments of $175.2 million, mainly due to the higher than expected prepayment
experience. Of this amount, $113.1 million was expensed through the income
statement and $62.1 million resulted in a write down through other comprehensive
income, a component of stockholders' equity.
During the same period, we reduced the discount rates we apply to value
our securitization assets, resulting in favorable valuation impacts of $29.3
million on interest-only strips and $7.1 million on servicing rights. Of this
amount, $23.1 million offset the adjustments expensed through the income
statement and $13.3 million offset write downs through other comprehensive
income. The discount rates were reduced primarily to reflect the impact of the
sustained decline in market interest rates.
During the six months ended December 31, 2003, we recorded gross
pre-tax valuation adjustments on our securitization assets primarily related to
prepayment experience of $39.8 million, of which $28.0 million was charged to
the income statement and $11.8 million was charged to other comprehensive
income. The valuation adjustment on interest-only strips related to prepayment
experience for the six months ended December 31, 2003 was offset by an $8.4
million favorable impact of reducing the discount rate applied to value the
residual cash flows from interest-only strips on December 31, 2003. Of this
amount, $5.2 million offset the portion of the adjustment expensed through the
income statement and $3.2 million offset the portion of the adjustment charged
to other comprehensive income. The breakout of the total adjustments in the six
months ended December 31, 2003 between interest-only strips and servicing rights
was as follows:
53
o We recorded gross pre-tax valuation adjustments on our interest
only-strips of $37.0 million, of which $25.2 million was
charged to the income statement and $11.8 million was charged
to other comprehensive income. The gross valuation adjustment
primarily reflects the impact of higher than anticipated
prepayments on securitized loans experienced in the first six
months of fiscal 2004 due to the continuing low interest rate
environment. The valuation adjustment on interest-only strips
for the six months ended December 31, 2003 was offset by an
$8.4 million favorable impact of reducing the discount rate
applied to value the residual cash flows from interest-only
strips on December 31, 2003. Of this amount, $5.2 million
offset the portion of the adjustment expensed through the
income statement and $3.2 million offset the portion of the
adjustment charged to other comprehensive income. The discount
rate was reduced to 10% on December 31, 2003 from 11% on
September 30, 2003 and June 30, 2003 primarily to reflect the
impact of the sustained decline in market interest rates.
o We recorded total pre-tax valuation adjustments on our
servicing rights of $2.8 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 six months 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 December 17, 2003 that mortgage refinancings as a percentage share of total
mortgage originations will decline from 68% in the second quarter of calendar
2003 to 25% in the second quarter of calendar 2004. The Mortgage Bankers
Association of America has also projected in its December 2003 economic forecast
that the 10-year treasury rate (which generally affects mortgage rates) will
increase slightly 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.
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):
54
Fiscal Year 2004
- ---------------- Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- -------------------------------------- ---------- --------- --------------
September 30, 2003.................... $ 16,658 $ 10,795 $ 5,863
December 31, 2003..................... 14,724 11,968 2,756
-------- -------- ---------
Total Fiscal 2004..................... $ 31,382 $ 22,763 $ 8,619
======== ======== =========
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.
The following table summarizes the volume of loan securitizations and
whole loan sales for the three months ended December 31, 2003 and 2002 (dollars
in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
------------------------- -----------------------
Securitizations: 2003 2002 2003 2002
--------- --------- --------- ----------
Business loans................................. $ 9,819 $ 29,520 $ 11,027 $ 59,518
Home equity loans.............................. 126,135 377,385 130,380 713,795
--------- --------- --------- ----------
Total....................................... $ 135,954 $ 406,905 $ 141,407 $ 773,313
========= ========= ========= ==========
Gain on sale of loans through securitization.. $ 14,307 $ 57,879 $ 15,107 $ 115,890
Securitization gains as a percentage of total
revenue...................................... 50.0% 77.6% 31.0% 77.7%
Whole loan sales............................... $ 7,975 $ -- $ 278,953 $ 1,537
Premiums on whole loan sales................... $ 78 $ -- $ 2,999 $ 32
As demonstrated in the fourth quarter of fiscal 2003 and the first six
months 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.
55
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.
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
December 31, 2003, investments in interest-only strips totaled $533.7 million,
including the fair value of overcollateralization related cash flows of $251.4
million.
56
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 or other relevant accounting literature because we are not required to
repurchase any loan and our ability to repurchase a loan is limited by contract.
At December 31, 2003, eight of our 26 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 $10.0 million of excess overcollateralization is being held by the
eight trusts as of December 31, 2003. For the six months ended December 31,
2003, we repurchased delinquent loans with an aggregate unpaid principal balance
of $32.0 million from securitization trusts primarily for trigger management. We
cannot predict when the eight 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
debentures 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 "Total 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 six months of fiscal 2004 and fiscal years 2003 and 2002. We received
$21.8 million, $37.6 million and $19.2 million of proceeds from the liquidation
of repurchased loans and REO for the six months ended December 31, 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 $8.9 million, $9.6 million
and $9.4 million at December 31, 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.
57
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
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Six months ended December 31, 2003:
Business loans.................. $ 219 $ 592 $ 603 $ 128 $1,441 $ -- $1,257 $ 943 $1,033 $ 955
Home equity loans............... -- 1,129 980 469 1,604 897 3,137 2,844 1,497 1,799
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total......................... $ 219 $1,721 $1,583 $ 597 $3,045 $ 897 $4,394 $3,787 $2,530 $2,754
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
% of Original Balance of Loans
Securitized..................... 0.05% 0.57% 0.45% 0.22% 1.11% 0.60% 1.45% 1.60% 1.14% 1.24%
Number of loans repurchased..... 1 23 14 9 37 16 55 56 37 37
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
------ ------ ------ ------ ------ ------ ------- ------- -------
Six months ended December 31, 2003:
Business loans.................. $ 637 $ 398 $ 262 $ 96 $ 49 $ -- $ 184 $ -- $ 8,797
Home equity loans............... 2,830 2,685 1,115 1,074 327 429 422 -- 23,238
------ ------ ------ ------ ------ ------ ------ ------ -------
Total......................... $3,467 $3,083 $1,377 $1,170 376 $ 429 $ 606 $ -- $32,035
====== ====== ====== ====== ====== ====== ====== ====== =======
% of Original Balance of Loans
Securitized..................... 1.58% 1.67% 1.72% 0.59% 0.31% 0.41% 0.35% --
Number of loans repurchased..... 43 40 22 15 5 5 11 -- 426
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.
58
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 December 31, 2003 balance sheet a liability of $36.0 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.
59
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 December 31, 2003
(dollars in millions)
2003-2 2003-1 2002-4 2002-3 2002-2 2002-1 2001-4
------ ------ ------ ------ ------ ------ ------
Original balance of loans securitized:
Business loans........................... $ 27 $ 33 $ 30 $ 34 $ 34 $ 32 $ 29
Home equity loans........................ 146 417 350 336 346 288 287
------ ------ ------ ------ ------ ------ ------
Total.................................... $ 173 $ 450 $ 380 $ 370 $ 380 $ 320 $ 316
====== ====== ====== ====== ====== ====== ======
Current balance of loans securitized:
Business loans........................... $ 26 $ 28 $ 25 $ 27 $ 26 $ 23 $ 20
Home equity loans........................ 142 348 247 199 186 136 119
------ ------ ------ ------ ------ ------ ------
Total.................................... $ 168 $ 376 $ 272 $ 226 $ 212 $ 159 $ 139
====== ====== ====== ====== ====== ====== ======
Weighted-average interest rate on loans
securitized:
Business loans........................... 15.61% 15.90% 16.00% 15.97% 16.00% 15.76% 15.80%
Home equity loans........................ 8.98% 9.70% 10.46% 10.84% 10.90% 10.89% 10.70%
Total.................................... 10.02% 10.16% 10.97% 11.46% 11.54% 11.59% 11.42%
Percentage of first mortgage loans.......... 87% 87% 87% 87% 87% 90% 90%
Weighted-average loan-to-value.............. 76% 77% 76% 77% 76% 75% 77%
Weighted-average remaining term (months) on
loans securitized....................... 277 262 252 243 229 223 222
Original balance of Trust Certificates...... $ 173 $ 450 $ 376 $ 370 $ 380 $ 320 $ 322
Current balance of Trust Certificates....... $ 168 $ 362 $ 253 $ 213 $ 199 $ 144 $ 126
Weighted-average pass-through interest rate
to Trust Certificate holders(a).......... 2.33% 5.10% 6.11% 7.45% 8.44% 7.81% 5.35%
Highest Trust Certificate pass-through
interest rate............................ 8.00% 3.78% 8.61% 6.86% 7.39% 6.51% 5.35%
Overcollateralization requirements:
Required percentages:
Initial.................................. -- -- 1.00% -- -- -- --
Final target............................. 4.10% 5.50% 5.75% 3.50% 3.50% 4.50% 4.25%
Stepdown overcollateralization........... 8.20% 11.00% 11.50% 7.00% 7.00% 9.00% 8.50%
Required dollar amounts:
Initial.................................. -- -- $ 4 -- -- -- --
Final target............................. $ 7 $ 25 $ 22 $ 13 $ 13 $ 14 $ 13
Current status:
Overcollateralization amount............. -- $ 10 $ 16 $ 11 $ 13 $ 14 $ 13
Final target reached or anticipated date
to reach.............................. 11/2004 10/2004 3/2004 Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach................................. 4/2007 5/2006 1/2006 10/2005 7/2005 10/2004 7/2004
Annual surety wrap fee...................... 0.45% 0.20% (b) (b) (b) 0.21% 0.20%
Servicing rights:
Original balance......................... $ -- $ 16 $ 14 $ 13 $ 15 $ 13 $ 13
Current balance.......................... $ -- $ 13 $ 10 $ 8 $ 9 $ 7 $ 6
- -----------------
(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
"-- Six months ended December 31, 2003 Compared to Six months ended
December 31, 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. 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.
60
Summary of Selected Mortgage Loan Securitization Trust Information (Continued)
Current Balances as of December 31, 2003
(dollars in millions)
2001-3 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1
------ ------ ------ ------ ------ ------ ------
Original balance of loans securitized:
Business loans........................... $ 31 $ 35 $ 29 $ 27 $ 16 $ 28 $ 25
Home equity loans........................ 269 320 246 248 134 275 212
------ ------ ------ ------ ------ ------ ------
Total.................................... $ 300 $ 355 $ 275 $ 275 $ 150 $ 303 $ 237
====== ====== ====== ====== ====== ====== ======
Current balance of loans securitized:
Business loans........................... $ 18 $ 22 $ 17 $ 11 $ 6 $ 12 $ 10
Home equity loans........................ 104 110 79 71 37 73 51
------ ------ ------ ------ ------ ------ ------
Total.................................... $ 122 $ 132 $ 96 $ 82 $ 43 $ 85 $ 61
====== ====== ====== ====== ====== ====== ======
Weighted-average interest rate on loans
securitized:
Business loans........................... 15.93% 15.97% 16.03% 16.12% 16.05% 16.05% 16.01%
Home equity loans........................ 11.09% 11.23% 11.46% 11.61% 11.42% 11.42% 11.39%
Total.................................... 11.81% 12.05% 12.25% 12.22% 12.09% 12.05% 12.11%
Percentage of first mortgage loans.......... 90% 91% 89% 87% 91% 84% 80%
Weighted-average loan-to-value.............. 75% 76% 75% 76% 76% 76% 76%
Weighted-average remaining term (months) on
loans Securitized......................... 215 212 208 200 199 207 196
Original balance of Trust Certificates...... $ 306 $ 355 $ 275 $ 275 $ 150 $ 300 $ 235
Current balance of Trust Certificates....... $ 111 $ 116 $ 85 $ 73 $ 39 $ 75 $ 54
Weighted-average pass-through interest rate
to Trust Certificate holders............. 5.73% 8.77% 8.12% 7.05% 7.61% 7.05% 7.04%
Highest Trust Certificate pass-through
interest rate (a)........................ 6.17% 6.99% 6.28% 7.05% 7.61% 8.04% 7.93%
Overcollateralization requirements:
Required percentages:
Initial.................................. -- -- -- -- -- 0.90% 0.75%
Final target............................. 4.00% 4.40% 4.10% 4.50% 4.75% 5.95% 5.95%
Stepdown overcollateralization........... 8.00% 8.80% 8.20% 9.00% 9.50% 11.90% 11.90%
Required dollar amounts:
Initial.................................. -- -- -- -- -- $ 3 $ 2
Final target............................. $ 12 $ 16 $ 11 $ 12 $ 7 $ 18 $ 14
Current status:
Overcollateralization amount............. $ 12 $ 16 $ 10 $ 12 $ 6 $ 11 $ 8
Final target reached or anticipated date
to reach.............................. Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach................................. 4/2004 Yes(b) Yes(b) Yes Yes Yes Yes
Annual surety wrap fee...................... 0.20% 0.20% 0.20% 0.21% 0.21% 0.21% 0.19%
Servicing rights:
Original balance......................... $ 12 $ 15 $ 11 $ 14 $ 7 $ 14 $ 10
Current balance.......................... $ 5 $ 6 $ 4 $ 4 $ 2 $ 3 $ 2
- ------------------
(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
"-- Six months ended December 31, 2003 Compared to Six months ended
December 31, 2002 -- Gain on Sale of Loans - Securitizations" for further
description of the notional bonds.
(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.
61
Summary of Selected Mortgage Loan Securitization Trust Information (Continued)
Current Balances as of December 31, 2003
(dollars in millions)
1999-4 1999-3 1999-2 1999-1 1998(a) 1997(a) 1996(a)
------ ------ ------ ------ ------ ------ ------
Original balance of loans securitized:
Business loans........................... $ 25 $ 28 $ 30 $ 16 $ 57 $ 45 $ 29
Home equity loans........................ 197 194 190 169 448 130 33
------ ------ ------ ------ ------ ------ ------
Total.................................... $ 222 $ 222 $ 220 $ 185 $ 505 $ 175 $ 62
====== ====== ====== ====== ====== ====== ======
Current balance of loans securitized:
Business loans........................... $ 9 $ 9 $ 9 $ 5 $ 12 $ 8 $ 5
Home equity loans........................ 56 52 54 43 84 16 3
------ ------ ------ ------ ------ ------ ------
Total.................................... $ 65 $ 61 $ 63 $ 48 $ 96 $ 24 $ 8
====== ====== ====== ====== ====== ====== ======
Weighted-average interest rate on loans
securitized:
Business loans........................... 16.05% 15.73% 15.75% 15.85% 15.68% 15.93% 15.89%
Home equity loans........................ 11.03% 10.83% 10.52% 10.65% 10.79% 11.55% 11.12%
Total.................................... 11.76% 11.59% 11.26% 11.15% 11.40% 12.98% 13.94%
Percentage of first mortgage loans.......... 86% 87% 89% 93% 90% 80% 78%
Weighted-average loan-to-value.............. 76% 76% 76% 77% 76% 75% 65%
Weighted-average remaining term (months) on
loans Securitized........................ 191 195 201 203 186 139 103
Original balance of Trust Certificates...... $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61
Current balance of Trust Certificates....... $ 57 $ 55 $ 55 $ 43 $ 85 $ 20 $ 6
Weighted-average pass-through interest rate
to Trust Certificate holders............. 6.85% 6.78% 6.70% 6.56% 7.67% 7.16% 6.37%
Highest Trust Certificate pass-through
interest rate............................. 7.68% 7.49% 7.13% 6.58% 6.86% 7.53% 7.95%
Overcollateralization requirements:
Required percentages:
Initial.................................. 1.00% 1.00% 0.50% 0.50% 1.50% 2.43% 1.94%
Final target............................. 5.50% 5.00% 5.00% 5.00% 5.10% 7.43% 8.94%
Stepdown overcollateralization........... 11.00% 10.00% 10.00% 10.00% 10.21% 14.86% 12.90%
Required dollar amounts:
Initial.................................. $ 2 $ 2 $ 1 $ 1 $ 7 $ 4 $ 1
Final target............................. $ 12 $ 11 $ 11 $ 9 $ 26 $ 13 $ 6
Current status:
Overcollateralization amount............ $ 8 $ 8 $ 7 $ 6 $ 12 $ 4 $ 3
Final target reached or anticipated date
to reach.............................. Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach................................. Yes(b) Yes Yes(b) Yes Yes(b) Yes(b) Yes
Annual surety wrap fee...................... 0.21% 0.21% 0.19% 0.19% 0.22% 0.26% 0.18%
Servicing rights:
Original balance......................... $ 10 $ 10 $ 10 $ 8 $ 18 $ 7 $ 4
Current balance.......................... $ 3 $ 2 $ 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. 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.
62
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 December 31, 2003, we applied a discount rate of 10% 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 a 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% and on December 31, 2003 we reduced that discount rate to
10%, based on the following factors:
o We have experienced a period of sustained low 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 425 basis points and five-year
rates have declined approximately 300 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 trust certificate pass-through interest rate has
declined 429 basis points, from 8.04% in the 2000-2 securitization
to 3.75% in the 2003-2 securitization.
o The weighted average interest rate on loans securitized has
declined from a high of 12.01% in the 2000-3 securitization to
10.02% in the 2003-2 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.
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 the December 31,
2003 reduction in discount rate from 11% to 10% was to increase the valuation of
our interest-only strips by $8.4 million at December 31, 2003. The 10% discount
rate that we apply to our residual cash flow portion of our interest-only strips
also reflects 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.
63
o At origination, approximately 90% to 95% of securitized business
purpose loans had prepayment fees and approximately 80% to 85% of
securitized home equity loans had prepayment fees. Currently in
our total portfolio, approximately 50% to 55% of securitized
business purpose loans have prepayment fees and approximately 55%
to 60% 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. At June 30, 2003 and December 31, 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.
The blended discount rate used to value the interest-only strips,
including the overcollateralization cash flows, was 8% at December 31, 2003 and
9% at 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.
64
As was previously discussed, for the past nine 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.
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.....................................$ 2,370,779
Balance sheet carrying value of retained interests (a).............$ 533,677
Weighted-average collateral life (in years)........................ 3.9
- ----------------
(a) Amount includes interest-only strips and servicing rights.
65
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............................ $ 23,687 $ 44,947
Credit loss rate............................ 4,762 9,523
Floating interest rate certificates (a)..... 723 1,446
Discount rate............................... 16,941 33,030
- --------------
(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."
66
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 December 31, 2003
2003-2 2003-1 2002-4 2002-3 2002-2 2002-1 2001-4
------ ------ ------ ------ ------ ------ ------
Interest-only strip residual discount rate:
Initial valuation........................ 11% 13% 13% 13% 13% 13% 13%
Current valuation........................ 10% 10% 10% 10% 10% 10% 10%
Interest-only strip overcollateralization
discount rate:
Initial valuation........................ 8% 7% 9% 7% 7% 7% 7%
Current valuation........................ 8% 5% 9% 7% 7% 7% 5%
Servicing rights discount rate:
Initial valuation........................ (d) 11% 11% 11% 11% 11% 11%
Current valuation........................ (d) 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%
Home equity loans...................... 22% 22% 22% 22% 22% 22% 22%
Ramp period (months):
Business loans......................... 27 27 27 27 27 27 27
Home equity loans...................... 30 30 30 30 30 30 30
Current assumptions (b):
Expected Constant Prepayment Rate (CPR):
Business loans ........................ 11% 11% 11% 11% 11% 11% 11%
Home equity loans ..................... 22% 22% 22% 22% 22% 22% 22%
Ramp period (months):
Business loans......................... 27 27 27 27 27 27 27
Home equity loans...................... 30 30 30 30 30 30 30
CPR adjusted to reflect ramp:
Business loans......................... 5% 11% 13% 16% 18% 20% 23%
Home equity loans...................... 6% 23% 25% 25% 25% 25% 27%
Current prepayment experience (c):
Business loans......................... -- 23% 16% 20% 21% 24% 21%
Home equity loans...................... -- 26% 41% 50% 49% 48% 46%
Annual credit loss rates:
Initial assumption....................... 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%
Actual experience........................ -- 0.01% 0.02% 0.07% 0.11% 0.14% 0.25%
Servicing fees:
Contractual fees......................... (d) 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%
Ancillary fees........................... (d) 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) The majority of the home equity loan prepayment ramp rates have been
increased for the next 3 months to provide for the expected near term
continuation of higher than average prepayments.
(c) Current experience is a six-month historical average.
(d) Servicing rights for the 2003-2 loans were sold to a third party servicer.
67
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at December 31, 2003 (Continued)
2001-3 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1
------ ------ ------ ------ ------ ------ ------
Interest-only strip residual discount rate:
Initial valuation........................ 13% 13% 13% 13% 13% 13% 11%
Current valuation........................ 10% 10% 10% 10% 10% 10% 10%
Interest-only strip overcollateralization
discount rate:
Initial valuation........................ 7% 7% 6% 7% 8% 8% 8%
Current valuation........................ 6% 7% 6% 7% 8% 8% 8%
Servicing rights discount rate:
Initial valuation........................ 11% 11% 11% 11% 11% 11% 11%
Current valuation........................ 9% 9% 9% 9% 9% 9% 9%
Prepayment rates:
Initial assumption (a):
Expected Constant Prepayment Rate (CPR):
Business loans ........................ 11% 11% 11% 10% 10% 10% 10%
Home equity loans...................... 22% 22% 22% 24% 24% 24% 24%
Ramp period (months):
Business loans......................... 24 24 24 24 24 24 24
Home equity loans...................... 30 30 30 24 24 24 18
Current assumptions (b):
Expected Constant Prepayment Rate (CPR):
Business loans ........................ 11% 11% 11% 11% 11% 11% 11%
Home equity loans...................... 22% 22% 22% 22% 22% 22% 22%
Ramp period (months):
Business loans......................... 27 27 27 27 27 Na Na
Home equity loans...................... 30 30 30 30 30 30 Na
CPR adjusted to reflect ramp:
Business loans......................... 21% 18% 15% 12% 23% 35% 29%
Home equity loans...................... 30% 30% 38% 40% 41% 43% 40%
Current prepayment experience (c):
Business loans......................... 23% 21% 22% 44% 37% 34% 28%
Home equity loans...................... 42% 43% 40% 41% 44% 41% 41%
Annual credit loss rates:
Initial assumption....................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Current assumption....................... 0.40% 0.40% 0.50% 0.40% 0.50% 0.45% 0.65%
Actual experience........................ 0.52% 0.32% 0.52% 0.45% 0.45% 0.53% 0.74%
Servicing fees:
Contractual fees......................... 0.50% 0.50% 0.50% 0.70% 0.50% 0.50% 0.50%
Ancillary fees........................... 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) To provide for the near term continuation of higher than average
prepayments, prepayment assumptions for trusts beyond the ramp period start
at approximately the current run rate and ramp down to the expected CPR over
3 months for both business and home equity loans.
(c) Current experience is a six-month historical average.
Na = not applicable
68
Summary of Material Mortgage Loan Securitization
Valuation Assumptions and Actual Experience at December 31, 2003 (Continued)
1999-4 1999-3 1999-2 1999-1 1998(d) 1997(d) 1996(d)
------ ------ ------ ------ ------ ------ ------
Interest-only strip residual discount rate:
Initial valuation........................ 11% 11% 11% 11% 11% 11% 11%
Current valuation........................ 10% 10% 10% 10% 10% 10% 10%
Interest-only strip overcollateralization
discount rate:
Initial valuation........................ 8% 7% 7% 7% 7% 7% 8%
Current valuation........................ 8% 7% 7% 7% 7% 7% 8%
Servicing rights discount rate:
Initial valuation........................ 11% 11% 11% 11% 11% 11% 11%
Current valuation........................ 9% 9% 9% 9% 9% 9% 9%
Prepayment rates:
Initial assumption (a):
Expected Constant Prepayment Rate (CPR):
Business loans ........................ 10% 10% 10% 10% 13% 13% 13%
Home equity loans...................... 24% 24% 24% 24% 24% 24% 24%
Ramp period (months):
Business loans......................... 24 24 24 24 24 24 24
Home equity loans...................... 18 18 18 18 12 12 12
Current assumptions (b):
Expected Constant Prepayment Rate (CPR):
Business loans ........................ 11% 10% 10% 10% 10% 15% 10%
Home equity loans...................... 22% 22% 22% 22% 23% 22% 20%
Ramp period (months):
Business loans......................... Na Na Na Na Na Na Na
Home equity loans...................... Na Na Na Na Na Na Na
CPR adjusted to reflect ramp:
Business loans......................... 26% 18% 37% 29% 20% 27% 12%
Home equity loans...................... 34% 39% 41% 36% 40% 40% 28%
Current prepayment experience (c):
Business loans......................... 26% 18% 35% 36% 18% 29% 6%
Home equity loans...................... 35% 38% 40% 35% 40% 39% 25%
Annual credit loss rates:
Initial assumption....................... 0.30% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
Current assumption....................... 0.70% 0.65% 0.35% 0.55% 0.60% 0.40% 0.45%
Actual experience........................ 0.65% 0.68% 0.41% 0.52% 0.55% 0.35% 0.41%
Servicing fees:
Contractual fees......................... 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%
Ancillary fees........................... 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) To provide for the near term continuation of higher than average
prepayments, prepayment assumptions for trusts beyond the ramp period start
at approximately the current run rate and ramp down to the expected CPR over
3 months for both business and home equity loans.
(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
69
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. We do not service the loans in the 2003-2
securitization, our most recent securitization, which closed in October 2003.
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 $2.8 million write down of servicing rights recorded in the
first six months 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.
On June 30, 2003, we reduced the discount rate on servicing rights cash
flows to 9% and used the same discount rate to value servicing rights at
December 31, 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.
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.
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.
70
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 nine 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 six months ended December 31, 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.
Results of Operations
Summary Financial Results
(dollars in thousands, except per share data)
Three Months Ended Six Months Ended
December 31, December 31,
------------------------ Percentage --------------------------- Percentage
2003 2002 Decrease 2003 2002 Decrease
-------- -------- ---------- --------- -------- ----------
Total revenues................. $28,591 $74,618 (61.7)% $ 48,792 $149,085 (67.3)%
Total expenses................. 68,627 70,979 (3.3)% 131,196 142,306 (7.8)%
Net income (loss).............. (24,822) 2,111 (51,090) 3,932
Return on average equity....... (10.57)% 11.20% (10.20)% 10.68%
Return on average assets....... (525.90)% 0.90% (443.79)% 0.85%
Earnings (loss) per share:
Basic........................ $ (8.35) $ 0.72 $ (17.26) $ 1.36
Diluted...................... $ (8.35) $ 0.69 $ (17.26) $ 1.30
Dividends declared per share... $ -- $ 0.08 $ -- $ 0.16
Summary
For the second quarter of fiscal 2004, we recorded a net loss of $24.8
million. The loss primarily resulted from liquidity issues which substantially
reduced our ability to originate loans and generate revenues during the second
quarter of fiscal 2004, a decrease in both the gain and size of the
securitization transaction recorded during the quarter, expense levels that
would support greater loan origination volume, and $12.0 million of pre-tax
charges for valuation adjustments on our securitization assets charged to the
income statement.
71
Loan origination volume decreased to $103.1 million for the quarter
ended December 31, 2003, compared to origination volume of $403.0 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 second quarter, our expense base for the quarter would have supported
greater origination volume.
For the six months ended December 31, 2003, we recorded a net loss of
$51.1 million compared to net income of $3.9 million for the same period in
fiscal 2003. Decreases in the gain on sale of loans recorded during the first
six months of fiscal 2004 were marginally offset by the favorable impact of
trading activity, general and administrative expenses, and sales and marketing
expenses. See below for further discussion of gain on sale, general and
administrative expenses, other expenses and the securitization assets valuation
adjustment recorded during the period.
During the quarter ended December 31, 2003, we recorded total pre-tax
adjustments on our securitization assets of $14.7 million, of which $12.0
million was reflected as an expense on the income statement and $2.7 million 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 $51.7 million loss and the $8.6 million pre-tax
reduction to other comprehensive income for the six months ended December 31,
2003 partially offset by the favorable impact of the Exchange Offer, total
stockholders' equity was reduced to $25.6 million at December 31, 2003. For the
same period in fiscal 2003, we recorded total pre-tax valuation adjustments of
$33.1 million, of which $22.7 million was reflected as an expense on the income
statement and $10.4 million was reflected as an adjustment to other
comprehensive income.
The loss per common share for the first six months of fiscal 2004 was
$17.26 per share on average common shares of 2,960,000 compared to diluted net
income per share of $1.30 per share on average common shares of 3,014,000 for
the first six months of fiscal 2003. A dividend of $0.16 per share was paid for
the first six months of fiscal 2003. No dividend was paid in the first six
months of fiscal 2004. The common dividend payout ratio based on diluted
earnings per share was 12.3% for the first six months of fiscal 2003.
At our annual meeting of shareholders held on December 31, 2003, our
shareholders approved three proposals to enable us to consummate the Exchange
Offer: a proposal to increase the number of authorized shares of common stock
from 9.0 million to 209.0 million, a proposal to increase the number of
authorized shares of preferred stock from 3.0 million to 203.0 million, and a
proposal to authorize us to issue Series A Preferred Stock in connection with
our Exchange Offer and the common stock issuable upon the conversion of the
Series A Preferred Stock. Shareholder approval of these issuances of securities
was required pursuant to the NASDAQ Corporate Governance Rules as the issuance
of such shares could result in a change in control of our company.
72
Loan Originations
The following schedule details our loan originations (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
--------------------------- ---------------------------
2003 2002 2003 2002
--------- --------- -------- ---------
Business purpose loans....... $ -- $ 32,187 $ -- $ 61,050
Home equity loans............ 103,084 370,764 227,136 712,617
--------- --------- --------- ---------
$ 103,084 $ 402,951 $ 227,136 $ 773,667
========= ========= ========= =========
During the first six months of fiscal 2004, our subsidiary, American
Business Credit, Inc., did not originate any business purpose loans. During the
six months ended December 31, 2002, American Business Credit, Inc. originated
$61.1 million of business purpose loans. Previously discussed liquidity issues
have substantially reduced our ability to originate business purpose loans
during the first two quarters of fiscal 2004. Pursuant to our adjusted business
strategy and depending on the availability of a credit facility to fund business
purpose loans, we plan to continue to originate business purpose loans, however
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 those purchased through the Bank Alliance Services program, decreased
$485.5 million, or 68.1%, for the six months ended December 31, 2003 to $227.1
million from $712.6 million for the six months ended December 31, 2002.
Liquidity issues have reduced our ability to originate home equity loans.
American Business Mortgage Services, Inc. home equity loan originations for the
six months ended December 31, 2003 decreased by $276.2 million, or 96.4%, from
the prior year period. We no longer originate loans through retail branches,
which resulted in a decrease in loan originations of $82.4 million, or 99.2%,
from the same six-month period in the prior year. The Bank Alliance Services
program's loan originations for the six months ended December 31, 2003 decreased
$22.9 million, or 25.4%, over the comparable prior year period. Based on our
adjusted business strategy, which emphasizes whole loan sales, smaller publicly
underwritten or 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, as part of our focus on developing broker
relationships, a lower cost source of originations, we have acquired a broker
operation that operates in the west coast and have expanded the broker business
within HomeAmerican Credit.
Revenues
Total Revenues. For the second quarter of fiscal 2004 total revenues
decreased $46.0 million, or 61.7%, to $28.6 million from $74.6 million for
fiscal 2003. For the first six months of fiscal 2004 total revenues decreased
$100.3 million, or 67.3%, to $48.8 million from $149.1 million for the first six
months of fiscal 2003. Our limited ability to borrow under credit facilities to
finance new loan originations for much of the first six months of fiscal 2004
and our inability to complete a securitization in the first quarter of fiscal
2004 accounted for this decrease in total revenues.
73
Gain on Sale of Loans - Securitizations. For the second quarter of
fiscal 2004, gains of $14.3 million were recorded on the securitization of
$136.0 million of loans. This was a decrease of $43.6 million, or 75.3% below
gains of $57.9 million were recorded on the securitization of $406.9 million of
loans for the second quarter of fiscal 2003. For the six months ended December
31, 2003, gains of $15.1 million were recorded on the securitization of $141.5
million of loans. This was a decrease of $100.8, or 87.0% over gains of $115.9
million recorded on securitizations of $773.3 million of loans for the six
months ended December 31, 2002.
The decrease in securitization gains for the three and six months ended
December 31, 2003 was due to our reduced level of loan originations during the
first six months of fiscal 2004 and our inability to complete a securitization
of loans during the first quarter. We completed a privately-placed
securitization, with servicing released, recognizing gain on $136.0 million of
loans in the second quarter. The $15.1 million in gains recorded in the six
months ended December 31, 2003 resulted from $136.0 million of loans securitized
in the second quarter, 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 to $0.1 million for the three months ended December 31, 2003, from a
loss of $2 thousand for the three months ended December 31, 2002. For the six
months ended December 31, 2003, gains on whole loan sales increased to $3.0
million from gains of $33 thousand for the six months ended December 31, 2002.
The volume of whole loan sales increased $277.5 million, to $279.0 million for
the six months ended December 31, 2003 from $1.5 million for the six months
ended December 31, 2002. The increase in the volume of whole loan sales for the
six months ended December 31, 2003 resulted from management's decision to adjust
its business strategy to emphasize more whole loan sales and our inability to
complete a securitization in the fourth quarter of fiscal 2003 and the first
quarter of fiscal 2004. See "-- Business Strategy" and "-- Liquidity and Capital
Resources" for further detail.
Interest and Fees. For the second quarter of fiscal 2002, interest and
fee income decreased $2.4 million, or 52.8%, to $2.2 million compared to $4.6
million in the same period of fiscal 2003. For the six months ended December 31,
2003, interest and fee income decreased $1.9 million, or 21.9%, to $6.8 million
compared to $8.7 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 originations.
During the second quarter of fiscal 2004, interest income decreased
$0.9 million, or 41.1%, to $1.4 million from $2.3 million for the second quarter
of fiscal 2003. The decrease for the second quarter was due to a lower average
balance of loans carried on balance sheet during the second quarter of fiscal
2004 resulting from the reduction in loan originations. During the six months
ended December 31, 2003, interest income increased $1.1 million, or 27.2%, to
$5.3 million from $4.1 million for the six months ended December 31, 2002. The
increase for the six-month period resulted from 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 $0.4 million of investment
interest income due to lower invested cash balances and lower interest rates on
invested cash balances due to general decreases in market interest rates.
During the second quarter of fiscal 2004, other fees decreased $1.5
million, or 64.5%, to $0.8 million from $2.3 million for the second quarter of
fiscal 2003. Other fees decreased $3.0 million for the six months ended December
31, 2003, or 66.1%, to $1.6 million from $4.6 million for the six months ended
December 31, 2002. These decreases were mainly due to decreases in fees related
to loan originations, which resulted from our reduced 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.
74
Interest Accretion on Interest-Only Strips. Interest accretion of $10.2
million and $21.3 million were earned in the three and six months ended December
31, 2003 compared to $11.5 million and $22.2 million in the three and six months
ended December 31, 2002. The decrease reflects the decline in the balance of our
interest-only strips of $45.9 million, or 7.9%, to $533.7 million at December
31, 2003 from $579.6 million at December 31, 2002. However, cash flows from
interest-only strips for the six months ended December 31, 2003 totaled $96.8
million, an increase of $24.0 million, or 32.9%, from the six months ended
December 31, 2002 due to the larger size of our more recent securitizations and
additional securitizations reaching final target overcollateralization levels
and stepdown overcollateralization levels.
Servicing Income. Servicing income is comprised of contractual and
ancillary fees collected on securitized loans 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 December 31, 2003,
servicing income increased $1.2 million, to $1.8 million from $0.6 million for
the three months ended December 31, 2002. For the six months ended December 31,
2003, servicing income increased $0.3 million, or 15.9%, to $2.5 million from
$2.2 million for the six months ended December 31, 2002. Because loan prepayment
levels in the first six months of fiscal 2004 increased from the first six
months 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
six months of fiscal 2004 has resulted in higher levels of amortization.
The following table summarizes the components of servicing income for
the three and six months ended December 31, 2003 and 2002 (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
---------------------- -----------------------
2003 2002 2003 2002
-------- -------- --------- ----------
Contractual and ancillary fees............... $ 11,859 $ 11,289 $ 24,952 $ 21,450
Amortization of servicing rights............. (10,050) (10,645) (22,425) (19,269)
-------- -------- --------- ----------
Net servicing income......................... $ 1,809 $ 644 $ 2,527 $ 2,181
======== ======== ========= ==========
Expenses
Total Expenses. Total expenses decreased $2.4 million, or 3.3%, to
$68.6 million for the three months ended December 31, 2003 compared to $71.0
million for the three months ended December 31, 2002. Total expenses decreased
$11.1 million, or 7.8%, to $131.2 million for the six months ended December 31,
2003 compared to $142.3 million for the six months ended December 31, 2002. As
described in more detail below, this decrease was mainly a result of decreases
in losses on derivative financial instruments classified as trading, sales and
marketing expenses, general and administrative expenses and interest expense
during the six months ended December 31, 2003, partially offset by increases in
employee related costs, provision for loan losses and for the second quarter,
securitization assets valuation adjustments.
Interest Expense. The two major components of interest expense are
interest on subordinated debentures and interest on warehouse lines of credit
used to fund loans. During the second quarter of fiscal 2004, interest expense
decreased $0.5 million, or 2.9%, to $16.7 million compared to $17.2 million for
the second quarter of fiscal 2003. During the first six months of fiscal 2004,
interest expense decreased $0.8 million, or 2.2%, to $33.5 million compared to
$34.2 million for the six months ended December 31, 2002. The decrease in
interest expense for the three and six months ended December 31, 2003 was
primarily attributable to the decline in average interest rates paid on
subordinated debentures outstanding.
75
The following schedule details interest expense (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
----------------------- ----------------------
2003 2002 2003 2002
-------- -------- -------- --------
Interest on subordinated debentures.......... $ 16,138 $ 16,749 $ 32,231 $ 33,558
Interest to fund loans....................... 478 368 1,171 633
Other interest............................... 34 33 66 42
-------- -------- -------- --------
$ 16,650 $ 17,150 $ 33,468 $ 34,233
======== ======== ======== ========
Average subordinated debentures outstanding during the three months
ended December 31, 2003 was $693.9 million compared to $677.2 million during the
three months ended December 31, 2002. Average interest rates paid on
subordinated debentures outstanding decreased to 8.93% during the three months
December 31, 2003 from 9.47% during the three months ended December 31, 2002.
Average subordinated debentures outstanding during the six months ended December
31, 2003 was $700.9 million compared to $669.8 million during the six months
ended December 31, 2002. Average interest rates paid on subordinated debentures
outstanding decreased to 8.85% during the six months ended December 31, 2003
from 9.59% during the six months ended December 31, 2002.
Rates offered on subordinated debentures were reduced beginning in the
fourth quarter of fiscal 2001 and had 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 debentures issued at its peak rate, which was the month of
February 2001, was 11.85% compared to the average interest rate of subordinated
debentures issued in the month of June 2003 of 7.49%. The weighted-average
interest rate on subordinated debentures issued during the month of December
2003 was 9.08%, an increase that reflects a general rise in market interest
rates since June 30, 2003 and our financial condition. Our ability to maintain
the rates offered on subordinated debentures, 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 average outstanding balances under warehouse lines of credit were
$66.6 million during the three months ended December 31, 2003, compared to $51.3
million during the three months ended December 31, 2002. The average outstanding
balances under warehouse lines of credit were $93.9 million during the six
months ended December 31, 2003, compared to $37.7 million during the six months
ended December 31, 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 2.00% to 2.50%. One-month LIBOR has
decreased from approximately 1.4% at December 31, 2002 to 1.12% at December 31,
2003.
Provision for Credit Losses. The provision for credit losses on loans
and leases available for sale for the three months ended December 31, 2003
increased $2.4 million, or 165.6%, to $3.8 million, compared to $1.4 million for
the three months ended December 31, 2002. The provision for credit losses on
loans and leases available for sale for the six months ended December 31, 2003
increased $5.0 million, or 168.0%, to $8.0 million, compared to $3.0 million for
the six months ended December 31, 2002. The increase in the provision for loan
losses for the three and six-month periods ended December 31, 2003 was primarily
due the higher amounts of loans repurchased from securitization trusts. 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 $6.9 million at December 31, 2003, compared to
$5.4 million at June 30, 2003 and $9.9 million at December 31, 2002. See
"--Total Portfolio Quality" for further detail.
76
The allowance for credit losses was $3.2 million, or 2.7% of loans and
leases available for sale at December 31, 2003 compared to $2.8 million or 1.0%
of loans and leases available for sale at June 30, 2003 and $3.6 million, or
5.7% of loans and leases available for sale at December 31, 2002. The allowance
for credit losses increased from June 30, 2003 due to the increase of the
non-accrual loan balance being carried on our balance sheet at December 31,
2003. The allowance for credit losses as a percentage of gross receivables
decreased from December 31, 2002 due to the increase in the balance of accruing
loans available for sale and a decrease in the amount of non-accrual loans
carried on our balance sheet. See "-- Total Portfolio Quality" for a discussion
of non-accrual loans carried on our balance sheet. 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 and six months ended December 31, 2003 and 2002 (in
thousands):
Three Months Ended Six Months Ended
December 31, December 31,
---------------------- ---------------------
2003 2002 2003 2002
------- ------- ------- -------
Balance at beginning of period........... $ 5,470 $ 3,184 $ 2,848 $ 3,705
Provision for credit losses............... 3,814 1,436 7,970 2,974
(Charge-offs) recoveries, net............. (6,100) (1,039) (7,634) (3,098)
------- ------- ------- -------
$ 3,184 $ 3,581 $ 3,184 $ 3,581
======= ======= ======= =======
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 December 31, 2003: Loans Loans Leases Total
- ----------------------------------------- -------- -------- --------- --------
Balance at beginning of period........... $ 1,355 $ 3,977 $ 138 $ 5,470
Provision for credit losses.............. 769 3,058 (13) 3,814
(Charge-offs) recoveries, net............ (1,428) (4,714) 42 (6,100)
-------- -------- ------ --------
Balance at end of period................. $ 696 $ 2,321 $ 167 $ 3,184
======== ======== ====== ========
Business Home
Purpose Equity Equipment
Six Months Ended December 31, 2003: Loans Loans Leases Total
- ----------------------------------------- -------- -------- --------- --------
Balance at beginning of period........... $ 593 $ 2,085 $ 170 $ 2,848
Provision for credit losses.............. 1,880 6,133 (43) 7,970
(Charge-offs) recoveries, net............ (1,777) (5,897) 40 (7,634)
-------- -------- ------ --------
Balance at end of period................. $ 696 $ 2,321 $ 167 $ 3,184
======== ======== ====== ========
Business Home
Purpose Equity Equipment
Three Months Ended December 31, 2002: Loans Loans Leases Total
- ----------------------------------------- -------- -------- --------- --------
Balance at beginning of period........... $ 931 $ 1,977 $ 276 $ 3,184
Provision for credit losses.............. 778 573 85 1,436
(Charge-offs) recoveries, net............ (322) (652) (65) (1,039)
-------- -------- ------ --------
Balance at end of period................. $ 1,387 $ 1,898 $ 296 $ 3,581
======== ======== ====== ========
77
Business Home
Purpose Equity Equipment
Six Months Ended December 31, 2002: Loans Loans Leases Total
- ----------------------------------------- -------- -------- --------- --------
Balance at beginning of period........... $ 1,388 $ 1,998 $ 319 $ 3,705
Provision for credit losses.............. 849 1,867 258 2,974
(Charge-offs) recoveries, net............ (849) (1,966) (283) (3,098)
-------- -------- ------ --------
Balance at end of period................. $ 1,388 $ 1,899 $ 294 $ 3,581
======== ======== ====== ========
The following table summarizes net charge-off experience by loan type
for the three and six months ended December 31, 2003, and 2002 (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
--------------------- --------------------
2003 2002 2003 2002
--------- ------- ------- -------
Business purpose loans................... $ 1,428 $ 322 $ 1,777 $ 849
Home equity loans........................ 4,714 652 5,897 1966
Equipment leases......................... (42) 65 (40) 283
--------- ------- ------- -------
Total.................................... $ 6,100 $ 1,039 $ 7,634 $ 3,098
========= ======= ======= =======
Employee Related Costs. For the second quarter of fiscal 2004, employee
related costs increased $0.8 million, or 7.3%, to $11.8 million from $11.0
million in the second quarter of fiscal 2003. For the six months ended December
31, 2003, employee related costs increased $5.1 million, or 24.7%, to $25.6
million from $20.5 million in the prior year. The increase in employee related
costs for the three and six months ended December 31, 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. The decrease in SFAS No. 91 deferrals
totaled $16.3 million. Decreases in loan origination commissions, base salaries
due to the workforce reductions discussed below, and bonuses partially offset
the effect of reduced SFAS No. 91 cost deferrals.
Total employees at December 31, 2003 were 753 compared to 1,048 at
December 31, 2002. At January 31, 2004, total employees were 712. Since June 30,
2003, our workforce has decreased by 407 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 250 employees. In addition, we experienced a net
loss of approximately 157 additional employees who have resigned since June 30,
2003. These workforce reductions and resignations represent a 36% decrease in
staffing levels from June 30, 2003.
Sales and Marketing Expenses. For the second quarter of fiscal 2004,
sales and marketing expenses decreased $3.4 million, or 52.3%, to $3.1 million
from $6.5 million for the second quarter of fiscal 2003. For the six months
ended December 31, 2003, sales and marketing expenses decreased $7.2 million, or
55.0%, to $5.9 million from $13.2 million for the six months ended December 31,
2002. The decreases were 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
debentures. 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.
78
Trading (Gains) and Losses. During the three months ended December 31,
2003, we recognized trading losses of $38 thousand on derivative financial
instruments. This compares to trading losses of $1.0 million for the three
months ended December 31, 2002. For the six months ended December 31, 2003, we
recognized net trading gains of $5.1 million compared to trading losses of $4.5
million for the six months ended December 31, 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 second quarter of fiscal
2004, general and administrative expenses decreased $2.1 million, or 8.9%, to
$21.3 million from $23.3 million for the second quarter of fiscal 2003. For the
six months ended December 31, 2003, general and administrative expenses
decreased $3.8 million, or 8.5%, to $40.5 million from $44.3 million for the six
months ended December 31, 2002.The decrease for the six-month period was
primarily attributable to a decrease of $6.4 million in costs associated with
servicing and collecting our total managed portfolio including expenses
associated with REO and delinquent loans, and a $3.2 million decrease in costs
associated with customer retention incentives, partially offset by $4.0 million
in fees on new credit facilities, a $1.2 million increase in professional fee
expenses and a $0.7 million increase in business insurance expense.
Securitization Assets Valuation Adjustment. During the three months
ended December 31, 2003, we recorded total pre-tax valuation adjustments on our
securitization assets of $14.7 million, of which $12.0 million was reflected as
expense on the income statement and $2.7 million was reflected as an adjustment
to other comprehensive income. For the three months ended December 31, 2002, we
recorded total pre-tax valuation adjustments on our securitization assets of
$16.4 million, of which $10.6 million was reflected as expense on the income
statement and $5.8 million was reflected as an adjustment to other comprehensive
income.
During the six months ended December 31, 2003, we recorded total
pre-tax valuation adjustments on our securitization assets of $31.4 million, of
which $22.8 million was reflected as an expense on the income statement and $8.6
million was reflected as an adjustment to other comprehensive income. During the
six months ended December 31, 2002, we recorded total pre-tax valuation
adjustments on our securitization assets of $33.1 million, of which $22.7
million was reflected as an expense on the income statement and $10.4 million
was reflected as an adjustment to other comprehensive income.
See "-- Off-Balance Sheet Arrangements -- Securitizations" for further
detail of these adjustments.
79
Balance Sheet Information
Balance Sheet Data
(Dollars in thousands, except per share data)
December 31, June 30,
2003 2003
------------ -----------
Cash and cash equivalents......................... $ 29,620 $ 47,475
Loan and lease receivables, net:
Available for sale............................. 115,792 271,402
Interest and fees.............................. 19,822 15,179
Other.......................................... 30,636 23,761
Interest-only strips.............................. 533,677 598,278
Servicing rights.................................. 94,086 119,291
Receivable for sold loans......................... -- 26,734
Deferred income tax asset......................... 16,442 --
Total assets...................................... 911,406 1,159,351
Subordinated debentures........................... 629,674 719,540
Senior collateralized subordinated notes.......... 34,459 --
Warehouse lines and other notes payable........... 87,940 212,916
Accrued interest payable.......................... 39,323 45,448
Deferred income tax liability..................... -- 17,036
Total liabilities................................. 885,800 1,117,282
Total stockholders' equity........................ 25,606 42,069
Book value per common share....................... $ 8.14 $ 14.28
Total assets decreased $247.9 million, or 21.4%, to $911.4 million at
December 31, 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, servicing rights 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 operating
losses during the first and second quarters of fiscal 2004 and a reduction in
the issuance of subordinated debentures.
Loan and lease receivables - Available for sale decreased $155.6
million, or 57.3% due to whole loan sales and a privately-placed securitization
during the second quarter ended December 31, 2003, coupled with a reduction in
loan originations caused by our liquidity issues.
80
Activity of our interest-only strips for the three months ended
December 31, 2003 and 2002 was as follows (in thousands):
Six Months Ended
December 31,
----------------------
2003 2002
--------- ---------
Balance at beginning of period.............................. $ 598,278 $ 512,611
Initial recognition of interest-only strips................. 25,523 94,182
Cash flow from interest-only strips......................... (97,170) (72,858)
Required purchases of additional overcollateralization...... 12,801 37,680
Interest accretion.......................................... 21,057 22,247
Termination of lease securitization (a)..................... (1,759) (1,741)
Net temporary adjustments to fair value (b)................. (5,070) 7,485
Other than temporary adjustments to fair value (b).......... (19,983) (20,002)
--------- ---------
Balance at end of period.................................... $ 533,677 $ 579,604
========= =========
(a) Reflects release of lease collateral from lease securitization trusts which
were terminated in accordance with the trust documents after the full payout
of trust note certificates. Lease receivables of $1.8 million and $1.6
million, respectively, were recorded on our balance sheet at December 31,
2003 and 2002 as a result of the terminations.
(b) Net temporary adjustments to fair value are recorded through other
comprehensive income, which is a component of equity. Other than temporary
adjustments to decrease the fair value of interest-only strips are recorded
through the income statement.
The following table summarizes our purchases of overcollateralization
by securitization trust for the six months ended December 31, 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 Other(a) Total
------ ------ ------ -------- -----
Six Months Ended December
31, 2003:
Required purchases of
additional
overcollateralization..... $9,292 $7,411 $1,978 $(2,636) $16,045
====== ====== ====== ======= =======
(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
====== ====== ====== ======= ====== ====== ====== ====== ====== ======= =======
81
Servicing rights decreased $25.2 million, or 21.1%, to $94.1 million at
December 31, 2003 from $119.3 million at June 30, 2003, primarily due to our
inability to complete a securitization in the first three months of fiscal 2004,
completing a privately-placed securitization with servicing released in the
second quarter of fiscal 2004, amortization of servicing rights and a $2.8
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 $231.5 million, or 20.7%, to $885.8 million
at December 31, 2003 from $1,117.3 million at June 30, 2003 primarily due to
decreases in warehouse lines and other notes payable, subordinated debentures
outstanding, deferred income taxes and other liabilities. The decrease in
warehouse lines and other notes payable was due to sales during the first six
months of fiscal 2004 of loans that we originated in fiscal 2003 and to the
substantial reduction in the amount of loans we originated during the first six
months of fiscal 2004. Other liabilities decreased $26.2 million, or 28.4%, to
$65.8 million from $92.0 million due mainly to a $27.6 million decrease in the
loan funding liability related to decreased loan originations.
During the six months ended December 31, 2003, subordinated debentures
decreased $89.9 million, or 12.5%, to $629.7 million due to the conversion of
$73.6 million of subordinated debentures into 39.1 million shares of Series A
Preferred Stock and $34.5 million of senior collateralized subordinated notes
and the temporary discontinuation of sales of new subordinated debentures for
approximately a six-week period during the first quarter of fiscal 2004. 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 $16.4 million at December 31, 2003. This
change from a liability position is the result of the federal and state tax
benefits of $31.3 million recorded on our pre-tax loss for the first six months
of fiscal 2004, which will be realized against anticipated future years' state
and federal taxable income. Factors we considered in determining that it is more
likely than not we will realize this deferred tax asset included; the
circumstances producing the losses for the fourth quarter of fiscal 2003 and the
first six months of fiscal 2004; the anticipated impact our adjusted business
strategy will have on producing more currently taxable income than our previous
strategy produced due to higher loan originations and shifting from
securitization to whole loan sales; and the likely utilization of our net
operating loss carryforwards. In addition, a federal benefit of $2.3 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.
82
Total Portfolio Quality
The following table provides data concerning delinquency experience,
real estate owned and loss experience for the total loan and lease portfolio in
which we have interests, either because the loans and leases are on our balance
sheet or sold into securitizations in which we have retained interests. The
total portfolio is divided into the portion of the portfolio managed and
serviced by us and the portion of the portfolio serviced by others. See "--
Reconciliation of Non-GAAP Financial Measures" for a reconciliation of total
portfolio and REO measures to our balance sheet. See "-- Deferment and
Forbearance Arrangements" for the amounts of previously delinquent loans managed
by us 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):
December 31, September 30, June 30,
2003 2003 2003
------------------------- --------------------- ---------------------
Delinquency by Type Amount % Amount % Amount %
---------------- ------- -------------- ------ ------------- ------
Managed by ABFS:
Business Purpose Loans
Total managed portfolio........... $ 307,807 $ 364,970 $ 393,098
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 6,640 2.16% $ 5,761 1.57% $ 4,849 1.23%
61-90 days...................... 7,109 2.31 6,129 1.68 4,623 1.18
Over 90 days.................... 47,449 15.41 42,831 11.74 38,466 9.79
----------- ------ ----------- ------ ----------- ------
Total delinquencies............. $ 61,198 19.88% $ 54,721 14.99% $ 47,938 12.20%
=========== ====== =========== ====== =========== ======
REO............................... $ 1,879 $ 4,491 $ 5,744
=========== =========== ===========
Home Equity Loans
Total managed portfolio........... $ 2,179,052 $ 2,601,125 $ 3,249,501
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 53,522 2.46% $ 53,514 2.06% $ 48,332 1.49%
61-90 days...................... 31,668 1.45 36,729 1.41 24,158 0.74
Over 90 days.................... 125,212 5.75 122,997 4.73 108,243 3.33
----------- ------ ----------- ------ ----------- ------
Total delinquencies............. $ 210,402 9.66% $ 213,240 8.20% $ 180,733 5.56%
=========== ====== =========== ====== =========== ======
REO............................... $ 22,359 $ 21,561 $ 22,256
=========== =========== ===========
Equipment Leases
Total managed portfolio........... $ 3,669 $ 5,705 $ 8,475
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 419 11.42% $ 248 4.34% $ 162 1.91%
61-90 days...................... 93 2.54 40 0.70 83 0.98
Over 90 days.................... 127 3.46 200 3.51 154 1.82
----------- ------ ----------- ------ ----------- ------
Total delinquencies............. $ 639 17.42% $ 488 8.55% $ 399 4.71%
=========== ====== =========== ====== =========== ======
Total Managed by ABFS
Total managed portfolio............. $ 2,490,528 $ 2,971,800 $ 3,651,074
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 60,581 2.43% $ 59,523 2.00% $ 53,343 1.46%
61-90 days...................... 38,870 1.56 42,898 1.44 28,864 0.79
Over 90 days.................... 172,788 6.94 166,028 5.59 146,863 4.02
----------- ------ ----------- ------ ----------- ------
Total delinquencies............. $ 272,239 10.93% $ 268,449 9.03% $ 229,070 6.27%
=========== ====== =========== ====== =========== ======
REO............................... $ 24,238 0.97% $ 26,052 0.88% $ 28,000 0.77%
=========== ====== =========== ====== =========== ======
Serviced by Others:
Total portfolio serviced by others $ 167,582 $ -- $ --
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 10,112 6.04% $ -- --% $ -- --%
61-90 days...................... 3,198 1.91 -- -- -- --
Over 90 days.................... 1,984 1.18 -- -- -- --
----------- ------ ----------- ------ ----------- ------
Total delinquencies............. $ 15,294 9.13% $ -- --% $ -- --%
=========== ====== =========== ====== =========== ======
(Continued on next page)
83
Total Portfolio Quality (continued)
December 31, September 30, June 30,
2003 2003 2003
------------------------- --------------------- ---------------------
Amount % Amount % Amount %
---------------- ------- -------------- ------ ------------- ------
Total portfolio..................... $ 2,658,110 $ 2,971,800 $ 3,651,074
=========== =========== ===========
Period of delinquency:
31-60 days...................... $ 70,693 2.66% $ 59,523 2.00% $ 53,343 1.46%
61-90 days...................... 42,068 1.58 42,898 1.44 28,864 0.79
Over 90 days.................... 174,772 6.58 166,028 5.59 146,863 4.02
----------- ------ ----------- ------ ----------- ------
Total delinquencies............. $ 287,533 10.82% $ 268,449 9.03% $ 229,070 6.27%
=========== ====== =========== ====== =========== ======
REO............................... $ 24,238 0.91% $ 26,052 0.88% $ 28,000 0.77%
=========== ====== =========== ====== =========== ======
Losses experienced during the
period (a)(b):
Loans........................... $ 12,375 1.77% $ 8,100 0.97% $ 7,390 0.83%
====== ====== ======
Leases.......................... (41) (3.49)% 1 0.06% 55 2.14%
----------- ====== ----------- ====== ----------- ======
Total Losses..................... $ 12,334 1.76% $ 8,101 0.97% $ 7,445 0.84%
=========== ====== =========== ====== =========== ======
(a) Percentage based on annualized losses and average total portfolio.
(b) Losses recorded on our books were $7.7 million ($6.1 million from
charge-offs through the provision for loan losses and $1.6 million for write
downs of real estate owned) and losses absorbed by loan securitization
trusts were $4.6 million for the three months ended December 31, 2003.
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 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):
December 31, September 30, June 30,
2003 2003 2003
------------ ------------- --------
Delinquent loans and leases on balance sheet (a).... $ 7,213 $ 11,825 $ 5,412
% of on balance sheet loan and lease receivables.... 6.18% 7.21% 2.04%
Loans and leases in non-accrual status on
balance sheet (b)............................... $ 6,896 $ 11,941 $ 5,358
% of on balance sheet loan and lease receivables.... 5.91% 7.28% 2.02%
Allowance for losses on available for sale loans
and leases.................................... $ 3,184 $ 5,470 $ 2,848
% of available for sale loans and leases............ 2.7% 3.3% 1.0%
Real estate owned on balance sheet.................. $ 3,077 $ 4,566 $ 4,776
- -----------------
(a) Delinquent loans and leases are included in total delinquencies in the
previously presented "Total Portfolio Quality" table. Included in total
delinquencies are loans in non-accrual status of $6.6 million, $10.7
million and $5.0 million at December 31, 2003, September 30, 2003 and June
30, 2003, respectively.
(b) It is our policy to suspend the accrual of interest income when a loan is
contractually delinquent for 90 days or more. Non-accrual loans and leases
are included in total delinquencies in the previously presented "Total
Portfolio Quality" table.
84
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 the borrower's 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.
In a deferment arrangement, we make advances 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 delinquent 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
include: (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 or his designee.
If the deferment arrangement is approved, a collector contacts the borrower
regarding the approval and the revised payment terms.
For borrowers who are three or more payments delinquent, we will
consider using a forbearance arrangement. In a forbearance arrangement, we make
advances 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 will create a
payment plan for the borrower which 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 on behalf of the borrower.
85
Principal guidelines currently applicable to the forbearance process
include the following: (i) the borrower must have first and/or second mortgages
with us; (ii) the borrower's account was originated at least six months prior
to the request for forbearance; (iii) the borrower's acount must be at least
three payments delinquent to qualify for a forbearance agreement; (iv) the
borrower must submit a written request for forbearance containing an explanation
for his or her previous delinquency and setting forth the reasons that the
borrower now believes he or she is able to meet his or her loan obligations;
and (v) the borrower must make a down payment of at least one month's past due
payments of principal and interest in order to enter into a forbearance
agreement, and the borrower who is six or more payments delinquent must make a
down payment of at least two past due payments. No request for forbearance may
be denied without review by our Senior Vice President for Collections or his
designee.
For delinquent borrowers with business purpose loans, we may enter into
written forbearance agreements. 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 also depends upon one or more of the
following factors: our assessment of the individual borrower's current financial
situation, reasons for the delinquency 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. 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 be declared in default and collection actions
resumed.
The following table presents, as of the end of our last seven 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
Portfolio
Under Under Managed
Deferment Forbearance Total(a) by ABFS
------------- ------------- ------------- -----------
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
December 31, 2003............. 152,664 75,769 228,433 9.17
- ------------
(a) Included in cumulative unpaid principal balance are loans with arrangements
that were entered into longer than twelve months ago. At December 31, 2003,
there was $25.3 million of cumulative unpaid principal balance under
deferment arrangements and $32.2 million of cumulative unpaid principal
balance under forbearance arrangements that were entered into prior to
October 2002.
86
Additionally, there are loans under deferment and forbearance
arrangements, which have returned to delinquent status. At December 31, 2003
there was $53.8 million of cumulative unpaid principal balance under deferment
arrangements and $58.7 million of cumulative unpaid principal balance under
forbearance arrangements that are now reported as delinquent 31 days or more.
Over the previous twelve 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.
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 two quarters of fiscal 2004 (dollars in thousands):
Unpaid Principal Balance Impacted by
Arrangements
------------------------------------------------
% of
Portfolio
Under Under Managed
Quarter Ended: Deferment Forbearance Total by ABFS
-------------- -------------- ------------ -----------
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
December 31, 2003............. 52,029 14,272 66,301 2.66
Delinquent loans and leases. Total delinquencies (loans and leases with
payments past due greater than 30 days, excluding REO) in the total portfolio
were $287.5 million at December 31, 2003 compared to $229.1 million at June 30,
2003 and $220.9 million at December 31, 2002. Total delinquencies as a
percentage of the total portfolio were 10.82% at December 31, 2003 compared to
6.27% at June 30, 2003 and 6.62% at December 31, 2002. The increases 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 total 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 the amount of loans
originated also contributed to the increase in the delinquency percentage in
fiscal 2004 from 2003. As the total 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 $7.2 million at December
31, 2003.
87
Real estate owned. Total REO, comprising foreclosed properties and
deeds acquired in lieu of foreclosure, decreased to $24.2 million, or 0.97% of
the total managed portfolio at December 31, 2003 compared to $34.4 million, or
1.03% at December 31, 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 $3.1 million at
December 31, 2003.
Loss experience. During the three months ended December 31, 2003, we
experienced net loan and lease charge-offs in the total portfolio of $12.3
million, or 1.76% on an annualized basis, compared to net loan and lease
charge-offs in the total portfolio of $5.9 million, or 0.72% during the three
months ended December 31, 2002, and $8.1 million, or 0.97% during the three
months ended September 30, 2003. The increase in net loan charge-offs from prior
periods was mainly due to the larger volume of loans which became delinquent and
an acceleration in the amount of seriously delinquent loans which were
liquidated during the current period. 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.
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 debentures). 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.
88
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 debentures 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 debentures, 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.
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 December 31, 2003
-----------------------------------------------------------------------------------------
Months Months Months Months Months There- Fair
1 to 12 13 to 24 25 to 36 37 to 48 49 to 60 after Total Value
------- -------- -------- -------- -------- ------- ------- -------
Rate Sensitive Assets:
Loans and leases available for sale (a).$ 109,275 $ 75 $ 84 $ 93 $ 104 $ 6,161 $115,792 $120,666
Interest-only strips.................... 123,883 117,503 105,478 82,777 65,052 232,568 727,261 533,677
Servicing rights........................ 29,230 22,998 18,023 14,130 11,066 35,089 130,536 94,086
Investments held to maturity............ 199 419 242 -- -- -- 860 891
Rate Sensitive Liabilities:
Fixed interest rate borrowings..........$ 291,144 $196,869 $126,030 $ 18,116 $ 11,778 $ 21,322 $665,259 $663,968
Average interest rate................... 8.09% 9.19% 9.33% 9.18% 9.89% 11.19% 8.81%
Variable interest rate borrowings.......$ 86,814 $ -- $ -- $ -- $ -- $ -- $ 86,814 $ 86,814
Average interest rate................... 3.57% -- -- -- -- -- 3.57%
- --------------
(a) For purposes of this table, all loans which qualify for securitization or
whole loan sale are reflected as maturing within twelve months, since loans
available for sale are generally held for less than three months prior to
securitization or whole loan sale. Leases available for sale were sold in
January 2004. Cash received from the sale of these leases was $4.8 million
and was included in months 1 to 12 in the table.
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.
89
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.
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 December 31, 2003, $261.9 million of debt issued by loan
securitization trusts was floating interest rate certificates based on one-month
LIBOR, representing 11.2% of total debt issued by loan securitization trusts. In
accordance with accounting principles generally accepted in the United States of
America, the changes in fair value are generally recognized as part of net
adjustments to other comprehensive income, which is a component of retained
earnings. As of December 31, 2003, the interest rate sensitivity for $14.9
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. 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. The interest rate sensitivity for $160.2 million of
floating interest rate certificates issued from the 2003-2 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 portfolio were subject to
prepayment fees. Currently, approximately 50-55% of business loans and 55-60% of
home equity loans in the total 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 Debentures and Senior Collateralized Subordinated Notes.
We also experience interest rate risk to the extent that as of December 31, 2003
approximately $373.3 million of our liabilities were comprised of fixed interest
rate subordinated debentures and senior collateralized subordinated notes with
scheduled maturities of greater than one year. To the extent that market
interest rates demanded on subordinated debentures increase in the future, the
interest rates paid on replacement debt could exceed interest rates currently
paid thereby increasing interest expense and reducing net income.
Strategies for Use of Derivative Financial Instruments. All derivative
financial instruments are recorded on the balance sheet at fair value with
realized and unrealized gains and losses included in the statement of income in
the period incurred.
90
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.
The Company recorded the following gains and losses on the fair value
of derivative financial instruments accounted for as hedges for the three and
six-month periods ended December 31, 2003 and 2002. Any ineffectiveness related
to hedging transactions during the period was immaterial. Ineffectiveness is a
measure of the difference in the change in fair value of the derivative
financial instrument as compared to the change in the fair value of the item
hedged (in thousands):
91
Three Months Ended Six Months Ended
December 31, December 31,
------------------------- ----------------------
2003 2002 2003 2002
----------- ----------- ---------- ----------
Offset by losses and gains recorded on
securitizations:
Gains (losses) on derivative financial
instruments........................... $ -- $ 1,104 $ -- (1,735)
Offset by losses and gains recorded on the
fair value of hedged items:
Gains (losses) on derivative financial
instruments........................... (648) (2,087) (648) (3,054)
Amount settled in cash - received (paid).. (692) (2,422) (692) (2,422)
At December 31, 2003 and 2002, outstanding Eurodollar futures contracts
and forward starting interest rate swap contracts accounted for as hedges and
the related unrealized gains (losses) recorded as assets (liabilities) on the
balance sheet were as follows (in thousands):
December 31, 2003 December 31, 2002
----------------------------- -----------------------------
Notional Unrealized Notional Unrealized
Amount Gain Amount (Loss)
------------- ------------- ------------ --------------
Eurodollar futures contracts $50,000 $44 -- --
Forward starting interest rate swaps -- -- $84,370 $(2,087)
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 and six-month periods ended December 31, 2002, we used interest rate
swap contracts to protect the future securitization spreads on loans in our
pipeline. Loans in the pipeline represent loan applications for which we are in
the process of obtaining all the documentation required for a loan approval or
approved loans, which have not been accepted by the borrower and are not
considered to be firm commitments. We believed there was a greater chance that
market interest rates we would obtain on the subsequent securitization of these
loans would increase rather than decline, and chose to protect the spread we
could earn in the event of rising rates.
However due to a decline in market interest rates during the period the
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 and six-month periods ended December 31, 2002. The losses are
summarized in the table below. During the three and six-month periods ended
December 31, 2003, we did not utilize derivative financial instruments to
protect future securitization spreads on loans in our pipeline.
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 of fiscal 2003 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.
92
We recorded the following gains and losses on forward starting interest
rate swap contracts classified as trading for the three and six-month periods
ended December 31, 2003 and 2002 (in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
------------------------------ --------------------------
2003 2002 2003 2002
------------- ------------- ----------- -----------
Trading Gains/(Losses) on forward starting
interest rate swaps:
Related to loan pipeline -- $ (407) $ -- $ (2,924)
Related to whole loan sales -- -- 5,097 --
Amount settled in cash - (paid) -- (2,671) (1,212) (2,671)
At December 31, 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 December 31, 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):
Notional Unrealized
Amount Loss
---------- -----------
Forward starting interest rate swaps $10,630 $ 263
Related to Interest-only Strips. We have an interest rate swap
contract, which is not designated as an accounting hedge, designed to reduce the
exposure to changes in the fair value of certain interest-only strips due to
changes in one-month LIBOR. Unrealized gains and losses on the interest rate
swap contract are due to changes in the interest rate swap yield curve during
the periods the contract is in place. Net gains and losses on this interest rate
swap contract include the amount of cash settlement with the contract counter
party each period. Net gains and losses on this interest rate swap contract for
the three and six-month periods ended December 31, 2003 and 2002 were as follows
(in thousands):
Three Months Ended Six Months Ended
December 31, December 31,
------------------------------ --------------------------
2003 2002 2003 2002
------------ -------------- ------------ ----------
Unrealized gain (loss) on interest rate
swap contract $ 109 $ (417) $ 286 $ (295)
Cash interest received (paid) on
interest rate swap contract (91) (270) (257) (540)
--------- -------- -------- -------
Net gain (loss) on interest rate swap
contract $ 18 $ (687) $ 29 $ (835)
========= ======== ======== =======
93
The cumulative net unrealized loss of $48 thousand at December 31, 2003
is included as a trading liability in Other liabilities. Terms of the interest
rate swap contract at December 31, 2003 were as follows (dollars in thousands):
Notional amount $ 14,887
Rate received - Floating (a) 1.20%
Rate paid - Fixed 2.89%
Maturity date April 2004
Unrealized loss $ 48
Sensitivity to 0.1% change in interest rates $ 2
- -----------
(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.
In the future, we may expand the types of derivative financial
instruments we use to hedge interest rate risk to include other types of
derivative contracts. However, an effective interest rate risk management
strategy is complex and no such strategy can completely insulate us from
interest rate changes. Poorly designed strategies or improperly executed
transactions may increase rather than mitigate risk. Hedging involves
transaction and other costs that could increase as the period covered by the
hedging protection increases. Although it is expected that such costs would be
offset by income realized from securitizations in that period or in future
periods, we may be prevented from effectively hedging fixed interest rate loans
held for sale without reducing income in current or future periods. In addition,
while Eurodollar rates, interest rate swap yield curves and the pass-through
interest rate of securitizations are generally strongly correlated, this
correlation has not held in periods of financial market disruptions (e.g., the
so-called Russian Crisis in the later part of 1998).
Liquidity and Capital Resources
Liquidity and capital resource management is a process focused on
providing the funding to meet our short and long-term cash needs. We have used a
substantial portion of our funding sources to build our total 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 debentures and senior
collateralized subordinated notes. Our cash needs change as the mix of loan
sales through securitization shifts to whole loan sales, as the total portfolio
grows, as our interest-only strips grow and release more cash, as subordinated
debentures and senior collateralized subordinated notes mature, as operating
expenses change and as revenues change. Because we have historically experienced
negative cash flows from operations under our prior business strategy, 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 debentures and senior collateralized subordinated notes, 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).
94
Initially, we finance our loans under two secured credit facilities.
These credit facilities are 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 six months of fiscal 2004, we recorded a net loss of
$51.1 million. The loss primarily resulted from liquidity issues described
below, which substantially reduced our ability to originate loans and generate
revenues during the first six months of fiscal 2004, our inability to complete a
securitization of loans during the first quarter of fiscal 2004, and $22.8
million of net 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. 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."
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 adversely impacted our short-term liquidity
position and contributed to our loss for fiscal 2003. 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 sold existing loans, extended or expanded existing credit facilities,
or added new credit facilities. Our ability to borrow under credit facilities to
fund new loan originations was limited during most of the first six months of
fiscal 2004. 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 2003 to
September 30, 2003. We entered into a subsequent amendment to this facility,
which extended its maturity date to October 17, 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 debentures for approximately a six-week period
during the first quarter of fiscal 2004 further impaired our liquidity.
95
As a result of these liquidity issues, since June 30, 2003 our loan
origination volume was substantially reduced. From July 1, 2003 through December
31, 2003, we originated $227.1 million of loans which represents a significant
reduction as compared to originations of $773.7 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 and
second quarters of fiscal 2004 and we anticipate incurring losses in future
periods, at least through the fourth quarter of fiscal 2004. In light of the
losses during the first and second quarters of fiscal 2004, 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" and "-- Credit Facilities." 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 debentures 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 debentures when due.
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.
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.
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, October 31, 2003, November 30, 2003 and December 31, 2003 in
light of the losses during the first and second quarters 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 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 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.
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 December 31, 2003,
we sold approximately $501.2 million (which includes $222.3 million of loans
sold by the expired mortgage conduit facility described under "--Credit
Facilities") 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.
96
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 amended $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.
The following table summarizes our short and long-term capital
resources and obligations as of December 31, 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 debentures. 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 3 to 5 More than
1 year years years 5 years Total
--------------------------------------------------------------
(In thousands)
Capital Resources from:
Unrestricted cash............................... $ 14,759 $ -- $ -- $ -- $ 14,759
Loans........................................... 109,275 159 197 6,161 115,792
Interest-only strips............................ 123,883 222,981 147,829 232,568 727,261
Servicing rights................................ 29,230 41,021 25,196 35,089 130,536
Investments..................................... 199 661 -- -- 860
--------- -------- --------- --------- ---------
277,346 264,822 173,222 273,818 989,208
--------- -------- --------- --------- ---------
Contractual Obligations (a)
Subordinated debentures......................... 285,571 295,348 28,313 20,442 629,674
Accrued interest-subordinated debentures (b).... 18,117 16,015 1,910 3,001 39,043
Senior collateralized subordinated
notes.......................................... 5,239 26,759 1,582 879 34,459
Warehouse lines of credit (c)................... 86,814 -- -- -- 86,814
Convertible promissory note..................... -- 475 -- -- 475
Capitalized lease (d)........................... 376 331 -- -- 707
Operating leases (e)............................ 3,666 10,439 10,897 30,667 55,669
Services and equipment (f)...................... 2,486 -- -- -- 2,486
--------- -------- --------- --------- ---------
402,269 349,367 42,702 54,989 849,327
--------- -------- --------- --------- ---------
Excess (Shortfall).............................. $(124,923) $(84,545) $ 130,520 $ 218,829 $ 139,881
========= ======== ========= ========= =========
97
(a) See "--Contractual Obligations."
(b) This table reflects interest payment terms elected by subordinated
debenture holders as of December 31, 2003. In accordance with the terms of
the subordinated debenture offering, subordinated debenture 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 debentures 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.
Cash flow from operations. One of our corporate goals is to achieve
sustainable positive cash flow from operations. However, we cannot be certain
that we will achieve our projections regarding declines in negative cash flow
from historical levels 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.
98
Cash flow from operations for the six months ended December 31, 2003
was a positive $149.5 million compared to a negative $41.3 million for the first
six months of fiscal 2003. The positive cash flow from operations for the six
months ended December 31, 2003 was due to our sales during the six-month period
of loans originated in prior periods that were carried on our balance sheet at
June 30, 2003. During the six months ended December 31, 2003, we received cash
on whole loan sales closed during the period of $253.2 million and $26.7 million
from a whole loan sale transaction, which closed on June 30, 2003, but settled
in cash on July 1, 2003. Additionally, cash flow from our interest-only strips
in the first six months of fiscal 2004 increased $48.8 million, compared to the
first six months 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 cash flow from operations to continue to fluctuate in the
foreseeable future, our goal is to improve upon our historical levels of
negative cash flow from operations. 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 occur
in fiscal 2004 due to the nature of our operations and the timing to implement
our business strategy adjustments. We generally expect the level of cash flow
from operations to fluctuate.
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.
99
Contractual obligations. Following is a summary of future payments
required on our contractual obligations as of December 31, 2003 (in thousands):
Payments Due by Period
----------------------------------------------------------------------
Less than 1 to 3 4 to 5 More than
Contractual Obligations Total 1 year years years 5 years
- -------------------------------- ----------- ----------- ----------- ---------- ----------
Subordinated debentures.............. $629,674 $285,571 $295,348 $28,313 $20,442
Accrued interest - subordinated
debentures (a) ................... 39,043 18,117 16,015 1,910 3,001
Senior collateralized
subordinated notes................ 34,459 5,239 26,759 1,582 879
Warehouse lines of credit (b)........ 86,814 86,814 -- -- --
Convertible promissory note.......... 475 -- 475 -- --
Capitalized lease (c)................ 707 376 331 -- --
Operating leases (d)................. 55,669 3,666 10,439 10,897 30,667
Services and equipment (e)........... 2,486 2,486 -- -- --
-------- -------- -------- -------- -------
Total obligations.................... $849,327 $402,269 $349,367 $ 42,702 $54,989
======== ======== ======== ======== =======
(a) This table reflects interest payment terms elected by subordinated
debenture holders as of December 31, 2003. In accordance with the terms
of the subordinated debenture offering, subordinated debenture 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.
100
The following is a description of the warehouse and operating lines of
credit facilities, which were available to us at December 31, 2003 (in
thousands):
Facility Amount Amount
Amount Utilized Available
---------- --------- ---------
Revolving credit facilities:
Warehouse revolving line of credit, expiring
September 2004 (a) .................................. $ 200,000 $ 8,010 $ 191,990
Warehouse revolving line of credit, expiring
October 2006 (b) ..................................... 250,000 78,804 171,196
Operating revolving line of credit, expiring
January 2004 (c) ..................................... 5,000 -- 5,000
--------- --------- ---------
Total revolving credit facilities......................... 455,000 86,814 368,186
Other facilities:
Capitalized leases, maturing January 2006 (d) ......... 651 651 --
--------- --------- ---------
Total credit facilities................................... $ 455,651 $ 87,465 $ 368,186
========= ========= =========
- -------------
(a) $200.0 million warehouse revolving line of credit with JP Morgan Chase
Bank entered into on September 22, 2003 and expiring September 2004.
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. Further detail and provisions of this
facility are described below.
Additionally, we have a letter of credit facility with JP Morgan Chase
Bank to secure lease obligations for corporate office space. The
amount of the letter of credit was $8.0 million at December 31, 2003.
The letter of credit was collateralized by cash and will decrease over
the term of the lease.
(b) $250.0 million warehouse revolving line of credit with Chrysalis
Warehouse Funding, LLC, entered into on October 14, 2003 and expiring
October 2006. 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. Further detail and
provisions of this facility are described below.
(c) $5.0 million revolving line of credit facility from Firstrust Savings
Bank. The obligations under this facility were 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 was
one-month LIBOR plus a margin. This facility expired pursuant to its
terms on January 14, 2004.
(d) Capitalized leases, imputed interest rate of 8.0%, collateralized by
computer equipment.
Until their expiration, two other facilities were utilized for portions of
fiscal 2004 including:
o A warehouse line of credit with Credit Suisse First Boston Mortgage
Capital, LLC originally for $200.0 million. $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.
o A $25.0 million warehouse line of credit facility from Residential
Funding Corporation. Under this warehouse facility, advances could be
obtained, subject to specific conditions described in the agreements.
In connection with our receipt of a waiver of our non-compliance with
101
financial covenants at September 30, 2003, we agreed not to make
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.
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. The facility provided for the sale of loans into an off-balance sheet
facility. See "-- Overview -- Remedial Steps Taken to Address Liquidity Issues"
and "Application of Critical Accounting Policies" for further discussion of the
off-balance sheet features of this facility. On October 16, 2003, we refinanced
through another mortgage warehouse conduit facility $40.0 million of loans that
were previously held in the above off-balance sheet mortgage conduit facility.
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, with servicing
released, of the $173.5 million of loans 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.
On September 22, 2003, we entered into definitive agreements with a JP
Morgan Chase Bank for a $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
from a warehouse lender 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
debentures 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 was 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 debentures 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 debentures 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
Chrysalis Warehouse Funding, LLC 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 non-usage 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.
102
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 debentures to $750.0
million or less; (ii) make quarterly reductions commencing in April 2004 of an
amount of subordinated debentures pursuant to the formulas set forth in the loan
agreement; (iii) maintain maximum interest rates offered on subordinated
debentures 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 debentures 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 debentures.
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.
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, which was reduced to
$50 million). We have requested and obtained waivers from these covenant
provisions from both lenders. The lender under the $50.0 million warehouse
credit facility granted us a waiver for our non-compliance with a financial
covenant in that credit facility through December 31, 2003 and converted this
facility to an $8.0 million letter of credit facility. This $50.0 million
facility was replaced by the new $200.0 million facility described above and the
principal amount that remains on this facility is the $8.0 million letter of
credit which secures our lease on our principal executive office. 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.
103
In addition, in light of the losses for the first and second quarters
of fiscal 2004, we requested and obtained waivers or amendments to several
credit facilities to address our non-compliance with certain financial
covenants.
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 debentures 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 (the registration statement was declared effective on November
10, 2003). This lender also waived the minimum net worth requirement at October
31, 2003, November 30, 2003 and December 31, 2003 under the $200.0 million
credit facility and the $8.0 million letter of credit facility.
Because we anticipate incurring losses through the fourth 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 debentures. The issuance of subordinated debentures funds
the majority of our remaining operating cash requirements. We rely significantly
on our ability to issue subordinated debentures since our cash flow from
operations is not sufficient to meet these requirements. In order to expand our
businesses we have issued subordinated debentures to partially fund growth and
to partially fund maturities of subordinated debentures. In addition, at times
we have elected to utilize proceeds from the issuance of subordinated debentures
to fund loans instead of using our warehouse credit facilities, depending on our
determination of liquidity needs. During the six months ended December 31, 2003,
subordinated debentures decreased by $89.9 million compared to an increase of
$36.8 million in the six months ended December 31, 2002. The reduction in the
level of subordinated debentures was due to the Exchange Offer and the resulting
conversion of $73.6 million of subordinated debentures into 39.1 million of
shares of Series A Preferred Stock and $34.5 million of senior collateralized
subordinated notes. The decrease also resulted from our temporary
discontinuation of sales of new subordinated debentures for a portion of the
first quarter of fiscal 2004.
On December 1, 2003, we mailed an Exchange Offer to holders of our
subordinated debentures that was issued prior to April 1, 2003. Holders of such
subordinated debentures had the ability to exchange their notes for (i) equal
amounts of senior collateralized subordinated notes and shares of Series A
Preferred Stock; and/or (ii) dollar-for-dollar for shares of Series A Preferred
Stock. Senior collateralized subordinated notes issued in the exchange have
interest rates equal to 10 basis points above the subordinated debentures
tendered. Senior collateralized subordinated notes with maturities of 12 months
were issued in exchange for subordinated debentures tendered with maturities of
less than 12 months, while subordinated debentures with maturities greater than
36 months were exchanged for senior collateralized subordinated notes with the
same maturity or reduced to 36 months. All other senior collateralized
subordinated notes issued in the exchange have maturities equal to the
subordinated debentures tendered. The senior collateralized subordinated notes
are secured by a security interest in certain cash flows originating from
interest-only strips of our subsidiaries held by ABFS Warehouse Trust 2003-1
with an aggregate value of at least an amount equal to 150% of the outstanding
principal balance of the senior collateralized subordinated notes; provided
that, such collateral coverage may not fall below 100% of the outstanding
principal balance of the senior collateralized subordinated notes, as determined
by us on any quarterly balance sheet date. In the event of liquidation, to the
extent the collateral securing the senior collateralized subordinated notes is
not sufficient to repay these notes, the deficiency portion of the senior
collateralized subordinated notes will rank junior in right of payment behind
our senior indebtedness and all of our other existing and future senior debt and
debt of our subsidiaries and equally in right of payment with the subordinated
debentures, and any future subordinated debentures issued by us and other
unsecured debt.
104
Pursuant to the terms of the Exchange Offer, in the first closing of
the Exchange Offer on December 31, 2003, we exchanged $73.6 million of
outstanding subordinated debentures for 39.1 million shares of Series A
Preferred Stock and $34.5 million of senior collateralized subordinated notes.
On December 31, 2003, we also extended the expiration date of the Exchange Offer
to February 6, 2004. As a result of the second closing of the Exchange Offer on
February 6, 2004, we exchanged an additional $41.9 million of eligible
subordinated debentures for 22.0 million shares of Series A Preferred Stock and
$19.9 million of senior collateralized subordinated notes.
Anthony J. Santilli, our Chairman, Chief Executive Officer and
President, Beverly Santilli, our Executive Vice President, and Dr. Jerome
Miller, our director, each held subordinated debentures eligible to participate
in the Exchange Offer. Each named individual tendered all such eligible
subordinated debentures in the Exchange Offer and as of February 6, 2004, the
expiration date of the Exchange Offer, pursuant to the terms of the Exchange
Offer, were holders of the following number of shares of Series A Preferred
Stock ("SAPS") and aggregate amount of senior collateralized subordinated notes
("SCSN"): Mr. Santilli: SAPS - 4,691, SCSN - $4,691; Mrs. Santilli: SAPS -
4,691, SCSN - $4,691; Dr. Miller: SAPS - 30,164, SCSN - $30,164.
Under a registration statement declared effective by the SEC on
November 7, 2003, we registered $295.0 million of subordinated debentures. Of
the $295.0 million, $252.9 million of debt from this registration statement was
available for future issuance as of December 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 debentures 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 debentures when due.
The weighted-average interest rate of our subordinated debentures
issued in the month of December 2003 was 9.07%, compared to debentures issued in
the month of June 2003, which had a weighted-average interest rate of 7.49%.
Debentures 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 debentures, 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 December 31, 2003 was 17.7 months compared to 19.5 months
at June 2003.
105
Terms of the Series A Preferred Stock. The Series A Preferred Stock has
a par value of $.001 per share and may be redeemed at our option at a price
equal to the liquidation value plus accrued and unpaid dividends after the
second anniversary of the issuance date.
Upon any voluntary or involuntary liquidation, the holders of the
Series A Preferred Stock will be entitled to receive a liquidation preference of
$1.00 per share, plus accrued and unpaid dividends to the date of liquidation.
Based on the shares of Series A Preferred Stock outstanding on December 31,
2003, the liquidation value equals $39.1 million.
Monthly cash dividend payments will be $.0083 per share of Series A
Preferred Stock (equivalent to $.10 per share annually or 10% annually of the
liquidation value). Payment of cash dividends on the Series A Preferred Stock is
subject to compliance with applicable Delaware state law. Based on the shares of
Series A Preferred Stock outstanding on December 31, 2003, the annual cash
dividend requirement equals $3.9 million.
On or after the second anniversary of the issuance date (or on or after
the one year anniversary of the issuance date if no dividends are paid on the
Series A Preferred Stock), each share of the Series A Preferred Stock is
convertible at the option of the holder into a number of shares of our common
stock determined by dividing: (A) $1.00 plus an amount equal to accrued but
unpaid dividends (if the conversion date is prior to the second anniversary of
the issuance date because the Series A Preferred Stock has become convertible
due to a failure to pay dividends), $1.20 plus an amount equal to accrued but
unpaid dividends (if the conversion date is prior to the third anniversary of
the issuance date but on or after the second anniversary of the issuance date)
or $1.30 plus an amount equal to accrued but unpaid dividends (if the conversion
date is on or after the third anniversary of the issuance date) by (B) the
market value of a share of our common stock (which figure shall not be less than
$5.00 per share regardless of the actual market value on the conversion date).
Based on the $5.00 per share market value floor and if each share of Series A
Preferred Stock issued at the December 31, 2003 and February 6, 2004 closings
converted on the anniversary dates listed below, the number of shares of the
Company's common stock which would be issued upon conversion follows (shares in
thousands):
December 31, 2003 Closing February 6, 2004 Closing
------------------------------------ ----------------------------------
Convertible Convertible
Number of into Number Number of into Number
Preferred of Common Preferred of Common
Shares Shares Shares Shares
---------------- ---------------- ---------------- ------------
Second anniversary date 39,095 9,382 22,015 5,284
Third anniversary date 39,095 10,165 22,015 5,724
As described above, the conversion ratio of the Series A Preferred
Stock increases during the first three years after its issuance, which provides
the holders of the Series A Preferred Stock with a discount on the shares of
common stock that will be issued upon conversion. This discount, which is
referred to as a beneficial conversion feature, was valued at $4.6 million on
December 31, 2003. The value of the beneficial conversion feature equals the
excess of the intrinsic value of the shares of common stock that will be issued
upon conversion of the Series A Preferred Stock, over the value of the Series A
Preferred Stock on the date it was issued. The $4.6 million will be amortized to
the income statement over the three-year period that the holders of the Series A
Preferred Stock earn the discount as additional non-cash dividends on the Series
A Preferred Stock.
Sales into special purpose entities and off-balance sheet facilities.
We rely significantly on access to the asset-backed securities market through
securitizations to provide permanent funding of our loan production. We also may
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 debentures 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.
106
Other liquidity considerations. In December 2003, our shareholders
approved an amendment to our Certificate of Incorporation to increase the number
of shares of authorized preferred stock from 3.0 million shares to 203.0 million
shares. In addition to meeting the requirements of the Exchange Offer, the
preferred shares may be used to raise equity capital, redeem outstanding debt or
acquire other companies, although no such acquisitions are currently
contemplated. The Board of Directors has discretion with respect to designating
and establishing the terms of each series of preferred stock prior to issuance.
A 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 debentures, increases in delinquencies and
credit losses in our total 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 debentures 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 former
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.
Jeffrey S. Steinberg, one of our directors, received $58 thousand in
consulting fees from us during the quarter ended December 31, 2003.
Barry Epstein, Managing Director of the National Wholesale Residential
Mortgage Division, received 200,000 shares of restricted common stock on
December 24, 2003 under the terms of his employment agreement and restricted
stock agreement with us. The shares were issued by us as a material inducement
to Mr. Epstein's employment and are subject to transfer restrictions and
forfeiture unless the performance goals set forth in the employment agreement
are met.
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.
107
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 total portfolio and total real estate owned, referred to as
REO, information. The total portfolio measure includes loans and leases recorded
on our balance sheet and securitized loans and leases both managed by us and
serviced by others. 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 portfolio and total REO. The following tables reconcile the total
portfolio measures presented in "-- Total Portfolio Quality." (dollars in
thousands):
December 31, 2003: Delinquencies
- --------------------------------------------------------------------------
Amount %
-------------------------
On-balance sheet loan and lease
receivables..................... $ 116,673 $ 7,213 6.18%
Securitized loan and lease
receivables..................... 2,541,437 280,320 11.03%
---------- ---------
Total Portfolio................... $2,658,110 $ 287,533 10.82%
========== =========
On-balance sheet REO.............. $ 3,077
Securitized REO................... 21,161
----------
Total REO......................... $ 24,238
==========
108
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 Portfolio................... $2,971,800 $ 268,449 9.03%
========== =========
On-balance sheet REO.............. $ 4,566
Securitized REO................... 21,486
----------
Total REO......................... $ 26,052
==========
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 Portfolio................... $3,651,074 $ 229,070 6.27%
========== =========
On-balance sheet REO.............. $ 4,776
Securitized REO................... 23,224
----------
Total REO......................... $ 28,000
==========
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.
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.
109
In connection with the acquisition of the California mortgage broker
operation, we assumed the obligations under a lease for approximately 3,700
square feet of space in West Hills, California. The remaining term of the lease
is 2 3/4 years, expiring September 30, 2006 at an annual rental of approximately
$0.1 million.
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.
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."
110
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 Control occurred during
the quarter that have materially affected or which are reasonably likely to
materially affect Internal Control. Based on that evaluation, there have been no
such changes 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.
111
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. This
inquiry was ended on December 22, 2003. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Overview."
On January 21, 2004, January 28, 2004 and February 12, 2004, three
purported class action lawsuits were filed against us and our director and Chief
Executive Officer, Anthony Santilli, and our Chief Financial Officer, Albert
Mandia, in the United States District Court for the Eastern District of
Pennsylvania. The first two suits also name former director, Richard Kaufman, as
a defendant. The complaints are captioned: Richard Weisinger v. American
Business Financial Services, Inc., et. al., Civil Action No. 04-265; Sean Ruane
v. American Business Financial Services, Inc., Civil Action No. 04-400, and
Operative Plasterers' and Cement Masons' International Employees' Trust Fund,
et.al v. American Business Financial Services, Inc., et. al., Civil Action No.
04-CV-617. The lawsuits were brought on behalf of all purchasers of our common
stock between for the class period January 27, 2000 and June 25, 2003 with
respect to the first two suits filed. The class period related to the third suit
is January 27, 2000 through June 12, 2003.
The first two lawsuits allege that, among other things we and the named
directors and officers violated Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934. These lawsuits allege that, among other things, during the
applicable class period, our forbearance and foreclosure practices enabled us
to, among other things, allegedly inflate our financial results. These two
lawsuits appear to relate to the same subject matter as the Form 8-K we filed on
June 13, 2003 disclosing a subpoena from the Civil Division of the U.S.
Attorney's Office into our forbearance and foreclosure practices. The U.S.
Attorney's inquiry was subsequently concluded in December 2003. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Overview - Subpoena from U.S. Attorney's Office." These two
lawsuits seek unspecified compensatory damages, costs and expenses related to
bringing the action, and other unspecified relief.
The third lawsuit alleges that the defendants issued false and
misleading financial statements in violation of GAAP, the Securities Exchange
Act of 1934 and SEC rules by entering into forbearance agreements with
borrowers, understating default and foreclosure rates and failing to properly
adjust prepayment assumptions to hide the impact on net income. This lawsuit
seeks unspecified damages, interest, costs and expenses of the litigation, and
injunctive or other relief.
Procedurally, these lawsuits are in a very preliminary stage and no
class has been certified in any of the actions. We do not expect that we will be
required to file a response to the lawsuits for several months. We believe that
we have several defenses to the claims raised by these lawsuits and intend to
vigorously defend the lawsuits. Due to the inherent uncertainties in litigation
and because the ultimate resolution of these proceedings are influenced by
factors outside our control, we are currently unable to predict the ultimate
outcome of this litigation or its impact on our financial position or results of
operations.
112
Item 2. Changes in Securities and Use of Proceeds
Amendment and Restatement of the Certificate of Incorporation. At the
annual meeting of our stockholders held on December 31, 2003, our Amended and
Restated Certificate of Incorporation was amended and restated to increase the
number of authorized shares of our: (i) common stock from 9,000,000 to
209,000,000; and (ii) preferred stock from 3,000,000 to 203,000,000. In
connection with the Exchange Offer, our Board of Directors designated
200,000,000 shares of preferred stock as Series A Convertible Preferred Stock,
and we filed the Certificate of Designation, Preferences and Rights of Series A
Convertible Preferred Stock (the "Certificate of Designation") with the Delaware
Secretary of State.
Dilutive and Other Effects of Issuance of Series A Convertible
Preferred Stock. As of February 6, 2004, the closing of the Exchange Offer, we
issued 61.1 million shares of Series A Convertible Preferred Stock. Our
stockholders generally do not have preemptive rights with respect to our
preferred stock. Therefore, existing holders of common stock do not have any
preferential rights to purchase shares of the Series A Convertible Preferred
Stock or other shares of preferred stock that may be designated by the Board.
The shares of the Series A Convertible Preferred Stock are convertible into
common stock, and the maximum number of shares of our common stock into which
61.1 million shares of the Series A Convertible Preferred Stock issued in
connection with the Exchange Offer can be converted is 15.9 million, provided
that: (i) all dividends on the Series A Convertible Preferred Stock will have
been paid by the conversion date; (ii) the conversion date is on or after the
3rd anniversary of the issuance date; and (iii) the market price of a share of
common stock is $5.00. The issuance of 15.9 million shares of common stock upon
conversion of the Series A Convertible Preferred Stock outstanding as of
February 6, 2004 and the potential issuance of shares of common stock if we
issue additional shares of Series A Convertible Preferred Stock could result in
the dilution of the equity interests of current holders of our common stock. The
rights and preferences of holders of the Series A Convertible Preferred Stock
are senior to the rights and preferences of the holders of our common stock. If
our Board of Directors issues another series of preferred stock, the rights and
preferences of such series may be senior to the rights and preferences of the
shares of the Series A Convertible Preferred Stock and would be also senior to
the rights and preferences of the common stock.
Securities Issued in Non-Public Offerings. As of February 6, 2004, in
connection with the Exchange Offer, we issued $54.3 million in aggregate
principal amount of senior collateralized subordinated notes and 61.1 million
shares of Series A Convertible Preferred Stock in exchange for $115.4 million in
aggregate principal amount of investment notes issued prior to April 1, 2003. We
issued the foregoing senior collateralized subordinated notes and shares of the
Series A Convertible Preferred Stock in reliance on the exemption from the
registration under Section 3(a)(9) of the Securities Act of 1933, as amended
(the "Securities Act").
We believe that the Exchange Offer meets all of the requirements of the
exemption provided by Section 3(a)(9) of the Securities Act because (i) we are
the issuer of both (a) the senior collateralized subordinated notes and the
Series A Convertible Preferred Stock issued in the Exchange Offer and (b) the
investment notes exchanged; (ii) the Exchange Offer involves an exchange
exclusively with our existing security holders and did not involve any new
consideration being paid by security holders; and (iii) we did not pay, and do
not intend to pay, any compensation for soliciting holders of investment notes
to participate in the Exchange Offer.
113
Each share of the Series A Convertible Preferred Stock is convertible
into shares of our common stock pursuant to the formula set forth in the
Certificate of Designation and described below. On or after the second
anniversary of the issuance date (or on or after the one year anniversary of the
issuance date if no dividends are paid on the Series A Preferred Convertible
Stock), each share of the Series A Convertible Preferred Stock is convertible at
the option of the holder into a number of shares of common stock determined by
dividing: (i) $1.00 plus accrued but unpaid dividends (if the conversion date is
prior to the second anniversary of the issuance date because the Series A
Convertible Preferred Stock has become convertible due to a failure to pay
dividends), $1.20 plus accrued but unpaid dividends (if the conversion date is
prior to the third anniversary of the issuance date, but on or after the second
anniversary of the issuance date) or $1.30 plus accrued and unpaid dividends (if
the conversion date is on or after the third anniversary of the issuance date)
by (ii) the market price of a share of common stock (which figure shall not be
less than $5.00 per share regardless of the actual market price, such $5.00
minimum figure to be subject to adjustment for stock splits, including reverse
stock splits) on the conversion date.
As of December 24, 2003, we issued a convertible non-negotiable
promissory note (the "Note") in the principal amount of $475,000 to Rekaren,
Incorporated, a California corporation ("Rekaren"), as partial consideration for
the purchase of certain assets of Rekaren. At any time on or after December 24,
2004 and before January 31, 2005, the outstanding principal balance of, and
accrued interest under, the Note is convertible, at the holder's option, into
the number of shares of our common stock determined by dividing the aggregate
principal amount of the Note by the conversion price of $5.00 per share (the
conversion price is subject to adjustments in case of a stock split,
combination, reclassification or other similar event effected by us with respect
to the common stock). We issued the Note in reliance on the exemption from
registration under Section 4(2) of the Securities Act based upon a determination
that the investor was sophisticated, had access to, and was provided with,
information that would otherwise be contained in a registration statement and
there was no general solicitation.
As of December 24, 2003, we issued 200,000 shares of common stock to
Barry Epstein, the newly hired experienced industry professional to head the
National Wholesale Residential Mortgage Division, as an inducement material to
his employment with us pursuant to the Employment Agreement and Restricted Stock
Agreement by and between us and Mr. Epstein, dated December 24, 2003. We issued
the foregoing shares in reliance on the exemption from registration under
Section 4(2) of the Securities Act based upon a determination that the security
was issued to a sophisticated investor who had access to, and was provided with,
information that would otherwise be contained in a registration statement and
there was no general solicitation.
Item 3. Defaults Upon Senior Securities - None
114
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of the stockholders of the Company was held December 31,
2003. The following proposals were presented to stockholders and voted on at the
annual meeting.
Proposal 1. The election as directors of all of the following nominees for the
term set forth below:
Michael R. DeLuca (for a three year term to expire in 2006)
Warren E. Palitz (for a three year term to expire in 2006)
Jeffrey S. Steinberg (for a three year term to expire in 2006)
Harold E. Sussman (for a one year term to expire in 2004)
The term of office of the following incumbent directors continued after the
annual meeting: Anthony J. Santilli, Leonard Becker and Jerome Miller
Proposal 2. To approve an amendment to and the restatement of the Company's
Amended and Restated Certificate of Incorporation to increase the number of
authorized shares of common stock from 9,000,000 to 209,000,000 shares.
Proposal 3. To approve an amendment to and the restatement of the Company's
Amended and Restated Certificate of Incorporation to increase the number of
authorized shares of Preferred Stock from 3,000,000 to 203,000,000 shares.
Proposal 4. To approve a proposal to issue shares of the Series A Preferred
Stock in connection with the Exchange Offer and shares of common stock issuable
upon the conversion of Series A Preferred Stock.
Proposal 5. To ratify the appointment of BDO Seidman, LLP to serve as the
Company's independent public accountants for fiscal 2004.
The results of the voting at the annual meeting were as follows:
Shares Shares
For Withheld
Proposal 1
Michael R. DeLuca 1,533,342 7,021
Warren E. Palitz 1,533,342 7,021
Jeffrey S. Steinberg 1,533,342 7,021
Harold E. Sussman 1,533,342 7,021
Shares Shares Shares Broker
For Against Abstaining Nonvotes
Proposal 2 1,537,501 1,862 1,000 0
Proposal 3 1,532,155 7,208 1,000 0
Proposal 4 1,532,519 6,844 1,000 0
Proposal 5 1,537,332 1,621 1,000 0
Item 5. Other Information - None
115
Item 6. Exhibits and Reports on Form 8-K
Exhibits
Exhibit
Number Description
- ------- --------------------------------------------------------------
3.1 Amended and Restated Certificate of Incorporation of the
Company (Incorporated by reference to Appendix A to the
Registrant's Definitive Proxy Statement filed on December 11,
2003).
4.1 Certificate of Designation related to the Series A Convertible
Preferred Stock (Incorporated by reference to Appendix B to
the Registrant's Definitive Proxy Statement filed on December
11, 2003).
4.2 Indenture dated December 31, 2003 between the Company and U.S.
Bank National Association as Trustee.
10.1 Master Loan and Security Agreement, dated as of October 14,
2003, between ABFS Warehouse Trust 2003-2 and Chrysalis
Warehouse Funding, LLC. (Incorporated by reference to Exhibit
10.1 of the Registrant's Current Report on Form 8-K filed on
October 16, 2003).
10.2 Asset Purchase Agreement, dated as of October 14, 2003,
between ABFS Warehouse Trust 2003-1 and ABFS Warehouse Trust
2003-2 (Incorporated by reference to Exhibit 10.2 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.3 Asset Purchase Agreement, dated as of October 14, 2003, among
HomeAmerican Credit, Inc., d/b/a Upland Mortgage, American
Business Mortgage Services, Inc., and American Business
Credit, Inc., as Sellers and ABFS Warehouse Trust 2003-1, as
Purchaser (Incorporated by reference to Exhibit 10.3 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.4 Amended and Restated Trust Agreement between HomeAmerican
Credit, Inc., American Business Mortgage Services, Inc., and
American Business Credit, Inc., ABFS Consolidated Holdings,
Inc., as IOS Depositor and Wilmington Trust Company as Owner
Trustee (Incorporated by reference to Exhibit 10.4 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.5 Trust Agreement between ABFS Warehouse Trust 2003-1 and
Wilmington Trust Company (Incorporated by reference to Exhibit
10.5 of the Registrant's Current Report on Form 8-K filed on
October 16, 2003).
10.6 Pledge and Security Agreement, dated as of October 14, 2003,
between ABFS Warehouse Trust 2003-1 and Clearwing Capital,
LLC. (Incorporated by reference to Exhibit 10.6 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.7 Fee and Right of First Refusal Letter addressed to ABFS
Warehouse Trust 2003-1, ABFS Warehouse Trust 2003-2, American
Business Financial Services, Inc. and its subsidiaries from
Clearwing Capital, LLC. (Incorporated by reference to Exhibit
10.7 of the Registrant's Current Report on Form 8-K filed on
October 16, 2003).
116
10.8 Waiver, dated October 3, 2003, to Indenture, dated September
22, 2003, between ABFS Mortgage Loan Warehouse Trust 2003-1
and JPMorgan Chase Bank, as Indenture Trustee (Incorporated by
reference to Exhibit 10.8 of the Registrant's Current Report
on Form 8-K filed on October 16, 2003).
10.9 Waiver, dated as of October 8, 2003, to Indenture, dated
September 22, 2003, between ABFS Mortgage Loan Warehouse Trust
2003-1 and JPMorgan Chase Bank, as Indenture Trustee
(Incorporated by reference to Exhibit 10.9 of the Registrant's
Current Report on Form 8-K filed on October 16, 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 Extension of the Expiration Date, dated October 10, 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 10.11 of
the Registrant's Current Report on Form 8-K filed on October
16, 2003).
10.12 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).
10.13 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).
10.14 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).
10.15 Servicing Agreement, dated October 14, 2003, between ABFS
Warehouse Trust 2003-2, as Owner, Chrysalis Warehouse Funding,
LLC, as Lender, American Business Credit, Inc., as Servicer,
and Countrywide Home Loans Servicing LP, as Backup Servicer
(Incorporated by reference to Exhibit 10.15 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.16 Second Amended and Restated Indenture, dated as of October 16,
2003, by and between ABFS Mortgage Loan Warehouse Trust
2000-2, as Issuer, and JPMorgan Chase Bank, as Indenture
Trustee (Incorporated by reference to Exhibit 10.1 of the
Registrant's Current Report on Form 8-K filed on October 24,
2003).
10.17 ABFS Mortgage Loan Warehouse Trust 2000-2 Secured Notes Series
2000-2 Purchase Agreement, dated as of October 16, 2003, by
and between ABFS Greenmont, Inc., ABFS Mortgage Loan Warehouse
Trust 2000-2 and JPMorgan Chase Bank (Incorporated by
reference to Exhibit 10.2 of the Registrant's Current Report
on Form 8-K filed on October 24, 2003).
117
10.18 Fee Letter Agreement, dated October 16, 2003, addressed to
American Business Financial Services, Inc. from JPMorgan Chase
Bank (Incorporated by reference to Exhibit 10.3 of the
Registrant's Current Report on Form 8-K filed on October 24,
2003).
10.19 Second Amended and Restated Sale and Servicing Agreement,
dated as of October 16, 2003, by and among ABFS Greenmont,
Inc., as Depositor, HomeAmerican Credit, Inc., d/b/a Upland
Mortgage, and American Business Mortgage Services, Inc., as
Originators and Subservicers, ABFS Mortgage Loan Warehouse
Trust 2000-2, as Trust, American Business Credit, Inc., as an
Originator and Servicer, American Business Financial Services,
Inc., as Sponsor, JPMorgan Chase Bank, as Indenture Trustee
and JPMorgan Chase Bank, as Collateral Agent (Incorporated by
reference to Exhibit 10.4 of the Registrant's Current Report
on Form 8-K filed on October 24, 2003).
10.20 Waiver to the 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 and to the 9/03 Amendment to the
Senior Secured Credit Agreement, among: American Business
Credit, Inc., HomeAmerican Credit, Inc., New Jersey Mortgage
and Investment Corp., American Business Financial Services,
Inc. and The Chase Manhattan Bank, as amended (Incorporated by
reference to Exhibit 10.117 of the Registrant's Annual Report
on Form 10-K/A, Amendment No. 2, filed on December 11, 2003).
10.21 Amendment, dated December 1, 2003, to Consulting Agreement by
and between the Company and Milton Riseman, dated July 3, 2003
(Incorporated by reference to Exhibit 10.119 of the
Registrant's Annual Report on Form 10-K/A, Amendment No. 2,
filed on December 11, 2003).
10.22 Joint Agreement dated December 22, 2003 (Incorporated by
reference to Exhibit 99.2 of the Registrant's Current Report
on Form 8-K filed on December 24, 2003).
10.23 Security Agreement dated December 31, 2003 by and among ABFS
Consolidated Holdings, Inc., American Business Mortgage
Services, Inc., HomeAmerican Credit, Inc., American Business
Credit, Inc. and U.S. Bank National Association, as trustee.
(Incorporated by reference to Exhibit 10.1 of the Registrant's
Current Report on Form 8-K filed on January 2, 2004).
10.24 Second Waiver Letter, dated as of October 31, 2003, from
JPMorgan Chase Bank regarding (i) the Sale and Servicing
Agreement, dated as of September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., d/b/a Upland
Mortgage ("Upland"), American Business Mortgage Services, Inc.
("ABMS"), American Business Credit, Inc. ("ABC"), ABFS
Mortgage Loan Warehouse Trust 2003-1, as trust ("Trust"),
American Business Financial Services, Inc., and JPMorgan Chase
Bank, as indenture trustee ("Indenture Trustee") and
collateral agent, (ii) the Indenture, dated as of September
22, 2003, between the Trust and the Indenture Trustee; and
(iii) the 3/02 Amended and Restated Senior Secured Credit
Agreement, dated March 15, 2002 (as amended and supplemented
by the 10/02 Letter of Credit Supplement, the 12/02 Amendment,
the 3/03 Amendment, 3/31/03 Amendment and the 9/03 Amendment),
among Upland, ABMS, ABC, Tiger Relocation Company, ABFS
Residual 2002, Inc., and JPMorgan Chase Bank.
118
10.25 Third Waiver Letter, dated as of December 31, 2003, from
JPMorgan Chase Bank regarding (i) the Sale and Servicing
Agreement, dated as of September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., d/b/a Upland
Mortgage ("Upland"), American Business Mortgage Services, Inc.
("ABMS"), American Business Credit, Inc. ("ABC"), ABFS
Mortgage Loan Warehouse Trust 2003-1, as trust ("Trust"),
American Business Financial Services, Inc., and JPMorgan Chase
Bank, as indenture trustee ("Indenture Trustee") and
collateral agent, (ii) the Indenture, dated as of September
22, 2003, between the Trust and the Indenture Trustee; and
(iii) the 3/02 Amended and Restated Senior Secured Credit
Agreement, dated March 15, 2002 (as amended and supplemented
by the 10/02 Letter of Credit Supplement, the 12/02 Amendment,
the 3/03 Amendment, 3/31/03 Amendment and the 9/03 Amendment),
among Upland, ABMS, ABC, Tiger Relocation Company, ABFS
Residual 2002, Inc., and JPMorgan Chase Bank
10.26 Employment Agreement dated December 24, 2003, by and between
American Business Financial Services, Inc. and Barry Epstein.
10.27 Restricted Stock Agreement dated December 24, 2003, by and
between American Business Financial Services, Inc. and Barry
Epstein.
10.28 Change in Control Agreement between the Company and Stephen M.
Giroux.
31.1 Chief Executive Officer's Certificate
31.2 Chief Financial Officer's Certificate
32.2 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 December 31, 2003 or thereafter:
October 16, 2003
(Item 5 and 7) announcing definitive agreement on a $250 million revolving
mortgage loan warehouse credit facility to fund loan originations.
October 24, 2003
(Items 5 and 7) announcing refinancing through a mortgage conduit facility of
$40.0 million of mortgage loans previously held in an expired off-balance sheet
mortgage conduit facility and $133.0 million of mortgage loans previously held
in other warehouse facilities.
November 5, 2003
(Items 7 and 12) announcing issuance of press release reporting financial
results for the first quarter of fiscal year 2004 ended September 30, 2003.
December 24, 2003
(Items 5 and 7) announcing that issuer had entered into a joint agreement with
the U. S. Attorney's Office for the Eastern District of Pennsylvania, pursuant
to which the U.S. Attorney's Office ended the inquiry focused on the issuer's
forbearance policy initiated pursuant to a civil subpoena dated May 14, 2003
previously disclosed by the issuer.
119
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: February 17, 2004 By: /s/ Albert W. Mandia
-------------------------------------------
Albert W. Mandia
Executive Vice President and Chief Financial
Officer (principal financial officer)
120
EXHIBIT INDEX
Exhibit
Number Description
- ------- ------------------------------------------------------------
3.1 Amended and Restated Certificate of Incorporation of the
Company (Incorporated by reference to Appendix A to the
Registrant's Definitive Proxy Statement filed on December 11,
2003).
4.1 Certificate of Designation related to the Series A Convertible
Preferred Stock (Incorporated by reference to Appendix B to
the Registrant's Definitive Proxy Statement filed on December
11, 2003).
4.2 Indenture dated December 31, 2003 between the Company and U.S.
Bank National Association as Trustee.
10.1 Master Loan and Security Agreement, dated as of October 14,
2003, between ABFS Warehouse Trust 2003-2 and Chrysalis
Warehouse Funding, LLC. (Incorporated by reference to Exhibit
10.1 of the Registrant's Current Report on Form 8-K filed on
October 16, 2003).
10.2 Asset Purchase Agreement, dated as of October 14, 2003,
between ABFS Warehouse Trust 2003-1 and ABFS Warehouse Trust
2003-2 (Incorporated by reference to Exhibit 10.2 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.3 Asset Purchase Agreement, dated as of October 14, 2003, among
HomeAmerican Credit, Inc., d/b/a Upland Mortgage, American
Business Mortgage Services, Inc., and American Business
Credit, Inc., as Sellers and ABFS Warehouse Trust 2003-1, as
Purchaser (Incorporated by reference to Exhibit 10.3 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.4 Amended and Restated Trust Agreement between HomeAmerican
Credit, Inc., American Business Mortgage Services, Inc., and
American Business Credit, Inc., ABFS Consolidated Holdings,
Inc., as IOS Depositor and Wilmington Trust Company as Owner
Trustee (Incorporated by reference to Exhibit 10.4 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.5 Trust Agreement between ABFS Warehouse Trust 2003-1 and
Wilmington Trust Company (Incorporated by reference to Exhibit
10.5 of the Registrant's Current Report on Form 8-K filed on
October 16, 2003).
10.6 Pledge and Security Agreement, dated as of October 14, 2003,
between ABFS Warehouse Trust 2003-1 and Clearwing Capital,
LLC. (Incorporated by reference to Exhibit 10.6 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.7 Fee and Right of First Refusal Letter addressed to ABFS
Warehouse Trust 2003-1, ABFS Warehouse Trust 2003-2, American
Business Financial Services, Inc. and its subsidiaries from
Clearwing Capital, LLC. (Incorporated by reference to Exhibit
10.7 of the Registrant's Current Report on Form 8-K filed on
October 16, 2003).
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10.8 Waiver, dated October 3, 2003, to Indenture, dated September
22, 2003, between ABFS Mortgage Loan Warehouse Trust 2003-1
and JPMorgan Chase Bank, as Indenture Trustee (Incorporated by
reference to Exhibit 10.8 of the Registrant's Current Report
on Form 8-K filed on October 16, 2003).
10.9 Waiver, dated as of October 8, 2003, to Indenture, dated
September 22, 2003, between ABFS Mortgage Loan Warehouse Trust
2003-1 and JPMorgan Chase Bank, as Indenture Trustee
(Incorporated by reference to Exhibit 10.9 of the Registrant's
Current Report on Form 8-K filed on October 16, 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 Extension of the Expiration Date, dated October 10, 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 10.11 of
the Registrant's Current Report on Form 8-K filed on October
16, 2003).
10.12 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).
10.13 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).
10.14 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).
10.15 Servicing Agreement, dated October 14, 2003, between ABFS
Warehouse Trust 2003-2, as Owner, Chrysalis Warehouse Funding,
LLC, as Lender, American Business Credit, Inc., as Servicer,
and Countrywide Home Loans Servicing LP, as Backup Servicer
(Incorporated by reference to Exhibit 10.15 of the
Registrant's Current Report on Form 8-K filed on October 16,
2003).
10.16 Second Amended and Restated Indenture, dated as of October 16,
2003, by and between ABFS Mortgage Loan Warehouse Trust
2000-2, as Issuer, and JPMorgan Chase Bank, as Indenture
Trustee (Incorporated by reference to Exhibit 10.1 of the
Registrant's Current Report on Form 8-K filed on October 24,
2003).
10.17 ABFS Mortgage Loan Warehouse Trust 2000-2 Secured Notes Series
2000-2 Purchase Agreement, dated as of October 16, 2003, by
and between ABFS Greenmont, Inc., ABFS Mortgage Loan Warehouse
Trust 2000-2 and JPMorgan Chase Bank (Incorporated by
reference to Exhibit 10.2 of the Registrant's Current Report
on Form 8-K filed on October 24, 2003).
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10.18 Fee Letter Agreement, dated October 16, 2003, addressed to
American Business Financial Services, Inc. from JPMorgan Chase
Bank (Incorporated by reference to Exhibit 10.3 of the
Registrant's Current Report on Form 8-K filed on October 24,
2003).
10.19 Second Amended and Restated Sale and Servicing Agreement,
dated as of October 16, 2003, by and among ABFS Greenmont,
Inc., as Depositor, HomeAmerican Credit, Inc., d/b/a Upland
Mortgage, and American Business Mortgage Services, Inc., as
Originators and Subservicers, ABFS Mortgage Loan Warehouse
Trust 2000-2, as Trust, American Business Credit, Inc., as an
Originator and Servicer, American Business Financial Services,
Inc., as Sponsor, JPMorgan Chase Bank, as Indenture Trustee
and JPMorgan Chase Bank, as Collateral Agent (Incorporated by
reference to Exhibit 10.4 of the Registrant's Current Report
on Form 8-K filed on October 24, 2003).
10.20 Waiver to the 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 and to the 9/03 Amendment to the
Senior Secured Credit Agreement, among: American Business
Credit, Inc., HomeAmerican Credit, Inc., New Jersey Mortgage
and Investment Corp., American Business Financial Services,
Inc. and The Chase Manhattan Bank, as amended (Incorporated by
reference to Exhibit 10.117 of the Registrant's Annual Report
on Form 10-K/A, Amendment No. 2, filed on December 11, 2003).
10.21 Amendment, dated December 1, 2003, to Consulting Agreement by
and between the Company and Milton Riseman, dated July 3, 2003
(Incorporated by reference to Exhibit 10.119 of the
Registrant's Annual Report on Form 10-K/A, Amendment No. 2,
filed on December 11, 2003).
10.22 Joint Agreement dated December 22, 2003 (Incorporated by
reference to Exhibit 99.2 of the Registrant's Current Report
on Form 8-K filed on December 24, 2003).
10.23 Security Agreement dated December 31, 2003 by and among ABFS
Consolidated Holdings, Inc., American Business Mortgage
Services, Inc., HomeAmerican Credit, Inc., American Business
Credit, Inc. and U.S. Bank National Association, as trustee.
(Incorporated by reference to Exhibit 10.1 of the Registrant's
Current Report on Form 8-K filed on January 2, 2004).
10.24 Second Waiver Letter, dated as of October 31, 2003, from
JPMorgan Chase Bank regarding (i) the Sale and Servicing
Agreement, dated as of September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., d/b/a Upland
Mortgage ("Upland"), American Business Mortgage Services, Inc.
("ABMS"), American Business Credit, Inc. ("ABC"), ABFS
Mortgage Loan Warehouse Trust 2003-1, as trust ("Trust"),
American Business Financial Services, Inc., and JPMorgan Chase
Bank, as indenture trustee ("Indenture Trustee") and
collateral agent, (ii) the Indenture, dated as of September
22, 2003, between the Trust and the Indenture Trustee; and
(iii) the 3/02 Amended and Restated Senior Secured Credit
Agreement, dated March 15, 2002 (as amended and supplemented
by the 10/02 Letter of Credit Supplement, the 12/02 Amendment,
the 3/03 Amendment, 3/31/03 Amendment and the 9/03 Amendment),
among Upland, ABMS, ABC, Tiger Relocation Company, ABFS
Residual 2002, Inc., and JPMorgan Chase Bank.
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10.25 Third Waiver Letter, dated as of December 31, 2003, from
JPMorgan Chase Bank regarding (i) the Sale and Servicing
Agreement, dated as of September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., d/b/a Upland
Mortgage ("Upland"), American Business Mortgage Services, Inc.
("ABMS"), American Business Credit, Inc. ("ABC"), ABFS
Mortgage Loan Warehouse Trust 2003-1, as trust ("Trust"),
American Business Financial Services, Inc., and JPMorgan Chase
Bank, as indenture trustee ("Indenture Trustee") and
collateral agent, (ii) the Indenture, dated as of September
22, 2003, between the Trust and the Indenture Trustee; and
(iii) the 3/02 Amended and Restated Senior Secured Credit
Agreement, dated March 15, 2002 (as amended and supplemented
by the 10/02 Letter of Credit Supplement, the 12/02 Amendment,
the 3/03 Amendment, 3/31/03 Amendment and the 9/03 Amendment),
among Upland, ABMS, ABC, Tiger Relocation Company, ABFS
Residual 2002, Inc., and JPMorgan Chase Bank
10.26 Employment Agreement dated December 24, 2003, by and between
American Business Financial Services, Inc. and Barry Epstein.
10.27 Restricted Stock Agreement dated December 24, 2003, by and
between American Business Financial Services, Inc. and Barry
Epstein.
10.28 Change in Control Agreement between the Company and Stephen M.
Giroux.
31.1 Chief Executive Officer's Certificate
31.2 Chief Financial Officer's Certificate
32.2 Certification pursuant to Section 906 of the Sarbanes Oxley
Act of 2002.
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