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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 March 31, 2004
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.
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(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) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [X] YES [ ] NO
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X] NO
The number of shares outstanding of the registrant's sole class of
common stock as of May 3, 2004 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 March 31, 2004 and June 30, 2003...............................................1
Consolidated Statements of Income for the three and nine months ended March 31, 2004 and 2003....................2
Consolidated Statement of Stockholders' Equity for the nine months ended March 31, 2004..........................3
Consolidated Statements of Cash Flow for the nine months ended March 31, 2004 and 2003 ..........................4
Notes to Consolidated Financial Statements.......................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................40
Item 3. Quantitative and Qualitative Disclosures about Market Risk............................................120
Item 4. Controls and Procedures...............................................................................120
PART II OTHER INFORMATION
Item 1. Legal Proceedings.....................................................................................120
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities......................122
Item 3. Defaults Upon Senior Securities.......................................................................123
Item 4. Submission of Matters to a Vote of Security Holders...................................................123
Item 5. Other Information.....................................................................................123
Item 6. Exhibits and Reports on Form 8-K......................................................................124
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollar amounts in thousands)
MARCH 31, JUNE 30,
2004 2003
---------- -----------
ASSETS (UNAUDITED) (Note)
Cash and cash equivalents (includes restricted cash of $15,197 at March 31,
2004 and $16,988 at June 30, 2003) $ 31,375 $ 47,475
Loan and lease receivables, net
Available for sale 121,518 271,402
Interest and fees 20,655 15,179
Other 36,362 23,761
Interest-only strips (includes the fair value of over-collateralization
related cash flows of $239,567 at March 31, 2004 and $279,245 at
June 30, 2003) 496,709 598,278
Servicing rights 82,823 119,291
Receivable for sold loans - 26,734
Prepaid expenses 15,438 3,477
Property and equipment, net 26,180 23,302
Deferred income tax asset 38,581 -
Other assets 28,578 30,452
---------- -----------
Total assets $ 898,219 $ 1,159,351
========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Subordinated debentures $ 585,797 $ 719,540
Senior collateralized subordinated notes 55,420 -
Warehouse lines and other notes payable 86,644 212,916
Accrued interest payable 37,571 45,448
Accounts payable and other accrued expenses 32,687 30,352
Deferred income tax liability - 17,036
Other liabilities 89,936 91,990
---------- -----------
Total liabilities 888,055 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 March 31, 2004 and 3,000,000 at June 30, 2003;
Issued: 61,807,088 shares of Series A at March 31, 2004 62 -
Common stock, par value $.001, authorized shares, 209,000,000 at March 31,
2004 and 9,000,000 at June 30, 2003; Issued: 3,653,165 shares at March 31,
2004 and June 30, 2003 (including treasury shares of 506,273 at March 31,
2004 and 706,273 at June 30, 2003) 4 4
Additional paid-in capital 84,035 23,985
Accumulated other comprehensive income 5,017 14,540
Unearned compensation (760) -
Retained earnings (deficit) (71,168) 13,104
Treasury stock, at cost (6,426) (8,964)
---------- -----------
10,764 42,669
Note receivable (600) (600)
---------- -----------
Total stockholders' equity 10,164 42,069
---------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 898,219 $ 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 NINE MONTHS ENDED
MARCH 31, MARCH 31,
----------------------------- ----------------------------
2004 2003 2004 2003
----------- --------- ----------- -----------
REVENUES
Gain on sale of loans:
Securitizations $ - $ 54,504 $ 15,107 $ 170,394
Whole loan sales 7,208 (4) 10,207 29
Interest and fees 4,870 4,665 11,690 13,393
Interest accretion on interest-only strips 9,605 12,114 30,942 34,361
Servicing income 1,283 486 3,810 2,667
Other income 478 1 480 7
----------- --------- ----------- -----------
Total revenues 23,444 71,766 72,236 220,851
----------- --------- ----------- -----------
EXPENSES
Interest 16,901 16,824 50,369 51,057
Provision for credit losses 4,876 1,718 12,846 4,692
Employee related costs 11,175 9,418 36,826 29,965
Sales and marketing 4,590 6,963 10,524 20,136
Trading (gains) and losses (1,745) 782 (6,815) 5,257
General and administrative 23,256 25,375 63,736 69,633
Securitization assets valuation adjustment 15,085 10,657 37,848 33,303
----------- --------- ----------- -----------
Total expenses 74,138 71,737 205,334 214,043
----------- --------- ----------- -----------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES
(BENEFIT) (50,694) 29 (133,098) 6,808
Provision for income taxes (benefit) (19,263) (192) (50,577) 2,655
----------- --------- ----------- -----------
INCOME (LOSS) BEFORE DIVIDENDS ON PREFERRED STOCK (31,431) 221 (82,521) 4,153
Dividends on Preferred Stock 1,751 - 1,751 -
----------- --------- ----------- -----------
NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCK $ (33,182) $ 221 $ (84,272) $ 4,153
=========== ========= =========== ===========
EARNINGS (LOSS) PER COMMON SHARE:
Basic $ (10.53) $ 0.07 $ (27.79) $ 1.43
=========== ========= =========== ===========
Diluted $ (10.53) $ 0.06 $ (27.79) $ 1.36
=========== ========= =========== ===========
AVERAGE COMMON SHARES:
Basic 3,182 2,941 3,033 2,909
=========== ========= =========== ===========
Diluted 3,182 3,103 3,033 3,043
=========== ========= =========== ===========
See accompanying notes to consolidated financial statements.
2
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED MARCH 31, 2004
(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 61,807 62 - - 61,428 - - -
Issuance of restricted
common stock - - 200 - (1,778) - (760) -
Cash dividends declared on
preferred stock ($0.025
per share) - - - - - - - (1,351)
Amortization of beneficial
conversion feature - - - - 400 - - (400)
Comprehensive income:
Net loss - - - - - - - (82,521)
Net unrealized loss
on interest-only
strips - - - - - (9,523) - -
------ ----- ----- --- -------- -------- ------ ---------
Total comprehensive loss - - - - - (9,523) - (82,521)
------ ----- ----- --- -------- -------- ------ ---------
BALANCE MARCH 31, 2004 61,807 $ 62 3,147 $ 4 $ 84,035 $ 5,017 $ (760) $ (71,168)
====== ===== ===== === ======== ======== ====== =========
TOTAL
TREASURY NOTE STOCKHOLDERS'
STOCK RECEIVABLE EQUITY
-------- ---------- -------------
Balance June 30, 2003 $ (8,964) $ (600) $ 42,069
Issuance of preferred stock - - 61,490
Issuance of restricted
common stock 2,538 - -
Cash dividends declared on
preferred stock ($0.025
per share) - - (1,351)
Amortization of beneficial
conversion feature - - -
Comprehensive income:
Net loss - - (82,521)
Net unrealized loss
on interest-only
strips - - (9,523)
--------- ------ ---------
Total comprehensive loss - - (92,044)
--------- ------ ---------
BALANCE MARCH 31, 2004 $ (6,426) $ (600) $ 10,164
========= ====== =========
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)
NINE MONTHS ENDED
MARCH 31,
------------------------------------
2004 2003
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ (82,521) $ 4,153
Adjustments to reconcile net income to net cash used in operating
activities:
Gain on sale of loans (25,314) (170,423)
Depreciation and amortization 38,545 38,085
Interest accretion on interest-only strips (30,942) (34,361)
Securitization assets valuation adjustment 37,848 33,303
Provision for credit losses 12,846 4,692
Loans originated for sale (535,335) (1,226,712)
Proceeds from sale of loans 678,062 1,208,940
Principal payments on loans and leases 23,293 14,626
Increase in accrued interest and fees on loan and lease receivables (5,476) (1,862)
Purchase of initial overcollateralization on securitized loans -- (3,800)
Required purchase of additional overcollateralization on
securitized loans (21,826) (53,496)
Cash flow from interest-only strips 133,587 109,849
(Increase) decrease in prepaid expenses (11,961) 56
(Decrease) increase in accrued interest payable (7,877) 2,444
(Decrease) increase in accounts payable and accrued expenses 2,503 7,953
Accrued interest payable reinvested in subordinated debentures 29,159 28,174
Decrease in deferred income taxes payable (50,489) (549)
(Decrease) increase in loans in process (13,245) 1,884
(Payments) receipts on derivative financial instruments (3,136) (8,529)
Other, net (5,180) 4,065
----------- -----------
Net cash provided by (used in) operating activities 162,541 (41,508)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment, net (8,416) (4,277)
Principal receipts and maturity of investments 33 25
----------- -----------
Net cash used in investing activities (8,383) (4,252)
----------- -----------
4
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW (CONTINUED)
(dollar amounts in thousands)
(unaudited)
NINE MONTHS ENDED
MARCH 31,
------------------------------------
2004 2003
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of subordinated debentures $ 131,824 $ 136,977
Redemptions of subordinated debentures (177,499) (110,653)
Net repayments on revolving lines of credit (100,353) (495)
Principal payments on lease funding facility -- (2,091)
Principal payments under capital lease obligations (236) (138)
Net repayments of other notes payable (26,158) --
Financing costs incurred (1,561) (688)
Lease incentive receipts 4,562 2,123
Exercise of employee stock options -- (2)
Exercise of non-employee stock options -- 50
Grant of restricted stock option -- 9
Cash dividends paid on common stock -- (699)
Cash dividends paid on preferred stock (837) --
----------- -----------
Net cash provided by (used in) financing activities (170,258) 24,393
----------- -----------
Net decrease in cash and cash equivalents (16,100) (21,367)
Cash and cash equivalents at beginning of year 47,475 108,599
----------- -----------
Cash and cash equivalents at end of period $ 31,375 $ 87,232
=========== ===========
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 $ 117,227 $ --
Increase in senior collateralized subordinated notes $ 55,420 $ --
Increase in preferred stock $ 62 $ --
Increase in additional paid-in capital $ 61,745 $ --
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ -- $ (1,020)
Increase in warehouse lines and other notes payable $ -- $ 1,020
Cash paid during the period for:
Interest $ 29,087 $ 20,439
Income taxes $ 105 $ 759
See accompanying notes to consolidated financial statements.
5
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
American Business Financial Services, Inc. ("ABFS"), together with its
subsidiaries (the "Company"), is a financial services organization operating
mainly 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. However, the
Company's business strategy adjustments include increasing loan origination by
offering adjustable-rate loans. 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, and a small office in Roseland, New
Jersey. The Company recently acquired a broker operation in West Hills,
California and opened new broker offices in Edgewater, Maryland and Irvine,
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 direct retail branch offices.
Effective June 30, 2003, the Company no longer originates home equity loans
through direct 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 and
senior collateralized subordinated notes upon maturity, maintaining adequate
warehouse credit facilities or lines of credit to fund increasing loan
originations, 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 and senior collateralized subordinated notes at
maturity and may result in continued losses.
6
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
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. However, during
the nine months ended March 31, 2004, the Company experienced positive cash flow
from operations of $162.5 million, primarily due to whole loan sales of loans it
originated in prior periods that were carried on its balance sheet at June 30,
2003. The following table compares the principal amount of loans sold in whole
loan sales during the nine months ended March 31, 2004, to the amount of loans
originated during the same period (in thousands).
Whole Loan Loans
Quarter Ended Sales Originated
------------------------------------------ ---------- -----------
September 30, 2003 $ 245,203 $ 124,052
December 31, 2003 7,975(a) 103,084
March 31, 2004 228,629 241,449
---------- ----------
Total for nine months ended March 31, 2004 $ 481,807 $ 468,585
========== ==========
(a) During the quarter ended December 31, 2003, the Company completed a
securitization of $173.5 million of mortgage loans.
For the nine months ended March 31, 2004, the Company recorded a net loss before
dividends on preferred stock of $82.5 million. The loss primarily resulted from:
a) liquidity issues described below, which substantially reduced the Company's
ability to originate loans and generate revenues during the first nine months of
fiscal 2004, b) the Company's inability to complete securitizations of loans
during the first and third quarters of fiscal 2004, c) operating expense levels
which would support greater loan origination volume, and d) $37.8 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 nine months of fiscal 2004 due
to the continuing low interest rate environment. For the nine months ended March
31, 2004, the Company originated $468.6 million of loans, which represents a
significant reduction as compared to $1.18 billion 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. The Company's short-term liquidity has been negatively
impacted by several events and issues, which have occurred beginning with the
fourth quarter of fiscal 2003.
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.
7
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS (CONTINUED)
Second, the Company's ability to borrow under credit facilities to finance new
loan originations was limited for much 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 July 5, 2003. In
addition, the Company was unable to borrow under a $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 March
31, 2004, the Company originated $468.6 million of loans, which represents a
significant reduction as compared to originations of $1.18 billion of loans for
the same period in fiscal 2003. The Company also experienced a loss in loan
origination employees. As a result of the decrease in loan originations and
liquidity issues described above, the Company incurred a loss for the first
three quarters of fiscal 2004 and depending on the Company's ability to
recognize gains on its future securitizations, it anticipates incurring losses
at least through the first quarter of fiscal 2005.
The combination of the Company's current cash position and expected sources of
operating cash in the fourth quarter of fiscal 2004 may not be sufficient to
cover its operating cash requirements. On March 31, 2004, the Company had
unrestricted cash of approximately $16.2 million and up to $364.4 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. For the quarter ended March 31, 2004, the Company
originated $241.4 million of loans.
The Company's short-term plan to achieve these levels of loan originations
includes replacing the loan origination employees lost and creating an expanded
broker initiative. The broker initiative involves significantly increasing the
use of loan brokers to increase loan volume and obtaining additional resources
in the form of senior officers to manage the broker program. In December 2003,
the Company hired an experienced industry professional who manages the wholesale
business and acquired a broker operation with 35 employees located in
California. In February 2004, the Company hired a second experienced industry
professional to start up a broker operation on the west coast. In March 2004,
the Company opened a mortgage broker office in Maryland and hired three
experienced senior managers and a loan origination staff of 40. In addition, the
Company hired 12 mortgage broker account executives to expand its broker
presence in the eastern, southern and mid-western areas of the U.S.
8
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS (CONTINUED)
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 six to twelve 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. The
Company can provide no assurances that it will be able to continue issuing
subordinated debentures. In the event the Company is unable to offer additional
subordinated debentures for any reason, it has developed a contingent financial
restructuring plan. This plan is described later in this note.
In light of the losses during the quarters ended September 30, 2003, December
31, 2003 and March 31, 2004, the Company requested and obtained waivers for its
non-compliance with financial covenants in its credit facility agreements and
servicing agreements. See Notes 5 and 7 for more detail.
Remedial Actions to Address Short-term Liquidity. The Company undertook specific
remedial actions to address short-term liquidity concerns including selling
loans on a whole loan basis, securing new credit and warehouse facilities,
refinancing an off-balance sheet mortgage conduit facility, mailing an Offer to
Exchange to holders of the Company's subordinated debentures and suspending the
payment of quarterly dividends on its common stock.
The Company entered into an agreement with an investment bank on June 30, 2003
to sell up to $700.0 million of mortgage loans, entered into a forward sale
agreement in March 2004 for $300.0 million of mortgage loans, and it solicited
bids and commitments from other participants in the whole loan sale market. In
total, from June 30, 2003 through March 31, 2004, the Company sold approximately
$729.8 million of loans (which includes $222.3 million of loans sold by the
expired mortgage conduit facility) through whole loan sales. 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.
9
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS (CONTINUED)
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 these two new credit facilities totaling $450.0 million, it may
only use the proceeds of advances under 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. These loans 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, with servicing released, of the $173.5 million of loans
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 $43.6 million of eligible subordinated
debentures for 22.7 million shares of Series A Preferred Stock and $20.9 million
of senior collateralized subordinated notes.
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.
10
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS (CONTINUED)
Subordinated Debentures and Senior Collateralized Subordinated Notes. At March
31, 2004 there were approximately $303.4 million of subordinated debentures and
$12.5 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.
The Company can provide no assurances that it will be able to continue issuing
subordinated debentures. 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,
obtaining working capital funding 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.
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 nine-month period
ended March 31, 2004 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.
11
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BASIS OF FINANCIAL STATEMENT PRESENTATION (CONTINUED)
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 OPTIONS
The Company has stock option plans that provide for the periodic granting of
options to key employees, non-employee directors and other designated
individuals. 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):
12
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK OPTIONS (CONTINUED)
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
-------------------------- -------------------------
2004 2003 2004 2003
--------- ----- --------- -------
Net income (loss), as reported $ (33,182) $ 221 $ (84,272) $ 4,153
Stock based compensation costs, net of
tax effects determined under fair
value method for all awards 214(a) 64(a) 403(a) (52)
--------- ----- --------- -------
Pro forma $ (32,968) $ 285 $ (83,869) $ 4,101
========= ===== ========= =======
Earnings (loss) per share - basic
As reported $ (10.53) $0.07 $ (27.79) $ 1.43
Pro forma $ (10.53) $0.10 $ (27.79) $ 1.41
Earnings (loss) per share - diluted
As reported $ (10.53) $0.06 $ (27.79) $ 1.36
Pro forma $ (10.53) $0.09 $ (27.79) $ 1.35
(a) The pro forma adjustments for stock option costs are favorable to net
income (loss) because the value of stock options forfeited during these
periods exceeded the value of stock options vesting during these periods.
RESTRICTED CASH BALANCES
The Company held restricted cash balances of $8.1 million at March 31, 2004
primarily collateralizing a letter of credit facility, $6.6 million and $11.0
million related to borrower escrow accounts at March 31, 2004 and June 30, 2003,
respectively, and $0.5 million and $6.0 million related to deposits for future
settlement of derivative financial instruments at March 31, 2004 and June 30,
2003, respectively.
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.
13
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
3. LOAN AND LEASE RECEIVABLES
Loan and lease receivables - available for sale were comprised of the following
(in thousands):
MARCH 31, JUNE 30,
2004 2003
--------- -----------
Real estate secured loans (a) (b) $ 123,794 $ 270,096
Leases, net of unearned income of $550 at June 30, 2003 (c) -- 4,154
--------- -----------
123,794 274,250
Less: allowance for credit losses on loan and lease
receivables available for sale 2,276 2,848
--------- -----------
$ 121,518 $ 271,402
========= ===========
(a) Includes deferred direct loan origination costs of $1.2 million and $6.8
million at March 31, 2004 and June 30, 2003, respectively.
(b) Includes $2.1 million at March 31, 2004 for the adjustment to fair value for
$48.3 million of loans committed for sale under a forward sale agreement
entered into in March 2004. See Note 11.
(c) Includes deferred direct lease origination costs of $28 thousand at June 30,
2003. On January 22, 2004, the Company sold the lease portfolio balance as
of December 31, 2003.
Real estate secured loans have contractual maturities of up to 30 years.
At March 31, 2004 and June 30, 2003, the accrual of interest income was
suspended on real estate secured loans of $5.7 million and $5.4 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $1.9 million and $1.4 million at
March 31, 2004 and June 30, 2003, respectively.
Average balances of non-accrual loans were $8.1 million for the nine months
ended March 31, 2004 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 continued 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. The Company received cash from this sale in January 2004.
14
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
3. LOAN AND LEASE RECEIVABLES (CONTINUED)
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, deferment, tax and
insurance 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.
15
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
4. INTEREST-ONLY STRIPS
The activity for interest-only strip receivables for the nine months ended March
31, 2004 and 2003 were as follows (in thousands):
March 31,
-------------------------------
2004 2003
---------- ----------
Balance at beginning of period $ 598,278 $ 512,611
Initial recognition of interest-only strips 25,523 141,511
Cash flow from interest-only strips (133,587) (109,849)
Required purchases of additional overcollateralization 21,826 53,496
Interest accretion 30,942 34,361
Termination of lease securitization (a) (1,759) (1,741)
Adjustment for obligation to repurchase loans 2,485 2,158
Net temporary adjustments to fair value (b) (14,651) 6,128
Other than temporary fair value adjustment (b) (32,348) (28,784)
---------- ----------
Balance at end of period $ 496,709 $ 609,891
========== ==========
(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 March 31, 2004 and 2003, the fair
value of overcollateralization related cash flows were $239.6 million and $290.6
million, respectively.
The Company's interest-only strips collateralize 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
$56.2 million.
Interest-only strips also secure the Company's senior collateralized
subordinated notes. The senior collateralized subordinated notes are secured by
a security interest in certain cash flows originating from interest-only strips
of certain 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. At March 31,
2004, the Company's interest in the cash flows from the interest-only strips
held in the trust, which secure the senior collateralized subordinated notes,
totaled $438.5 million, of which approximately $83.1 million represented 150% of
the outstanding principal balance of the senior collateralized subordinated
notes. See Note 7 for more detail on the senior collateralized subordinated
notes.
16
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
4. INTEREST-ONLY STRIPS (CONTINUED)
Beginning in the second quarter of fiscal 2002 and on a quarterly basis
thereafter, the Company's prepayment rates, as well as those throughout the
mortgage industry, remained at higher than expected levels due to continuing low
interest rates during this period. As a result, over the last ten quarters the
Company has recorded cumulative pre-tax write downs to its interest-only strips
in the aggregate amount of $151.1 million and pre-tax adjustments to the value
of servicing rights of $10.8 million, for total adjustments of $161.9 million,
mainly due to the higher than expected prepayment experience. Of this amount,
$105.1 million was expensed through the income statement and $56.8 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 March 15, 2004 that mortgage
refinancings as a percentage share of total mortgage originations will decline
from 51% in the first quarter of calendar 2004 to 30% in the first quarter of
calendar 2005. The Mortgage Bankers Association of America has also projected in
its March 2004 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 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.
17
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
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
March 31, 2004 23,191 15,085 8,106
--------- -------- --------
Total Fiscal 2004 $ 54,573 $ 37,848 $ 16,725
========= ======== ========
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 nine months ended March 31, 2004, the Company recorded gross pre-tax
valuation adjustments on its securitization assets primarily related to
prepayment experience of $63.0 million, of which $43.1 million was charged to
the income statement and $19.9 million was charged to other comprehensive
income. The valuation adjustment on interest-only strips for the nine months
ended March 31, 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. Of this amount, $5.3 million offset the portion of
the adjustment expensed through the income statement and $3.1 million offset the
portion of the adjustment charged to other comprehensive income. The breakout of
the total adjustments in the nine months ended March 31, 2004 between
interest-only strips and servicing rights was as follows:
18
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
4. INTEREST-ONLY STRIPS (CONTINUED)
o The Company recorded gross pre-tax valuation adjustments on its
interest only-strips of $57.5 million, of which $37.6 million was
charged to the income statement and $19.9 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 nine months of fiscal
2004 due to the continuing low interest rate environment. The
valuation adjustment on interest-only strips for the nine months
ended March 31, 2004 was partially 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, $5.3 million offset the portion of the adjustment
expensed through the income statement and $3.1 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 $5.5 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 nine months of fiscal 2004 due to the continuing low interest
rate environment.
5. SERVICING RIGHTS
Activity for the servicing rights asset for the nine months ended March 31, 2004
and 2003 were as follows (in thousands):
March 31,
-----------------------
2004 2003
--------- ---------
Balance at beginning of year $ 119,291 $ 125,288
Initial recognition of servicing rights - 42,171
Amortization (30,967) (30,015)
Write down (5,501) (4,519)
--------- ---------
Balance at end of period $ 82,823 $ 132,925
========= =========
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 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 nine months of
fiscal 2004, the Company recorded total pre-tax valuation adjustments on its
servicing rights of $5.5 million, which was charged to the income statement.
19
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
5. SERVICING RIGHTS (CONTINUED)
In 22 of the 26 securitizations serviced by the Company, servicing rights can be
terminated by financial insurers representing bondholders or certificate holders
(collectively, "bond insurers") under certain circumstances, such as the
Company's failure to make required servicer payments, defined changes of
control, reaching specified loss levels on underlying mortgage pools or other
events constituting a breach, including, in some cases, financial covenants of
the pooling and servicing and sale and servicing agreements (collectively,
"servicing agreements"). In the remaining four securitizations, the Company's
servicing rights can be terminated by the trustee under similar circumstances.
In the case of certain of the servicing agreements, the associated bond insurers
have the additional ability to terminate servicing rights in their sole
discretion at the end of a servicing term.
As a result of the Company's non-compliance at September 30, 2003 with the net
worth covenant in several of its servicing agreements with two bond insurers,
the Company requested and obtained waivers of the non-compliance from the two
bond insurers. In connection with a waiver of the net worth covenant granted by
one bond insurer for the remaining term of the related servicing agreements, the
servicing agreements with that bond insurer were amended to provide for 120-day
term-to-term servicing. The second bond insurer waived the Company's
non-compliance with net worth requirements and amended the related servicing
agreements principally to provide for 30-day term-to-term servicing. The Company
is currently operating under a waiver of the net worth requirement granted by
this second bond insurer and has been re-appointed as servicer under the amended
servicing agreements with both of these bond insurers for all relevant periods
since the execution of the amended servicing agreements.
A third bond insurer, as a condition to its participation in the Company's
October 2003 securitization, required that the Company amend a servicing
agreement related to a previous securitization in which the bond insurer had
participated as bond insurer. The resulting amendment to this servicing
agreement provided, among other things, for a specifically designated back-up
servicer and for 90-day term-to-term servicing. On April 30, 2004 this amended
servicing agreement was further amended principally to provide for 30-day
term-to-term servicing and for the Company's reappointment as servicer for an
initial 30-day term.
On March 5, 2004, the Company entered into agreements with its fourth bond
insurer, which amended the servicing agreements related to all securitizations
insured by this bond insurer. These amendments principally provided for a
specifically designated back-up servicer. The original provisions of these
servicing agreements providing for 3-month term-to-term servicing were not
altered by these amendments.
As a result of the foregoing amendments to our servicing agreements, all of the
Company's servicing agreements associated with bond insurers now provide for
term-to-term servicing.
20
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
6. OTHER ASSETS AND OTHER LIABILITIES
Other assets were comprised of the following (in thousands):
MARCH 31, JUNE 30,
2004 2003
-------- --------
Goodwill $ 15,703 $ 15,121
Financing costs, debt offerings 3,535 3,984
Real estate owned 2,508 4,776
Due from securitization trusts for
servicing related activities 924 1,344
Investments held to maturity 848 881
Other 5,060 4,346
-------- --------
$ 28,578 $ 30,452
======== ========
Other liabilities were comprised of the following (in thousands):
MARCH 31, JUNE 30,
2004 2003
-------- --------
Obligation for repurchase of securitized loans $ 42,778 $ 27,954
Commitments to fund closed loans 21,942 35,187
Unearned lease incentives 13,115 9,465
Escrow deposits held 6,576 10,988
Deferred rent incentive 3,741 -
Trading liabilities, at fair value 2 334
Hedging liabilities, at fair value 1 6,335
Periodic advance guarantee 670 650
Other 1,111 1,077
-------- --------
$ 89,936 $ 91,990
======== ========
See Note 3 for an explanation of the obligation for the repurchase of
securitized loans.
21
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE
Subordinated debentures were comprised of the following (in thousands):
MARCH 31, JUNE 30,
2004 2003
-------- ---------
Subordinated debentures (a) $ 572,568 $ 702,423
Subordinated debentures - money market notes (b) 13,229 17,117
--------- ---------
Total subordinated debentures $ 585,797 $ 719,540
========= =========
Senior collateralized subordinated notes were comprised of the following
(in thousands):
MARCH 31, JUNE 30,
2004 2003
-------- --------
Senior collateralized subordinated notes (c) $ 55,420 $ --
======== ========
Warehouse lines and other notes payable were comprised of the following
(in thousands):
MARCH 31, JUNE 30,
2004 2003
-------- ---------
Warehouse revolving line of credit (d) $ 25,675 $ --
Warehouse revolving line of credit (e) 59,923 --
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) 571 807
Convertible promissory note (j) 475 --
Bank overdraft (k) -- 26,158
-------- ---------
Total warehouse lines and other notes payable $ 86,644 $ 212,916
======== =========
(a) Subordinated debentures due April 2004 through April 2014, interest rates
ranging from 3.75% to 13.00%; average rate at March 31, 2004 was 9.61%,
average remaining maturity was 15.7 months, subordinated to all of the
Company's senior indebtedness. The average rate on subordinated debentures
including money market notes was 9.40% at March 31, 2004.
(b) Subordinated debentures - money market notes due upon demand, interest rate
at 4.85%; subordinated to all of the Company's senior indebtedness.
22
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
(c) Senior collateralized subordinated notes due April 2004 through April 2014,
interest rates ranging from 5.40% to 13.10%; average rate at March 31, 2004
was 9.86%, average remaining maturity was 22.0 months. The senior
collateralized subordinated notes are secured by a security interest in
certain cash flows originating from interest-only strips of certain 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 issued in
the Exchange Offer plus priority lien obligations secured by the
interest-only strips and/or the cash flows from the interest-only strips;
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 behind
the existing and future debt of the Company's 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 March 31, 2004, the Company's interest
in the cash flows from the interest-only strips held in the trust which
secure the senior collateralized subordinated notes totaled $438.5 million,
of which $83.1 million represents 150% of the outstanding principal balance
of the senior collateralized subordinated notes at March 31, 2004.
(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. 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 $56.2 million.
(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, until it expired in
December 2003. In December 2003, the Company was issued a stand alone
letter of credit for $8.0 million collateralized by cash.
(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.
23
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
(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.
At March 31, 2004, warehouse lines and other notes payable were collateralized
by $90.9 million of loan receivables and $1.0 million of computer equipment.
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
off-balance sheet mortgage conduit facility described above. 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 3.44%
and 2.24% at March 31, 2004 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 March 31, 2005 -
$415,072; 2006 - $188,865; 2007 - $87,191; 2008 - $12,113; and, 2009 - $6,229.
24
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
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 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.
COVENANTS UNDER CURRENT CREDIT FACILITIES. 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) have a net worth of at least $28.0 million by September 30, 2003;
with quarterly increases of $2.0 million thereafter; (ii) 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; (iii)
as of the end of any month, commencing January 31, 2004, the aggregate
outstanding balance of subordinated debentures must be less than the aggregate
outstanding balance as of the end of the prior month; 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 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, and its ownership of an amount of
repurchased loans not to exceed 1.5% of the managed portfolio.
25
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
On October 14, 2003, the Company 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). The Company 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 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 not to exceed 10 percentage points above comparable rates for FDIC
insured products; and (iv) maintain minimum cash and cash equivalents of not
less than $10.0 million. In addition to events of default which are typical for
this type of facility, an event of default would occur if: (1) the Company is
unable to sell subordinated 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.
WAIVERS AND AMENDMENTS OF FINANCIAL COVENANTS. 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 existing 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 obtained waivers from these covenant provisions from both
lenders. Commencing August 21, 2003, the lender under the $50.0 million
warehouse credit facility (which had been amended in December 2002 to add a
letter of credit facility) granted the Company a series of waivers for its
non-compliance with a financial covenant in that credit facility through
November 30, 2003 and on September 22, 2003, in connection with the creation of
the new $200.0 million credit facility on the same date, reduced this facility
to an $8.0 million letter of credit facility, which secured the lease on the
Company's principal executive office. This letter of credit facility expired
according to its terms on December 22, 2003, but the underlying letter of credit
was renewed for a one year term on December 18, 2003. 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, second and third 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.
26
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
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, that we obtain a written commitment for another credit
facility of at least $200.0 million and close that additional facility by
October 3, 2003, and that we have a minimum net worth of $28.0 million at
September 30, 2003, $25.0 million at October 31, 2003 and November 30, 2003,
$30.0 million at December 31, 2003 and $32.0 million at March 31, 2004.
The lender under the new $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.
The lender on the new $200.0 million credit facility agreed to extend the date
by which the Company was required to close an additional credit facility of at
least $200.0 million from October 3, 2003 to October 8, 2003. The Company
subsequently obtained an additional waiver from this lender, which extended this
required closing date for obtaining the additional credit facility to October
14, 2003 (this condition was satisfied by the closing of the $250.0 million
facility described above). Prior to the closing of the second credit facility,
our borrowing capacity on the new $200.0 million facility was limited to $80.0
million.
This lender also waived the minimum net worth requirements at September 30,
2003, October 31, 2003, November 30, 2003, December 31, 2003 and March 31, 2004
under the $200.0 million 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.
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, $181.7 million of debt from this registration statement was
available for future issuance as of March 31, 2004.
27
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
On December 1, 2003, the Company mailed an Exchange Offer to holders of eligible
debentures. Holders of such eligible debentures had the ability to exchange
their debentures 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 eligible debentures tendered
with maturities of less than 12 months, while eligible 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 Offer 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 certain 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 principal balance of the senior collateralized
subordinated notes issued in the Exchange Offer plus priority lien obligations
secured by the interest-only strips and/or the cash flows from the interest-only
strips; provided that, such collateral coverage may not fall below 100% of the
principal balance of the senior collateralized subordinated notes issued in the
Exchange Offer, 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 behind the existing and
future 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. At March 31, 2004, the Company's interest in
the cash flows from the interest-only strips held in the trust, which secure the
senior collateralized subordinated notes, totaled $438.5 million, of which $83.1
million represented 150% of the principal balance of the senior collateralized
subordinated notes outstanding at March 31, 2004.
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 $43.6
million of eligible debentures for 22.7 million shares of Series A Preferred
Stock and $20.9 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.
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.
28
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
7. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
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 $2.6 million and $21.5 million in the three and
nine months ended March 31, 2004 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 eligible
debentures. Holders of such eligible debentures had the ability to exchange
their debentures 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, 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 $43.6
million of eligible subordinated debentures for 22.7 million shares of Series A
Preferred Stock and $20.9 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 March 31, 2004, the liquidation value equals $61.8 million.
Dividend Payments. Monthly dividend payments will be $0.008334 per share of
Series A Preferred Stock (equivalent to $0.10 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 March 31, 2004, the annual dividend
requirement equals $6.2 million.
29
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
8. STOCKHOLDERS' EQUITY (CONTINUED)
TERMS OF THE SERIES A PREFERRED STOCK (CONTINUED)
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 in the first
exchange offer 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):
Convertible
Number of into Number of
Preferred Common
Shares Shares
--------- --------------
Second anniversary date 61,807 14,834
Third anniversary date 61,807 16,070
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 $5.3 million. 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 $5.3 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.
RESTRICTED SHARES GRANTED
The Company entered into an employment agreement dated December 24, 2003 with an
experienced industry professional who directs 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 March 31, 2004 was $3.80 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.
30
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
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, including
alternative mortgage transactions. Although this New Jersey decision is on
appeal to the New Jersey Supreme Court which could overrule the decision, the
Company is currently evaluating its impact on the Company's future lending
activities in the State of New Jersey and results of operations. The Company
expects that, as a result of the publicity surrounding "predatory lending"
practices and this recent New Jersey court decision regarding the Parity Act, it
may be subject to other class action suits in the future.
31
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
9. LEGAL PROCEEDINGS (CONTINUED)
On January 21, 2004, January 28, 2004, February 12, 2004 and February 18, 2004,
four purported class action lawsuits were filed against the Company and its
director and Chief Executive Officer, Anthony Santilli, and its Chief Financial
Officer, Albert Mandia, in the United States District Court for the Eastern
District of Pennsylvania. The first two suits and the fourth suit also name
former director, Richard Kaufman, as a defendant. The complaints are captioned:
Weisinger v. American Business Financial Services, Inc. et al, Civil Action No.
04-265; Ruane v. American Business Financial Services, Inc. et al, Civil Action
No. 04-400, Operative Plasterers' and Cement Masons' International Employees'
Trust Fund v. American Business Financial Services, Inc. et al, Civil Action No.
04-617, and Vieni v. American Business Financial Services, Inc. et al, Civil
Action No. 04-687. The lawsuits were brought by purchasers of the Company's
common stock who were seeking to represent a class of all purchasers of its
common stock for a proposed class period January 27, 2000 through June 25, 2003
with respect to the first two suits and fourth suit filed. A proposed class
period for the third suit is January 27, 2000 through June 12, 2003. As of May
3, 2004, no motions for class certification have been filed.
The first two and fourth lawsuits allege that, among other things, the Company
and the named directors and officers violated Sections 10(b) and 20(a) of the
Exchange Act. These three lawsuits allege that, among other things, during the
applicable class period, the Company's forbearance and foreclosure practices
enabled it to, among other things, allegedly inflate its financial results.
These three 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 the Company's forbearance and foreclosure practices.
The U.S. Attorney's inquiry was subsequently concluded in December 2003. These
three 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 Exchange Act 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.
As of May 3, 2004, the four cases were consolidated, and two competing motions
for appointment of lead plaintiff were pending before the court.
On March 15, 2004, a shareholder derivative action was filed against the
Company, as a nominal defendant, and its director and Chief Executive Officer,
Anthony Santilli, its Chief Financial Officer, Albert Mandia, its directors,
Messrs. Becker, DeLuca and Sussman, and its former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania. The complaint is captioned: Osterbauer v. Santilli et al, Civil
Action No. 04-1105. The lawsuit was brought nominally on behalf of the Company,
as a shareholder derivative action, alleging that the named directors and
officers breached their fiduciary duties to the Company, engaged in the abuse of
control, gross mismanagement and other violations of law during the period from
January 27, 2000 through June 25, 2003. The lawsuit seeks unspecified
compensatory damages, equitable or injunctive relief and costs and expenses
related to bringing the action, and other unspecified relief. The parties have
agreed to stay this case pending disposition of any motion to dismiss the
anticipated consolidated amended complaint filed in the putative securities
class actions.
32
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
9. LEGAL PROCEEDINGS (CONTINUED)
Procedurally, these lawsuits are in a very preliminary stage. The Company
believes that it has several defenses to the claims raised by these lawsuits and
intends 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 the Company's control, it is currently unable to
predict the ultimate outcome of this litigation or its impact on the Company's
financial position or results of operations.
In addition, from time to time, the Company is involved as plaintiff or
defendant in various other legal proceedings arising in the normal course of its
business. While the Company 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 the Company's 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. The
stand alone 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 by the end of fiscal 2004.
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
in December 2003, 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 1/2 years, expiring September 30, 2006 at an
annual rental of approximately $0.1 million.
33
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
10. COMMITMENTS (CONTINUED)
LEASE AGREEMENTS (CONTINUED)
In connection with the opening of the Irvine, California mortgage broker
operation, the Company entered into a sublease on March 4, 2004 for
approximately 6,400 square feet of space. The term of the sublease is 1 2/3
years and expires November 30, 2005. The terms of the sublease require average
minimum annual rental payments of $0.1 million.
In connection with the opening of the Maryland mortgage broker operation, the
Company entered into a sublease on March 15, 2004 for approximately 10,300
square feet of space in Edgewater, Maryland. The term of the sublease is 3 years
and expires March 15, 2007. The terms of the sublease require increased payments
annually for the term of the lease with average minimum annual rental payments
of $0.2 million.
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 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 is carrying on its
balance sheet a $0.7 million liability for its obligations to the ABFS 2003-1
securitization trust which was created 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.
34
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
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 or the date the terms and pricing for a whole loan sale are fixed.
The Company recorded the following gains and losses on the fair value of
derivative financial instruments accounted for as hedges for the three and
nine-month periods ended March 31, 2004 and 2003. Any ineffectiveness related to
hedging transactions during the period was immaterial. Ineffectiveness is a
measure of the difference in the change in fair value of the derivative
financial instrument as compared to the change in the fair value of the item
hedged (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------- ----------------------
2004 2003 2004 2003
----------- ----------- ---------- ----------
Offset by losses and gains recorded on
securitizations:
Gains (losses) on derivative financial
instruments $ - $ (2,071) $ - $ (3,806)
Offset by losses and gains recorded on the
fair value of hedged items:
Gains (losses) on derivative financial
instruments (1,066) (16) (1,714) (3,070)
Amount settled in cash - received (paid) (927) (2,619) (1,619) (5,041)
In March 2004, the Company entered into a forward sale agreement providing for
the sale of $300.0 million of home equity mortgage loans and business purpose
loans at a price of 104.4%. In the month of March 2004, the Company sold $224.0
million of loans under this commitment, recognizing gains of $7.1 million. At
March 31, 2004, the Company recorded a gain of $2.1 million on $48.3 million of
loans carried on its balance sheet, which are committed for sale under this
forward sale commitment in April 2004.
At March 31, 2004 and 2003, outstanding forward sale commitments, 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 for these derivative financial instruments
were as follows (in thousands):
35
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
11. DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED)
MARCH 31,
--------------------------------------------------------------
2004 2003
----------------------------- -----------------------------
Notional Unrealized Notional Unrealized
Amount (Loss) Amount (Loss)
------------- ------------- ------------ --------------
Forward loan sale commitments $ 76,032 $ -- $ -- $ --
Eurodollar futures contracts 50,000 (100) -- --
Forward starting interest rate swaps -- -- 47,497 (2,809)
TRADING ACTIVITY
The Company recorded the following gains and losses on forward starting interest
rate swap contracts classified as trading for the three and nine-month periods
ended March 31, 2004 and 2003 (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------------ --------------------------
2004 2003 2004 2003
------------- ------------- ----------- -----------
Trading Gains/(Losses) on forward starting
interest rate swaps:
Related to loan pipeline $ -- $ (784) $ -- $ (3,708)
Related to whole loan sales -- -- 5,097 --
Amount settled in cash - (paid) -- -- (1,212) (2,671)
At March 31, 2004, there were no outstanding derivative financial instruments
accounted for as trading activity, which were utilized to manage interest rate
risk on loans in our pipeline or expected to be sold in whole loan sale
transactions. At March 31, 2003, outstanding forward starting interest rate swap
contracts used to manage interest rate risk on loans in the Company's pipeline
and associated unrealized losses recorded as liabilities on the balance sheet
were as follows (in thousands):
Notional Unrealized
Amount (Loss)
-------- ----------
Forward starting interest rate swaps $72,503 $ (22)
The 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 nine-month periods ended
March 31, 2004 and 2003 were as follows (in thousands):
36
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
11. DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED)
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------------ --------------------------
2004 2003 2004 2003
------------- ------------- ----------- -----------
Unrealized gain (loss) on interest rate
swap contract $ 47 $ 215 $ 333 $ (80)
Cash interest received (paid) on
interest rate swap contract (48) (277) (305) (817)
------ ------ ------ -------
Net gain (loss) on interest rate swap
contract $ (1) $ (62) $ 28 $ (897)
====== ====== ====== =======
This interest rate swap contract matures in April 2004. Terms of the interest
rate swap contract at March 31, 2004 were as follows (dollars in thousands):
Notional amount $ 1,372
Rate received - Floating (a) 1.20%
Rate paid - Fixed 2.89%
Maturity date April 2004
Unrealized loss $ 1
Sensitivity to 0.1% change in interest rates (b)
-----------
(a) Rate represents the spot rate for one-month LIBOR paid on the
securitized floating interest rate certificate at the end of the
period.
(b) Not meaningful.
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 NINE MONTHS ENDED
MARCH 31, MARCH 31,
--------------------------- --------------------------
2004 2003 2004 2003
------------ ----------- ------------ ----------
EARNINGS
(a) Net Income $ (33,182) $ 221 $ (84,272) $ 4,153
========= ====== ========= ========
AVERAGE COMMON SHARES
(b) Average common shares outstanding 3,182 2,941 3,033 2,909
Average potentially dilutive shares (i) 162 (ii) 134
--------- ------ --------- --------
(c) Average common and potentially
dilutive shares 3,182 3,103 3,033 3,043
========= ====== ========= ========
EARNINGS PER COMMON SHARE
Basic (a/b) $ (10.53) $ 0.07 $ (27.79) $ 1.43
Diluted (a/c) $ (10.53) $ 0.06 $ (27.79) $ 1.36
(i) 233 shares anti-dilutive for the period
(ii) 116 shares anti-dilutive for the period
37
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
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.
38
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 2004
13. SEGMENT INFORMATION (CONTINUED)
TREASURY
NINE MONTHS ENDED LOAN AND RECONCILING
MARCH 31, 2004: ORIGINATION FUNDING SERVICING ALL OTHER ITEMS CONSOLIDATED
----------- ------- --------- --------- ----------- ------------
EXTERNAL REVENUES:
Gain on sale of loans:
Securitizations $ 15,107 $ - $ - $ - $ - $ 15,107
Whole loan sales 10,207 - - - - 10,207
Interest income 8,570 19 369 30,959 - 39,917
Non-interest income 2,668 - 35,269 - (30,932) 7,005
INTER-SEGMENT REVENUES - 48,355 - 27,863 (76,218) -
OPERATING EXPENSES:
Interest expense 17,596 47,888 (891) 34,131 (48,355) 50,369
Non-interest expense 55,788 6,234 27,991 21,566 - 111,579
Depreciation and amortization 1,727 48 638 3,125 - 5,538
Securitization assets
valuation adjustments - - - 37,848 - 37,848
INTER-SEGMENT EXPENSE 58,795 - - - (58,795) -
INCOME TAX EXPENSE (BENEFIT) (36,995) (2,202) 3,002 (14,382) - (50,577)
--------- --------- --------- --------- ---------- ---------
INCOME (LOSS) BEFORE DIVIDENDS ON
PREFERRED STOCK $ (60,359) $ (3,594) $ 4,898 $ (23,466) $ - $ (82,521)
========= ========= ========= ========= ========== =========
SEGMENT ASSETS $ 191,017 $ 254,530 $ 71,722 $ 512,316 $ (131,366) $ 898,219
========= ========= ========= ========= ========== =========
TREASURY
NINE MONTHS ENDED LOAN AND RECONCILING
MARCH 31, 2003: ORIGINATION FUNDING SERVICING ALL OTHER ITEMS CONSOLIDATED
----------- ------- --------- --------- ----------- ------------
EXTERNAL REVENUES:
Gain on sale of loans:
Securitizations $ 170,394 $ - $ - $ - $ - $ 170,394
Whole loan sales 29 - - - - 29
Interest income 5,930 322 590 34,361 - 41,203
Non-interest income 6,140 3 33,031 - (29,949) 9,225
INTER-SEGMENT REVENUES - 56,681 - 57,673 (114,354) -
OPERATING EXPENSES:
Interest expense 17,263 50,025 (247) 40,697 (56,681) 51,057
Non-interest expense 37,621 7,068 30,221 49,087 - 123,997
Depreciation and amortization 2,467 84 885 2,250 - 5,686
Securitization assets
valuation adjustment - - - 33,303 - 33,303
INTER-SEGMENT EXPENSE 87,622 - - - (87,622) -
INCOME TAX EXPENSE (BENEFIT) 14,633 (67) 1,077 (12,988) - 2,655
--------- --------- --------- --------- ---------- ---------
INCOME (LOSS) BEFORE DIVIDENDS ON
PREFERRED STOCK $ 22,887 $ (104) $ 1,685 $ (20,315) $ - $ 4,153
========= ========= ========= ========= ========== =========
SEGMENT ASSETS $ 100,636 $ 192,470 $ 126,763 $ 647,729 $ (94,659) $ 972,939
========= ========= ========= ========= ========== =========
39
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 financial services organization operating mainly in
the eastern and central portions of the United States. Recent expansion has
positioned us to 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 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. Certain business purpose
loans originated by us in prior periods are held for sale. 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. However, our
business strategy adjustments include increasing loan originations by offering
adjustable-rate loans. Our customers are primarily credit-impaired borrowers who
are generally unable to obtain financing from banks or savings and loan
associations and who are attracted to our products and services. We originate
loans through a combination of channels including a national processing center
located at our centralized operating office in Philadelphia, Pennsylvania, and a
small office in Roseland, New Jersey. We also recently acquired a broker
operation in West Hills, California and opened new broker offices in Edgewater,
Maryland and Irvine, 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 direct retail branch offices.
Effective June 30, 2003, we no longer originate loans through direct 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 by the end of fiscal 2004. 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.
40
Our loan origination volumes, and accordingly our financial results,
are affected by the economic environment, including interest rates, consumer
spending and debt levels, real estate values and employment rates. Additionally,
our loan originations are affected by competitive conditions and regulatory
influences.
Our principal revenues are derived from gains on the sale of loans in
either securitizations or whole loan sales, interest accretion on our
interest-only strips, interest income earned on loans while they are carried on
our balance sheet and income from servicing loans.
Our principal expenses include interest expense incurred on our
subordinated debentures and senior collateralized subordinated notes, interest
expense incurred to fund loans while they are carried on our balance sheet, the
provision for losses recognized on loans carried on our balance sheet and loans
repurchased from securitization trusts, employee related costs, marketing costs,
costs to service and collect loans and other administrative expenses.
Our critical success factors include our ability to originate loans,
our ability to sell loans into securitizations or on a whole loan basis, our
ability to maintain credit and warehouse facilities to fund loan originations,
and our ability to raise capital through the sale of subordinated debentures.
THE FIRST EXCHANGE OFFER. On December 1, 2003, we mailed an Offer to
Exchange, referred to as the first 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 debentures 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 certain 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
issued in this exchange offer plus priority lien obligations secured by the
interest-only strips and/or the cash flows from the interest-only strips;
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 behind the existing and future debt of our
subsidiaries and equally in right of payment with the deficiency portion of the
senior collateralized subordinated notes, and any future subordinated debentures
issued by us and other unsecured debt. At March 31, 2004, our interest in the
cash flows from the interest-only strips held in the trust, which secure the
senior collateralized subordinated notes totaled $438.5 million, of which
approximately $83.1 million represented 150% of the outstanding principal
balance of the senior collateralized subordinated notes.
41
Pursuant to the terms of the first exchange offer, in the first closing
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 first exchange offer to February 6, 2004. As
a result of the second closing on February 6, 2004, we exchanged an additional
$43.6 million of eligible subordinated debentures for 22.7 million shares of
Series A Preferred Stock and $20.9 million of senior collateralized subordinated
notes.
THE SECOND EXCHANGE OFFER. In May 2004, we plan to mail a second
exchange offer to holders of our subordinated debentures issued prior to
November 1, 2003. Holders of such subordinated debentures will have the ability
to exchange their debentures 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 second exchange offer will have interest rates
equal to 10 basis points above the subordinated debentures tendered. For senior
collateralized subordinated notes issued in exchange for subordinated debentures
with maturities of 36 months or less, maturity dates will be the remaining
maturity date of the subordinated debenture tendered, while subordinated
debentures with maturities greater than 36 months will be exchanged for senior
collateralized subordinated notes with the same maturity or reduced to 36
months, at the option of the holders. The senior collateralized subordinated
notes issued in the second exchange offer will be 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 principal balance of senior collateralized
subordinated notes outstanding plus priority lien obligations secured by the
interest-only strips and/or the cash flow from the interest-only strips;
provided that, such collateral coverage may not fall below 100% of the principal
balance of the senior collateralized subordinated notes outstanding, 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 outstanding is not sufficient to repay these notes, the
deficiency portion of the senior collateralized subordinated notes outstanding
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 deficiency portion of the senior
collateralized subordinated notes to be issued in this exchange offer,
subordinated debentures issued by us and other unsecured debt.
We are making the second exchange offer to increase our stockholders'
equity and to reduce the amount of our outstanding debt. An increase in the
stockholders' equity and a reduction in the outstanding debt will assist us in:
o achieving compliance with the financial covenants contained in our
credit facilities and certain of our servicing agreements;
o complying with the continued listing standards contained in the
NASDAQ Marketplace Rules which include a requirement to maintain
stockholders' equity of at least $10.0 million; and
o enhancing our ability to implement our adjusted business strategy
and to obtain additional financing to fund our ongoing operations,
including securitization opportunities, to the extent they arise.
42
CURRENT FINANCIAL POSITION AND FUTURE LIQUIDITY ISSUES. On March 31,
2004, we had cash of approximately $31.4 million (including unrestricted cash of
$16.2 million) and up to $364.4 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 fourth quarter of fiscal 2004 may not be sufficient to cover our
operating cash requirements.
For the next six to twelve 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. We can provide no assurances that we will be able to continue issuing
subordinated debentures. In the event that we are unable to offer additional
subordinated debentures for any reason, we have developed a contingent financial
restructuring plan. See "-- Business Strategy Adjustments" for a discussion of
this plan.
Several events and issues have negatively impacted our short-term
liquidity and contributed to our losses for fiscal 2003 and the first nine
months of fiscal 2004, including our inability to complete our typical publicly
underwritten securitization during the fourth quarter of fiscal 2003 and the
first and third quarters 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 $82.5 million for the
fiscal year ended June 30, 2003 and the first nine months of fiscal 2004,
respectively. In addition, depending on our ability to recognize gains on our
future securitizations, we anticipate incurring operating losses at least
through the first quarter of fiscal 2005.
For the third quarter of fiscal 2004, we recorded a net loss before
dividends on preferred stock of $31.4 million. The loss primarily resulted from
liquidity issues we have experienced since the fourth quarter of fiscal 2003,
which substantially reduced our loan origination volume and our ability to
generate revenues, our inability to complete a securitization during the third
quarter, and a net $15.1 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 third quarter of fiscal 2004.
During the nine months ended March 31, 2004, we recorded gross pre-tax
valuation adjustments on our securitization assets primarily related to
prepayment experience of $63.0 million, of which $43.1 million was charged to
the income statement and $19.9 million was charged to other comprehensive
income. The valuation adjustment on interest-only strips for the nine months
ended March 31, 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. Of this amount, $5.3 million offset the portion of
the adjustment expensed through the income statement and $3.1 million offset the
portion of the adjustment charged to other comprehensive income.
43
As a result of these liquidity issues, since June 30, 2003, our loan
origination volume was substantially reduced. From July 1, 2003 through March
31, 2004, we originated $468.6 million of loans which represents a significant
reduction as compared to originations of $1.18 billion 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, if any, 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 lost
since June 30, 2003 and building 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."
At March 31, 2004, we had total indebtedness of approximately $727.9
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 March 31, 2004 to assets
which are available to repay those obligations (in thousands):
SECURED AND UNSECURED
SENIOR DEBT SUBORDINATED TOTAL
OBLIGATIONS DEBENTURES DEBT/ASSETS
----------- ------------ -----------
Outstanding debt obligations (a)(f)...... $ 142,064 (b) $ 585,797 $ 727,861
========= ========= =========
Assets available to repay debt:
Cash................................. $ - $ 16,178 $ 16,178 (c)
Loans................................ 90,887 (d) 30,631 121,518
Interest-only strips (f)............. 167,409 (a)(b) 329,300 496,709 (e)
Servicing rights..................... - 82,823 82,823 (e)
--------- --------- --------
Total assets available............... $ 258,296 $ 458,932 $ 717,228
========= ========= =========
(a) Includes the impact of the exchange of $117.2 million of subordinated
debentures (unsecured subordinated debentures) for $55.4 million of senior
collateralized subordinated notes (secured and senior debt obligations) and
61.8 million shares of Series A Preferred Stock in the December 31, 2003 and
February 6, 2004 closings of the first exchange offer. At March 31, 2004,
our interest in the cash flows from the interest-only strips held in the
trust, which secure the senior collateralized subordinated notes totaled
$438.5 million, of which $83.1 million represents 150% of the principal
balance of the senior collateralized subordinated notes outstanding at March
31, 2004. For presentation purposes, $83.1 million is included in the column
entitled "secured and senior debt obligations" in the table above.
(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 $56.2 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 $15.2 million at March 31, 2004.
(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
March 31, 2004.
(f) The effects on this table of every $1,000,000 of existing subordinated
debentures that is exchanged in the second exchange offer for a combination
of $500,000 of senior collateralized subordinated notes and 500,000 shares
of Series A preferred stock would be as follows for "Outstanding debt
obligations": the column entitled "unsecured subordinated debentures" would
decrease by $1,000,000; the column entitled "secured and senior debt
obligations" would increase by $500,000. The effect for "Interest-only
strips" would be as follows: the column entitled "unsecured subordinated
debentures" would decrease by $750,000; the column entitled "secured and
senior debt obligations" would increase by $750,000.
44
REMEDIAL STEPS TAKEN TO ADDRESS LIQUIDITY ISSUES. Since June 30, 2003,
we undertook specific remedial actions to address short-term liquidity concerns
including selling loans on a whole loan basis, securing new credit and warehouse
facilities, refinancing an off-balance sheet mortgage conduit facility, mailing
the first exchange offer to holders of our subordinated debentures and
suspending the payment of quarterly dividends on our common stock.
We entered into an agreement on June 30, 2003 with an investment bank
to sell up to $700.0 million of mortgage loans, entered into a forward sale
agreement in March 2004 for $300.0 million of mortgage loans and solicited bids
and commitments from other participants in the whole loan sale market. In total,
from June 30, 2003 through March 31, 2004, we sold approximately $729.8 million
(which includes $222.3 million of loans sold by the expired mortgage conduit
facility described under "-- Liquidity and Capital Resources -- Credit
Facilities") of loans through whole loan sales.
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,
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.
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. Under the terms of this conduit facility it terminated
upon the disposition of the loans held by it.
On December 1, 2003, we mailed the first exchange offer to holders of
our subordinated debentures issued prior to April 1, 2003. See " -- The First
Exchange Offer." In May 2004, we intend to mail a second exchange offer, to
holders of our subordinated debentures issued prior to November 1, 2003.
See "-- The Second Exchange Offer."
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 continued 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.
45
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
have replaced certain of the loan origination employees we lost since June 30,
2003 and developed our expanded broker initiative in order to increase loan
originations. On December 24, 2003, we hired an experienced industry
professional who manages the wholesale business and 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
our loan origination volume from our 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. In addition, in February 2004, we hired a second
experienced industry professional to start up a broker operation on the west
coast. In March 2004, we opened a mortgage broker office in Maryland and hired
three experienced senior managers and a loan origination staff of 40. In
addition, we hired 12 mortgage broker account executives to expand our broker
presence in the eastern, southern and mid-western areas of the U.S. 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
In addition to the adjustments to our business strategy described
above, 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 debenture 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,
obtaining working capital funding 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.
CREDIT FACILITIES, SERVICING AGREEMENTS AND WAIVERS RELATED TO
FINANCIAL COVENANTS. As a result of the losses experienced in fiscal 2003 and
the first nine months of fiscal 2004, we failed to comply with the terms of
certain of the financial covenants in our credit facilities. We requested and
obtained waivers from our lenders, as necessary, for our non-compliance with
financial covenants as of June 30, 2003, September 30, 2003, October 31, 2003,
November 30, 2003, December 31, 2003 and March 31, 2004. See "-- Liquidity and
Capital Resources -- Credit Facilities" and "-- Liquidity and Capital Resources
- -- Waivers and Amendments of Financial Covenants" for more detail.
46
In addition, as a result of our non-compliance at September 30, 2003
with the net worth covenant in several of our pooling and servicing and sale and
servicing agreements (collectively, "servicing agreements"), we requested and
obtained waivers of the non-compliance from the two financial insurers
representing bondholders or certificateholders under separate servicing
agreements (collectively, "bond insurers"). In connection with the granting of
these waivers, these two bond insurers required amendments to their associated
servicing agreements providing for term-to-term servicing, which the associated
bond insurer may fail to renew in its sole discretion. Two other bond insurers
also required us to amend the servicing agreements with respect to which each
serves as bond insurer to provide, in the case of one bond insurer, for
term-to-term servicing and a designated back-up servicer, and in the case of the
other bond insurer, for a designated back-up servicer.
As a result of these amendments to our servicing agreements, all of our
servicing agreements associated with the bond insurers now provide for
term-to-term servicing with provisions for reappointment that vary among the
agreements. See "-- Liquidity and Capital Resources."
Because we anticipate incurring losses through at least the first
quarter of fiscal 2005, 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 $243.9
million at March 31, 2004 from $229.1 million at June 30, 2003 and $170.8
million at June 30, 2002. The managed portfolio includes loans held as available
for sale on our balance sheet and loans serviced for others. 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 11.12% at
March 31, 2004 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, 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 $229.4
million of previously delinquent loans at March 31, 2004, 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, reflect it as a
delinquent loan in our delinquency statistics and resume collection actions.
During the final six months of fiscal 2003 and the first six months 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 $229.4 million of cumulative unpaid principal balance of
loans under deferment and forbearance arrangements at June 30, 2003 and March
31, 2004, 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 10.46% at March
31, 2004 compared to 4.52% at June 30, 2002. Additionally, there are loans under
deferment and forbearance arrangements which have returned to delinquent status.
At March 31, 2004, there was $49.6 million of cumulative unpaid principal
balance under deferment arrangements and $55.1 million of cumulative unpaid
principal balance under forbearance arrangements that are now reported as
delinquent 31 days or more. See "-- Total Portfolio Quality -- Deferment and
Forbearance Arrangements."
47
CLASS ACTIONS AND DERIVATIVE ACTION LAWSUITS. On January 21, 2004,
January 28, 2004, February 12, 2004 and February 18, 2004, four 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 and the fourth suit also name former director, Richard Kaufman,
as a defendant. The complaints are captioned: Weisinger v. American Business
Financial Services, Inc. et al, Civil Action No. 04-265; Ruane v. American
Business Financial Services, Inc. et al, Civil Action No. 04-400, Operative
Plasterers' and Cement Masons' International Employees' Trust Fund v. American
Business Financial Services, Inc. et al, Civil Action No. 04-617, and Vieni v.
American Business Financial Services, Inc. et al, Civil Action No. 04-687. The
lawsuits were brought by purchasers of our common stock who were seeking to
represent a class of all purchasers of our common stock for a proposed class
period January 27, 2000 through June 25, 2003 with respect to the first two
suits and fourth suit filed. A proposed class period for the third suit is
January 27, 2000 through June 12, 2003. As of May 3, 2004, no motions for class
certification have been filed.
The first two and fourth lawsuits allege that, among other things, we
and the named directors and officers violated Sections 10(b) and 20(a) of the
Exchange Act. These three 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 three
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. These three
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 Exchange Act 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.
As of May 3, 2004, the four cases were consolidated, and two competing
motions for appointment of lead plaintiff were pending before the court.
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania. The complaint is captioned: Osterbauer v. Santilli et al, Civil
Action No. 04-1105. The lawsuit was brought nominally on behalf of the Company,
as a shareholder derivative action, alleging that the named directors and
officers breached their fiduciary duties to the Company, engaged in the abuse of
control, gross mismanagement and other violations of law during the period from
January 27, 2000 through June 25, 2003. The lawsuit seeks unspecified
compensatory damages, equitable or injunctive relief and costs and expenses
related to bringing the action, and other unspecified relief. The parties have
agreed to stay this case pending disposition of any motion to dismiss the
anticipated consolidated amended complaint filed in the putative securities
class actions.
Procedurally, these lawsuits are in a very preliminary stage. 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.
48
LISTING ON THE AMERICAN STOCK EXCHANGE AND THE NASDAQ STOCK MARKET. We
have applied to list our common stock on the American Stock Exchange, referred
to as AMEX in this document, and our application is under review by the AMEX
staff. We believe we meet all of the requirements for listing on AMEX. However,
we cannot assure you that we will be able to list our common stock for trading
on AMEX.
On April 1, 2004, we received a notice from the NASDAQ Stock Market
that we were not in compliance with the requirement for continued listing of our
common stock on the NASDAQ National Market System on the basis that we have not
met the requirement that the minimum market value of our publicly held shares
equal at least $5.0 million. Our non-compliance with this requirement is the
result of recent declines in the price of our common stock which we believe is
partially the result of an extremely large short position in our stock and
manipulation aimed at depressing the bid price utilized to calculate this
requirement. Under NASDAQ rules, we have 90 days, or until June 28, 2004, to
become compliant with this requirement for a period of 10 consecutive trading
days. If we do not meet this requirement, our common stock will not continue to
be listed on the NASDAQ National Market System and we may elect to have our
stock traded on the NASDAQ SmallCap Market. If we are unable to maintain our
listing on the NASDAQ National Market or list our common stock on AMEX or
another permitted exchange, the value of our common stock and our ability to
continue to sell subordinated debentures would be negatively impacted by making
the process of complying with the state securities laws more difficult, costly
and time consuming. As a result, we may be unable to continue to sell
subordinated debentures in certain states, which would have a material adverse
effect on our liquidity and our ability to repay maturing debt when due.
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 continue replacing the loan origination employees we lost during
the first six months of fiscal 2004 and build on our 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 senior officers to manage the broker program. We have made progress in this
initiative. In December 2003, we hired an experienced industry professional who
manages our wholesale business and acquired a broker operation with 35 employees
located in California. In February 2004, we hired a second experienced industry
professional to start up a broker operation on the west coast. In March 2004, we
opened a mortgage broker office in Maryland and hired three experienced senior
managers and a loan origination staff of 40. In addition, we hired 12 mortgage
broker account executives to expand our broker presence in the eastern, southern
and mid-western areas of the U.S.
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. We expect to execute our securitizations, if
any, 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.
49
o Broadening our mortgage loan product line and increasing loan
originations. Historically we have originated primarily fixed-rate
loans. Under our business strategy, we plan to originate
adjustable-rate, alt-A and alt-B 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.
During the three months ended March 31, 2004, 19.5% of the loans
which we originated were adjustable-rate mortgage loans.
o Offering more competitive interest rates charged to borrowers on
new products. By offering more competitive interest rates charged
on new products, we expect to originate loans with higher credit
quality. In addition, by offering more 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.
o Reducing origination of the types of loans that are not well
received in the whole loan sale and securitization markets. During
the first three quarters of fiscal 2004, we did not originate any
business purpose loans. We intend 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.
o Reducing the cost of loan originations. We have implemented plans
to:
o reduce the cost to originate in our Upland Mortgage direct
channel by broadening the product line and offering more
competitive interest rates in order to increase origination
volume, and reducing marketing costs;
o reduce the cost to originate in our broker channel by: a)
increasing volume by broadening the mortgage loan product
line, b) consolidating some of the broker channel's operating
functions to our centralized operating office in Philadelphia,
and c) developing and expanding broker relationships through
our broker initiative; 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 net attrition of
approximately 90 additional employees, an 8% reduction, who have
resigned since June 30, 2003. We expect that our workforce will
increase over the current level as we replace loan origination
employees.
50
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.
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.
51
Although we are licensed or otherwise qualified to originate loans in
43 states, our loan originations are concentrated mainly in the eastern half of
the United States. Recent expansion has positioned us to increase originations
in the western portion of the United States, especially California. 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.
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.
CLASS ACTIONS AND DERIVATIVE ACTION LAWSUITS. On January 21, 2004,
January 28, 2004, February 12, 2004 and February 18, 2004, four 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 and the fourth suit also name former director, Richard Kaufman,
as a defendant. The complaints are captioned: Weisinger v. American Business
Financial Services, Inc. et al, Civil Action No. 04-265; Ruane v. American
Business Financial Services, Inc. et al, Civil Action No. 04-400, Operative
Plasterers' and Cement Masons' International Employees' Trust Fund v. American
Business Financial Services, Inc. et al, Civil Action No. 04-617, and Vieni v.
American Business Financial Services, Inc. et al, Civil Action No. 04-687. The
lawsuits were brought by purchasers of our common stock who were seeking to
represent a class of all purchasers of our common stock for a proposed class
period January 27, 2000 through June 25, 2003 with respect to the first two
suits and fourth suit filed. A proposed class period for the third suit is
January 27, 2000 through June 12, 2003. As of May 3, 2004, no motions for class
certification have been filed.
The first two and fourth lawsuits allege that, among other things, we
and the named directors and officers violated Sections 10(b) and 20(a) of the
Exchange Act. These three 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 three
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. These three
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 Exchange Act 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.
As of May 3, 2004, the four cases were consolidated, and two competing
motions for appointment of lead plaintiff were pending before the court.
52
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania. The complaint is captioned: Osterbauer v. Santilli et al, Civil
Action No. 04-1105. The lawsuit was brought nominally on behalf of the Company,
as a shareholder derivative action, alleging that the named directors and
officers breached their fiduciary duties to the Company, engaged in the abuse of
control, gross mismanagement and other violations of law during the period from
January 27, 2000 through June 25, 2003. The lawsuit seeks unspecified
compensatory damages, equitable or injunctive relief and costs and expenses
related to bringing the action, and other unspecified relief. The parties have
agreed to stay this case pending disposition of any motion to dismiss the
anticipated consolidated amended complaint filed in the putative securities
class actions.
Procedurally, these lawsuits are in a very preliminary stage. 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.
CIVIL SUBPOENA. 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 13 months following the agreement. 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.
53
Under our revised forbearance policy, eligible borrowers are 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.
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.
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 nine months ended March
31, 2004 were 21.0% of total revenues compared to 77.2% for the nine months
ended March 31, 2003. The decline in the percentage of total revenues comprised
of securitization gains resulted from our inability to complete securitizations
in the first and third quarters of fiscal 2004 and the reduction in loans
originated during the first nine 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.
54
INTEREST-ONLY STRIPS. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 55.3% of our
total assets at March 31, 2004 and 51.6% of our total assets at June 30, 2003
and are carried at their fair values. Fair value is based on a discounted cash
flow analysis which estimates the present value of the future expected residual
cash flows and overcollateralization cash flows utilizing assumptions made by
management at the time the loans are sold. These assumptions include the rates
used to calculate the present value of expected future residual cash flows and
overcollateralization cash flows, referred to as the discount rates, and
expected prepayment and credit loss rates on pools of loans sold through
securitizations. We believe the accounting estimates used in determining the
fair value of interest-only strips are critical accounting estimates because
estimates of prepayment and credit loss rates are made based on management's
expectation of future experience, which is based in part, on historical
experience, current and expected economic conditions and in the case of
prepayment rate assumptions, consideration of the impact of changes in market
interest rates. The actual loan prepayment rate may be affected by a variety of
economic and other factors, including prevailing interest rates, the
availability of alternative financing to borrowers and the type of loan. We
re-evaluate expected future cash flows from our interest-only strips on a
quarterly basis. We monitor the current assumptions for prepayment and credit
loss rates against actual experience and other economic and market conditions
and we adjust assumptions if deemed appropriate. Even a small unfavorable change
in our assumptions made as a result of unfavorable actual experience or other
considerations could have a significant adverse impact on our estimate of
residual cash flows and on the value of these assets. In the event of an
unfavorable change in these assumptions, the fair value of these assets would be
overstated, requiring an accounting adjustment. In accordance with the
provisions of Emerging Issues Task Force guidance on issue 99-20, "Recognition
of Interest Income and Impairment on Purchased and Retained Beneficial Interests
in Securitized Financial Assets," referred to as EITF 99-20 in this document,
and SFAS No. 115 "Accounting for Certain Investments in Debt and Equity
Securities," referred to as SFAS No. 115 in this document, changes in the fair
value of interest-only strips that are deemed to be temporary changes are
recorded through other comprehensive income, a component of stockholders'
equity. Other than temporary adjustments to decrease the fair value of
interest-only strips are recorded through the income statement, which would
adversely affect our income in the period of adjustment.
During the nine months ended March 31, 2004, we recorded total pre-tax
valuation adjustments on our interest only-strips of $49.1 million, of which, in
accordance with EITF 99-20, $32.4 million was charged to the income statement
and $16.8 million was charged to other comprehensive income. The valuation
adjustment reflects the impact of higher than anticipated prepayments on
securitized loans experienced during the nine months ended March 31, 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 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.
55
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 9.2% of our total assets at March 31, 2004 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.
Amortization of the servicing rights asset for securitized loans is
calculated individually for each securitized loan pool and is recognized in
proportion to, and over the period of, estimated future servicing income on that
particular pool of loans. A review for impairment is performed on a quarterly
basis by stratifying the serviced loans by loan type, which is considered to be
the predominant risk characteristic. If our analysis indicates the carrying
value of servicing rights is not recoverable through future cash flows from
contractual servicing and other ancillary fees, a valuation allowance or write
down would be required.
During the nine months ended March 31, 2004, our valuation analysis
indicated that valuation adjustments of $5.5 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. 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.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is maintained
primarily to account for loans 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
based upon a variety of factors, including, periodic analysis of the available
for sale loans, 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
charge-offs reduce the allowance. If the actual collection of outstanding loans
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 March 31, 2004 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 related to
interest-only strips and servicing rights in the nine months ended March 31,
2004, see "-- Securitizations."
56
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.
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.
57
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.
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.
From the second quarter of fiscal 2002 through the second quarter of
fiscal 2004, we increased the prepayment rate assumptions used to value our
securitization assets, thereby decreasing the fair value of these assets. See
"-- Securitizations" for discussion of the impacts of these increases in
prepayment rate assumptions.
58
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 and "-- Overview -- Current Financial Position and
Future Liquidity Issues" for information concerning our use of off-balance sheet
arrangements in fiscal 2003, fiscal 2004 and our expectations for future
periods.
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.
59
At March 31, 2004 and June 30, 2003, the mortgage securitization trusts
held loans with an aggregate principal balance due of $2.2 billion and $3.4
billion as assets and owed $2.0 billion and $3.2 billion to third party
investors, respectively. Revenues from the sale of loans to securitization
trusts were $15.1 million, or 21% of total revenues for the nine months ended
March 31, 2004 and $170.4 million, or 77.2% of total revenues for the nine
months ended March 31, 2003. The revenues for the nine months ended March 31,
2004 and March 31, 2003 are net of $2.2 million and $5.1 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 $496.7 million and $82.8 million,
respectively at March 31, 2004, which combined represent 64.5% of our total
assets. Net cash flows received from interest-only strips and servicing rights
were $146.3 million for the nine months ended March 31, 2004 and $89.0 million
for the nine months ended March 31, 2003. These amounts are included in our
operating cash flows.
We also used special purpose entities in our sales of loans to a $300.0
million off-balance sheet mortgage conduit facility 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.
60
Declines in market interest rates had resulted in reductions in the
levels of securitization pass-through interest rates leading to an improvement
in interest rate spreads in our more recent securitizations. 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 ten 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, our prepayment rates, as well as those throughout the mortgage
industry, remained at higher than expected levels due to continuing low interest
rates during this period. As a result, over the last ten quarters we have
recorded cumulative pre-tax write downs to our interest-only strips in the
aggregate amount of $151.1 million and pre-tax adjustments to the value of
servicing rights of $10.8 million, for total adjustments of $161.9 million,
mainly due to the higher than expected prepayment experience. Of this amount,
$105.1 million was expensed through the income statement and $56.8 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 nine months ended March 31, 2004, we recorded gross pre-tax
valuation adjustments on our securitization assets primarily related to
prepayment experience of $63.0 million, of which $43.1 million was charged to
the income statement and $19.9 million was charged to other comprehensive
income. The valuation adjustment on interest-only strips related to prepayment
experience for the nine months ended March 31, 2004 was partially 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 nine
months ended March 31, 2004 between interest-only strips and servicing rights
was as follows:
o We recorded gross pre-tax valuation adjustments on our interest
only-strips of $57.5 million, of which $37.6 million was charged
to the income statement and $19.9 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 nine months of fiscal
2004 due to the continuing low interest rate environment. The
valuation adjustment on interest-only strips for the nine months
ended March 31, 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. 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.
61
o We recorded total pre-tax valuation adjustments on our servicing
rights of $5.5 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 nine 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 March 15, 2004 that mortgage refinancings as a percentage share of total
mortgage originations will decline from 51% in the first quarter of calendar
2004 to 30% in the first quarter of calendar 2005. The Mortgage Bankers
Association of America has also projected in its March 2004 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):
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
March 31, 2004 23,191 15,085 8,106
--------- -------- --------
Total Fiscal 2004 $ 54,573 $ 37,848 $ 16,725
========= ======== ========
62
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 and nine months ended March 31, 2004 and 2003
(dollars in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------- ------------------------
SECURITIZATIONS: 2004 2003 2004 2003
--------- ---------- --------- -----------
Business loans................................. $ -- $ 33,748 $ 11,027 $ 93,267
Home equity loans.............................. -- 369,881 130,380 1,083,676
--------- ---------- --------- -----------
Total....................................... $ -- $ 403,629 $ 141,407 $ 1,176,943
========= ========== ========= ===========
Gain on sale of loans through securitization.. $ -- $ 54,504 $ 15,107 $ 170,394
Securitization gains as a percentage of total
revenue...................................... n/a 75.9% 21.0% 77.2%
Whole loan sales............................... $ 228,629 $ 702 $ 481,807 $ 2,239
Premiums on whole loan sales................... $ 7,208 $ (4) $ 10,207 $ 29
As demonstrated in the fourth quarter of fiscal 2003 and the first nine
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.
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, conditions in the asset-backed
securities markets relating to the loans we originate, credit quality of the
total portfolio of loans we originate or potential changes to the legal and
accounting principles underlying securitization transactions.
63
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
March 31, 2004, investments in interest-only strips totaled $496.7 million,
including the fair value of overcollateralization related cash flows of
$239.6 million.
TRIGGER MANAGEMENT. Repurchasing delinquent loans from securitization
trusts benefits us by allowing us to limit the level of delinquencies and losses
in the securitization trusts and as a result, we can avoid exceeding specified
limits on delinquencies and losses that trigger a temporary reduction or
discontinuation of cash flow from our interest-only strips until the delinquency
or loss triggers are no longer exceeded. We have the right, but are not
obligated, to repurchase a limited amount of delinquent loans from
securitization trusts. In addition, we elect to repurchase loans in situations
requiring more flexibility for the administration and collection of these loans.
The purchase price of a delinquent loan is at the loan's outstanding contractual
balance. A foreclosed loan is one where we, as servicer, have initiated formal
foreclosure proceedings against the borrower and a delinquent loan is one that
is 31 days or more past due. The foreclosed and delinquent loans we typically
elect to repurchase are usually 90 days or more delinquent and the subject of
foreclosure proceedings, or where a completed foreclosure is imminent. The
related allowance for loan losses on these repurchased loans is included in our
provision for credit losses in the period of repurchase. Our ability to
repurchase these loans does not disqualify us for sale accounting under SFAS No.
140 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.
64
At March 31, 2004, five 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 $12.9 million of excess overcollateralization is being held by the
five trusts as of March 31, 2004. For the nine months ended March 31, 2004, we
repurchased delinquent loans with an aggregate unpaid principal balance of $49.7
million from securitization trusts primarily for trigger management. We cannot
predict when the five 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 nine months of fiscal 2004 and fiscal years 2003 and 2002. We received
$36.8 million, $37.6 million and $19.2 million of proceeds from the liquidation
of repurchased loans and REO for the nine months ended March 31, 2004 and for
fiscal years 2003 and 2002, respectively. We carried as assets on our balance
sheet, repurchased loans and REO in the amounts of $7.0 million, $9.6 million
and $9.4 million at March 31, 2004 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.
65
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
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
NINE MONTHS ENDED MARCH 31, 2004:
Business loans................ $ 219 $ 592 $ 1,008 $ 589 $ 2,202 $ 247 $ 1,257 $ 943 $ 1,467 $ 1,054
Home equity loans............. -- 1,129 2,236 3,094 3,092 2,026 3,137 2,844 4,341 1,967
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total....................... $ 219 $ 1,721 $ 3,244 $ 3,683 $ 5,294 $ 2,273 $ 4,394 $ 3,787 $ 5,808 $ 3,021
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original Balance of Loans
Securitized................... 0.05% 0.57% 0.91% 1.34% 1.93% 1.52% 1.45% 1.6% 2.62% 1.36%
Number of loans repurchased... 1 23 32 53 59 25 55 56 91 43
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
------- ------- ------- ------- ------- ------- ------- ------- --------
NINE MONTHS ENDED MARCH 31, 2004:
Business loans................ $ 1,044 $ 470 $ 458 $ 455 $ 49 $ 350 $ 720 $ -- $ 13,124
Home equity loans............. 3,823 3,033 1,115 2,866 327 970 481 100 36,581
------- ------- ------- ------- ------- ------- ------- ------- --------
Total....................... $ 4,867 $ 3,503 $ 1,573 $ 3,321 $ 376 $ 1,320 $ 1,201 $ 100 $ 49,705
======= ======= ======= ======= ======= ======= ======= ======= ========
% of Original Balance of Loans
Securitized................... 2.21% 1.89% 1.97% 1.66% 0.31% 1.26% 0.69% 0.16%
Number of loans repurchased... 65 48 23 36 5 17 16 1 649
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.
SFAS No. 140 was effective on a prospective basis for transfers and
servicing of financial assets and extinguishments of liabilities occurring after
March 31, 2001. SFAS No. 140 requires that we record an obligation to repurchase
loans from securitization trusts at the time we have the contractual right to
repurchase the loans, whether or not we actually repurchase them. For
securitization trusts 2001-2 and forward, to which this rule applies, we have
the contractual right to repurchase a limited amount of loans greater than 180
days past due. In accordance with the provisions of SFAS No. 140, we have
recorded on our March 31, 2004 balance sheet a liability of $42.8 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.
66
MORTGAGE LOAN SECURITIZATION TRUST INFORMATION. The following tables
provide information regarding the nature and principal balances of mortgage
loans securitized in each trust, the securities issued by each trust, and the
overcollateralization requirements of each trust.
SUMMARY OF SELECTED MORTGAGE LOAN SECURITIZATION TRUST INFORMATION
CURRENT BALANCES AS OF MARCH 31, 2004
(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.......................... $ 25 $ 26 $ 24 $ 25 $ 25 $ 20 $ 18
Home equity loans....................... 132 294 211 171 163 119 106
------- ------- ------- ------- ------- ------- -------
Total................................... $ 157 $ 320 $ 235 $ 196 $ 188 $ 139 $ 124
======= ======= ======= ======= ======= ======= =======
WEIGHTED-AVERAGE INTEREST RATE ON LOANS
SECURITIZED:
Business loans.......................... 15.61% 15.89% 16.00% 15.96% 15.99% 15.75% 15.79%
Home equity loans....................... 8.91% 9.67% 10.46% 10.86% 10.91% 10.87% 10.69%
Total................................... 9.99% 10.17% 11.03% 11.51% 11.60% 11.57% 11.45%
Percentage of first mortgage loans......... 88% 87% 87% 87% 87% 91% 90%
Weighted-average loan-to-value............. 76% 77% 76% 77% 76% 75% 77%
Weighted-average remaining term (months) on
loans securitized..................... 272 257 246 238 223 220 217
Original balance of Trust Certificates..... $ 173 $ 450 $ 376 $ 370 $ 380 $ 320 $ 322
Current balance of Trust Certificates...... $ 155 $ 301 $ 213 $ 183 $ 175 $ 124 $ 110
Weighted-average pass-through interest rate
to Trust Certificate holders(a)....... 8.00% 5.20% 6.34% 6.78% 8.27% 8.28% 5.35%
Highest Trust Certificate pass-through
interest rate......................... 8.00% 3.78% 8.61% 6.86% 7.39% 6.29% 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............ $ 2 $ 18 $ 22 $ 13 $ 13 $ 14 $ 13
Final target reached or anticipated
date to reach......................... 12/2004 12/2004 Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach................................. 1/2007 4/2006 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......................... $ -- $ 12 $ 9 $ 7 $ 8 $ 6 $ 5
- --------------------
(a) Rates for securitizations 2001-2 and forward include rates on notional
bonds, or the impact of premiums to loan collateral received on trust
certificates, included in securitization structure. The sale of notional
bonds allows us to receive more cash at the closing of a securitization.
(b) Credit enhancement was provided through a senior/subordinate certificate
structure.
67
SUMMARY OF SELECTED MORTGAGE LOAN SECURITIZATION TRUST INFORMATION (CONTINUED)
CURRENT BALANCES AS OF MARCH 31, 2004
(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 $ 21 $ 15 $ 9 $ 6 $ 11 $ 9
Home equity loans....................... 92 96 68 62 31 66 45
------- ------- ------- ------- ------- ------- -------
Total................................... $ 110 $ 117 $ 83 $ 71 $ 37 $ 77 $ 54
======= ======= ======= ======= ======= ======= =======
WEIGHTED-AVERAGE INTEREST RATE ON LOANS
SECURITIZED:
Business loans.......................... 15.93% 15.94% 15.96% 16.09% 16.05% 16.05% 16.17%
Home equity loans....................... 11.11% 11.23% 11.44% 11.60% 11.42% 11.43% 11.40%
Total................................... 11.89% 12.06% 12.24% 12.19% 12.12% 12.11% 12.18%
Percentage of first mortgage loans......... 90% 90% 89% 86% 90% 84% 80%
Weighted-average loan-to-value............. 75% 76% 75% 76% 76% 76% 76%
Weighted-average remaining term (months) on
loans Securitized..................... 210 206 204 196 195 201 190
Original balance of Trust Certificates..... $ 306 $ 355 $ 275 $ 275 $ 150 $ 300 $ 235
Current balance of Trust Certificates...... $ 98 $ 102 $ 72 $ 65 $ 34 $ 68 $ 47
Weighted-average pass-through interest rate
to Trust Certificate holders (a)........ 5.74% 6.48% 8.44% 7.05% 7.61% 7.04% 7.01%
Highest Trust Certificate pass-through
interest rate........................... 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 $ 11 $ 6 $ 4 $ 9 $ 6
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(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 $ 1 $ 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.
(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.
68
SUMMARY OF SELECTED MORTGAGE LOAN SECURITIZATION TRUST INFORMATION (CONTINUED)
CURRENT BALANCES AS OF MARCH 31, 2004
(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.......................... $ 8 $ 9 $ 8 $ 4 $ 10 $ 7 $ 4
Home equity loans....................... 48 46 47 39 74 15 3
------- ------- ------- ------- ------- ------- -------
Total................................... $ 56 $ 55 $ 55 $ 43 $ 84 $ 22 $ 7
======= ======= ======= ======= ======= ======= =======
WEIGHTED-AVERAGE INTEREST RATE ON LOANS
SECURITIZED:
Business loans.......................... 16.14% 15.93% 15.81% 15.59% 15.81% 15.93% 15.97%
Home equity loans....................... 11.00% 10.82% 10.51% 10.62% 10.82% 11.52% 11.08%
Total................................... 11.74% 11.62% 11.26% 11.12% 11.41% 12.91% 13.88%
Percentage of first mortgage loans......... 86% 87% 89% 93% 90% 82% 78%
Weighted-average loan-to-value............. 76% 76% 76% 77% 76% 76% 65%
Weighted-average remaining term (months) on
loans Securitized....................... 188 191 198 197 182 138 101
Original balance of Trust Certificates..... $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61
Current balance of Trust Certificates...... $ 50 $ 50 $ 49 $ 39 $ 75 $ 19 $ 5
Weighted-average pass-through interest rate
to Trust Certificate holders............ 6.83% 6.77% 6.66% 6.56% 6.37% 7.17% 7.67%
Highest Trust Certificate pass-through
interest rate........................... 7.68% 7.49% 7.13% 6.58% 6.67% 7.28% 7.67%
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% 16.45%
REQUIRED DOLLAR AMOUNTS:
Initial................................. $ 2 $ 2 $ 1 $ 1 $ 7 $ 4 $ 1
Final target............................ $ 12 $ 11 $ 11 $ 9 $ 26 $ 13 $ 6
CURRENT STATUS:
Overcollateralization amount............ $ 6 $ 6 $ 5 $ 4 $ 9 $ 3 $ 3
Final target reached or anticipated
date to reach......................... Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach................................. Yes Yes Yes Yes Yes(b) Yes Yes(b)
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......................... $ 2 $ 2 $ 2 $ 2 $ 3 $ 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.
69
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.
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 March 31, 2004, 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,
which were considered at that time:
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 had
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:
70
o Underlying loan collateral with fixed interest rates, which are
higher than others in the non-conforming mortgage industry. Average
interest rate of securitized loans exceeds the industry average by
100 basis points or more. All of the securitized loans have fixed
interest rates, which are more predictable than adjustable rate
loans.
o At origination, approximately 90% to 95% of securitized business
purpose loans had prepayment fees and approximately 80% to 85% of
securitized home equity loans had prepayment fees. At March 31,
2004, in our total portfolio, approximately 45% to 50% of
securitized business purpose loans had prepayment fees and
approximately 55% to 60% of securitized home equity loans had
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 85-90% and
10-15%, 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 March 31, 2004, 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 8.4% at March 31, 2004 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.
71
As was previously discussed, for the past ten 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..................................... $ 2,229,320
Balance sheet carrying value of retained interests (a)............. $ 579,532
Weighted-average collateral life (in years)........................ 3.9
- -------------
(a) Amount includes interest-only strips and servicing rights.
72
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............................. $ 22,194 $ 42,513
Credit loss rate............................. 4,354 8,709
Floating interest rate certificates (a)...... 680 1,361
Discount rate................................ 15,085 29,423
- ---------------
(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."
73
The following tables provide information regarding the initial and
current assumptions applied in determining the fair values of mortgage loan
related interest-only strips and servicing rights for each securitization trust.
SUMMARY OF MATERIAL MORTGAGE LOAN SECURITIZATION
VALUATION ASSUMPTIONS AND ACTUAL EXPERIENCE AT MARCH 31, 2004
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............................. (c) 11% 11% 11% 11% 11% 11%
Current valuation............................. (c) 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:
Expected Constant Prepayment Rate (CPR):
Business loans ............................. 10% 10% 10% 10% 10% 10% 10%
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.............................. 8% 13% 16% 18% 20% 23% 21%
Home equity loans........................... 10% 17% 17% 17% 17% 19% 21%
CURRENT PREPAYMENT EXPERIENCE (b):
Business loans.............................. 13% 26% 14% 25% 20% 32% 19%
Home equity loans........................... 18% 37% 47% 49% 43% 46% 42%
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% 0.04% 0.10% 0.15% 0.15% 0.24%
Servicing fees:
Contractual fees.............................. (c) 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%
Ancillary fees................................ (c) 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. Starting with 2001-4, 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. Starting with 2001-1, the home equity loan prepayment ramp
begins at 2% in month one and ramps to an expected rate over 30 months.
(b) Current experience is a six-month historical average.
(c) Servicing rights for the 2003-2 loans were sold to a third party servicer.
74
SUMMARY OF MATERIAL MORTGAGE LOAN SECURITIZATION
VALUATION ASSUMPTIONS AND ACTUAL EXPERIENCE AT MARCH 31, 2004 (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:
Expected Constant Prepayment Rate (CPR):
Business loans ............................... 10% 10% 10% 10% 10% 10% 10%
Home equity loans............................. 22% 22% 22% 22% 22% 22% 22%
Ramp period (months):
Business loans................................ 24 24 24 Na Na Na Na
Home equity loans............................. Na Na Na Na Na Na Na
CPR adjusted to reflect ramp:
Business loans................................ 18% 15% 12% 10% 10% 10% 10%
Home equity loans............................. 22% 22% 22% 22% 22% 22% 22%
CURRENT PREPAYMENT EXPERIENCE (b):
Business loans................................ 24% 26% 22% 53% 29% 20% 21%
Home equity loans............................. 41% 40% 43% 43% 44% 35% 40%
Annual credit loss rates:
Initial assumption.............................. 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Current assumption.............................. 0.50% 0.45% 0.70% 0.50% 0.55% 0.60% 0.80%
Actual experience............................... 0.51% 0.41% 0.65% 0.51% 0.52% 0.57% 0.73%
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% 1.25% 1.25% 1.25%
- ----------
(a) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected Constant Prepayment Rate. The business loan
prepayment ramp begins at 3% in month one ramps to an expected peak rate
over 27 months then declines to the final expected CPR by month 40. The
home equity loan prepayment ramp begins at 2% in month one and ramps to an
expected rate over 30 months.
(b) Current experience is a six-month historical average.
Na = not applicable
75
SUMMARY OF MATERIAL MORTGAGE LOAN SECURITIZATION
VALUATION ASSUMPTIONS AND ACTUAL EXPERIENCE AT MARCH 31, 2004 (CONTINUED)
1999-4 1999-3 1999-2 1999-1 1998 (c) 1997 (c) 1996 (c)
------ ------ ------ ------ -------- -------- --------
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:
Expected Constant Prepayment Rate (CPR):
Business loans ........................... 10% 10% 10% 10% 10% 10% 10%
Home equity loans......................... 22% 22% 22% 22% 22% 22% 22%
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............................ 10% 10% 10% 10% 10% 10% 10%
Home equity loans......................... 22% 22% 22% 22% 22% 22% 22%
CURRENT PREPAYMENT EXPERIENCE (b):
Business loans............................ 29% 26% 41% 34% 25% 29% 17%
Home equity loans......................... 40% 36% 40% 37% 40% 26% 23%
Annual credit loss rates:
Initial assumption.......................... 0.30% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
Current assumption.......................... 0.75% 0.70% 0.45% 0.55% 0.58% 0.40% 0.45%
Actual experience........................... 0.81% 0.68% 0.45% 0.54% 0.54% 0.36% 0.39%
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% 1.25% 1.25% 1.25%
- ---------
(a) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected Constant Prepayment Rate. The business loan
prepayment ramp begins at 3% in month one ramps to an expected peak rate
over 27 months then declines to the final expected CPR by month 40. The
home equity loan prepayment ramp begins at 2% in month one and ramps to an
expected rate over 30 months.
(b) Current experience is a six-month historical average.
(c) Amounts represent weighted-average percentages for four 1998
securitization pools, two 1997 securitization pools and two 1996
securitization pools.
Na = not applicable
76
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 Estimates -- Servicing Rights" for a
discussion of the $5.5 million write down of servicing rights recorded in the
first nine months of fiscal 2004 and "-- Application of Critical Accounting
Estimates -- 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 March
31, 2004. 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,
reaching specified loss levels on underlying mortgage pools and failure to
obtain renewals under term-to-term agreements. All of our servicing agreements
associated with bond insurers now provide for term-to-term servicing with terms
ranging from 30 days to 120 days. Under the term-to-term servicing provisions in
certain of our servicing agreements, the associated bond insurers have the right
to elect not to re-appoint us as servicer in their sole discretion. See
"-- Overview -- Credit Facilities, Servicing Agreements and Waivers Related to
Financial Covenants" and "-- Liquidity and Capital Resources."
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.
77
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 total 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 ten quarters, our prepayment experience has exceeded our
expectations for prepayments on our total 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 nine months ended March 31, 2004 and 2003. 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 NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------- PERCENTAGE ------------------------ PERCENTAGE
2004 2003 DECREASE 2004 2003 DECREASE
-------- ------- ---------- -------- -------- ----------
Total revenues........................... $ 23,444 $71,766 (67.3)% $ 72,236 $220,851 (67.3)%
Total expenses........................... 74,138 71,737 3.3 % 205,334 214,043 (4.1)%
Income (loss) before
dividends on preferred stock........... (31,431) 221 (82,521) 4,153
Dividends on preferred stock............. 1,751 -- 1,751 --
Net income (loss) attributable
to common stock........................ (33,182) 221 (84,272) 4,153
Return on average equity................. (a) 1.17% (a) 7.47%
Return on average assets................. (a) 0.09% (a) 0.60%
Earnings (loss) per common share:
Basic................................. $ (10.53) $ 0.07 $ (27.79) $ 1.43
Diluted............................... $ (10.53) $ 0.06 $ (27.79) $ 1.36
Common dividends declared per share...... $ -- $ 0.08 $ -- $ 0.24
(a) Not meaningful.
78
SUMMARY
For the third quarter of fiscal 2004, we recorded a net loss
attributable to common stock of $33.2 million. The loss primarily resulted from
liquidity issues which substantially reduced our ability to originate loans and
generate revenues during the third quarter of fiscal 2004, our inability to
complete a securitization of loans during the quarter ended March 31, 2004,
expense levels that would support greater loan origination volume, and $15.1
million of pre-tax charges for valuation adjustments on our securitization
assets charged to the income statement. Dividends of $1.75 million were recorded
on the Series A preferred stock, which was issued in the first exchange offer.
Loan origination volume decreased to $241.5 million for the quarter
ended March 31, 2004, compared to origination volume of $403.7 million for the
same period in fiscal 2003, due to our previously discussed short term liquidity
issues. While we originated loans at a substantially reduced level during the
third quarter, our expense base for the quarter would have supported greater
origination volume.
For the nine months ended March 31, 2004, we recorded a net loss
attributable to common stock of $84.3 million compared to net income
attributable to common stock of $4.2 million for the same period in fiscal 2003.
Decreases in the gain on sale of loans recorded during the first nine months of
fiscal 2004 were marginally offset by the favorable impact of trading activity,
general and administrative expenses, and sales and marketing expenses. Dividends
of $1.75 million were recorded on the Series A preferred stock, which was issued
in the first exchange offer. 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 March 31, 2004, we recorded total pre-tax
adjustments on our securitization assets of $23.2 million, of which $15.1
million was reflected as an expense on the income statement and $8.1 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 $84.3 million loss and the $16.7 million pre-tax
reduction to other comprehensive income for adjustments on our securitization
assets for the nine months ended March 31, 2004 partially offset by the
favorable impact of the first exchange offer, total stockholders' equity was
reduced to $10.2 million at March 31, 2004. For the same period in fiscal 2003,
we recorded total pre-tax valuation adjustments of $50.0 million, of which $33.3
million was reflected as an expense on the income statement and $16.7 million
was reflected as an adjustment to other comprehensive income.
The loss per common share for the first nine months of fiscal 2004 was
$27.79 per share on average common shares of 3,033,000 compared to diluted net
income per share of $1.36 per share on average common shares of 3,043,000 for
the first nine months of fiscal 2003. No common dividends were paid in the first
nine months of fiscal 2004. Common dividends of $0.24 per share were paid for
the first nine months of fiscal 2003. The common dividend payout ratio based on
diluted earnings per share was 17.6% for the first nine 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 first
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 the first 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.
79
LOAN ORIGINATIONS
The following schedule details our loan originations (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------- ----------------------
2004 2003 2004 2003
-------- -------- -------- ----------
Home equity loans............ $241,449 $371,554 $468,585 $1,084,170
Business purpose loans....... -- 32,119 -- 93,170
-------- -------- -------- ----------
Total loan originations....... $241,449 $403,673 $468,585 $1,177,340
======== ======== ======== ==========
Home equity loans are originated by our subsidiaries, HomeAmerican
Credit, doing business as Upland Mortgage, and American Business Mortgage
Services, Inc., and purchased through the Bank Alliance Services program. Total
home equity loan originations decreased $615.6 million, or 56.8%, for the nine
months ended March 31, 2004 to $468.6 million from $1.1 billion for the nine
months ended March 31, 2003. Liquidity issues had substantially reduced our
ability to originate home equity loans. 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 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 acquired a broker operation located in West Hills,
California, opened broker offices in Irvine, California and Edgewater, Maryland
and have expanded the broker business within HomeAmerican Credit. See " --
Business Strategy."
The following schedule details our home equity loan originations by
source for the three and nine month periods ended March 31, 2004 and 2003 (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
-------------------- -----------------------
2004 2003 2004 2003
-------- -------- -------- ----------
Direct channel................... $135,212 $126,043 $281,435 $ 378,773
Retail branches ............... -- 40,491 649 123,569
Broker channel ................. 66,847 154,544 79,861 441,169
Bank Alliance Services program .. 39,390 50,476 106,640 $ 140,659
-------- -------- -------- ----------
Total home equity loans.......... $241,449 371,554 $468,585 $1,084,170
======== ======== ======== ==========
During the first nine months of fiscal 2004, our subsidiary, American
Business Credit, Inc., did not originate any business purpose loans. During the
nine months ended March 31, 2003, American Business Credit, Inc. originated
$93.2 million of business purpose loans. Previously discussed liquidity issues
have substantially reduced our ability to originate business purpose loans
during the first three 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 may continue to originate business purpose loans,
however at lower volumes, to meet demand in the whole loan sale and
securitization markets. See " -- Business Strategy."
80
REVENUES
TOTAL REVENUES. For the third quarter of fiscal 2004 total revenues
decreased $48.3 million, or 67.3%, to $23.4 million from $71.8 million for
fiscal 2003. For the first nine months of fiscal 2004 total revenues decreased
$148.6 million, or 67.3%, to $72.2 million from $220.9 million for the first
nine months of fiscal 2003. Our ability to borrow under credit facilities to
finance new loan originations was limited for much of the first six months of
fiscal 2004 and our inability to complete a securitization in the first and
third quarters of fiscal 2004 accounted for this decrease in total revenues.
GAIN ON SALE OF LOANS -- SECURITIZATIONS. During the third quarter of
fiscal 2004, we were unable to complete a securitization of loans, and therefore
no gains were recorded. In the third quarter of fiscal 2003 we recorded gains of
$54.5 million on the securitization of $403.6 million of loans. For the nine
months ended March 31, 2004, gains of $15.1 million were recorded on the
securitization of $141.5 million of loans. This was a decrease of $155.3
million, or 91.1% below gains of $170.4 million recorded on securitizations of
$1.2 billion of loans for the nine months ended March 31, 2003.
The decrease in securitization gains for the three and nine months
ended March 31, 2004 was due to our inability to complete securitizations of
loans during the first and third quarters and our reduced level of loan
originations during the first nine months of fiscal 2004. We completed a
privately-placed securitization, with servicing released, recognizing gains on
$136.0 million of loans in the second quarter. The $15.1 million in gains
recorded in the nine months ended March 31, 2004 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 realized 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 $7.2 million for the three months ended March 31, 2004, from a loss
of $4 thousand for the three months ended March 31, 2003. For the nine months
ended March 31, 2004, gains on whole loan sales increased to $10.2 million from
gains of $29 thousand for the nine months ended March 31, 2003. The volume of
whole loan sales increased $479.6 million, to $481.8 million for the nine months
ended March 31, 2004 from $2.2 million for the nine months ended March 31, 2003.
The increase in the volume of whole loan sales for the nine months ended March
31, 2004 resulted from management's decision to adjust its business strategy to
emphasize more whole loan sales and our inability to complete securitizations in
the fourth quarter of fiscal 2003 and the first and third quarters of fiscal
2004. See "-- Business Strategy" and "-- Liquidity and Capital Resources" for
further detail.
INTEREST AND FEES. For the third quarter of fiscal 2004, interest and
fee income increased $0.2 million, or 4.4%, to $4.9 million compared to $4.7
million in the same period of fiscal 2003. For the nine months ended March 31,
2004, interest and fee income decreased $1.7 million, or 12.7%, to $11.7 million
compared to $13.4 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 loans originated and sold during the same quarter.
The following schedule details interest and fees (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
-------------- ------------------
2004 2003 2004 2003
------ ------ ------- -------
Interest on loans and invested cash..........$3,711 $2,705 $ 8,975 $ 6,842
Other fees................................... 1,159 1,960 2,715 6,551
------ ------ ------- -------
Total interest and fees......................$4,870 $4,665 $11,690 $13,393
====== ====== ======= =======
81
During the third quarter of fiscal 2004, interest income increased $1.0
million, or 37.2%, to $3.7 million from $2.7 million for the third quarter of
fiscal 2003. The increase for the third quarter was due to a higher average
balance of loans carried on balance sheet during the third quarter of fiscal
2004 resulting from our inability to complete a securitization in the third
quarter of fiscal 2004. During the nine months ended March 31, 2004, interest
income increased $2.1 million, or 31.2%, to $9.0 million from $6.8 million for
the nine months ended March 31, 2003. The increase for the nine-month period
resulted from our carrying a higher average loan balance during the first and
third quarters of fiscal 2004 as compared to fiscal 2003 due to our inability to
complete securitizations in the fourth quarter of fiscal 2003 and the first and
third quarters of fiscal 2004. This increase was offset by a decrease of $0.5
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 third quarter of fiscal 2004, other fees decreased $0.8
million, or 40.9%, to $1.2 million from $2.0 million for the third quarter of
fiscal 2003. Other fees decreased $3.8 million for the nine months ended March
31, 2004, or 58.6%, to $2.7 million from $6.6 million for the nine months ended
March 31, 2003. These decreases were mainly due to our reduced ability to
originate loans during these periods. Our ability to collect certain fees in
connection with loans we originate and sell in the future may be impacted by
proposed laws and regulations by various authorities. See "-- Legal and
Regulatory Considerations."
INTEREST ACCRETION ON INTEREST-ONLY STRIPS. Interest accretion of $9.6
million and $30.9 million were earned in the three and nine months ended March
31, 2004 compared to $12.1 million and $34.4 million in the three and nine
months ended March 31, 2003. The decrease reflects the decline in the balance of
our interest-only strips of $113.2 million, or 18.6%, to $496.7 million at March
31, 2004 from $609.9 million at March 31, 2003. However, cash flows from
interest-only strips for the nine months ended March 31, 2004 totaled $111.8
million, an increase of $55.4 million from the nine months ended March 31, 2003
due to 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 March 31, 2004, servicing
income increased $0.8 million, to $1.3 million from $0.5 million for the three
months ended March 31, 2003. For the nine months ended March 31, 2004, servicing
income increased $1.1 million, or 42.9%, to $3.8 million from $2.7 million for
the nine months ended March 31, 2003. Because loan prepayment levels in the
first nine months of fiscal 2004 increased from the first nine months of fiscal
2003, the amortization of servicing rights has also increased. Amortization is
recognized in proportion to contractual and ancillary fees collected. Therefore
the collection of additional prepayment fees in the first nine months of fiscal
2004 has resulted in higher levels of amortization.
The following table summarizes the components of servicing income for
the three and nine months ended March 31, 2004 and 2003 (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
--------------------- ------------------
2004 2003 2004 2003
-------- -------- -------- --------
Contractual and ancillary fees...............$ 9,825 $ 11,232 $ 34,777 $ 32,682
Amortization of servicing rights............. (8,542) (10,746) (30,967) (30,015)
-------- -------- -------- --------
Net servicing income.........................$ 1,283 $ 486 $ 3,810 $ 2,667
======== ======== ======== ========
82
EXPENSES
TOTAL EXPENSES. Total expenses increased $2.4 million, or 3.3%, to
$74.1 million for the three months ended March 31, 2004 compared to $71.7
million for the three months ended March 31, 2003. Total expenses decreased $8.7
million, or 4.1%, to $205.3 million for the nine months ended March 31, 2004
compared to $214.0 million for the nine months ended March 31, 2003. As
described in more detail below, the increase for the third quarter of fiscal
2004 was due to increases in employee related costs, provision for loan losses
and securitization assets valuation adjustments. The decrease for the nine-month
period 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 nine months ended March
31, 2004, partially offset by increases in employee related costs, provision for
loan losses and securitization assets valuation adjustments.
INTEREST EXPENSE. The three major components of interest expense are
interest on subordinated debentures, interest on warehouse lines of credit used
to fund loans, and interest on senior collateralized subordinated notes. During
the third quarter of fiscal 2004, interest expense increased $0.1 million, or
0.5%, to $16.9 million compared to $16.8 million for the third quarter of fiscal
2003. During the first nine months of fiscal 2004, interest expense decreased
$0.7 million, or 1.3%, to $50.4 million compared to $51.1 million for the nine
months ended March 31, 2003.
The increase in interest expense for the three months ended March 31,
2004 was primarily attributable to higher average outstanding balances under
warehouse lines of credit due to a higher volume of loans held on balance sheet
during the period.
The decrease in interest expense for the nine months ended March 31,
2004 was primarily attributable to the decline in average subordinated
debentures outstanding as a result of the first exchange offer, partially offset
by higher average outstanding balances under warehouse lines of credit and
interest expense on senior collateralized subordinated notes issued in the first
exchange offer.
The following schedule details interest expense (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
-------------------- -------------------
2004 2003 2004 2003
------- -------- ------- -------
Interest on subordinated debentures...........$14,474 $ 16,439 $46,705 $49,997
Interest to fund loans....................... 1,264 356 2,435 989
Interest on senior collateralized subordinated
notes ..................................... 1,135 -- 1,144 --
Other interest................................ 28 29 85 71
------- -------- ------- -------
Total interest expense..................$16,901 $ 16,824 $50,369 $51,057
======= ======== ======= =======
Average subordinated debentures outstanding during the three months
ended March 31, 2004 were $610.0 million compared to $704.3 million during the
three months ended March 31, 2003, the decrease as a result of the first
exchange offer. Average interest rates paid on subordinated debentures
outstanding increased to 9.27% during the three months March 31, 2004 from 9.09%
during the three months ended March 31, 2003. Average subordinated debentures
outstanding during the nine months ended March 31, 2004 were $670.6 million
compared to $684.2 million during the nine months ended March 31, 2003. Average
interest rates paid on subordinated debentures outstanding decreased to 8.99%
during the nine months ended March 31, 2004 from 9.42% during the nine months
ended March 31, 2003.
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
83
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 March 2004
was 10.91%, an increase that reflects our financial condition. We expect to
reduce the interest rates offered on subordinated debentures over time as our
business and cash needs, our financial condition, liquidity, future results of
operations, market interest rates and competitive factors permit.
The average outstanding balances under warehouse lines of credit were
$152.7 million during the three months ended March 31, 2004, compared to $51.4
million during the three months ended March 31, 2003. The average outstanding
balances under warehouse lines of credit were $113.5 million during the nine
months ended March 31, 2004, compared to $42.3 million during the nine months
ended March 31, 2003. The increase in the average balance on warehouse lines was
due to a higher volume of loans held on balance sheet during the fiscal 2004
periods. 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 1.3% at March 31, 2003 to 1.1% at March 31,
2004.
Average senior collateralized subordinated notes was $47.2 million
during the three months ended March 31, 2004 resulting from the first exchange
offer. The average rate paid on senior collateralized subordinated notes
outstanding was 9.72% during the three months ended March 31, 2004.
PROVISION FOR CREDIT LOSSES. The provision for credit losses on loans
and leases available for sale for the three months ended March 31, 2004
increased $3.2 million, or 183.8%, to $4.9 million, compared to $1.7 million for
the three months ended March 31, 2003. The provision for credit losses on loans
and leases available for sale for the nine months ended March 31, 2004 increased
$8.1 million, or 173.8%, to $12.8 million, compared to $4.7 million for the nine
months ended March 31, 2003. The increase in the provision for loan losses for
the three and nine month periods ended March 31, 2004 was primarily due to 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. During the nine months ended March
31, 2004 we repurchased $37.0 million of loans from securitization trusts,
compared to $19.5 million of loan repurchases for the comparable period in
fiscal 2003. Principal loss severity on repurchased loans generally ranged from
15% to 35%. See "--Securitizations -- Trigger Management" for further discussion
of repurchases from securitization trusts.
Non-accrual loans were $5.7 million at March 31, 2004, compared to $5.4
million at June 30, 2003 and $5.9 million at March 31, 2003. See "-- Total
Portfolio Quality" for further detail.
The allowance for credit losses was $2.3 million, or 1.8% of loans and
leases available for sale at March 31, 2004 compared to $2.8 million or 1.0% of
loans and leases available for sale at June 30, 2003 and $2.0 million, or 3.6%
of loans and leases available for sale at March 31, 2003. The allowance for
credit losses as a percentage of loans available for sale at March 31, 2004
increased from June 30, 2003 due to the decrease in the balance of accruing
loans available for sale relative to the amount of more heavily reserved
non-accrual loans carried on our balance sheet. Compared to March 31, 2003, the
allowance as a percentage of loans available for sale decreased due to the
higher balance of accruing loans. 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.
84
The following table summarizes changes in the allowance for credit
losses for the three and nine months ended March 31, 2004 and 2003 (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
----------------- -------- -------
2004 2003 2004 2003
------- ------- -------- -------
Balance at beginning of period.......... $ 3,184 $ 3,581 $ 2,848 $ 3,705
Provision for credit losses.............. 4,876 1,718 12,846 4,692
(Charge-offs) recoveries, net............ (5,784) (3,346) (13,418) (6,444)
------- ------- -------- -------
Balance at end of period................. $ 2,276 $ 1,953 $ 2,276 $ 1,953
======= ======= ======== ========
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 MARCH 31, 2004: LOANS LOANS LEASES TOTAL
----------------------------------------- ------- ------- -------- --------
Balance at beginning of period........... $ 696 $ 2,321 $ 167 $ 3,184
Provision for credit losses.............. 1,088 3,955 (167) 4,876
(Charge-offs) recoveries, net............ (1,281) (4,503) $ - (5,784)
------- ------- -------- --------
Balance at end of period................. $ 503 $ 1,773 $ - $ 2,276
======= ======= ======== ========
BUSINESS HOME
PURPOSE EQUITY EQUIPMENT
NINE MONTHS ENDED MARCH 31, 2004: LOANS LOANS LEASES TOTAL
----------------------------------------- ------- -------- --------- --------
Balance at beginning of period........... $ 593 $ 2,085 $ 170 $ 2,848
Provision for credit losses.............. 2,968 10,088 (210) 12,846
(Charge-offs) recoveries, net............ $(3,058) (10,400) 40 (13,418)
------- -------- -------- --------
Balance at end of period................. $ 503 $ 1,773 $ - $ 2,276
======= ======== ======== ========
BUSINESS HOME
PURPOSE EQUITY EQUIPMENT
THREE MONTHS ENDED MARCH 31, 2003: LOANS LOANS LEASES TOTAL
----------------------------------------- ------- -------- -------- --------
Balance at beginning of period........... $ 1,387 $ 1,898 $ 296 $ 3,581
Provision for credit losses.............. 229 1,392 97 1,718
(Charge-offs) recoveries, net............ (1,016) (2,153) (177) (3,346)
------- -------- -------- --------
Balance at end of period................. $ 600 $ 1,137 $ 216 $ 1,953
======= ======== ======== ========
BUSINESS HOME
PURPOSE EQUITY EQUIPMENT
NINE MONTHS ENDED MARCH 31, 2003: LOANS LOANS LEASES TOTAL
----------------------------------------- ------- -------- -------- --------
Balance at beginning of period........... $ 1,388 $ 1,998 $ 319 $ 3,705
Provision for credit losses.............. 1,079 3,257 356 4,692
(Charge-offs) recoveries, net............ (1,867) (4,118) (459) (6,444)
------- -------- -------- --------
Balance at end of period................. $ 600 $ 1,137 $ 216 $ 1,953
======= ======== ======== ========
85
The following table summarizes net charge-off experience by loan type
for the three and nine months ended March 31, 2004, and 2003 (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
-------------- ---------------
2004 2003 2004 2003
------ ------ ------- ------
Business purpose loans................... $1,281 $1,016 $ 3,058 $1,867
Home equity loans........................ 4,503 2,153 10,400 4,118
Equipment leases......................... - 177 (40) 459
------ ------ ------- ------
Total.................................... $5,784 $3,346 $13,418 $6,444
====== ====== ======= ======
EMPLOYEE RELATED COSTS. For the third quarter of fiscal 2004, employee
related costs increased $1.8 million, or 18.7%, to $11.2 million from $9.4
million in the third quarter of fiscal 2003. For the nine months ended March 31,
2004, employee related costs increased $6.9 million, or 22.9%, to $36.8 million
from $30.0 million in the prior year. The increase in employee related costs for
the three and nine months ended March 31, 2004 was primarily attributable to a
decrease in the amount of expenses deferred under SFAS No. 91, "Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases," referred to as SFAS No. 91 in this document,
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 $23.2 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 March 31, 2004 were 781 compared to 1,093 at March
31, 2003. Since June 30, 2003, our workforce has decreased by approximately 340
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 90
additional employees who have resigned since June 30, 2003. These workforce
reductions and resignations represent a 30% decrease in staffing levels from
June 30, 2003. As part of our business strategy's focus on offering a broader
mortgage product line, we have added 101 employees in our broker business since
December 31, 2003.
SALES AND MARKETING EXPENSES. For the third quarter of fiscal 2004, sales and
marketing expenses decreased $2.4 million, or 34.1%, to $4.6 million from $7.0
million for the third quarter of fiscal 2003. For the nine months ended March
31, 2004, sales and marketing expenses decreased $9.6 million, or 47.7%, to
$10.5 million from $20.1 million for the nine months ended March 31, 2003. The
decreases were primarily due to decreases in expenses for direct mail
advertising and broker commissions for home equity and business loan
originations. We expect to continue streamlining our sales and marketing costs
in the future by offering a wider array of loan products that we believe will
enable us to increase our loan origination conversion rates. By increasing our
conversion rates, we expect to be able to lower our overall sales and marketing
costs per dollar originated. See "-- Business Strategy" for further discussion.
TRADING (GAINS) AND LOSSES. During the three months ended March 31,
2004, we recognized net gains of $1.7 million on derivative financial
instruments and hedged items. This compares to net losses of $0.8 million for
the three months ended March 31, 2003. For the nine months ended March 31, 2004,
we recognized net gains of $6.8 million compared to net losses of $5.3 million
for the nine months ended March 31, 2003. For more detail on our hedging and
trading activities see "-- Interest Rate Risk Management -- Strategies for Use
of Derivative Financial Instruments."
GENERAL AND ADMINISTRATIVE EXPENSES. For the third quarter of fiscal
2004, general and administrative expenses decreased $2.1 million, or 8.4%, to
$23.3 million from $25.4 million for the third quarter of fiscal 2003. For the
nine months ended March 31, 2004, general and administrative expenses decreased
86
$5.9 million, or 8.5%, to $63.7 million from $69.6 million for the nine months
ended March 31, 2003. The decrease for the nine-month period was primarily
attributable to a decrease of $12.6 million in costs associated with servicing
and collecting our total managed portfolio including expenses associated with
REO and delinquent loans, and a $5.2 million decrease in costs associated with
customer retention incentives, partially offset by $8.9 million in fees on new
credit facilities, a $1.6 million increase in professional fee expenses, a $1.1
million increase in business insurance expense, and a $0.7 million write-off of
deferred selling costs related to the first exchange offer.
SECURITIZATION ASSETS VALUATION ADJUSTMENT. During the three months
ended March 31, 2004, we recorded total pre-tax valuation adjustments on our
securitization assets of $23.2 million, of which $15.1 million was reflected as
expense on the income statement and $8.1 million was reflected as an adjustment
to other comprehensive income. For the three months ended March 31, 2003, we
recorded total pre-tax valuation adjustments on our securitization assets of
$16.9 million, of which $10.7 million was reflected as expense on the income
statement and $6.2 million was reflected as an adjustment to other comprehensive
income.
During the nine months ended March 31, 2004, we recorded total pre-tax
valuation adjustments on our securitization assets of $54.6 million, of which
$37.8 million was reflected as an expense on the income statement and $16.7
million was reflected as an adjustment to other comprehensive income. During the
nine months ended March 31, 2003, we recorded total pre-tax valuation
adjustments on our securitization assets of $50.0 million, of which $33.3
million was reflected as an expense on the income statement and $16.7 million
was reflected as an adjustment to other comprehensive income.
See "-- Off-Balance Sheet Arrangements" and "-- Securitizations" for
further detail of these adjustments.
87
BALANCE SHEET INFORMATION
BALANCE SHEET DATA
(Dollars in thousands, except per share data)
MARCH 31, JUNE 30,
2004 2003
-------- ----------
Cash and cash equivalents......................... $ 31,375 $ 47,475
Loan and lease receivables, net:
Available for sale.............................. 121,518 271,402
Interest and fees............................... 20,655 15,179
Other........................................... 36,362 23,761
Interest-only strips.............................. 496,709 598,278
Servicing rights.................................. 82,823 119,291
Receivable for sold loans......................... -- 26,734
Deferred income tax asset......................... 38,581 --
Total assets...................................... 898,219 1,159,351
Subordinated debentures........................... 585,797 719,540
Senior collateralized subordinated notes.......... 55,420 --
Warehouse lines and other notes payable........... 86,644 212,916
Accrued interest payable.......................... 37,571 45,448
Deferred income tax liability..................... -- 17,036
Total liabilities................................. 888,055 1,117,282
Total stockholders' equity........................ 10,164 42,069
Book value per common share....................... $ 3.23 $ 14.28
Total assets decreased $261.1 million, or 22.5%, to $898.2 million at
March 31, 2004 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
reduced our ability to originate loans for sale, our operating losses during the
first, second and third quarters of fiscal 2004 and a reduction in the issuance
of subordinated debentures.
Loan and lease receivables - Available for sale decreased $149.9
million, or 55.2% due to whole loan sales and a privately-placed securitization
during the second quarter ended December 31, 2003, coupled with a reduction in
loan originations caused by our liquidity issues. Loan and lease receivables at
June 30, 2003 were at a historically high level due to our inability to complete
a securitization during the fourth quarter of fiscal 2003.
88
Activity of our interest-only strips for the nine months ended March
31, 2004 and 2003 was as follows (in thousands):
NINE MONTHS ENDED
MARCH 31,
-------------------------
2004 2003
--------- ---------
Balance at beginning of period..............................$ 598,278 $ 512,611
Initial recognition of interest-only strips................. 25,523 141,511
Cash flow from interest-only strips......................... (133,587) (109,849)
Required purchases of additional overcollateralization...... 21,826 53,496
Interest accretion.......................................... 30,942 34,361
Termination of lease securitization (a)..................... (1,759) (1,741)
Adjustment to obligation to repurchase loans................ 2,485 2,158
Net temporary adjustments to fair value (b)................. (14,651) 6,128
Other than temporary adjustments to fair value (b).......... (32,348) (28,784)
--------- ---------
Balance at end of period....................................$ 496,709 $ 609,891
========= =========
(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 nine months ended March 31, 2004 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)
2003-2 2003-1 2002-4 2002-3 Other(a) TOTAL
------ ------- ------ ------ -------- -------
NINE MONTHS ENDED MARCH 31, 2004:
Required purchases of additional
overcollateralization.....................$1,651 $13,377 $9,322 $1,978 $(4,502) $21,826
====== ======= ====== ====== ======= =======
(a) includes the recovery of $9.5 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
====== ======= ======= ======= ======= ======= ====== ====== ====== ===== =======
89
Servicing rights decreased $36.5 million, or 30.6%, to $82.8 million at
March 31, 2004 from $119.3 million at June 30, 2003, primarily due to our
inability to complete a securitization in the first and third quarters of fiscal
2004, completing a privately-placed securitization with servicing released in
the second quarter of fiscal 2004, amortization of servicing rights and a $5.5
million write down of servicing rights 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 $229.2 million, or 20.5%, to $888.1 million
at March 31, 2004 from $1,117.3 million at June 30, 2003 primarily due to
decreases in warehouse lines and other notes payable, subordinated debentures
outstanding and deferred income taxes. The decrease in warehouse lines and other
notes payable was due to sales during the first nine 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 nine months of fiscal 2004.
During the nine months ended March 31, 2004, subordinated debentures
decreased $133.7 million, or 18.6 %, to $585.8 million primarily due to the
conversion of $117.2 million of subordinated debentures into 61.8 million shares
of Series A Preferred Stock and $55.4 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 $38.6 million at March 31, 2004. This
change from a liability position is the result of the federal and state tax
benefits of $50.6 million recorded on our pre-tax loss for the nine months ended
March 31, 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
nine months ended March 31, 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
securitizations to whole loan sales; and the likely utilization of our net
operating loss carryforwards. In addition, a federal benefit of $5.2 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 $0.2 million overpayment on our June 30,
2002 federal tax return.
90
TOTAL PORTFOLIO QUALITY
The following table provides data concerning delinquency experience,
real estate owned and loss experience for the total loan and lease portfolio in
which we have interests, either because the loans and leases are on our balance
sheet or sold into securitizations in which we have retained interests. The
total portfolio is divided into the portion of the portfolio managed and
serviced by us and the portion of the portfolio serviced by others. See "--
Reconciliation of Non-GAAP Financial Measures" for a reconciliation of total
portfolio and REO measures to our balance sheet. See "-- Deferment and
Forbearance Arrangements" for the amounts of previously delinquent loans managed
by us subject to these deferment and forbearance arrangements which are not
included in this table if borrowers are current on principal and interest
payments as required under the terms of the original note (exclusive of
delinquent payments advanced or fees paid by us on the borrower's behalf as part
of the deferment or forbearance arrangement) (dollars in thousands):
MARCH 31, DECEMBER 31, SEPTEMBER 30,
2004 2003 2003
---------------------- ---------------------- ----------------------
DELINQUENCY BY TYPE AMOUNT % AMOUNT % AMOUNT %
- ------------------- ---------- ----- ---------- ----- ---------- -----
MANAGED BY ABFS:
BUSINESS PURPOSE LOANS
Total managed portfolio.................$ 278,608 $ 307,807 $ 364,970
========== ========== ==========
Period of delinquency:
31-60 days............................$ 4,864 1.75% $ 6,640 2.16% $ 5,761 1.57%
61-90 days............................ 5,798 2.08 7,109 2.31 6,129 1.68
Over 90 days.......................... 52,434 18.82 47,449 15.41 42,831 11.74
---------- ----- ---------- ----- ---------- -----
Total delinquencies...................$ 63,096 22.65% $ 61,198 19.88% $ 54,721 14.99%
========== ===== ========== ===== ========== =====
REO.....................................$ 4,411 $ 1,879 $ 4,491
========== ========== ==========
HOME EQUITY LOANS
Total managed portfolio.................$1,914,165 $2,179,052 $2,601,125
========== ========== ==========
Period of delinquency:
31-60 days............................$ 36,885 1.93% $ 53,522 2.46% $ 53,514 2.06%
61-90 days............................ 21,964 1.15 31,668 1.45 36,729 1.41
Over 90 days.......................... 121,999 6.37 125,212 5.75 122,997 4.73
---------- ----- ---------- ----- ---------- -----
Total delinquencies...................$ 180,848 9.45% $ 210,402 9.66% $ 213,240 8.20%
========== ===== ========== ===== ========== =====
REO.....................................$ 21,778 $ 22,359 $ 21,561
========== ========== ==========
EQUIPMENT LEASES
Total managed portfolio.................$ - $ 3,669 $ 5,705
========== ========== ==========
Period of delinquency:
31-60 days............................$ - -% $ 419 11.42% $ 248 4.34%
61-90 days............................ - - 93 2.54 40 0.70
Over 90 days.......................... - - 127 3.46 200 3.51
---------- ----- ---------- ----- ---------- -----
Total delinquencies...................$ - -% $ 639 17.42% $ 488 8.55%
========== ===== ========== ===== ========== =====
TOTAL MANAGED BY ABFS
Total managed portfolio...................$2,192,773 $2,490,528 $2,971,800
========== ========== ==========
Period of delinquency:
31-60 days............................$ 41,749 1.90% $ 60,581 2.43% $ 59,523 2.00%
61-90 days............................ 27,762 1.27 38,870 1.56 42,898 1.44
Over 90 days.......................... 174,433 7.95 172,788 6.94 166,028 5.59
---------- ----- ---------- ----- ---------- -----
Total delinquencies...................$ 243,944 11.12% $ 272,239 10.93% $ 268,449 9.03%
========== ===== ========== ===== ========== =====
REO.....................................$ 26,189 1.19% $ 24,238 0.97% $ 26,052 0.88%
========== ===== ========== ===== ========== =====
SERVICED BY OTHERS:
Total portfolio serviced by others......$ 156,644 $ 167,582 $ -
========== ========== ==========
Period of delinquency:
31-60 days............................$ 8,649 5.52% $ 10,112 6.04% $ - -%
61-90 days............................ 3,529 2.25 3,198 1.91 - -
Over 90 days.......................... 5,804 3.71 1,984 1.18 - -
---------- ----- ---------- ----- ---------- -----
Total delinquencies...................$ 17,982 11.48% $ 15,294 9.13% $ - -%
========== ===== ========== ===== ========== =====
91
TOTAL PORTFOLIO QUALITY (CONTINUED)
MARCH 31, DECEMBER 31, SEPTEMBER 30,
2004 2003 2003
------------------- ------------------- ------------------
AMOUNT % AMOUNT % AMOUNT %
---------- ----- ---------- ------ ---------- ----
TOTAL PORTFOLIO..................... $2,349,417 $2,658,110 $2,971,800
========== ========== ==========
Period of delinquency:
31-60 days...................... $ 50,398 2.15% $ 70,693 2.66% $ 59,523 2.00%
61-90 days...................... 31,291 1.33 42,068 1.58 42,898 1.44
Over 90 days.................... 180,237 7.67 174,772 6.58 166,028 5.59
---------- ----- ---------- ------ ---------- ----
Total delinquencies............. $ 261,926 11.15% $ 287,533 10.82% $ 268,449 9.03%
========== ===== ========== ====== ========== ====
REO............................... $ 26,189 1.11% $ 24,238 0.91% $ 26,052 0.88%
========== ===== ========== ====== ========== ====
Losses experienced during the period
(a)(b):
Loans........................... $ 10,923 1.71% $ 12,375 1.77% $ 8,100 0.97%
===== ====== ====
Leases.......................... - -% (41) (3.49)% 1 0.06%
---------- ===== ---------- ====== ---------- ====
Total Losses........................ $ 10,923 1.71% $ 12,334 1.76% $ 8,101 0.97%
========== ===== ========== ====== ========== ====
(a) Percentage based on annualized losses and average total portfolio.
(b) Losses recorded on our books were $7.6 million ($5.7 million from
charge-offs through the provision for loan losses and $1.9 million for
write downs of real estate owned) and losses absorbed by loan
securitization trusts were $3.3 million for the three months ended
March 31, 2004. 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 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):
MARCH 31, DECEMBER 31, SEPTEMBER 30,
2004 2003 2003
--------- ------------ ------------
Delinquent loans and leases on balance sheet (a)... $5,565 $7,213 $11,825
% of on balance sheet loan and lease receivables... 4.62% 6.18% 7.21%
Loans and leases in non-accrual status on balance
sheet (b).................................... $5,706 $6,896 $11,941
% of on balance sheet loan and lease receivables... 4.73% 5.91% 7.28%
Allowance for losses on available for sale loans
and leases................................... $2,276 $3,184 $ 5,470
% of available for sale loans and leases........... 1.84% 2.68% 3.25%
Real estate owned on balance sheet................. $2,508 $3,077 $ 4,566
____________________________
(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 $5.3 million, $6.6 million
and $10.7 million at March 31, 2004, December 31, 2003 and September 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.
92
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 may affect
the borrower's ability to make their regular payments. 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.
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 account 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 of collections or his designee.
93
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 principal and interest 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, we will generally declare the account in default, reflect it
as a delinquent loan in our delinquency statistics and resume collection
actions.
The following table presents, as of the end of our last eight 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
March 31, 2004................ 162,576 66,844 229,420 10.46
____________________________
(a) Included in cumulative unpaid principal balance are loans with arrangements
that were entered into longer than twelve months ago. At March 31, 2004,
there was $33.2 million of cumulative unpaid principal balance under
deferment arrangements and $35.1 million of cumulative unpaid principal
balance under forbearance arrangements that were entered into prior to
January 2003.
Additionally, there are loans under deferment and forbearance
arrangements, which have returned to delinquent status. At March 31, 2004 there
was $49.6 million of cumulative unpaid principal balance under deferment
arrangements and $55.1 million of cumulative unpaid principal balance under
forbearance arrangements that are now reported as delinquent 31 days or more.
94
During the final six months of fiscal 2003 and the first six months of
fiscal 2004, we experienced a pronounced increase in the number of borrowers
under deferment arrangements and in light of the weakened economic environment
during that twelve-month period 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 three 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
March 31, 2004................ 32,812 4,139 36,951 1.69
DELINQUENT LOANS AND LEASES. Total delinquencies (loans and leases with
payments past due greater than 30 days, excluding REO) in the total portfolio
were $261.9 million at March 31, 2004 compared to $229.1 million at June 30,
2003 and $220.1 million at March 31, 2003. Total delinquencies as a percentage
of the total portfolio were 11.15% at March 31, 2004 compared to 6.27% at June
30, 2003 and 6.33% at March 31, 2003. 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 and securitized
and an increase in whole loan sales with servicing released 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 $5.6 million at March 31, 2004.
REAL ESTATE OWNED. Total REO, comprising foreclosed properties and
deeds acquired in lieu of foreclosure, decreased to $26.2 million, or 1.11% of
the total portfolio at March 31, 2004 compared to $35.2 million, or 1.01% at
March 31, 2003. We discontinued requiring a borrower to execute a deed in lieu
of foreclosure as a condition to entering into a forbearance agreement. 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, may from time to time, include 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 the total 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 $2.5 million at March 31,
2004.
95
LOSS EXPERIENCE. During the three months ended March 31, 2004, we
experienced net loan and lease charge-offs in the total portfolio of $10.9
million, or 1.71% on an annualized basis, compared to net loan and lease
charge-offs in the total portfolio of $8.6 million, or 1.01% during the three
months ended March 31, 2003, and $12.3 million, or 1.76% during the three months
ended December 31, 2003. The increase in net loan charge-offs from the three
months ended March 31, 2003 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 "--
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.
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.
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.
96
INTEREST RATE SENSITIVITY. The following table provides information
about financial instruments that are sensitive to changes in interest rates. For
interest-only strips and servicing rights, the table presents projected
principal cash flows utilizing assumptions including prepayment and credit loss
rates. See "-- Off-Balance Sheet Arrangements -- Securitizations" for more
information on these assumptions. For debt obligations, the table presents
principal cash flows and related average interest rates by expected maturity
dates (dollars in thousands):
AMOUNT MATURING AFTER MARCH 31, 2004
---------------------------------------------------------------------------------------
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 available for sale (a).......... $116,850 $ 56 $ 60 $ 65 $ 71 $ 4,416 $121,518 $126,877
Interest-only strips.................. 122,222 113,137 95,733 73,210 57,191 203,961 665,454 496,709
Servicing rights...................... 25,825 20,284 15,897 12,464 9,765 30,748 114,983 82,823
Investments held to maturity.......... 328 448 72 -- -- -- 848 876
RATE SENSITIVE LIABILITIES:
Fixed interest rate borrowings........ $329,386 $188,941 $ 87,203 $ 12,113 $ 6,229 $ 18,391 $642,263 $640,993
Average interest rate................. 9.34% 9.53% 9.65% 9.62% 10.67% 11.98% 9.53%
Variable interest rate borrowings..... $ 85,598 $ -- $ -- $ -- $ -- $ -- $ 85,598 $ 85,598
Average interest rate................. 3.44% -- -- -- -- -- 3.44%
____________________________
(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.
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 0.20%.
See "-- Strategies for Use of Derivative Financial Instruments" for further
detail of our interest rate risk management for available for sale loans.
A significant variable affecting the gain on sale of fixed interest
rate loans sold in whole loan sale transactions is the change in market interest
rates between the date the loan was originated at a fixed rate of interest and
the date the loan was sold in a whole loan sale. If market interest rates
required by investors increase prior to sale of the loans, the premium expected
on sale of the loans would be reduced. This factor could have a material adverse
effect on our future results of operations and financial condition.
INTEREST-ONLY STRIPS AND SERVICING RIGHTS. A portion of the
certificates issued to investors by certain securitization trusts are floating
interest rate certificates based on one-month LIBOR plus an interest rate
spread. The fair value of the excess cash flow we will receive from these trusts
would be affected by any changes in interest rates paid on the floating interest
rate certificates. At March 31, 2004, $244 million of debt issued by loan
securitization trusts was floating interest rate certificates based on one-month
LIBOR, representing 12% of total debt issued by loan securitization trusts. In
accordance with accounting principles generally accepted in the United States of
97
America, the changes in fair value are generally recognized as part of net
adjustments to other comprehensive income, which is a component of retained
earnings. As of March 31, 2004, the interest rate sensitivity for $1.4 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 $147.6 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. At March 31, 2004, approximately 45-50% of business loans and
55-60% of home equity loans in the total portfolio were 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 March 31, 2004
approximately $312.1 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. The following discussion breaks down our use of derivative
financial instruments into hedging activity and trading activity.
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.
98
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 a
previous mortgage conduit facility, which we expected to be included in a term
securitization at a future date. The mortgage loans and mortgage loans
underlying residual interests in mortgage pools consisted 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. At March 31, 2004, we had $50.0 million of Eurodollar futures
contracts outstanding, which were designated as hedges of loans expected to be
sold through securitizations.
Related to Loans Expected to Be Sold Through Whole Loan Sale
Transactions. We may also utilize derivative financial instruments in an attempt
to mitigate the effect of changes in market interest rates between the date
loans are originated at fixed interest rates and the date that the loans will be
sold in a whole loan sale. We may hedge the effect of changes in market interest
rates with forward sale commitments, forward starting interest rate swaps,
Eurodollar futures, forward treasury sales or derivative contracts of similar
underlying securities.
In March 2004, we entered into a forward sale agreement providing for
the sale of $300.0 million of home equity mortgage loans and business purpose
loans at a price of 104.4%. During the month of March 2004, we sold $224.0
million of loans under this commitment, recognizing gains of $7.1 million on the
loans sold in the quarter ended March 31, 2004. At March 31, 2004, we recorded a
fair value adjustment of $2.1 million to write up $48.3 million of loans carried
on our balance sheet and committed for sale in April 2004 under this forward
sale agreement.
We recorded the following gains and losses on the fair value of
derivative financial instruments accounted for as hedges for the three and
nine-month periods ended March 31, 2004 and 2003. 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):
99
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------- --------------------
2004 2003 2004 2003
----------- ----------- ---------- --------
Offset by losses and gains recorded on
securitizations:
Gains (losses) on derivative financial
instruments.............................. $ -- $(2,071) $ -- $(3,806)
Offset by losses and gains recorded on the
fair value of hedged items:
Gains (losses) on derivative financial
instruments.............................. (1,066) (16) (1,714) (3,070)
Amount settled in cash - received (paid)..... (927) (2,619) (1,619) (5,041)
At March 31, 2004 and 2003, outstanding forward sale commitments,
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):
MARCH 31, 2004 MARCH 31, 2003
--------------------- -----------------------
Notional Unrealized Notional Unrealized
Amount (Loss) Amount (Loss)
------- ------ ------- -------
Forward loan sale commitment $76,032 $ -- $ -- $ --
Eurodollar futures contracts 50,000 (100) -- --
Forward starting interest rate swaps -- -- 47,497 (2,809)
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 nine-month periods ended March 31, 2003, we used interest rate
swap contracts to protect the future securitization spreads on loans in our
pipeline. Loans in the pipeline represent loan applications for which we are in
the process of obtaining all the documentation required for a loan approval or
approved loans, which have not been accepted by the borrower and are not
considered to be firm commitments. We believed there was a greater chance that
market interest rates we would obtain on the subsequent securitization of these
loans would increase rather than decline, and chose to protect the spread we
could earn in the event of rising rates.
However due to a decline in market interest rates during the period the
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 nine-month periods ended March 31, 2003. The losses are
summarized in the table below. During the three and nine-month periods ended
March 31, 2004, 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. Forward starting interest rate swap contracts with a notional
amount of $170.0 million were carried over from a disqualified hedging
relationship occurring in the fourth quarter of fiscal 2003. These forward
starting interest rate swap contracts 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.
100
We recorded the following gains and losses on forward starting interest
rate swap contracts classified as trading for the three and nine-month periods
ended March 31, 2004 and 2003 (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------------ --------------------------
2004 2003 2004 2003
------------- ------------- ----------- ------------
Trading Gains/(Losses) on forward
starting interest rate swaps:
Related to loan pipeline $ -- $ (784) $ -- $ (3,708)
Related to whole loan sales -- -- 5,097 --
Amount settled in cash - (paid) -- -- (1,212) (2,671)
At March 31, 2004, there were no outstanding derivative financial
instruments accounted for as trading activity, which were utilized to manage
interest rate risk on loans in our pipeline or expected to be sold in whole loan
sale transactions. At March 31, 2003, outstanding forward starting interest rate
swap contracts used to manage interest rate risk on loans in our pipeline and
related unrealized losses recorded as liabilities on the balance sheet were as
follows (in thousands):
Notional Unrealized
Amount (Loss)
-------- ----------
Forward starting interest rate swaps $72,503 $(22)
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 nine-month periods ended March 31, 2004 and 2003 were as follows
(in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------------ ---------------------------
2004 2003 2004 2003
------------ -------------- ------------ -----------
Unrealized gain (loss) on interest rate
swap contract $ 47 $ 215 $ 333 $ (80)
Cash interest received (paid) on
interest rate swap contract (48) (277) (305) (817)
--------- --------- --------- --------
Net gain (loss) on interest rate swap
contract $ (1) $ (62) $ 28 $ (897)
========= ========= ========= ========
101
This interest rate swap contract matures April 2004. Terms of the
interest rate swap contract at March 31, 2004 were as follows (dollars in
thousands):
Notional amount $ 1,372
Rate received - Floating (a) 1.20%
Rate paid - Fixed 2.89%
Maturity date April 2004
Unrealized loss $ 1
Sensitivity to 0.1% change in interest rates (b)
____________________________
(a) Rate represents the spot rate for one-month LIBOR paid on the
securitized floating interest rate certificate at the end of the
period.
(b) Not meaningful.
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.
LIQUIDITY AND CAPITAL RESOURCES
The following discussion of liquidity and capital resources should be
read in conjunction with the discussion contained in "-- Application of Critical
Accounting Estimates."
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 more whole loan sales, as the total
portfolio changes, as our interest-only strips mature 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, and more recently have been impacted by short-term liquidity issues,
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
102
obligations. 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. 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).
Under our business strategy, we initially 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.
Several events and issues have negatively impacted our short-term
liquidity. First, 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. Second, 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. Third, 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.
As a result of these liquidity issues, since June 30, 2003, our loan
origination volume was substantially reduced. From July 1, 2003 through March
31, 2004, we originated $468.6 million of loans, which represents a significant
reduction as compared to originations of $1.18 billion 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, second
and third quarters of fiscal 2004 and depending on our ability to recognize
gains on future securitizations, we anticipate incurring losses at least through
the first quarter of fiscal 2005.
For the first nine months of fiscal 2004, we recorded a loss before
dividends on preferred stock of $82.5 million. The loss primarily resulted from
liquidity issues described above, which substantially reduced our ability to
originate loans and generate revenues during the first nine months of fiscal
2004, operating expense levels which would support greater levels of loan
originations, our inability to complete a securitizations of loans during the
first and third quarters of fiscal 2004, and $37.8 million of net pre-tax
charges for valuation adjustments on our securitization assets. See "--
Securitizations" for more detail on the valuation adjustments.
103
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 losses experienced in fiscal 2003 and the first nine
months of fiscal 2004, we failed to comply with the terms of certain of the
financial covenants in our credit facilities. We requested and obtained waivers
from our lenders, as necessary, for our non-compliance with financial covenants
as of June 30, 2003, September 30, 2003, October 31, 2003, November 30, 2003,
December 31, 2003 and March 31, 2004. See "-- Overview -- Credit Facilities,
Servicing Agreements and Waivers Related to Financial Covenants" and "-- Credit
Facilities" and "-- Waivers and Amendments of Financial Covenants" for more
detail. As a result of our anticipated future losses 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 provide 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 covenant in several of our servicing agreements, we requested
and obtained waivers of the non-compliance from the two financial insurers
representing the certificate holders. In connection with a waiver of the net
worth covenant granted by one bond insurer for the remaining term of the related
servicing agreements, we amended the servicing agreements on September 30, 2003
principally to provide for 120-day term-to-term servicing and for our
appointment as servicer for an initial 120-day period commencing as of October
1, 2003. We were re-appointed servicer for an additional term under these
amended servicing agreements on January 29, 2004. The second bond insurer waived
our non-compliance with net worth requirements on an oral basis from September
30, 2003 through March 9, 2004, at which time it confirmed its prior oral waiver
in writing and extended the waiver through March 14, 2004. On February 20, 2004
we entered into an agreement with this second bond insurer amending the related
servicing agreements principally to provide for 30-day term-to-term servicing
and to re-appoint us as servicer for an initial term through March 15, 2004.
Subsequently, this bond insurer, on a monthly basis, has given us a waiver of
the net worth covenant and re-appointed us as servicer under these amended
servicing agreements for all relevant periods since the execution of the amended
servicing agreements. Reappointment as servicer under these amended servicing
agreements occurs in the sole discretion of the bond insurer.
Separately, one bond insurer, as a condition to its participation in
our October 31, 2003 securitization, required that we amend the servicing
agreement related to a previous securitization in which the bond insurer had
participated as bond insurer. The resulting amendment, dated October 31, 2003,
to this servicing agreement provided, among other things, for a specifically
designated back-up servicer, for 90-day term-to-term servicing and for our
re-appointment as servicer for an initial 90-day term commencing October 31,
2003. This bond insurer subsequently re-appointed us as servicer under the
amended servicing agreement for an additional term through April 30, 2004. On
April 30, 2004 this amended servicing agreement was further amended principally
to provide for 30-day term-to-term servicing and for our reappointment as
servicer for a 30-day term expiring May 31, 2004. Reappointment as servicer
under these amended servicing agreements is determined by reference to our
compliance with their servicing terms.
Also separately, on March 5, 2004, we entered into agreements with
another bond insurer which amended the servicing agreements related to all
securitizations insured by this bond insurer. These amendments principally
provided for a specifically designated back-up servicer. The original provisions
of these servicing agreements providing for 3-month term-to-term servicing were
not altered by these amendments. Reappointment as servicer under these amended
servicing agreements is determined by reference to our compliance with their
servicing terms.
As a result of the foregoing amendments to our servicing agreements,
all of our servicing agreements associated with bond insurers now provide for
term-to-term servicing.
104
Since June 30, 2003, we undertook specific remedial actions to address
short-term liquidity concerns including selling loans on a whole loan basis,
securing new credit and warehouse facilities, refinancing an off-balance sheet
mortgage conduit facility, mailing the first exchange offer to holders of our
subordinated debentures and suspending the payment of quarterly dividends on our
common stock.
We entered into an agreement on June 30, 2003 with an investment bank
to sell up to $700.0 million of mortgage loans, entered into a forward sale
agreement in March 2004 for $300.0 million of mortgage loans and solicited bids
and commitments from other participants in the whole loan sale market. In total,
from June 30, 2003 through March 31, 2004, we sold approximately $729.8 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.
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 debentures.
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. Under the terms of this conduit facility it terminated
upon the disposition of the loans held by it.
On December 1, 2003, we mailed the first exchange offer, to holders of
our subordinated debentures issued prior to April 1, 2003. Holders of such
subordinated debentures had the ability to exchange their debentures 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 "-- Overview -- The First Exchange Offer."
In May 2004, we intend to mail a second exchange offer, to holders of
our subordinated debentures issued prior to November 1, 2003. Holders of such
subordinated debentures will have the ability to exchange their debentures 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 "-- Overview -- The Second Exchange Offer."
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 and senior collateralized subordinated notes 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 and senior collateralized subordinated
notes when due.
105
The following table summarizes our short and long-term capital
resources and contractual obligations as of March 31, 2004. 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.
We can provide no assurances that we will be able to continue issuing
subordinated debentures. In the event that we are unable to offer additional
subordinated debentures for any reason, we have developed a contingent financial
restructuring plan. See "-- Business Strategy Adjustments" for a discussion of
this plan. 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.............................. $ 16,178 $ -- $ -- $ -- $ 16,178
Loans.......................................... 116,560 116 136 4,416 121,228
Interest-only strips (a)....................... 122,222 208,870 130,401 203,961 665,454
Servicing rights............................... 25,825 36,181 22,229 30,748 114,983
Investments.................................... 328 520 -- -- 848
--------- --------- -------- -------- --------
281,113 245,687 152,766 239,125 918,691
--------- --------- -------- -------- --------
Contractual Obligations (b)
Subordinated debentures........................ 316,590 235,434 17,080 16,693 585,797
Accrued interest-subordinated debentures (c)... 18,411 14,456 1,492 2,414 36,773
Senior collateralized subordinated notes....... 12,542 39,917 1,263 1,698 55,420
Accrued interest-senior collateralized
subordinated notes (d)........................ 148 492 8 37 685
Warehouse lines of credit (e).................. 85,598 -- -- -- 85,598
Convertible promissory note (f)................ -- 478 -- -- 478
Capitalized lease (g).......................... 377 236 -- -- 613
Operating leases (h)........................... 4,783 10,535 10,976 29,264 55,558
Services and equipment ........................ 1,722 -- -- -- 1,722
--------- --------- -------- -------- --------
440,171 301,548 30,819 50,106 822,644
--------- --------- -------- -------- --------
Excess (Shortfall)............................. $(159,058) $ (55,861) $121,947 $189,019 $ 96,047
========= ========= ======== ======== ========
(a) Reflects projected cash flows utilizing assumptions including prepayment and
credit loss rates. See "-- Application of Critical Accounting Estimates --
Interest-Only Strips."
(b) See "-- Contractual Obligations."
(c) This table reflects interest payment terms elected by subordinated debenture
holders as of March 31, 2004. 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.
(d) This table reflects interest payment terms elected by senior collateralized
subordinated note holders as of March 31, 2004.
(e) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(f) Amount includes principal and accrued interest at March 31, 2004.
(g) Amounts include principal and interest.
(h) Amounts include lease for office space.
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. Each funding source is described
in more detail below.
106
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 positive cash flow from
operations. Our achieving 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 negative because
we incur the cash expenses as we originate loans, 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. However, during the nine months ended March 31, 2004, we
experienced positive cash flow from operations, primarily due to whole loan
sales of loans we originated in prior periods that were carried on our balance
sheet at June 30, 2003.
Additionally, increasing market interest rates could negatively impact
our cash flows. 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. Increasing market interest rates would also
result in higher interest expense incurred on future issuances of subordinated
debentures and interest expense incurred to fund loans while they are carried on
our balance sheet.
Cash flow from operations for the nine months ended March 31, 2004 was
a positive $162.5 million compared to a negative $41.5 million for the first
nine months of fiscal 2003. The positive cash flow from operations for the nine
months ended March 31, 2004 was due to our sales during the nine-month period of
loans originated in prior periods that were carried on our balance sheet at June
30, 2003. During the nine months ended March 31, 2004, we received cash on whole
loan sales closed during the period of $481.8 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 nine months of fiscal 2004 increased $55.4 million, compared to the first
nine months of fiscal 2003. The following table compares the principal amount of
loans sold in whole loan sales during the nine months ended March 31, 2004, to
the amount of loans originated during the same period (in thousands).
107
Whole Loan Loans
Quarter Ended Sales Originated
---------------------------------------------------- ----------------- ----------------
September 30, 2003 $ 245,203 $ 124,052
December 31, 2003 7,975(a) 103,084
March 31, 2004 228,629 241,449
------------ ------------
Total for nine months ended March 31, 2004 $ 481,807 $ 468,585
============ ============
(a) During the quarter ended December 31, 2003, we completed a
securitization of $173.5 million of mortgage loans.
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 the fourth quarter of fiscal 2004 or any future quarter depending on the size
and frequency of our future securitizations and due to the nature of our
operations and the time required 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.
108
CONTRACTUAL OBLIGATIONS. Following is a summary of future payments
required on our contractual obligations as of March 31, 2004 (in thousands):
PAYMENTS DUE BY PERIOD
-------------------------------------------------------------
MORE
LESS THAN 1 TO 3 3 TO 5 THAN
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS 5 YEARS
- -------------------------------- -------- -------- -------- ------- -------
Subordinated debentures............ $585,797 $316,590 $235,434 $17,080 $16,693
Accrued interest - subordinated
debentures (a) ................. 36,773 18,411 14,456 1,492 2,414
Senior collateralized
subordinated notes................ 55,420 12,542 39,917 1,263 1,698
Accrued interest - senior
collateralized subordinated
notes (b) ........................ 685 148 492 8 37
Warehouse lines of credit (c)...... 85,598 85,598 -- -- --
Convertible promissory note(d)..... 478 -- 478 -- --
Capitalized lease (e).............. 613 377 236 -- --
Operating leases (f)............... 55,558 4,783 10,535 10,976 29,264
Services and equipment ............ 1,722 1,722 -- -- --
-------- -------- -------- ------- -------
Total obligations.................. $822,644 $440,171 $301,548 $30,819 $50,106
======== ======== ======== ======= =======
(a) This table reflects interest payment terms elected by subordinated
debenture holders as of March 31, 2004. 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) This table reflects interest payment terms elected by senior
collateralized subordinated note holders as of March 31, 2004.
(c) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(d) Amount includes principal and accrued interest at March 31, 2004.
(e) Amounts include principal and interest.
(f) Amounts include lease for office space.
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.
The following is a description of the warehouse and operating lines of
credit facilities, which were available to us at March 31, 2004 (in thousands):
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FACILITY AMOUNT AMOUNT
AMOUNT UTILIZED AVAILABLE
-------- -------- ----------
REVOLVING CREDIT FACILITIES:
Warehouse revolving line of credit, expiring September 2004(a) $200,000 $25,675 $174,325
Warehouse revolving line of credit, expiring October 2006(b) 250,000 59,923 190,077
-------- ------- --------
Total revolving credit facilities............................. 450,000 85,598 364,402
OTHER FACILITIES:
Capitalized leases, maturing January 2006(c) ............... 571 571 --
-------- ------- --------
Total credit facilities............................................ $450,571 $86,169 $364,402
======== ======= ========
___________
(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 stand alone letter of credit 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 March 31, 2004. The
letter of credit was collateralized by cash.
(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) 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
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 Estimates" 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.
110
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 JP
Morgan Chase Bank for a new $200.0 million credit facility for the purpose of
funding our loan originations. Pursuant to the terms of this facility, we are
required to, among other things: (i) have a net worth of at least $28.0 million
by September 30, 2003; with quarterly increases of $2.0 million thereafter; (ii)
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; (iii) as of the end of any month, commencing January 31, 2004,
the aggregate outstanding balance of subordinated debentures must be less than
the aggregate outstanding balance as of the end of the prior month; 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 our financial condition. These provisions require, among
other things, our 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%, our subordinated
debentures not to exceed $705.0 million at any time, and our ownership of an
amount of repurchased loans not to exceed 1.5% of the managed portfolio.
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 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 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.
111
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.
WAIVERS AND AMENDMENTS OF FINANCIAL COVENANTS. 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
existing at June 30, 2003 (one for $50.0 million and the other for $200.0
million, which was reduced to $50.0 million). We obtained waivers from these
covenant provisions from both lenders. Commencing August 21, 2003, the lender
under the $50.0 million warehouse credit facility (which had been amended in
December 2002 to add a letter of credit facility) granted us a series of waivers
for our non-compliance with a financial covenant in that credit facility through
November 30, 2003 and on September 22, 2003, in connection with the creation of
the new $200.0 million credit facility on the same date, reduced this facility
to an $8.0 million letter of credit facility, which secured the lease on our
principal executive office. This letter of credit facility expired according to
its terms on December 22, 2003, but the underlying letter of credit was renewed
for a one year term on December 18, 2003. We also entered into an amendment to
the $200.0 million credit facility which provided 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. 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, second and third
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 a $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 through December 31, 2003, at which time this
facility expired according to its terms.
The terms of our 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, that we obtain a written commitment for another credit
facility of at least $200.0 million and close that additional facility by
October 3, 2003, and that we have a minimum net worth of $28.0 million at
September 30, 2003, $25.0 million at October 31, 2003 and November 30, 2003,
$30.0 million at December 31, 2003 and $32.0 million at March 31, 2004.
112
The lender under the new $200.0 million facility agreed to extend the
deadline for our registration statement to be declared effective by the SEC to
November 10, 2003. Our registration statement was declared effective on November
7, 2003.
The lender on the new $200.0 million credit facility agreed to extend
the date by which we were required to close an additional credit facility of at
least $200.0 million from October 3, 2003 to October 8, 2003. We subsequently
obtained an additional waiver from this lender, which extended this required
closing date for obtaining the additional credit facility to October 14, 2003
(this condition was satisfied by the closing of the $250.0 million facility
described above). Prior to the closing of the second credit facility, our
borrowing capacity on the new $200.0 million facility was limited to $80.0
million.
Because we anticipate incurring losses at least through the first
quarter of fiscal 2005 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 nine months ended March 31, 2004,
subordinated debentures decreased by $133.7 million compared to an increase of
$54.5 million in the nine months ended March 31, 2003. The reduction in the
level of subordinated debentures was due to the first exchange offer and the
resulting conversion of $117.2 million of subordinated debentures into 61.8
million of shares of Series A Preferred Stock and $55.4 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 the first exchange offer to holders of
our subordinated debentures issued prior to April 1, 2003. Holders of such
subordinated debentures had the ability to exchange their debentures 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 certain 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
issued in the first exchange offer plus priority lien obligations secured by
interest-only strips and/or the cash flows from the interest-only strips;
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 behind the existing and future debt of our
subsidiaries and equally in right of payment with the deficiency portion of the
senior collateralized subordinated notes, and any future subordinated debentures
issued by us and other unsecured debt. At March 31, 2004, our interest in the
cash flows from interest-only strips held in the trust, which secure the senior
collateralized subordinated notes totaled $438.5 million, of which $83.1 million
represented 150% of the outstanding principal balance of senior collateralized
subordinated notes.
113
Pursuant to the terms of the first exchange offer, in the first closing
of the first 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 first exchange
offer to February 6, 2004. As a result of the second closing of the first
exchange offer on February 6, 2004, we exchanged an additional $43.6 million of
eligible subordinated debentures for 22.7 million shares of Series A Preferred
Stock and $20.9 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 first exchange offer. Each named individual tendered all such eligible
subordinated debentures in the first exchange offer and as of February 6, 2004,
the expiration date of the first exchange offer, pursuant to the terms of the
first 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, $181.7 million of debt from this registration statement was
available for future issuance as of March 31, 2004.
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 debenture 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 March 2004 was 10.91%, 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%. We expect to reduce the interest rates offered on subordinated
debentures over time as our business and cash needs, our financial condition,
liquidity, future results of operations, market interest rates and competitive
factors permit. The weighted average remaining maturity of our subordinated
debentures at March 2004 was 15.7 months compared to 19.5 months at June 2003.
114
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 March 31, 2004,
the liquidation value equals $61.8 million.
Monthly cash dividend payments are $0.008334 per share of Series A
Preferred Stock (equivalent to $0.10 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 March 31, 2004, the annual cash dividend
requirement equals $6.2 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 in the first exchange offer converted on the anniversary
dates listed below, the number of shares of our common stock which would be
issued upon conversion follows (shares in thousands):
Convertible
Number of into Number
Preferred of Common
Shares Shares
---------------- ----------------
Second anniversary date 61,807 14,834
Third anniversary date 61,807 16,070
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 $5.3 million. 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 $5.3 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.
In the past, we have relied significantly on access to the asset-backed
securities market through securitizations to provide permanent funding of our
loan production. Our adjusted business strategy will continue to rely on access
to this market. 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.
115
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.
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, formerly one of our directors and currently
employed by us, received $58 thousand in consulting fees from us during the
quarter ended December 31, 2003 and $60 thousand in consulting fees during the
quarter ended March 31, 2004 prior to his resignation from our Board on February
20, 2004.
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
for 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 three 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.
116
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.
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 first exchange offer. Each named individual tendered all such eligible
subordinated debentures in the first exchange offer and as of February 6, 2004,
the expiration date of the first exchange offer, pursuant to the terms of the
first 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.
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):
117
MARCH 31, 2004: Delinquencies
--------------------------------------------------------------------
Amount %
-----------------
On-balance sheet loan
receivables...................... $ 120,561 $ 5,565 4.62%
Securitized loan receivables...... 2,228,856 256,361 11.50%
---------- --------
Total Portfolio................... $2,349,417 $261,926 11.15%
========== ========
On-balance sheet REO.............. $ 2,508
Securitized REO................... 23,681
----------
Total REO......................... $ 26,189
==========
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
==========
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
==========
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 currently $8.0 million. The letter
of credit is currently issued by JPMorgan Chase Bank.
118
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 by the end of
fiscal 2004.
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.
In connection with the acquisition of the California mortgage broker
operation in December 2003, 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 1/2 years, expiring September 30, 2006 at an
annual rental of approximately $0.1 million.
In connection with the opening of the Irvine, California mortgage
broker operation, we entered into a sublease on March 4, 2004 for approximately
6,400 square feet of space. The term of the sublease is 1 2/3 years and expires
November 30, 2005. The terms of the sublease require average minimum annual
rental payments of $0.1 million.
In connection with the opening of the Maryland mortgage broker
operation, we entered into a sublease on March 15, 2004 for approximately 10,300
square feet of space in Edgewater, Maryland. The term of the sublease is 3 years
and expires March 15, 2007. The terms of the sublease require increased payments
annually for the term of the lease with average minimum annual rental payments
of $0.2 million.
RECENT ACCOUNTING PRONOUNCEMENTS
No new accounting pronouncements affecting us have been issued since
the filing of our June 30, 2003 Form 10-K.
119
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Interest Rate Risk Management."
ITEM 4. CONTROLS AND PROCEDURES
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.
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
120
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 although no such actions were pending at March 31, 2004. 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 -- Legal and
regulatory Considerations."
On January 21, 2004, January 28, 2004, February 12, 2004 and February
18, 2004, four 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 and the fourth suit also name
former director, Richard Kaufman, as a defendant. The complaints are captioned:
Weisinger v. American Business Financial Services, Inc. et al, Civil Action No.
04-265; Ruane v. American Business Financial Services, Inc. et al, Civil Action
No. 04-400, Operative Plasterers' and Cement Masons' International Employees'
Trust Fund v. American Business Financial Services, Inc. et al, Civil Action No.
04-617, and Vieni v. American Business Financial Services, Inc. et al, Civil
Action No. 04-687. The lawsuits were brought by purchasers of our common stock
who were seeking to represent a class of all purchasers of our common stock for
a proposed class period January 27, 2000 through June 25, 2003 with respect to
the first two suits and fourth suit filed. A proposed class period for the third
suit is January 27, 2000 through June 12, 2003. As of May 3, 2004, no motions
for class certification have been filed.
The first two and fourth lawsuits allege that, among other things, we
and the named directors and officers violated Sections 10(b) and 20(a) of the
Exchange Act. These three 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 three
121
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. These three
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 Exchange Act 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.
As of May 3, 2004, the four cases were consolidated, and two competing
motions for appointment of lead plaintiff were pending before the court.
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania. The complaint is captioned: Osterbauer v. Santilli et al, Civil
Action No. 04-1105. The lawsuit was brought nominally on behalf of the Company,
as a shareholder derivative action, alleging that the named directors and
officers breached their fiduciary duties to the Company, engaged in the abuse of
control, gross mismanagement and other violations of law during the period from
January 27, 2000 through June 25, 2003. The lawsuit seeks unspecified
compensatory damages, equitable or injunctive relief and costs and expenses
related to bringing the action, and other unspecified relief. The parties have
agreed to stay this case pending disposition of any motion to dismiss the
anticipated consolidated amended complaint filed in the putative securities
class actions.
Procedurally, these lawsuits are in a very preliminary stage. 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.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
EQUITY SECURITIES
Dilutive and Other Effects of Issuance of Series A Convertible
Preferred Stock. As of February 6, 2004, the closing of the first exchange
offer, we issued 61.8 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
61.8 million shares of the Series A Preferred Stock issued in connection with
the first exchange offer can be converted is 16.1 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 16.1 million shares of common stock upon conversion of
the Series A 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 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.
122
Securities Issued in Non-Public Offerings. As of February 6, 2004, in
connection with the first exchange offer, we issued $55.4 million in aggregate
principal amount of senior collateralized subordinated notes and 61.8 million
shares of Series A Convertible Preferred Stock in exchange for $117.2 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 first 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 first exchange offer and
(b) the investment notes exchanged; (ii) the first 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 first exchange offer.
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 Convertible Preferred
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.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES - NONE
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - NONE
ITEM 5. OTHER INFORMATION - NONE
123
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- --------- --------------------------------------------------------------
10.1 Form of AMENDED AND RESTATED POOLING AND SERVICING AGREEMENT,
dated as of March 5, 2004, by and among Prudential Securities
Secured Financing Corporation, in its capacity as Depositor of
the Trust ("Depositor"), American Business Credit, Inc., in
its capacity as servicer ("Servicer"), Wilshire Credit
Corporation, in its capacity as back-up servicer, and JPMorgan
Chase Bank (f/k/a The Chase Manhattan Bank), in its capacity
as trustee ("Trustee"), relating to:
(i) ABFS MORTGAGE LOAN TRUST 1996-2, amending and restating
the Pooling and Servicing Agreement, dated as of August
31, 1996, by and among the Depositor, the Servicer and
the Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1997-1, amending and restating
the Pooling and Servicing Agreement, dated as of March
1, 1997, by and among the Depositor, the Servicer and
the Trustee;
(iii) ABFS MORTGAGE LOAN TRUST 1997-2, amending and
restating the Pooling and Servicing Agreement, dated as
of September 1, 1997, by and among the Depositor, the
Servicer and the Trustee;
(iv) ABFS MORTGAGE LOAN TRUST 1998-1, amending and restating
the Pooling and Servicing Agreement, dated as of
February 1, 1998, by and among the Depositor, the
Servicer and the Trustee;
(v) ABFS MORTGAGE LOAN TRUST 1998-2, amending and restating
the Pooling and Servicing Agreement, dated as of June
1, 1998, by and among the Depositor, the Servicer and
the Trustee;
(vi) ABFS MORTGAGE LOAN TRUST 1998-3, amending and restating
the Pooling and Servicing Agreement, dated as of
September 1, 1998, by and among the Depositor, the
Servicer and the Trustee.
10.2 Form of AMENDED AND RESTATED SALE AND SERVICING AGREEMENT,
dated as of March 5, 2004, by and among Prudential Securities
Secured Financing Corporation, as depositor (the "Depositor"),
American Business Credit, Inc., as servicer (the "Servicer"),
Wilshire Credit Corporation, as Back-up Servicer, JPMorgan
Chase Bank (f/k/a Chase Bank of Texas, N.A.), as collateral
agent (the "Collateral Agent"), The Bank Of New York, as
indenture trustee (the "Indenture Trustee"), and:
(i) ABFS MORTGAGE LOAN TRUST 1998-4, as issuer (the "1998-4
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of November 1, 1998, by and among
the Depositor, the 1998-4 Trust, the Servicer, the
Collateral Agent and the Indenture Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-1, as issuer (the "1999-1
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of dated as of March 1, 1999, by
and among the Depositor, the 1999-1 Trust, the
Servicer, the Collateral Agent and the Indenture
Trustee;
(iii) ABFS MORTGAGE LOAN TRUST 1999-4, as issuer (the
"1999-4 Trust"), amending and restating the Sale and
Servicing Agreement, dated as of dated as December 1,
1999, by and among the Depositor, the 1999-4 Trust, the
Servicer, the Collateral Agent and the Indenture
Trustee.
124
10.3 Form of SUPPLEMENTAL INDENTURE NO. 1, dated as of March 5,
2004, between The Bank Of New York, as indenture trustee (the
"Indenture Trustee") and:
(i) ABFS MORTGAGE LOAN TRUST 1998-4, as issuer (the "1998-4
Trust"), supplementing the Indenture, dated as of
November 1, 1998, between the 1998-4 Trust and the
Indenture Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-1, as issuer (the "1999-1
Trust"), supplementing the Indenture, dated as of March
1, 1999, between the 1999-1 Trust and the Indenture
Trustee;
(iii)ABFS MORTGAGE LOAN TRUST 1999-4, as issuer (the
"1999-4 Trust"), supplementing the Indenture, dated as
of November 1, 1999, between the 1998-4 Trust and the
Indenture Trustee.
10.4 Form of amended DEFINED TERMS, constituting Appendix I to
Exhibits 10.2 and 10.3.
10.5 Form of AMENDED AND RESTATED SALE AND SERVICING AGREEMENT,
dated as of March 5, 2004, by and among Prudential Securities
Secured Financing Corporation, as depositor (the "Depositor"),
American Business Credit, Inc., as servicer (the "Servicer"),
Wilshire Credit Corporation, as back-up servicer, JPMorgan
Chase Bank, (f/k/a Chase Bank of Texas, N.A.), as collateral
agent (in such capacity, the "Collateral Agent"), and JPMorgan
Chase Bank (f/k/a The Chase Manhattan Bank), as indenture
trustee (in such capacity, the "Indenture Trustee"), and:
(i) ABFS MORTGAGE LOAN TRUST 1999-2, as issuer (the "1999-2
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of June 1, 1999, by and among the
Depositor, the 1999-2 Trust, the Servicer, the
Collateral Agent and the Indenture Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-3, as issuer (the "1999-3
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of September 1, 1999, by and among
the Depositor, the 1999-3 Trust, the Servicer, the
Collateral Agent and the Indenture Trustee.
10.6 Form of SUPPLEMENTAL INDENTURE NO. 1, dated as of March 5,
2004, between and JPMorgan Chase Bank (f/k/a The Chase
Manhattan Bank), as indenture trustee (the "Indenture
Trustee") and:
(i) ABFS MORTGAGE LOAN TRUST 1999-2, as issuer (the "1999-2
Trust"), supplementing the Indenture, dated as of June
1, 1999, between the 1999-2 Trust and the Indenture
Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-3, as issuer (the "1999-3
Trust"), supplementing the Indenture, dated as of
September 1, 1999, between the 1999-3 Trust and the
Indenture Trustee.
10.7 Form of amended DEFINED TERMS, constituting Appendix I to
Exhibits 10.5 and 10.6.
10.8 Amendment No. 1 to the POOLING AND SERVICING AGREEMENT, SERIES
2003-1, dated as of October 31, 2003, by and among Bear
Stearns Asset Backed Securities, Inc., as Depositor (the
"Depositor"), American Business Credit, Inc., as Servicer
("Servicer"), EMC Mortgage Corporation, as Back-Up Servicer,
JPMorgan Chase Bank, as Trustee and Collateral Agent, Bear
Stearns & Co. Inc., as Class A-1 Certificateholder, and Radian
Asset Assurance Inc., as Certificate Insurer, amending the
Pooling And Servicing Agreement relating to ABFS MORTGAGE LOAN
TRUST 2003-1, dated as of March 1, 2003, by and among the
Depositor, the Servicer, and JPMorgan Chase Bank, in its
capacity as trustee, collateral agent and back-up servicer.
125
10.9 AMENDMENT NO. 1 TO THE POOLING AND SERVICING AGREEMENT, SERIES
2002-1, dated as of February 20, 2004, by and among Bear
Stearns Asset Backed Securities, Inc., as depositor (the
"Depositor"), American Business Credit, Inc., as servicer
("ABC"), JPMorgan Chase Bank, as trustee and collateral agent
(the "Trustee"), Ambac Assurance Corporation, as Certificate
Insurer and party entitled to exercise the voting rights of
the Majority, and ABFS Warehouse Trust 2003-1, as Class R
Certificateholder, amending the POOLING AND SERVICING
AGREEMENT, dated as of March 1, 2002, by and among the
Depositor, ABC and the Trustee.
10.10 Form of AMENDMENT NO. 1 TO THE SALE AND SERVICING AGREEMENT,
dated as of February 20, 2004, by and among, American Business
Credit, Inc., as Servicer ("ABC"), JPMorgan Chase Bank
(formerly know as The Chase Manhattan Bank), as indenture
trustee and JPMorgan Chase Bank (as successor to Chase Bank of
Texas, N.A.) as collateral agent (collectively, the "Indenture
Trustee"), Ambac Assurance Corporation, as Note Insurer and as
the party entitled to exercise the voting rights of the
Majority Noteholders, ABFS Warehouse Trust 2003-1, as Holder
of a majority of the Percentage Interest in the Trust
Certificates, and:
(i) Prudential Securities Secured Financing Corporation, as
Depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-1, as issuer (the "2000-1 Trust"), amending
the Sale And Servicing Agreement, dated as of March 1,
2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-1 Trust;
(ii) Prudential Securities Secured Financing Corporation, as
Depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-2, as issuer (the "2000-2 Trust"), amending
the Sale And Servicing Agreement, dated as of June 1,
2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-2 Trust;
(iii)Prudential Securities Secured Financing Corporation,
as Depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-3, as issuer (the "2000-3 Trust"), amending
the Sale And Servicing Agreement, dated as of September
1, 2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-3 Trust;
(iv) Bear Stearns Asset Backed Securities, Inc., as
depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-4, as issuer (the "2000-4 Trust"), amending
the Sale And Servicing Agreement, dated as of December
1, 2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-4 Trust.
10.11 Waiver dated March 9, 2004 to the Pooling And Servicing
Agreement, dated as of March 1, 2002, as amended February
20, 2004 ("Pooling Agreement"), and the Sale And Servicing
Agreements, dated, respectively, as of March 1, 2000, June
1, 2000, September 1, 2000 and December 1, 2000, each as
amended February 20, 2004 ("Sale Agreements"), issued by
Ambac Assurance Corporation, as Certificate Insurer under
the Pooling Agreement and as Note Insurer under the Sale
Agreements.
10.12 Waiver, dated April 14, 2004, to the Pooling And Servicing
Agreement, dated as of March 1, 2002, as amended February
20, 2004 ("Pooling Agreement"), and the Sale And Servicing
Agreements, dated, respectively, as of March 1, 2000, June
1, 2000, September 1, 2000 and December 1, 2000, each as
amended February 20, 2004 ("Sale Agreements"), issued by
Ambac Assurance Corporation, as Certificate Insurer under
the Pooling Agreement and as Note Insurer under the Sale
Agreements.
126
10.13 Amendment No. 2 to the POOLING AND SERVICING AGREEMENT,
SERIES 2003-1, dated as of April 30, 2004, by and among Bear
Stearns Asset Backed Securities, Inc., as Depositor (the
"Depositor"), American Business Credit, Inc., as Servicer
("Servicer"), EMC Mortgage Corporation, as Back-Up Servicer,
JPMorgan Chase Bank, as Trustee and Collateral Agent, Bear
Stearns & Co. Inc., as Class A-1 Certificateholder, and
Radian Asset Assurance Inc., as Certificate Insurer,
amending the Pooling And Servicing Agreement relating to
ABFS MORTGAGE LOAN TRUST 2003-1, dated as of March 1, 2003,
by and among the Depositor, the Servicer, and JPMorgan Chase
Bank, in its capacity as trustee, collateral agent and
back-up servicer.
10.14 Fourth Waiver Letter, dated as of March 31, 2004, from
JPMorgan Chase Bank regarding the Sale and Servicing
Agreement, dated as of September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., American
Business Mortgage Services, Inc., American Business Credit,
Inc., ABFS Mortgage Loan Warehouse Trust 2003-1 ("Trust"),
American Business Financial Services, Inc., and JPMorgan
Chase Bank, as indenture trustee and collateral agent
("Indenture Trustee") and JPMorgan Chase Bank, as note
purchaser, and (ii) the Indenture, dated as of September 22,
2003, between the Trust and the Indenture Trustee.
10.15 Amendment No. 1 to Sale and Servicing Agreement, dated as of
May 12, 2004, amending the Sale and Servicing Agreement,
dated as of September 22, 2003, among ABFS Balapointe, Inc.,
HomeAmerican Credit, Inc., American Business Mortgage
Services, Inc., American Business Credit, Inc., ABFS
Mortgage Loan Warehouse Trust 2003-1, American Business
Financial Services, Inc., and JPMorgan Chase Bank, as note
purchaser and as indenture trustee and collateral agent.
31.1 Chief Executive Officer's Certificate
31.2 Chief Financial Officer's Certificate
32.1 Certification pursuant to Section 906 of the Sarbanes Oxley
Act of 2002.
127
Reports on Form 8-K
The following current reports on Form 8-K were filed or furnished to the SEC
during the quarter ended March 31, 2004:
January 2, 2004
(Items 5 & 7) announcing the results of the December 31, 2003 closing of the
first exchange offer and the results of the Annual Meeting of Stockholders held
on December 31, 2003.
February 13, 2004
(Items 5 & 7) announcing the results of the February 6, 2004 closing of the
first exchange offer.
February 17, 2004
(Items 7 & 12) announcing the issuance of press release reporting financial
results for the second quarter of fiscal year 2004 ended December 31, 2003.
128
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
DATE: May 14, 2004 By: /s/ Albert W. Mandia
--------------------
Albert W. Mandia
Executive Vice President and Chief
Financial Officer (principal
financial officer)
129
EXHIBIT INDEX
-------------
EXHIBIT
NUMBER DESCRIPTION
------------------------------------------------------------
10.1 Form of AMENDED AND RESTATED POOLING AND SERVICING
AGREEMENT, dated as of March 5, 2004, by and among
Prudential Securities Secured Financing Corporation, in its
capacity as Depositor of the Trust ("Depositor"), American
Business Credit, Inc., in its capacity as servicer
("Servicer"), Wilshire Credit Corporation, in its capacity
as back-up servicer, and JPMorgan Chase Bank (f/k/a The
Chase Manhattan Bank), in its capacity as trustee
("Trustee"), relating to:
(i) ABFS MORTGAGE LOAN TRUST 1996-2, amending and restating
the Pooling and Servicing Agreement, dated as of August
31, 1996, by and among the Depositor, the Servicer and
the Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1997-1, amending and restating
the Pooling and Servicing Agreement, dated as of March
1, 1997, by and among the Depositor, the Servicer and
the Trustee;
(iii)ABFS MORTGAGE LOAN TRUST 1997-2, amending and
restating the Pooling and Servicing Agreement, dated as
of September 1, 1997, by and among the Depositor, the
Servicer and the Trustee;
(iv) ABFS MORTGAGE LOAN TRUST 1998-1, amending and restating
the Pooling and Servicing Agreement, dated as of
February 1, 1998, by and among the Depositor, the
Servicer and the Trustee;
(v) ABFS MORTGAGE LOAN TRUST 1998-2, amending and restating
the Pooling and Servicing Agreement, dated as of June
1, 1998, by and among the Depositor, the Servicer and
the Trustee;
(vi) ABFS MORTGAGE LOAN TRUST 1998-3, amending and restating
the Pooling and Servicing Agreement, dated as of
September 1, 1998, by and among the Depositor, the
Servicer and the Trustee.
10.2 Form of AMENDED AND RESTATED SALE AND SERVICING AGREEMENT,
dated as of March 5, 2004, by and among Prudential
Securities Secured Financing Corporation, as depositor (the
"Depositor"), American Business Credit, Inc., as servicer
(the "Servicer"), Wilshire Credit Corporation, as Back-up
Servicer, JPMorgan Chase Bank (f/k/a Chase Bank of Texas,
N.A.), as collateral agent (the "Collateral Agent"), The
Bank Of New York, as indenture trustee (the "Indenture
Trustee"), and:
(i) ABFS MORTGAGE LOAN TRUST 1998-4, as issuer (the "1998-4
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of November 1, 1998, by and among
the Depositor, the 1998-4 Trust, the Servicer, the
Collateral Agent and the Indenture Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-1, as issuer (the "1999-1
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of dated as of March 1, 1999, by
and among the Depositor, the 1999-1 Trust, the
Servicer, the Collateral Agent and the Indenture
Trustee;
(iii)ABFS MORTGAGE LOAN TRUST 1999-4, as issuer (the
"1999-4 Trust"), amending and restating the Sale and
Servicing Agreement, dated as of dated as December 1,
1999, by and among the Depositor, the 1999-4 Trust, the
Servicer, the Collateral Agent and the Indenture
Trustee.
130
10.3 Form of SUPPLEMENTAL INDENTURE NO. 1, dated as of March 5,
2004, between The Bank Of New York, as indenture trustee
(the "Indenture Trustee") and:
(i) ABFS MORTGAGE LOAN TRUST 1998-4, as issuer (the "1998-4
Trust"), supplementing the Indenture, dated as of
November 1, 1998, between the 1998-4 Trust and the
Indenture Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-1, as issuer (the "1999-1
Trust"), supplementing the Indenture, dated as of March
1, 1999, between the 1999-1 Trust and the Indenture
Trustee;
(iii)ABFS MORTGAGE LOAN TRUST 1999-4, as issuer (the
"1999-4 Trust"), supplementing the Indenture, dated as
of November 1, 1999, between the 1998-4 Trust and the
Indenture Trustee.
10.4 Form of amended DEFINED TERMS, constituting Appendix I to
Exhibits 10.2 and 10.3.
10.5 Form of AMENDED AND RESTATED SALE AND SERVICING AGREEMENT,
dated as of March 5, 2004, by and among Prudential
Securities Secured Financing Corporation, as depositor (the
"Depositor"), American Business Credit, Inc., as servicer
(the "Servicer"), Wilshire Credit Corporation, as back-up
servicer, JPMorgan Chase Bank, (f/k/a Chase Bank of Texas,
N.A.), as collateral agent (in such capacity, the
"Collateral Agent"), and JPMorgan Chase Bank (f/k/a The
Chase Manhattan Bank), as indenture trustee (in such
capacity, the "Indenture Trustee"), and:
(i) ABFS MORTGAGE LOAN TRUST 1999-2, as issuer (the "1999-2
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of June 1, 1999, by and among the
Depositor, the 1999-2 Trust, the Servicer, the
Collateral Agent and the Indenture Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-3, as issuer (the "1999-3
Trust"), amending and restating the Sale and Servicing
Agreement, dated as of September 1, 1999, by and among
the Depositor, the 1999-3 Trust, the Servicer, the
Collateral Agent and the Indenture Trustee.
10.6 Form of SUPPLEMENTAL INDENTURE NO. 1, dated as of March 5,
2004, between and JPMorgan Chase Bank (f/k/a The Chase
Manhattan Bank), as indenture trustee (the "Indenture
Trustee") and:
(i) ABFS MORTGAGE LOAN TRUST 1999-2, as issuer (the "1999-2
Trust"), supplementing the Indenture, dated as of June
1, 1999, between the 1999-2 Trust and the Indenture
Trustee;
(ii) ABFS MORTGAGE LOAN TRUST 1999-3, as issuer (the "1999-3
Trust"), supplementing the Indenture, dated as of
September 1, 1999, between the 1999-3 Trust and the
Indenture Trustee.
10.7 Form of amended DEFINED TERMS, constituting Appendix I to
Exhibits 10.5 and 10.6.
10.8 Amendment No. 1 to the POOLING AND SERVICING AGREEMENT,
SERIES 2003-1, dated as of October 31, 2003, by and among
Bear Stearns Asset Backed Securities, Inc., as Depositor
(the "Depositor"), American Business Credit, Inc., as
Servicer ("Servicer"), EMC Mortgage Corporation, as Back-Up
Servicer, JPMorgan Chase Bank, as Trustee and Collateral
Agent, Bear Stearns & Co. Inc., as Class A-1
Certificateholder, and Radian Asset Assurance Inc., as
Certificate Insurer, amending the Pooling And Servicing
Agreement relating to ABFS MORTGAGE LOAN TRUST 2003-1, dated
as of March 1, 2003, by and among the Depositor, the
Servicer, and JPMorgan Chase Bank, in its capacity as
trustee, collateral agent and back-up servicer.
131
10.9 AMENDMENT NO. 1 TO THE POOLING AND SERVICING AGREEMENT,
SERIES 2002-1, dated as of February 20, 2004, by and among
Bear Stearns Asset Backed Securities, Inc., as depositor
(the "Depositor"), American Business Credit, Inc., as
servicer ("ABC"), JPMorgan Chase Bank, as trustee and
collateral agent (the "Trustee"), Ambac Assurance
Corporation, as Certificate Insurer and party entitled to
exercise the voting rights of the Majority, and ABFS
Warehouse Trust 2003-1, as Class R Certificateholder,
amending the POOLING AND SERVICING AGREEMENT, dated as of
March 1, 2002, by and among the Depositor, ABC and the
Trustee.
10.10 Form of AMENDMENT NO. 1 TO THE SALE AND SERVICING AGREEMENT,
dated as of February 20, 2004, by and among, American
Business Credit, Inc., as Servicer ("ABC"), JPMorgan Chase
Bank (formerly know as The Chase Manhattan Bank), as
indenture trustee and JPMorgan Chase Bank (as successor to
Chase Bank of Texas, N.A.) as collateral agent
(collectively, the "Indenture Trustee"), Ambac Assurance
Corporation, as Note Insurer and as the party entitled to
exercise the voting rights of the Majority Noteholders, ABFS
Warehouse Trust 2003-1, as Holder of a majority of the
Percentage Interest in the Trust Certificates, and:
(i) Prudential Securities Secured Financing Corporation, as
Depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-1, as issuer (the "2000-1 Trust"), amending
the Sale And Servicing Agreement, dated as of March 1,
2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-1 Trust;
(ii) Prudential Securities Secured Financing Corporation, as
Depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-2, as issuer (the "2000-2 Trust"), amending
the Sale And Servicing Agreement, dated as of June 1,
2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-2 Trust;
(iii)Prudential Securities Secured Financing Corporation,
as Depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-3, as issuer (the "2000-3 Trust"), amending
the Sale And Servicing Agreement, dated as of September
1, 2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-3 Trust;
(iv) Bear Stearns Asset Backed Securities, Inc., as
depositor (the "Depositor") and ABFS Mortgage Loan
Trust 2000-4, as issuer (the "2000-4 Trust"), amending
the Sale And Servicing Agreement, dated as of December
1, 2000 by and among the Depositor, ABC, the Indenture
Trustee and the 2000-4 Trust.
10.11 Waiver dated March 9, 2004 to the Pooling And Servicing
Agreement, dated as of March 1, 2002, as amended February
20, 2004 ("Pooling Agreement"), and the Sale And Servicing
Agreements, dated, respectively, as of March 1, 2000, June
1, 2000, September 1, 2000 and December 1, 2000, each as
amended February 20, 2004 ("Sale Agreements"), issued by
Ambac Assurance Corporation, as Certificate Insurer under
the Pooling Agreement and as Note Insurer under the Sale
Agreements.
10.12 Waiver, dated April 14, 2004, to the Pooling And Servicing
Agreement, dated as of March 1, 2002, as amended February
20, 2004 ("Pooling Agreement"), and the Sale And Servicing
Agreements, dated, respectively, as of March 1, 2000, June
1, 2000, September 1, 2000 and December 1, 2000, each as
amended February 20, 2004 ("Sale Agreements"), issued by
Ambac Assurance Corporation, as Certificate Insurer under
the Pooling Agreement and as Note Insurer under the Sale
Agreements.
132
10.13 Amendment No. 2 to the POOLING AND SERVICING AGREEMENT,
SERIES 2003-1, dated as of April 30, 2004, by and among Bear
Stearns Asset Backed Securities, Inc., as Depositor (the
"Depositor"), American Business Credit, Inc., as Servicer
("Servicer"), EMC Mortgage Corporation, as Back-Up Servicer,
JPMorgan Chase Bank, as Trustee and Collateral Agent, Bear
Stearns & Co. Inc., as Class A-1 Certificateholder, and
Radian Asset Assurance Inc., as Certificate Insurer,
amending the Pooling And Servicing Agreement relating to
ABFS MORTGAGE LOAN TRUST 2003-1, dated as of March 1, 2003,
by and among the Depositor, the Servicer, and JPMorgan Chase
Bank, in its capacity as trustee, collateral agent and
back-up servicer.
10.14 Fourth Waiver Letter, dated as of March 31, 2004, from
JPMorgan Chase Bank regarding the Sale and Servicing
Agreement, dated as of September 22, 2003, among ABFS
Balapointe, Inc., HomeAmerican Credit, Inc., American
Business Mortgage Services, Inc., American Business Credit,
Inc., ABFS Mortgage Loan Warehouse Trust 2003-1 ("Trust"),
American Business Financial Services, Inc., and JPMorgan
Chase Bank, as indenture trustee and collateral agent
("Indenture Trustee") and JPMorgan Chase Bank, as note
purchaser, and (ii) the Indenture, dated as of September 22,
2003, between the Trust and the Indenture Trustee.
10.15 Amendment No. 1 to Sale and Servicing Agreement, dated as of
May 12, 2004, amending the Sale and Servicing Agreement,
dated as of September 22, 2003, among ABFS Balapointe, Inc.,
HomeAmerican Credit, Inc., American Business Mortgage
Services, Inc., American Business Credit, Inc., ABFS
Mortgage Loan Warehouse Trust 2003-1, American Business
Financial Services, Inc., and JPMorgan Chase Bank, as note
purchaser and as indenture trustee and collateral agent.
31.1 Chief Executive Officer's Certificate
31.2 Chief Financial Officer's Certificate
32.1 Certification pursuant to Section 906 of the Sarbanes Oxley
Act of 2002.
133