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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 September 30, 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.
------------------------------------------------------
(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 and treasury stock as of November 9, 2004 were 3,598,342 shares and
54,823 shares, respectively.
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2004 and June 30, 2004................................1
Consolidated Statements of Operations for the three months ended September 30, 2004 and 2003..........3
Consolidated Statement of Stockholders' Equity for the three months ended September 30, 2004..........4
Consolidated Statements of Cash Flow for the three months ended September 30, 2004 and 2003 ..........5
Notes to Consolidated Financial Statements............................................................7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......52
Item 3. Quantitative and Qualitative Disclosures about Market Risk.................................155
Item 4. Controls and Procedures ...................................................................155
PART II OTHER INFORMATION
Item 1. Legal Proceedings..........................................................................156
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds................................159
Item 3. Defaults Upon Senior Securities ...........................................................160
Item 4. Submission of Matters to a Vote of Security Holders........................................160
Item 5. Other Information..........................................................................160
Item 6. Exhibits ..................................................................................161
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollar amounts in thousands)
SEPTEMBER 30, JUNE 30,
2004 2004
------------- ----------
(UNAUDITED) (NOTE)
ASSETS
Cash and cash equivalents ........................ $ 19,673 $ 910
Restricted cash .................................. 10,419 13,307
Loan and lease receivables:
Loans available for sale ........................ 336,511 304,275
Non-accrual loans (net of allowance for credit
losses of $1,238 at
September 30, 2004 and $1,469 at June 30, 2003) 3,314 1,993
Interest and fees receivable ..................... 15,304 18,089
Deferment and forbearance advances receivable .... 5,839 6,249
Loans subject to repurchase rights ............... 40,736 38,984
Interest-only strips (includes the fair value of
overcollateralization related cash flows of
$202,215 and $216,926 at September 30, 2004 and
June 30, 2004).................................. 448,812 459,086
Servicing rights ................................. 66,712 73,738
Deferred income tax asset ........................ 66,201 59,133
Property and equipment, net ...................... 25,182 26,047
Prepaid expenses ................................. 16,740 13,511
Other assets ..................................... 27,953 27,548
---------- ----------
TOTAL ASSETS ..................................... $1,083,396 $1,042,870
========== ==========
1
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS -- (CONTINUED)
(dollar amounts in thousands)
SEPTEMBER 30, JUNE 30,
2004 2004
------------- ----------
LIABILITIES
Subordinated debentures .......................... $ 490,026 $ 522,609
Senior collateralized subordinated notes ......... 97,454 83,639
Warehouse lines and other notes payable .......... 281,472 241,200
Accrued interest payable ......................... 38,324 37,675
Accounts payable and accrued expenses ............ 35,819 28,096
Liability for loans subject to repurchase rights . 47,925 45,864
Deferred income tax liability .................... -- --
Other liabilities ................................ 80,517 71,872
---------- ----------
Total liabilities ................................ 1,071,537 1,030,955
========== ==========
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, 203,000,000 shares at September 30,
2004 and June 30, 2004;
Issued: 109,435,580 shares of Series A at
September 30, 2004 and 93,787,111 shares of
Series A at June 30, 2004....................... 109 94
Common stock, par value $.001, authorized shares
209,000,000 at September 30, 2004 and June 30,
2004; Issued: 3,653,165 shares at September 30,
2004 and at June 30, 2004 3,653,165 shares in
2004 (including Treasury shares of 54,823 at
September 30, 2004 and 54,823 at June 30, 2004). 4 4
Additional paid-in capital ....................... 120,214 107,241
Accumulated other comprehensive income ........... 16,706 4,596
Unearned compensation ............................ (440) (495)
Stock awards outstanding ......................... 123 95
Retained earnings (deficit) ...................... (123,561) (98,324)
Treasury stock, at cost .......................... (696) (696)
---------- ----------
12,459 12,515
Note receivable .................................. (600) (600)
---------- ----------
Total stockholders' equity ....................... 11,859 11,915
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ....... $1,083,396 $1,042,870
========== ==========
- -----
Note: The balance sheet at June 30, 2004 has been derived from the audited
financial statements at that date.
See accompanying notes to consolidated financial statements.
2
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollar amounts in thousands, except per share data)
(unaudited)
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
-------- --------
REVENUES
Gain on sale of loans:
Whole loan sales ....................................... $ 6,119 $ 2,921
Securitizations ........................................ -- 799
Interest and fees ....................................... 7,696 4,653
Interest accretion on interest-only strips .............. 8,448 11,109
Servicing income ........................................ 845 718
Other income ............................................ 1 1
-------- --------
Total revenues .......................................... 23,109 20,201
-------- --------
EXPENSES
Interest ................................................ 18,155 16,818
Provision for credit losses ............................. 117 4,156
Employee related costs .................................. 11,943 13,852
Sales and marketing ..................................... 6,391 2,841
(Gains) and losses on derivative financial instruments .. 1,989 (5,108)
General and administrative .............................. 23,311 19,215
Securitization assets valuation adjustment .............. 29 10,795
-------- --------
Total expenses .......................................... 61,935 62,569
-------- --------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES ......... (38,826) (42,368)
Provision for income tax expense (benefit) (13,589) (16,100)
-------- --------
INCOME (LOSS) BEFORE DIVIDENDS ON PREFERRED STOCK ....... (25,237) (26,268)
Dividends on preferred stock ............................ 3,475 --
-------- --------
NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCK .......... $(28,712) $(26,268)
======== ========
EARNINGS (LOSS) PER COMMON SHARE:
Basic .................................................. $ (7.98) $ (8.10)
======== ========
Diluted ................................................ $ (7.98) $ (8.10)
======== ========
AVERAGE COMMON SHARES (IN THOUSANDS):
Basic .................................................. 3,598 3,242
======== ========
Diluted ................................................ 3,598 3,242
======== ========
See accompanying notes to consolidated financial statements.
3
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(amounts in thousands)
(unaudited)
PREFERRED STOCK COMMON STOCK
-------------------- -------------------- ACCUMULATED
NUMBER OF NUMBER OF ADDITIONAL OTHER
SHARES SHARES PAID-IN COMPREHENSIVE
OUTSTANDING AMOUNT OUTSTANDING AMOUNT CAPITAL INCOME
----------- ------ ----------- ------ ---------- -------------
Balance, June 30, 2004 .............................. 93,787 $ 94 3,598 $ 4 $107,241 $ 4,596
Comprehensive income (loss):
Net loss ........................................... -- -- -- -- -- --
Net unrealized gain on interest-only strips ........ -- -- -- -- -- 12,110
------- ---- ----- --- -------- -------
Total comprehensive income (loss) ................... -- -- -- -- -- 12,110
Issuance of preferred stock ......................... 15,649 15 -- -- 15,633 --
Valuation of restricted stock (110,000 shares) ...... -- -- -- -- (55) --
Stock awards outstanding ............................ -- -- -- -- -- --
Cash dividends declared on preferred stock
($0.025 per share)................................. -- -- -- -- (2,605) --
Preferred stock beneficial conversion feature:
Amortization of beneficial conversion feature ...... -- -- -- -- 870 --
Non-cash preferred dividend ........................ -- -- -- -- (870) --
------- ---- ----- --- -------- -------
Balance September 30, 2004 .......................... 109,436 $109 3,598 $ 4 $120,214 $16,706
======= ==== ===== === ======== =======
STOCK TOTAL
UNEARNED AWARDS RETAINED TREASURY NOTE STOCKHOLDERS'
(CONTINUED) COMPENSATION OUTSTANDING EARNINGS STOCK RECEIVABLE EQUITY
------------ ----------- --------- -------- ---------- -------------
Balance, June 30, 2004 ........................ $(495) $ 95 $ (98,324) $(696) $(600) $ 11,915
Comprehensive income (loss):
Net loss ..................................... -- -- (25,237) -- -- (25,237)
Net unrealized gain on interest-only strips .. -- -- -- -- -- 12,110
----- ---- --------- ----- ----- --------
Total comprehensive income (loss) ............. -- -- (25,237) -- -- (13,127)
Issuance of preferred stock ................... -- -- -- -- -- 15,648
Valuation of restricted stock (110,000 shares) 55 -- -- -- -- --
Stock awards outstanding ...................... -- 28 -- -- -- 28
Cash dividends declared on preferred stock
($0.025 per share) -- -- -- -- -- (2,605)
Preferred stock beneficial conversion feature:
Amortization of beneficial conversion
discount..................................... -- -- -- -- -- 870
Non-cash preferred dividend .................. -- -- -- -- -- (870)
----- ---- --------- ----- ----- --------
Balance September 30, 2004 $(440) $123 $(123,561) $(696) $(600) $ 11,859
===== ==== ========= ===== ===== ========
See accompanying notes to consolidated financial statements.
4
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(dollar amounts in thousands)
(unaudited)
THREE MONTHS ENDED
SEPTEMBER 30,
---------------------
2004 2003
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) ..................................... $ (25,237) $ (26,268)
Adjustments to reconcile net income to net cash used
in operating activities:
Gain on sale of loans ................................ (6,119) (3,720)
Depreciation and amortization ........................ 8,452 14,647
Interest accretion on interest-only strips ........... (8,448) (10,828)
Securitization assets valuation adjustment ........... 29 10,795
Provision for credit losses .......................... 117 4,156
Loans originated for sale ............................. (642,756) (158,284)
Proceeds from sale of loans ........................... 612,965 278,523
Principal payments on loans and leases ................ 1,947 4,169
(Increase) decrease in accrued interest and fees on
loan and lease receivables........................... 3,195 (2,217)
Cash proceeds from sale of securitization assets ...... 9,000 --
Required purchase of additional overcollateralization
on securitized loans................................. (4,615) (7,660)
Cash flow from interest-only strips ................... 33,141 56,222
Increase in prepaid expenses .......................... (3,229) (5,584)
(Decrease) increase in accrued interest payable ....... 649 (1,696)
Increase in accounts payable and accrued expenses ..... 6,812 2,372
Accrued interest payable reinvested in subordinated
debt................................................. 6,262 9,686
Decrease in deferred income taxes ..................... (13,587) (16,097)
Increase (decrease) in loans in process ............... 10,441 (24,148)
(Payments) on derivative financial instruments ........ (3,611) (1,378)
Other, net ............................................ 371 5,714
--------- ---------
Net cash provided by (used in) operating activities ... (14,221) 128,404
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment, net ............... (587) (6,774)
Principal receipts and maturity of investments ........ 839 11
--------- ---------
Net cash used in investing activities ................. 252 (6,763)
--------- ---------
5
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW -- (CONTINUED)
(dollar amounts in thousands)
(unaudited)
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2004 2003
-------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of subordinated debt ............ $ 45,525 $ 1,576
Redemptions of subordinated debt ....................... (53,538) (43,217)
Net borrowings (repayments) on revolving lines of
credit................................................ 40,356 (77,271)
Principal payments under capital lease obligations ..... (84) (77)
Net repayments of other notes payable .................. -- (26,158)
Financing costs incurred ............................... (721) (314)
Lease incentive receipts ............................... -- 3,562
Cash dividends paid on preferred stock ................. (1,694) --
-------- ---------
Net cash provided by (used in) financing activities .... 29,844 (141,899)
-------- ---------
Net (decrease) increase in cash and cash equivalents ... 15,875 (20,258)
Cash and cash equivalents at beginning of year ......... 14,217 47,475
-------- ---------
Cash and cash equivalents at end of year ............... $ 30,092 $ 27,217
======== =========
SUPPLEMENTAL DISCLOSURES:
Cash paid during the period for:
Interest .............................................. $ 11,244 $ 8,828
Income taxes .......................................... $ 38 $ 40
See accompanying notes to consolidated financial statements.
6
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 mortgage loans through its principal direct and
indirect subsidiaries. The Company also processes and purchases home mortgage
loans from other financial institutions through the Bank Alliance Services
program. Additionally, the Company services business purpose loans that it had
originated and sold in prior periods.
Historically, the Company's loans primarily consisted of fixed interest rate
loans secured by first or second mortgages on one-to-four family residences.
The Company's recent business strategy adjustments include increasing loan
originations by offering adjustable rate loans and purchase money mortgage
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 the Company's 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 network of mortgage brokers. During fiscal
2004, the Company acquired broker operations in West Hills, California and
Austin, Texas and opened new offices in Edgewater, Maryland and Irvine,
California to support the Company's broker operations. The Company's loan
servicing and collection activities are performed at its Philadelphia office.
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 its 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 it also
depends 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, or if it is unable to sell or securitize its loans, the lack of
adequate funds would adversely impact liquidity and result in continued losses
or reduce profitability. To the extent that the Company is not successful in
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 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.
The Company has historically experienced negative cash flow from operations
since 1996 primarily because, in general, its business strategy of selling
loans through securitizations had not generated cash flow immediately.
However, during fiscal 2004, the Company experienced positive cash flow from
operations of $6.8 million, primarily due to sales of loans on a whole loan
basis it originated in fiscal 2003. For the first three months of fiscal 2005,
the Company experienced negative operating cash flow of $14.2 million,
primarily due to its funding a $32.2 million increase in loans available for
sale.
7
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
For the first quarter of fiscal 2005, the Company recorded a net loss
attributable to common stock of $28.7 million. The loss for the first quarter
of fiscal 2005 primarily resulted from the Company's inability to reach the
loan origination levels required under its adjusted business strategy to
return to profitability, which substantially reduced its ability to generate
revenues, and its inability to complete a securitization during the first
quarter. Additionally, operating expenses increased in the first quarter of
fiscal 2005 as the Company began to add loan processing and marketing support
staff to support the future loan origination levels it expects to achieve
under its adjusted business strategy.
For the fiscal year ended June 30, 2004, the Company recorded a net loss
attributable to common stock of $115.1 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, second and third quarters of fiscal
2004, c) operating expense levels which would support greater loan origination
volume, and d) $46.4 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
fiscal 2004 due to the continuing low interest rate environment. In fiscal
2004, the Company originated $982.7 million of loans, which represents a
significant reduction as compared to $1.67 billion of loans originated in the
prior fiscal year.
LIQUIDITY CONCERNS. The Company's short-term liquidity has been negatively
impacted by several events and issues, which have occurred starting in 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. Because there was no
securitization, $453.4 million of the Company's $516.1 million of revolving
credit and conduit facilities then available was drawn upon at June 30, 2003.
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 loan originations in fiscal 2004
until it sold existing loans, extended existing credit facilities, or added
new credit facilities.
Second, the Company's ability to finance new loan originations in the first
three months of fiscal 2004 using borrowings under certain of its credit
facilities which carried over into fiscal 2004 was limited, terminated or
expired by October 31, 2003. Further advances under a non-committed portion of
one of these 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, 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.
8
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
Third, even though the Company was successful in obtaining one new credit
facility in September 2003 and obtaining a second new credit facility in
October 2003, see Remedial Actions to Address Liquidity Issues below, its
ability to finance new loan originations in the second and third quarters of
fiscal 2004 with borrowings under these new credit facilities was limited. The
limitations resulted from requirements to fund overcollateralization, which is
discussed below, in connection with new loan originations.
Fourth, 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, the Company's loan origination volume
was substantially reduced in fiscal 2004. From July 1, 2003 through June 30,
2004, the Company originated $982.7 million of loans, which represents a
significant reduction as compared to originations of $1.67 billion of loans in
fiscal 2003. As a result of the decrease in loan originations in fiscal 2004
and liquidity issues described above, the Company incurred a loss in fiscal
2004 and the first quarter of fiscal 2005 and depending on the Company's
ability to reach a profitable level of loan originations, complete
securitizations and recognize gains, it anticipates incurring losses at least
through the second quarter of fiscal 2005. During the first three months of
fiscal 2005, the Company originated $629.7 million of loans including $198.0
million in July 2004, $197.4 million in August 2004 and $234.3 million in
September 2004.
The Company anticipates that depending upon the size of its future quarterly
securitizations, it will need to increase loan originations to approximately
$400.0 million to $500.0 million per month to return to profitable operations.
If the Company is unable to complete quarterly securitizations, it will need
to increase its loan originations to approximately $500.0 million to $600.0
million per month to return to profitability.
The Company plans to achieve these increased levels of loan originations
through the continued application of its business strategy adjustments,
particularly as related to building an expanded broker channel and offering
adjustable rate mortgages and more competitively priced fixed rate mortgages.
The following actions were undertaken in fiscal 2004 to increase the Company's
ability to originate loans in its broker channel: (i) in December 2003 the
Company hired an experienced industry professional to manage the wholesale
business; (ii) in December 2003 the Company acquired a broker operation with
35 employees (63 employees at September 30, 2004) located in California; (iii)
in February 2004, the Company opened a mortgage broker office in Irvine,
California; (iv) 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 (74 employees at September 30, 2004); and (v) in June 2004 the
Company acquired a broker operation with 35 employees (36 employees at
September 30, 2004) located in Texas. In addition, the Company hired 38
mortgage broker account executives in its Upland Mortgage Broker Services
division to expand its broker presence in the eastern, southern and mid-
western areas of the United States and retained/hired 101 employees in its
Upland Broker Services Philadelphia headquarters to support its growing broker
network. In total, at September 30, 2004, the Company had 353 employees in its
broker operations including 182 account executives.
The Company's ability to achieve those levels of loan originations could be
hampered by a failure to implement its business strategy adjustments and by
loan funding limitations should the Company fail to maintain or replace
adequate credit facilities to finance new loan obligations.
9
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
The combination of the Company's current cash position and expected sources
of operating cash in fiscal 2005 may not be sufficient to cover its operating
cash requirements. 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. 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 under
"Subordinated Debentures and Senior Collateralized Subordinated Notes." On
September 30, 2004, the Company had unrestricted cash of approximately $19.7
million and up to $70.1 million available under its credit facilities.
Advances under these credit facilities can only be used to fund loan
originations and not for any other purposes.
Due to losses recorded in each of the quarters in fiscal 2004, the Company
requested and obtained waivers for its non-compliance with financial covenants
in its credit facility agreements and servicing agreements. See Note 8 for
more detail.
REMEDIAL ACTIONS TO ADDRESS LIQUIDITY ISSUES. The Company undertook
specific remedial actions to address liquidity issues including:
o The Company adjusted its business strategy beginning in early fiscal 2004.
The adjusted business strategy focuses on shifting from gain-on-sale
accounting and the use of securitization transactions as the Company's
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.
o The Company solicited bids and commitments from participants in the whole
loan sale market and entered into forward sale agreements. In total, from
June 30, 2003 through June 30, 2004, the Company sold approximately $1.1
billion (which includes $222.3 million of loans sold by the expired
mortgage conduit facility) of loans through whole loan sales. From July
1, 2004 through September 30, 2004, the Company sold an additional $586.5
million of loans through whole loan sales.
o The Company has entered into an informal arrangement with one recurring
purchaser of its loans whereby the purchaser maintains members of their
loan underwriting staff on the Company's premises to facilitate their
purchase of the Company's loans promptly after the Company originates
them. This arrangement accelerates the Company's receipt of cash proceeds
from the sale of loans, accelerates the pay down of its advances under
its warehouse credit facilities and adds to its liquidity. This quicker
turnaround time is expected to enable the Company to operate with smaller
committed warehouse credit facilities than would otherwise be necessary.
o On October 31, 2003, the Company completed a privately-placed
securitization, with servicing released, of $173.5 million of loans.
o The Company entered into two definitive loan agreements during fiscal
2004 for the purpose of funding its loan originations. These two
agreements replaced those credit facilities, which carried over into
fiscal 2004 but were limited, terminated or expired by October 31, 2003.
The Company entered into the first agreement on September 22, 2003 with a
financial institution for a one-year $200.0 million credit facility. It
entered into the second agreement on October 14, 2003 with a warehouse
lender for a three-year revolving mortgage loan warehouse credit facility
of up to $250.0 million. The one-year facility was extended to December
3, 2004, reduced on September 30, 2004 to
10
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
$100.0 million and reduced on November 4, 2004 to $60.0 million. The
reduction to $60.0 million will occur at a rate of $10.0 million per week
commencing on November 5, 2004. The three-year $250.0 million warehouse
credit facility continues to be available. See Note 10 for information
regarding the terms of these facilities.
o On November 5, 2004, the Company entered into a definitive agreement dated
as of November 4, 2004 with a warehouse lender for a one-year $100.0
million credit facility to replace the maturing $200.0 million credit
facility (reduced to $60.0 million). The Company also sold the
interest-only strips and servicing rights related to five of its mortgage
securitization trusts to an affiliate of this facility provider under the
terms of a September 27, 2004 sale agreement. The sale of these assets was
undertaken as part of the Company's negotiations to obtain the new $100.0
million credit facility and to raise cash to pay fees on new warehouse
credit facilities and as a result, the Company did not realize their full
value as reflected on its books. The Company wrote down the carrying value
of these interest-only strips and servicing rights by $5.4 million at June
30, 2004 to reflect their values under the terms of the sale agreement. On
September 27, 2004, the Company received proceeds from this sale of $9.7
million.
o On October 27, 2004, the Company entered into a commitment letter dated
October 26, 2004 and is negotiating the terms of a definitive agreement
with a warehouse lender for a three-year $30.0 million mortgage loan
warehouse facility and a two-year $23.0 million residual repurchase
facility. There can be no assurance that the Company will succeed in
entering into a definitive agreement regarding these facilities or that
this agreement will contain the terms and conditions acceptable to it. See
Note 8 for information regarding the terms of these facilities.
o On November 1, 2004, the Company received a commitment letter from two
warehouse lenders, including an affiliate of the lender on its $250.0
million credit facility, for a two-year $150.0 million mortgage loan
warehouse facility. The commitment letter becomes effective and legally
obligates the parties upon the Company's payment of fees described in the
commitment letter which have not been paid to date. However, there can be
no assurance that the Company will enter into definitive agreements
regarding the $150.0 million credit facility or that this agreement will
contain the terms and conditions acceptable to it. See Note 8 for
information regarding the terms of this facility.
o The Company mailed an Offer to Exchange on December 1, 2003 and May 14,
2004 ("the exchange offers") to holders of its subordinated debentures in
order to increase stockholders' equity and reduce the amount of
outstanding debt. These exchange offers resulted in the exchange of
$208.6 million of the Company's subordinated debentures for 109.4 million
shares of Series A preferred stock and $99.2 million of senior
collateralized subordinated notes. See Notes 10 and 11 for more detail on
the terms of the exchange offers, senior collateralized subordinated
notes and preferred stock issued. The issuance of 109.4 million shares of
Series A preferred stock results in an annual cash preferred dividend
obligation of $10.9 million.
o On January 22, 2004, the Company executed an agreement to sell its
interests in the remaining leases in its 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 the cash from this sale in January 2004 and
recognized a net gain of $0.5 million.
11
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
o The Company suspended payment of quarterly dividends on its common stock
beginning in the first quarter of fiscal 2004.
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 or senior collateralized
subordinated notes when due.
SUBORDINATED DEBENTURES AND SENIOR COLLATERALIZED SUBORDINATED NOTES. At
September 30, 2004 there were approximately $321.4 million of subordinated
debentures and $38.9 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 selling additional subordinated debentures and selling loans on
a whole loan basis and securitizing loans. 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 or other
prospective credit facilities. See Note 5 for more detail on obligations
collateralized by interest-only strips.
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, and obtaining working capital funding. No assurance can be
given that the Company will be able to successfully implement the contingent
financial restructuring plan, if necessary, and repay its outstanding debt
when due.
BASIS OF FINANCIAL STATEMENT PRESENTATION
The consolidated financial statements include the accounts of ABFS and its
subsidiaries (all of which are wholly owned). The consolidated financial
statements have been prepared in accordance with accounting principles
generally accepted in the United States of America. All significant
intercompany balances and transactions have been eliminated. In preparing the
consolidated financial statements, management is required to make estimates
and assumptions, which affect the reported amounts of assets and liabilities
as of the date of the consolidated financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates. These estimates include, among other
things, estimated prepayment, credit loss and discount rates on interest-only
strips and servicing rights, estimated servicing revenues and costs, valuation
of real estate owned, the net recoverable value of interest and fee
receivables and determination of the allowance for credit losses.
12
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BASIS OF FINANCIAL STATEMENT PRESENTATION -- (CONTINUED)
Certain prior period financial statement balances have been reclassified to
conform to current period presentation. All outstanding shares, average common
shares, earnings per common share and stock option amounts have been
retroactively adjusted to reflect the effect of a 10% stock dividend declared
on May 13, 2004. See Note 11 for further description.
RESTRICTED CASH
The Company held restricted cash balances of $8.0 million at September 30,
2004 collateralizing a letter of credit facility, $2.2 million and $3.1
million related to borrower escrow accounts at September 30, 2004 and June 30,
2004, respectively, and $0.1 million and $2.1 million at June 30, 2004 related
to deposits for future settlement of derivative financial instruments.
LOAN RECEIVABLES
Loans available for sale are loans the Company plans to sell or securitize
and are carried at the lower of amortized cost (principal balance, including
unamortized origination costs and fees) or fair value. Fair value is
determined by quality of credit risk, types of loans originated, current
interest rates, economic conditions, and other relevant factors.
Non-accrual loans consist primarily of loans repurchased from securitization
trusts and transferred from loans available for sale that are greater than 90
days delinquent. Non-accrual loans are carried at cost less an allowance for
credit losses.
INTEREST AND FEES RECEIVABLE
Interest and fees receivables are comprised mainly of accrued interest
receivable on loans and fees on loans that are less than 90 days delinquent.
Fee receivables include, among other types of fees, late fees and taxes and
insurance advances.
FORBEARANCE AND DEFERMENT ADVANCES RECEIVABLES
Under deferment and forbearance arrangements, the Company makes advances to
a securitization trust on behalf of a borrower in amounts equal to the
delinquent loan payments and may pay 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.
Advances made under deferment and forbearance arrangements result from a new
credit decision regarding the borrower's ability to repay the advance, as well
as perform under the original terms of the original loan, and do not involve
any modification of the terms of the original loan. These arrangements are
considered a new lending activity and do not qualify as troubled debt
restructurings under Statement of Financial Accounting Standard ("SFAS") No.
15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings."
The Company records the advances that it makes under deferment and forbearance
arrangements with borrowers as receivables on its balance sheet. The Company
carries these receivables at their estimated recoverable amounts. If the
original loan returns to a delinquency status of 90 days or more past due, the
Company writes the receivable off to expense. The Company did not record any
fee income on these arrangements during the three months ended September 30,
2004 or the fiscal year ended June 30, 2004.
13
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
LOANS SUBJECT TO REPURCHASE RIGHTS / LIABILITY FOR LOANS SUBJECT TO REPURCHASE
RIGHTS
Loans subject to repurchase rights is comprised of loans which were
securitized under SFAS No. 140 that the Company has a right to repurchase
because of a default by the borrower. SFAS No. 140 was effective on a
prospective basis for transfers of financial assets occurring after March 31,
2001. For securitizations recorded under SFAS No. 140 which have removal of
accounts provisions providing the Company with a contractual right to
repurchase delinquent loans, SFAS No. 140 requires that it recognize the loans
which are subject to these rights as assets on its balance sheet and record a
liability to reflect the repurchase cost. SFAS No. 140 requires this
accounting treatment because the default by the borrower has given the Company
effective control over the loans whether or not the Company actually
repurchases these loans. For securitization trusts 2001-2 through 2003-2, to
which this rule applies, the Company has the contractual right to repurchase a
limited amount of loans greater than 180 days past due, but no obligation to
do so. As delinquent loans in securitization trusts 2001-2 through 2003-2 age
greater than 180 days past due, the Company records an asset representing the
fair value of the loans and a liability to reflect the repurchase cost. In
accordance with the provisions of SFAS No. 140, the Company has recorded on
its September 30, 2004 balance sheet an asset of $40.7 million and a liability
of $47.9 million for delinquent loans subject to these removal of accounts
provisions under securitization trusts 2001-2 through 2003-2.
For securitization trusts 1998-3 through 2001-1, the Company also has rights
to repurchase a limited amount of delinquent loans, but is not obligated to do
so. No liabilities or assets have been recorded on its balance sheet related
to these rights. The amount of delinquent loans in securitization trusts 1998-
3 through 2001-1 which the company has the right to repurchase as of September
30, 2004 was $47.6 million.
ALLOWANCE FOR CREDIT LOSSES
The Company's allowance for credit losses on non-accrual loans and leases is
maintained to account for delinquent loans and leases and delinquent loans
that have been repurchased from securitization trusts. The allowance is
maintained at a level that management determines is adequate to absorb
estimated probable losses. The allowance is calculated based upon management's
estimate of its ability to collect on outstanding loans and leases based upon
a variety of factors, including, but not limited to, periodic analysis of the
non-accrual loans and leases, economic conditions and trends, historical
credit loss experience, borrowers' ability to repay and collateral
considerations. Additions to the allowance arise from the provision for credit
losses charged to operations or from the recovery of amounts previously
charged-off. Loan and lease charge-offs reduce the allowance. Delinquent loans
are charged off against the allowance in the period in which a loan is deemed
fully uncollectable or when liquidated in a payoff. Management considers the
current allowance to be adequate.
INTEREST-ONLY STRIPS
Prior to June 30, 2003, the Company sold most of the loans it originated
through securitizations. In connection with these securitizations, the Company
received cash and an interest-only strip, which represents the Company's
retained interest in the securitized loans. As a holder of the interest-only
strips, the Company is entitled to receive certain excess (or residual) cash
flows and overcollateralization cash flows, which are derived from payments
made to a trust from the securitized loans after deducting payments to
investors in the securitization trust and other miscellaneous fees. These
retained interests are carried at their fair value. Interest-only strips are
initially recorded at their allocated cost basis at the time of recording a
securitization gain and in accordance with SFAS No. 115 "Accounting for
Certain Investments in Debt and Equity Securities," referred to as SFAS No.
115 in this document, are then written up to their fair value through other
comprehensive income, a component of stockholders' equity.
14
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-ONLY STRIPS -- (CONTINUED)
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 the pools of loans sold through
securitizations. Cash flows are discounted from the date the cash is expected
to be available to the Company (the "cash-out method"). Management based its
estimates of prepayment and credit loss rates 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.
Excess cash flows are retained by the trust until certain
overcollateralization levels are established. The overcollateralization is the
excess of the aggregate principal balances of loans in a securitized pool over
investor interests. The overcollateralization serves as credit enhancement for
the investors.
PREPAYMENT RATES. The assumptions the Company uses to estimate future
prepayment rates are regularly compared to actual prepayment experience of the
individual securitization pools of mortgage loans and to an average of the
actual experience of other similar pools of mortgage loans at the same age.
Current economic conditions, current interest rates, loans repurchased from
securitization trusts and other factors are considered in our analysis of
prepayment experience and in forecasting future prepayment levels.
Analysis of prepayment experience and forecasts of prepayments consider that
prepayments on securitized loans may be initiated by the borrower, such as a
refinancing for a lower interest rate, initiated by the servicer in the
collection process for delinquent loans, or as a result of our repurchase of
delinquent loans from the securitization trusts for trigger management.
Prepayments initiated by the borrower are viewed as voluntary prepayments.
Voluntary prepayments are the most significant component of prepayment
experience, generally representing approximately 91% of total prepayments, and
are full cash payoffs of a securitized loan. Prepayments initiated by the
servicer are viewed as involuntary prepayments, generally representing
approximately 4% of total prepayment experience and are the result of
delinquent loan bulk sales, REO liquidations and settlements on delinquent
loans. Losses on these involuntary prepayments are absorbed by the
securitization trusts. Prepayments as a result of the Company's repurchase of
delinquent loans from the securitization trusts are also viewed as involuntary
and generally represent approximately 5% of total prepayment experience.
Losses on the liquidation of repurchased loans are absorbed on the Company's
books. Both voluntary and involuntary loan prepayments are incorporated in the
Company's prepayment assumption forecasts.
The Company's practice in forecasting prepayment assumptions for calculation
of the initial securitization gain and subsequent revaluations had been to use
an average historical prepayment rate of similar pools for the expected
constant prepayment rate assumption while a pool of mortgage loans was less
than a year old even though actual experience may be different. During that
period, before a pool of mortgage loans reached its expected constant
prepayment rate, actual experience both quantitatively and qualitatively was
generally not considered 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 was 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.
15
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-ONLY STRIPS -- (CONTINUED)
For the past twelve quarters, actual prepayment experience was generally
higher, most significantly on home equity loans, than historical averages for
prepayments prior to that eleven-quarter period. The long duration of
historically low interest rates, combined with increasing home values and high
consumer debt levels has given borrowers an extended opportunity to engage in
mortgage refinancing activities, which resulted in elevated prepayment
experience. Low interest rates and increasing home values provide incentive to
borrowers to convert high cost consumer debt into lower rate tax deductible
loans. As home values have increased, lenders have been highly successful in
educating borrowers that they have the ability to access the cash value in
their homes.
For the past twelve quarters, the Company assumed for each quarter end
valuation that the decline in interest rates had stopped and a rise in
interest rates would occur in the near term. Economic conditions and published
mortgage industry surveys supported the Company's assumption. The Company
believes that once it moves beyond the low interest rate environment and the
impact that environment has had on prepayments, the long recurring and highly
unfavorable prepayment experience over the past eleven quarters will leave the
Company with securitized mortgage pools which will experience future
prepayment speeds substantially lower than originally believed. Also, the rate
of increase in home values has slowed considerably, which the Company expects
will mean that fewer borrowers will have excess value in their homes to
access. As a result of analysis of these factors, the Company believes
prepayments will continue to remain at higher than normal levels for the near
term before declining to historical prepayment levels and then further
declining in the future. However, the Company cannot predict with certainty
what prepayment experience will be in the future. Any unfavorable difference
between the assumptions used to value securitization assets and actual
experience may have a significant adverse impact on the value of these assets.
In addition to the use of prepayment fees on loans it originated, the
Company has implemented programs and strategies in an attempt to reduce loan
prepayments. 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, such as the customer
retention incentive program, to qualified borrowers to deter prepayment of
their loan. The Company 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 for individual mortgage loan pools and averages for similar
mortgage loan pools. Delinquency trends, economic conditions, loans
repurchased from securitization trusts and other factors are also considered.
If the analysis indicates that loss experience may be different from
assumptions, the Company would adjust its assumptions as necessary. However,
the Company cannot predict with certainty what credit loss experience will be
in the future. Any unfavorable difference between the assumptions used to
value securitization assets and actual experience may have a significant
adverse impact on the value of these assets.
The Company may elect to repurchase delinquent loans from securitization
trusts to limit the level of delinquencies and losses in the securitization
trusts, and as a result, it can avoid exceeding specified limits on
delinquencies and losses that trigger a temporary reduction or discontinuation
of cash flow from its interest-only strips. See Note 4 for the amount of loans
the Company has repurchased from securitization trusts. Once a loan has been
included in a pool of securitized loans, its performance, including historical
loss experience if the loan has been repurchased, is reflected in the
performance of that pool of mortgage loans.
16
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-ONLY STRIPS -- (CONTINUED)
The Company may enter into deferment and forbearance arrangements with
borrowers in its managed portfolio who experience financial hardships. Any
credit losses ultimately realized on these arrangements are included in total
portfolio historical losses, which are used in developing credit loss
assumptions.
PERIODIC REVALUATIONS. The expected future cash flows from interest-only
strips are periodically re-evaluated. The current assumptions for prepayment
and credit loss rates are monitored against actual experience and other
economic conditions and are changed if deemed necessary. 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, decreases in the fair value of interest-only
strips that are deemed to be other than temporary adjustments to fair value
are recorded through the income statement, which would adversely affect our
income in the period of adjustment.
Additionally, to the extent any individual interest-only strip has a portion
of its initial write up to fair value still remaining in other comprehensive
income, other than temporary decreases in its fair value would first be
recorded as a reduction to other comprehensive income, which would adversely
affect our stockholders' equity in the period of adjustment.
See Note 5 for more information and the amounts of valuation assumptions
adjustments recorded.
The securitization trusts and their investors have no recourse to other
assets of the Company for failure of the securitized loans to pay when due.
SERVICING RIGHTS
When loans are sold through a securitization, the loans' servicing rights
have generally been retained and the Company capitalizes the benefit
associated with the rights to service securitized loans. However, the Company
does not service the loans in the 2003-2 securitization, the Company's most
recent securitization, which closed in October 2003.
Servicing rights 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. Servicing rights
are carried at the lower of cost or fair value. Fair value represents the
present value of projected net cash flows from servicing. The projected cash
flows from servicing fees incorporate assumptions made by management,
including prepayment rates and discount rates. These assumptions are similar
to those used to value the interest-only strips retained in a securitization.
Amortization of the servicing rights asset for securitized loans is
calculated individually for each securitized loan pool and is recognized in
proportion to servicing income on that particular pool of loans.
The expected future cash flows from servicing rights are periodically
reevaluated. The current assumptions for prepayment rates are monitored against
actual experience and other economic conditions and are changed if deemed
necessary. A review for impairment is performed on a quarterly basis by
stratifying the serviced loans by loan type, home equity or business purpose
loans, which is considered to be the predominant risk characteristic in the
portfolio of loans the Company services. In establishing loan type as the
predominant risk characteristic, the Company considered the following additional
loan characteristics and determined these characteristics as mostly uniform
within its two types of serviced loans and not predominant for risk
stratification:
17
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SERVICING RIGHTS -- (CONTINUED)
o Fixed versus floating rate loans - All loans the Company services in its
securitizations are fixed-rate loans.
o Conforming versus non-conforming loans - All loans the Company services
are sub-prime (non-conforming) loans, with over 80% of the loans serviced
having credit grades of A or B.
o Interest rate on serviced loans - The serviced loan portfolio has a high
penetration rate of prepayment fees. Sub-prime borrowers, in general, are
not as influenced by movement in market interest rates as conforming
borrowers. A sub-prime borrower's ability to `rate shop' is generally
limited due to personal credit circumstances that are not market driven.
o Loan collateral - All loans the Company services are secured by real
estate, with approximately 85% secured with first liens on residential
property.
o Individual loan size - The average loan size in the Company's serviced
portfolio is $71 thousand. The serviced portfolio is approximately $1.6
billion at September 30, 2004 with approximately 22 thousand loans. There
are no significant defining groupings with respect to loan size. No loans
are greater than $1.0 million, only $9.1 million of loans have principal
balances greater than $500 thousand, and only $30.3 million of loans have
principal balances greater than $350 thousand.
o Geographic location of loans - The largest percentage of loans the
Company services are geographically located in the mid-Atlantic and
northeast sections of the United States.
o Original loan term - Home equity loan terms are primarily 180, 240 or 360
months. Business purpose loan terms are primarily 120 or 180 months.
If the Company's quarterly 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.
PREPAID EXPENSES
Prepaid assets are comprised mainly of amounts paid for fees on warehouse
lines and operating lines of credit (facility fees), insurance coverage and
printed marketing materials and customer lists, which have not yet been
utilized. Costs for facility fees, printed materials and customer lists are
expensed as they are utilized. Other marketing and advertising costs are
expensed as incurred. Prepaid expenses included prepaid facility fees of $14.0
million at September 30, 2004 and $10.4 million at June 30, 2004.
INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax
return. Under the asset and liability method used by the Company to provide
for income taxes, deferred tax assets and liabilities are recognized for the
expected future tax consequences of temporary differences between the
financial statement and tax basis carrying amounts of existing assets and
liabilities.
Estimates of deferred tax assets and liabilities make up the deferred income
tax asset on the Company's balance sheet. These estimates involve significant
judgments and estimates by management, which may have a material impact on the
carrying value of the deferred income tax asset. The deferred income tax asset
is periodically reviewed to determine if it is more likely than not that the
Company will realize this deferred tax asset.
18
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK OPTIONS
The Company has stock option plans that provide for the periodic granting of
options to key employees and non-employee directors and accounts for options
granted under these plans under APB Opinion No. 25 "Accounting for Stock
Issued to Employees" ("APB No. 25"). The Company accounts for fixed 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. The Company
accounts for performance based stock options issued under these plans as
variable stock options and recognizes compensation expense based on the fair
value of the Company's common stock, as measured on the date of the grant, on
a straight-line basis over the vesting period of these stock options.
Had the Company accounted for stock options granted under these plans using
the fair value method of SFAS No. 123, "Accounting for Stock-Based Compensation"
("SFAS No. 123") and SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure" ("SFAS No. 148"), pro forma net income and earnings
per share would have been as follows (in thousands, except per share amounts):
THREE MONTHS ENDED SEPTEMBER 30,
--------------------------------
2004 2003
--------- ---------
Net income (loss) attributable
to common stock, as reported... $ (28,712) $(26,268)
Stock based compensation costs,
net of tax effects determined
under fair value method for all
awards......................... (64) (182)
-------- --------
Pro forma........................ $(28,776) $(26,450)
======== ========
Earnings (loss) per share -
basic
As reported.................. $ (7.98) $ (8.10)
Pro form..................... (8.00) (8.16)
-------- --------
Earnings (loss) per share -
diluted
As reported.................. $ (7.98) $ (8.10)
Pro forma ................... (8.00) (8.16)
======== ========
RECENT ACCOUNTING PRONOUNCEMENTS
No new accounting pronouncements affecting the Company have been issued
since the filing of its June 30, 2004 Form 10-K.
2. ACQUISITIONS
On December 24, 2003, the Company acquired a broker operation 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 $475 thousand convertible non-negotiable promissory note issued in the
December 2003 acquisition 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
19
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
2. ACQUISITIONS (CONTINUED)
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.
On June 11, 2004, the Company acquired a broker operation located and
primarily operating in the state of Texas. This acquisition was also for the
purpose of expanding the Company's capacity to originate loans through its
broker channel. Assets acquired in this transaction, mostly fixed assets, were
not material. The purchase price was comprised of issuing a $650 thousand
convertible non-negotiable promissory note to the seller and $150 thousand of
cash. As a result of this transaction, the Company increased its goodwill by
$612 thousand.
The $650 thousand convertible non-negotiable promissory note issued in the
June 2004 acquisition bears interest at 8% per annum and is to be paid in five
semi-annual installments of $108 thousand each commencing on December 31, 2004.
The final semi-annual installment is due on June 30, 2007. At any semi-annual
installment date, the holder of the note has the option to convert the note into
the number of shares of the Company's common stock as determined by dividing the
semi-annual principal payment amount by the closing price per common share on
the immediately preceding semi-annual payment date, subject to adjustment for
any changes in the capitalization of the Company affecting its common stock.
3. LOAN AND LEASE RECEIVABLES
LOANS AVAILABLE FOR SALE
Loans available for sale were comprised of the following (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
------------------ -------------
Loans available for sale, secured by real
estate, principal balance............... $329,331 $300,143
Valuation allowance(a).................... (100) (42)
Deferred direct loan origination costs ... 7,236 4,453
Other(b) ................................. 44 (279)
-------- --------
$336,511 $304,275
======== ========
- ---------------
(a) For estimated credit losses.
(b) Represents the SFAS No. 133 adjustment to the fair value of hedged loans.
Real estate secured loans have contractual maturities of up to 30 years.
The activity in the valuation allowance against available for sale loans is
summarized as follows (in thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
-------------
2004 2003
---- ------
Balance at beginning of the period ............................ $ 42 $1,319
Provision adjustment .......................................... 58 363
---- ------
Balance at end of the period .................................. $100 $1,682
==== ======
20
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
3. LOAN AND LEASE RECEIVABLES (CONTINUED)
NON-ACCRUAL LOANS
At September 30, 2004 and June 30, 2004, the accrual of interest income was
suspended on real estate secured loans of $4.6 million and $3.5 million,
respectively. Non-accrual loans at September 30, 2004 and June 30, 2004 were
comprised of the following (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
------------------ -------------
Loans repurchased from securitization
trusts.................................. $ 4,392 $ 3,281
Loans transferred from available for sale 80 181
Other .................................... 80 --
------- -------
4,552 3,462
Allowance for credit losses .............. (1,238) (1,469)
------- -------
Net non-accrual loans .................... $ 3,314 $ 1,993
======= =======
Average balances of non-accrual loans for the twelve months ended September
30, 2004 and June 30, 2004 were $5.6 million and $7.3 million, respectively.
4. ALLOWANCE FOR CREDIT LOSSES
The activity in the allowance for credit losses on non-accrual loans and
leases is summarized as follows (in thousands):
THREE MONTHS
ENDED SEPTEMBER 30,
----------------
2004 2003
------ -------
Balance at beginning of the period ......................... $1,469 $ 1,529
Provision for credit losses:
Business purpose loans .................................... 146 1,129
Home equity loans ......................................... (87) 2,694
Equipment leases .......................................... -- (30)
------ -------
Total provision.......................................... 59 3,793
------ -------
Loan charge-offs:
Business purpose loans .................................... (66) (352)
Home equity loans ......................................... (328) (1,198)
Equipment leases .......................................... -- (110)
------ -------
Total loan charge offs................................... (394) (1,660)
====== =======
Recoveries of loans previously charged off:
Business purpose loans .................................... 70 4
Home equity loans ......................................... 34 14
Equipment leases .......................................... -- 108
------ -------
Total recoveries......................................... 104 126
------ -------
Total charge-offs, net ..................................... (290) (1,534)
------ -------
Balance at end of the period ............................... $1,238 $ 3,788
====== =======
Ratio of net charge offs in the portfolio to the average
portfolio(a).............................................. 0.38% 3.37%
Ratio of allowance to non-accrual loans and leases ........ 27.21% 24.61%
- ---------------
(a) The average portfolio includes loans available for sale, non-accrual loans
and leases.
21
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
4. ALLOWANCE FOR CREDIT LOSSES (CONTINUED)
The following schedule details the provision for credit losses for the three
months ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
-------------
2004 2003
---- ------
Loans available for sale ...................................... $ 58 $ 363
Non-accrual loans ............................................. 59 3,823
Leases ........................................................ -- (30)
---- ------
Total Provision for Credit Losses ............................. $117 $4,156
==== ======
While the Company is under no obligation to do so, at times it elects to
repurchase delinquent loans from the 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, it 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 has the right, but not the obligation, to repurchase a
limited amount of delinquent loans from securitization trusts. In addition,
the Company may elect to repurchase delinquent 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 the Company, as servicer, has
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 the Company typically elects 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 the provision for credit losses in the period
of repurchase. The related REO writedown for REO repurchased is recorded
through general and administrative expense in the period of repurchase. The
Company's ability to repurchase these loans does not disqualify 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.
At September 30, 2004, one of the Company's twenty mortgage securitization
trusts was under a triggering event as a result of delinquencies exceeding
specified levels. There were no securitization trusts exceeding specified loss
levels at September 30, 2004. At June 30, 2004, four of the Company's mortgage
securitization trusts were under a triggering event. Approximately $5.0
million of excess overcollateralization is being held by the trust as of
September 30, 2004. For the three months ended September 30, 2004, the Company
repurchased delinquent loans with an aggregate unpaid principal balance of
$2.7 million from securitization trusts primarily for trigger management. The
Company cannot predict when the trust currently exceeding triggers will be
below trigger limits and release the excess overcollateralization. In order
for the trust to release the excess overcollateralization, delinquent loans
would need to decline, or the Company would need to repurchase delinquent
loans of up to $4.8 million as of September 30, 2004. If delinquencies
increase and the Company 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. The Company's ability
to continue to manage triggers in its securitization trusts in the future is
affected by the availability of cash from operations or through the sale of
subordinated debentures to fund these repurchases.
22
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
4. ALLOWANCE FOR CREDIT LOSSES (CONTINUED)
The following table summarizes the principal balances of loans and real
estate owned "REO" repurchased from securitization trusts (dollars in
thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
----------------
2004 2003
------ -------
By original loan type:
Business purpose loans .................................... $2,002 $ 4,380
Home equity loans ......................................... 701 11,963
------ -------
Total.................................................... $2,703 $16,343
====== =======
By loans and REO:
Loans repurchased ......................................... $2,607 $ 9,847
REO purchased ............................................. 96 6,496
------ -------
Total.................................................... $2,703 $16,343
====== =======
Number of loans repurchased ................................ 20 215
====== =======
The Company received $1.8 million and $7.6 million of proceeds from the
liquidation of repurchased loans and REO during the three-months ended
September 30, 2004 and 2003, respectively. The Company had repurchased loans
remaining on the balance sheet in the amounts of $4.4 million at September 30,
2004 and $3.3 million at June 30, 2004 and REO of $1.5 million at September
30, 2004 and $1.9 million at June 30, 2004.
5. INTEREST-ONLY STRIPS
The activity for interest-only strip receivables is summarized as follows
(in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
-------- --------
Balance at beginning of period .......................... $459,086 $598,278
Initial recognition of interest-only strips, including
initial overcollateralization of $0.................... -- 950
Proceeds from sale of interest-only strips(a) ........... (9,120) --
Cash flow from interest-only strips ..................... (33,141) (56,222)
Required purchases of additional overcollateralization .. 4,615 7,660
Interest accretion ...................................... 8,448 10,828
Adjustment for loans subject to repurchase rights ....... 309 162
Adjustments to fair value recorded through other
comprehensive income(b)................................ 18,644 (6,122)
Other than temporary fair value adjustment(c) ........... (29) (9,951)
-------- --------
Balance at end of period ................................ $448,812 $545,583
======== ========
- ---------------
(a) Reflects the proceeds received for the sale of interest-only strips related
to five securitization trusts. On June 30, 2004, the Company wrote down the
carrying value of these interest-only trusts by $4.1 million to reflect
their values under the terms of a September 27, 2004 sale agreement. The
sale of these assets is described in Note 8.
23
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
5. INTEREST-ONLY STRIPS (CONTINUED)
(b) Adjustments to the carrying value of interest-only strips for the initial
write up to fair value are recorded through other comprehensive income,
which is a component of stockholders' equity. Additionally, to the extent
any individual interest-only strip has a portion of its initial write up to
fair value still remaining in other comprehensive income at the time of
impairment, other than temporary decreases in its fair value would first be
recorded as a reduction to other comprehensive income.
(c) Recorded through the income statement.
Interest-only strips include overcollateralization balances that represent
undivided interests in securitizations maintained to provide credit
enhancement to investors in securitization trusts. At September 30, 2004 and
2003, the fair value of overcollateralization related cash flows were $202.2
million and $263.5 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 $47.6 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 September 30, 2004, our interest in the
cash flows from the interest-only strips held in the trust, which secure the
senior collateralized subordinated notes, totaled $401.6 million, of which
approximately $146.2 million represented 150% of the outstanding principal
balance of the senior collateralized subordinated notes. See Note 8 for more
detail on the senior collateralized subordinated notes.
Declining interest rates and resulting high prepayment rates over the last
twelve quarters have required revisions to our estimates of the value of our
securitization assets. 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
twelve quarters the Company has recorded cumulative pre-tax write downs to its
interest-only strips in the aggregate amount of $140.4 million and pre-tax
adjustments to the value of servicing rights of $12.1 million, for total
adjustments of $152.5 million, mainly due to the higher than expected prepayment
experience. On June 30, 2004, the Company wrote down the carrying value of its
interest-only strips and servicing rights related to five of our mortgage
securitization trusts by $5.4 million to reflect their values under the terms of
a September 27, 2004 sale agreement. The following table summarizes the net
cumulative write downs recorded on securitization assets over the last twelve
quarters (in thousands):
TOTAL INCOME OTHER
WRITE DOWN STATEMENT COMPREHENSIVE
(WRITE UP) IMPACT INCOME IMPACT
---------- --------- -------------
PRE-TAX ADJUSTMENT RESULTING FROM:
Prepayments............................................................................. $177,396 $128,697 $48,699
Discount rate........................................................................... (30,305) (18,427) (11,878)
Loss on sale............................................................................ 5,452 3,446 2,006
-------- -------- -------
Net cumulative write down............................................................... $152,543 $113,716 $38,827
======== ======== =======
During the first quarter of fiscal 2005, the Company recorded a pre-tax
write up of $18.6 million on its interest-only strips. The $18.6 million write
up was recorded as an increase to other comprehensive income, a component of
stockholders' equity. This write up of interest-only strips resulted from a
reduction to our
24
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
5. INTEREST-ONLY STRIPS (CONTINUED)
assumptions for loan prepayments expected to occur beyond 18 months.
Management believes that once it moves beyond the low interest rate
environment and the impact that environment has on loan prepayments, the long
running and highly unfavorable prepayment experience over the last twelve
quarters will leave the Company with securitized mortgage pools which will
experience future prepayment speeds substantially lower than originally
believed. No adjustments were recorded to servicing rights at September 30,
2004.
The breakout of the total securitization assets adjustments in fiscal 2004
and 2003 between interest-only strips and servicing rights was as follows (in
thousands):
YEAR ENDED JUNE 30, 2004 YEAR ENDED JUNE 30, 2003
------------------------------------ ------------------------------------
TOTAL INCOME OTHER TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE WRITE STATEMENT COMPREHENSIVE
DOWN IMPACT INCOME IMPACT DOWN IMPACT INCOME IMPACT
------- --------- ------------- ------- --------- -------------
Interest-only strips ............................... $57,031 $39,659 $17,372 $57,973 $39,900 $18,073
Servicing rights ................................... 6,791 6,791 -- 5,282 5,282 --
------- ------- ------- ------- ------- -------
Total securitization assets ........................ $63,822 $46,450 $17,372 $63,255 $45,182 $18,073
======= ======= ======= ======= ======= =======
The long duration of historically low interest rates, combined with
increasing home values and high consumer debt levels has given borrowers an
extended opportunity to engage in mortgage refinancing activities, which
resulted in elevated prepayment experience. Low interest rates and increasing
home values provide incentive to borrowers to convert high cost consumer debt
into lower rate tax deductible loans. As home values have increased, lenders
have been highly successful in educating borrowers that they have the ability
to access the cash value in their homes.
The persistence of historically low interest rate levels, unprecedented in
the last 40 years, has made the forecasting of prepayment levels difficult.
The Company assumed for each quarter end valuation that the decline in
interest rates had stopped and a rise in interest rates would occur in the
near term. This assumption was supported by published data. Consistent with
this view that interest rates would rise, 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. The Company
believes that once it moves beyond the low interest rate environment and the
impact that environment has had on prepayments, the long recurring and highly
unfavorable prepayment experience over the last eleven quarters will leave the
Company with securitized loan pools which will experience future prepayment
speeds substantially lower than originally believed. Also, the rate of
increase in home values has slowed considerably, which the Company expects
will mean that fewer borrowers will have excess value in their homes to
access. The Mortgage Bankers Association of America has forecast as of
September 17, 2004 that mortgage refinancings as a percentage share of total
mortgage originations will decline from 49% in the second quarter of calendar
2004 to 24% in the second quarter of calendar 2005. The Mortgage Bankers
Association of America has also projected in its September 2004 economic
forecast that the 10-year treasury rate (which generally affects mortgage
rates) will increase steadily each quarter in their forecast. As a result of
an analysis of these factors, the Company believes prepayments will continue
to remain at higher than normal levels for the near term before declining to
historical prepayment levels and then further declining in the future.
However, the Company cannot predict with certainty what our prepayment
experience will be in the future. Any unfavorable difference between the
assumptions used to value securitization assets and actual experience may have
a significant adverse impact on the value of these assets.
25
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
5. INTEREST-ONLY STRIPS (CONTINUED)
The following tables detail the net pre-tax write-up of the interest-only
strips for the first quarter of fiscal 2005 and the net pre-tax write downs of
the securitization assets by quarter for fiscal years 2004, 2003 and 2002 and
details the impact to the income statement and to other comprehensive income
in accordance with the provisions of SFAS No. 115 "Accounting for Certain
Investments in Debt and Equity Securities" and EITF 99-20 as they relate to
interest-only strips and SFAS No. 140 "Accounting for Transfers and Servicing
of Financial Assets and Extinguishment of Liabilities" as it relates to
servicing rights (in thousands):
FISCAL YEAR 2005:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED DOWN IMPACT INCOME IMPACT
- ------------- -------- --------- -------------
September 30, 2004........................................................................ $(18,614) $29 $(18,643)
FISCAL YEAR 2004:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED 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
June 30, 2004.............................................................................. 9,249 8,602 647
------- ------- -------
Total Fiscal 2004.......................................................................... $63,822 $46,450 $17,372
======= ======= =======
FISCAL YEAR 2003:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED 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:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED 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.
26
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
6. SERVICING RIGHTS
The activity for the loan and lease servicing rights asset is summarized as
follows (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
------------------
2004 2003
------- --------
Balance at beginning of the period........................ $73,738 $119,291
Amortization ............................................. (6,440) (12,375)
Proceeds from sale of servicing rights(a) ................ (586) --
Write down ............................................... -- (844)
------- --------
Balance at end of the period.............................. $66,712 $106,072
======= ========
- ---------------
(a) Reflects the proceeds received for the sale of servicing rights related to
five securitization trusts. On June 30, 2004, the Company wrote down the
carrying value of these servicing rights by $1.3 million to reflect their
values under the terms of a September 27, 2004 sale agreement. The sale of
these assets is described in Note 8.
Servicing rights are valued quarterly by the Company based on the current
estimated fair value of the servicing asset. The Company's valuation analysis
for September 30, 2004 indicated that no adjustment was required in the first
quarter of fiscal 2005. In the first quarter of fiscal 2004, the Company
recorded a $0.8 million write down of its servicing rights.
Under the servicing agreements associated with 16 of the 19 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, non-compliance with financial covenants in
the servicing agreements (the term "servicing agreements" includes sale and
servicing agreements and pooling and servicing agreements). In the remaining 3
securitizations serviced by the Company, servicing rights can be terminated by
the trustee under similar circumstances.
As a result of the Company's non-compliance at September 30, 2003 with the
net worth covenant in the separate servicing agreements with each of two bond
insurers, the Company requested and obtained waivers of the non-compliance from
the two bond insurers. In connection with the waiver of non-compliance granted
by one bond insurer, applicable to the remaining term of the related servicing
agreements as well as to prior occurrences of the non-compliance, the servicing
agreements with that bond insurer were amended to provide for 120-day
term-to-term servicing. In connection with the waiver of non-compliance granted
by the second bond insurer, applicable only to prior occurrences of
non-compliance, the servicing agreements with that bond insurer were amended to
provide for 30-day term-to-term servicing. Subsequently, this bond insurer has
given the Company a waiver of non-compliance with the net worth covenant on a
monthly basis and the Company is currently operating under such a waiver.
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
27
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
6. SERVICING RIGHTS (CONTINUED)
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. The Company has been
re-appointed as servicer under each of these servicing agreements, as amended,
for all relevant term-to-term servicing provision.
7. OTHER ASSETS AND OTHER LIABILITIES
Other assets were comprised of the following (in thousands):
SEPTEMBER 30, JUNE 30,
2004 2004
------------- --------
Goodwill ........................................... $16,315 $16,315
Financing costs, debt offerings .................... 3,727 3,567
Real estate owned .................................. 1,510 1,920
Investments held to maturity ....................... -- 839
Due from securitization trusts for servicing
related activities................................ 679 792
Other .............................................. 5,723 4,115
------- -------
$27,954 $27,548
======= =======
The activity in real estate owned during the three months ended September
30, 2004 and 2003 was as follows (in thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
----------------
2004 2003
------ -------
Balance at beginning of period ............................. $1,920 $ 4,776
Properties acquired through foreclosure(a) ................. 101 676
Properties purchased from securitization trusts(a) ......... 96 4,202
Sales/liquidation proceeds ................................. (433) (4,956)
Property revaluation losses ................................ -- (145)
(Loss) gain on sale/liquidation ............................ (174) 13
------ -------
Total ...................................................... $1,510 $ 4,566
====== =======
- ---------------
(a) At lower of cost or net realizable value.
28
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
7. OTHER ASSETS AND OTHER LIABILITIES (CONTINUED)
Other liabilities were comprised of the following (in thousands):
SEPTEMBER 30,
-----------------
2004 2003
------- -------
Commitments to fund closed loans .......................... $57,095 $46,654
Unearned lease incentives ................................. 12,470 12,793
Deferred rent incentive ................................... 5,298 4,908
Escrow deposits held ...................................... 2,207 3,113
Funds held in suspense .................................... 1,240 1,383
Periodic advance guarantee ................................ 670 670
Sold loan recourse liability .............................. 65 307
Hedging liabilities, at fair value ........................ -- 103
Trading liabilities (asset), at fair value ................ (2) 851
Other ..................................................... 1,475 1,090
------- -------
$80,518 $71,872
======= =======
Unearned lease incentives represent reimbursements received in conjunction
with the lease agreement for the Company's corporate office space in
Philadelphia, Pennsylvania. These funds represent reimbursement from the
landlord for leasehold improvements and furniture and equipment in the rented
space and will be recognized as an offset to rent expense over the term of the
lease or the life of the asset, whichever is shorter.
Deferred rent incentive represents the accrual of future rent payments,
which will be made mainly in conjunction with the lease agreement for the
Company's corporate office space in Philadelphia, Pennsylvania. This lease
agreement, which is for a term of eleven years, required no cash rent payments
during its first year. The Company is recording rent expense equal to the
aggregate cash rent payments, which will be paid in years two through eleven,
on a straight-line basis over the full eleven year life of the lease. The
balance in the deferred rent incentive accrual was established during the
first year and will be reduced to zero on a straight-line basis over years two
through eleven.
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE
Subordinated debentures were comprised of the following (in thousands):
SEPTEMBER 30, JUNE 30,
2004 2004
------------- --------
Subordinated debentures(a) ......................... $476,254 $509,928
Subordinated debentures - variable rate demand
notes(b).......................................... 13,772 12,681
-------- --------
Total subordinated debentures ...................... $490,026 $522,609
======== ========
Senior collateralized subordinated notes were comprised of the following (in
thousands):
SEPTEMBER 30, JUNE 30,
2004 2004
------------- --------
Senior collateralized subordinated notes(c) ........ $97,454 $83,639
======= =======
29
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
Warehouse lines and other notes payable were comprised of the following (in
thousands):
SEPTEMBER 30, JUNE 30,
2004 2004
------------- --------
Warehouse revolving line of credit(d) .............. $ 73,276 $ 53,223
Warehouse revolving line of credit(e) .............. 206,667 186,364
Capitalized leases(f) .............................. 404 488
Convertible promissory notes(g) .................... 1,125 1,125
-------- --------
Total warehouse lines and other notes payable ...... $281,472 $241,200
======== ========
- ---------------
(a) Subordinated debentures due October 2004 through July 2014, interest rates
ranging from 5.30% to 13.99%; average rate at September 30, 2004 was
10.44%, average remaining maturity was 11.5 months, subordinated to all of
the Company's senior indebtedness. The average rate on subordinated
debentures including variable rate demand notes was 10.30% at September 30,
2004.
(b) Subordinated debentures - variable rate demand notes due upon demand,
interest rate at 5.53%; subordinated to all of the Company's senior
indebtedness.
(c) Senior collateralized subordinated notes due October 2004 through July
2014, interest rates ranging from 5.40% to 13.10%; average rate at
September 30, 2004 was 9.84%, average remaining maturity was 16.5 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 and May 14, 2004 Exchange Offers. At September 30, 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 $401.6 million, of which $146.2 million represents 150% of the
outstanding principal balance of the senior collateralized subordinated
notes at September 30, 2004.
(d) $200.0 million warehouse revolving line of credit with JPMorgan Chase
Bank entered into on September 22, 2003 and with an original maturity of
September 2004. In September 2004, the maturity date of this facility was
extended to November 5, 2004 and the facility amount was reduced to
$100.0 million. In November 2004, the maturity date was extended to
December 3, 2004 and the facility amount will reduce to $60.0 million.
The reduction to $60.0 million will occur at a rate of $10.0 million per
week commencing November 5, 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.
30
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
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 September 30, 2004. The
letter of credit was collateralized by cash and expires on December 16,
2004.
(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
$47.6 million.
(f) Capitalized leases, maturing through January 2006, imputed interest rate
of 8.0%, collateralized by computer equipment. The original principal
amount of debt recorded under these leases was $1.0 million. The leases
mature through January 2006.
(g) Consists of two convertible non-negotiable promissory notes issued for
the acquisition of certain assets and operations of two mortgage broker
businesses. The first note, issued December 23, 2003, 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. The
second note, issued June 11, 2004, bears interest at 8% per annum and is
to be paid in five semi-annual installments of $108 thousand each
commencing on December 31, 2004. The final semi-annual installment is due
on June 30, 2007. At any semi-annual installment date, the holder of the
note has the option to convert the note into the number of shares of the
Company's common stock as determined by dividing the semi-annual
principal payment amount by the closing price per common share on the
immediately preceding semi-annual payment date, subject to adjustment for
any changes in the capitalization of the Company affecting its common
stock.
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 MONTHS ENDING SEPTEMBER 30,
- ---------------------------------
2005 ................................................................ $655,023
2006 ................................................................ 154,971
2007 ................................................................ 32,229
2008 ................................................................ 7,399
2009 ................................................................ 7,492
At September 30, 2004, warehouse lines and other notes payable were
collateralized by $296.6 million of loan receivables and $0.4 million of
computer equipment.
31
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
Interest rates paid on the revolving credit facilities range from London
Inter-Bank Offered Rate ("LIBOR") plus 2.00% to LIBOR plus 2.50%. The
weighted-average interest rate paid on the revolving credit facilities was
4.21% and 3.76% at September 30, 2004 and June 30, 2004, respectively.
FINANCIAL AND OTHER COVENANTS
GENERAL. 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 JUNE 30, 2004 CREDIT FACILITIES. On September 22, 2003, the
Company entered into definitive agreements with JP Morgan Chase Bank for a
$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 had a term of 364 days and
by its original terms would have expired September 21, 2004. This facility 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 the Company
services 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.
On September 20, 2004, the Company entered into an amendment to its $200.0
million credit facility which extended the scheduled expiration date of this
credit facility from September 21, 2004 to September 30, 2004.
32
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
FINANCIAL AND OTHER COVENANTS -- (CONTINUED)
On September 30, 2004, the Company entered into an amendment to the $200.0
million credit facility which extends the expiration date of this credit
facility from September 30, 2004 to November 5, 2004, and decreased the
facility from $200.0 million to $100.0 million. Since entering into this
facility on September 22, 2003, the amount outstanding under this facility at
any given time has not exceeded $100.0 million. In addition, the amendment
included changes which reduced the advance rate if the amount outstanding
under the facility exceeds $75.0 million. The amendment also changed the
portfolio composition requirements to accommodate fluctuations in the pledged
loans at the beginning and end of each month, providing greater flexibility to
the Company. The purpose of the amendment is to allow the Company to continue
to borrow under this facility, subject to its terms as described above, while
it finalizes the definitive agreement for a new credit facility. In light of
this amendment, on October 1, 2004, the Company entered into an amendment to
the $250.0 million credit facility described below which decreased the amount
of the additional credit facilities that it must maintain from $200.0 million
to $100.0 million, provided that there continues to be at least $40.0 million
available for funding newly originated loans as originally required by the
facility agreements.
On November 5, 2004, the Company entered into an additional amendment to this
$200.0 million facility (reduced to $100.0 million on September 30, 2004). The
amendment further extended the scheduled expiration date of this facility from
November 5, 2004 to December 3, 2004, further reduced the maximum amount that
can be borrowed under the facility from $100.0 million to $60.0 million. The
reduction will occur at a rate of $10.0 million per week commencing on November
5, 2004. This amendment also restored portfolio composition requirements to
their original terms except that funding for up to $60.0 million of newly
originated loans was made available and no loans older than 30 days may be
funded. The purpose of the amendment is to allow the Company to continue to
borrow under this facility, subject to its terms as described above, while it
finalizes the definitive agreements for its new credit facilities and transition
to those new facilities.
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 an affiliate of the
lender 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. Additional credit
support for a portion of the facility 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. The interest-only strips and residual
interests contributed to this special purpose entity also secured the Company's
fee obligations under this facility to an affiliate of the lender, as described
above. The interest-only strips sold pursuant to the previously described sale
agreement of September 27, 2004 were part of the interest-only strips
contributed to this special purpose entity for the purpose of securing the
Company's fee obligations to this lender affiliate. In consideration for the
release by this lender affiliate of its lien on the interest-only strips
involved in the September 27, 2004 sale, the Company prepaid $3.5 million of
fees owed or to be owed to the lender affiliate.
33
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
FINANCIAL AND OTHER COVENANTS -- (CONTINUED)
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 the Company's agreement to: (i) restrict the total amount of
indebtedness outstanding under the indenture related to its 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 for this $250.0 million facility, as amended,
granted the lender an option from the first anniversary of entering into the
definitive agreements up to November 30, 2005 to increase the credit amount to
$400.0 million with additional fees and interest payable by the Company. This
option will be satisfied upon the completion of the $150.0 million Warehouse
Facility.
The Company amended the security agreements related to the senior
collateralized subordinated notes to accommodate a request from the lender on
its $250.0 million credit facility, and its affiliate, dated September 30,
2004, to clarify an inconsistency between these agreements and the $250.0
million credit facility documents related to liens on certain assets
previously pledged by ABFS Warehouse Trust 2003-1 to Clearwing, the affiliate
of the lender.
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
$100.0 MILLION WAREHOUSE FACILITY. On November 5, 2004, the Company entered
into definitive agreements, dated as of November 4, 2004, with Fortress Credit
Corp. for a $100.0 million revolving mortgage warehouse credit facility to fund
loan originations, referred to as the $100.0 million facility, including up to
$30.0 million for newly originated loans ($40.0 million if the facility is
increased as described below). The $100.0 million facility has a term of one
year, with the right to extend upon mutual written agreement of the parties and
the Company's payment to the lender of a renewal fee equal to a percentage of
the maximum amount available under the facility. The lender may, at any time
during the period from the 121st day through the 300th day from the closing
date, in its sole discretion, increase the maximum amount available under the
facility up to $175.0 million, at which time the Company is obligated to pay a
commitment increase fee equal to 2.25% of the amount of the increase. The
Company's ability to utilize this facility for newly originated loans is subject
to its satisfaction of such requirements to be determined by the lender in its
sole discretion. The Company agreed to pay fees of $2.3 million upon closing and
approximately $3.8 million over the term of the facility (and if the facility is
increased to $175.0 million, an additional $2.6 million in fees), plus a monthly
non-usage fee equal to a percentage of the undrawn portion of the $100.0 million
facility. The $100.0 million facility has a floating interest rate based on
LIBOR plus a margin of 4.25% (which is increased to 7.5% for newly originated
loans) and is secured by the mortgage loans which are funded by advances under
the facility, as well as all assets, accounts receivable and all related
proceeds held by the special purpose entity organized to facilitate the
transaction, referred to as the borrower.
34
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
- -- (CONTINUED)
The $100.0 million facility contains representations, warranties, conditions
and covenants which are customary for facilities of this type, including
provisions which require the borrower to: (1) use the proceeds solely to fund
loan originations as described in the facility; (2) not incur any other
indebtedness except as specified in the facility; (3) not permit any liens,
claims or interests on, or any sale or disposition of, the collateral securing
the facility; and (4) provide the lender with all financial statements,
certificates and notices as specified in the facility. The $100.0 million
facility contains events of default typical for this type of facility, including
but not limited to, if: (1) the borrower fails to make any payment when due to
the lender; (2) the borrower breaches or fails to comply with the
representations, warranties, conditions or covenants under the facility; (3) the
Company becomes insolvent or the subject of insolvency proceedings; (4) a
material adverse change or effect as described in the facility occurs; (5)
certain members of management are no longer the Company's executive officers and
a satisfactory replacement has not been found within 60 days; (6) the Company is
unable to sell or issue subordinated notes for more than three consecutive weeks
or on more than two occasions in any 12-month period irrespective of the length
of time of such occasions; (7) the Company is delisted from the NASDAQ Stock
Market or any other stock market or securities exchange or trading of the
Company's stock is suspended for at least three consecutive days; (8) any of the
Company's servicing agreements, other than a servicing agreement relating to a
securitization in which one of our bond insurers or its affiliates have provided
bond insurance or similar credit enhancement, are terminated for cause or an
event of default; (9) the Company's net worth is negative at the end of any
calendar month or less than $10.0 million at the end of any calendar quarter;
(10) the Company fails to maintain cash and cash equivalents and undrawn
borrowing capacity under committed borrowing facilities of less than $20.0
million after December 30, 2004; or (11) the Company fails to maintain minimum
cash of at least $10.0 million after December 30, 2004. Subject to certain
exceptions and the expiration of any applicable cure period as described in the
$100.0 million facility, upon the occurrence of one or more events of default,
the lender may declare the amount outstanding under the facility immediately due
and payable. The Company expects to draw down on the full amount of this line to
the extent necessary to fund its loan originations.
The Company also sold the interest-only strips and servicing rights related
to five of its mortgage securitization trusts to an affiliate of this facility
provider under the terms of a September 27, 2004 sale agreement. The sale of
these assets was undertaken as part of the Company's negotiations to obtain the
new $100.0 million facility and to raise cash to pay fees on new warehouse
credit facilities and as a result, the Company did not realize their full value
as reflected on its books. The Company wrote down the carrying value of these
interest-only strips and servicing rights by $5.4 million at June 30, 2004 to
reflect their values under the terms of the sale agreement. On September 27,
2004, the Company received proceeds from this sale of $9.7 million.
COMMITMENT LETTER RELATED TO $30.0 MILLION WAREHOUSE FACILITY AND RESIDUAL
REPURCHASE FACILITY. On October 27, 2004, the Company executed a commitment
letter, dated as of October 26, 2004, with a lender for: (i) a $30.0 million
warehouse facility to fund the origination of residential mortgage loans,
including mortgage loans for which the complete documentation will not have been
received by the custodian at the time of funding and closing of such loans,
referred to as newly originated loans in this document; and (ii) a repurchase
facility of up to $23.0 million for specified interest-only strips owned by one
of the Company's subsidiaries. Pursuant to the commitment letter, the Company
agreed to organize a special purpose trust to act as borrower under the
warehouse facility, hold the related newly originated loans and act as seller
under the repurchase facility. The Company also agreed to form a second trust,
referred to as the parent trust, to hold 100% of the ownership interest in the
special purpose trust.
The warehouse facility will have a term of three years, although, upon the
termination of the repurchase facility at the close of its two-year term, the
Company has an option to terminate the warehouse facility on the second
anniversary of the closing date upon payment of a termination fee of $600
thousand. Pursuant to the commitment letter, the warehouse facility will have a
floating interest rate based upon LIBOR plus a margin of 2.5% per year.
35
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
- -- (CONTINUED)
The warehouse facility will be secured by, among other items, (i) newly
originated loans funded through the facility and proceeds from these loans; (ii)
a pledge of 100% of the common stock of ABFS Consolidated Holdings, Inc., the
Company's subsidiary that will own 97% of the parent trust; (iii) a certificate
issued by the parent trust entitling an entity organized by the lender to a
priority interest in all of the parent trust's assets and distributions,
including income derived from certain of the Company's interest-only strips;
(iv) certain servicing advances owned by American Business Credit, Inc., the
Company's subsidiary; and (v) the value of the interest-only strips in excess of
the amount necessary for the special purpose trust to satisfy its obligations
under the repurchase facility.
In connection with the warehouse facility, the lender on the Company's
$250.0 million credit facility must consent to certain aspects of the proposed
transaction. In addition, the parent trust will enter into an amendment to the
security agreement with the trustee for the Company's outstanding senior
collateralized subordinated notes pursuant to which collateral owned by the
parent trust will be pledged to secure the senior collateralized subordinated
notes.
In connection with the execution of the commitment letter, the Company
paid fees of approximately $1.9 million. The Company also agreed to pay fees on
the closing of the facility and over the term of the warehouse facility totaling
approximately $7.1 million, as well as an annual non-usage fee equal to a
percentage of the undrawn portion of the warehouse facility.
As described in the commitment letter, under the repurchase facility,
an entity organized by the lender for the purposes of the repurchase facility
transaction, referred to as the purchaser, will acquire specified interest-only
strips for up to $23.0 million, which amount will be initially adjusted to
reflect any pre-closing adjustments to the value of such interest-only strips
that may result from distributions on the interest-only strips after September
30, 2004, changes in market conditions or other factors as determined by the
purchaser, and may be reduced after the closing in case of a margin payment paid
to the purchaser, as described in the repurchase facility. The interest-only
strips to be transferred pursuant to this arrangement had an aggregate book
value of $86.0 million at September 30, 2004. Subject to certain limitations,
the repurchase price of the specified interest-only strips will be secured by
the collateral under the warehouse facility, other than the specified
interest-only strips necessary for the special purpose trust to satisfy its
obligations under the repurchase facility. The repurchase facility will
terminate two years after the closing date. The Company has an option to
terminate the repurchase facility by repurchasing the specified interest-only
strips in whole, but not in part, and paying the applicable exit fee equal to 3%
of the repurchase facility amount. The Company's execution of the definitive
agreement related to the repurchase facility will require the consent of the
lender under its $250.0 million credit facility.
The commitment letter is subject to, among other things, (i) the approval by
the lender's investment committee on or prior to November 5, 2004 and (ii) the
execution of definitive agreements not later than November 5, 2004. On November
8, 2004, the lender amended the commitment letter to notify the Company that it
had obtained the approval of its investment committee and to extend the deadline
for the execution of definitive agreements from November 5, 2004 to November 22,
2004. The Company currently anticipates entering into an interim repurchase
facility with this lender which will expire when definitive agreements related
to the warehouse facility and the permanent repurchase facility is executed.
36
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
- -- (CONTINUED)
The availability of the warehouse facility and the repurchase facility,
referred to as the facilities, is subject to the satisfaction of certain initial
conditions which include, but are not limited to, the following: (i) the
Company's receipt of one or more definitive commitments from one or more other
new lenders for warehouse funding of at least $100.0 million with a minimum of
$30.0 million available for funding newly originated loans; and (ii) the
Company's assignment to the lender of a "key man" life insurance policy equal to
at least $2.0 million on the life of Mr. Santilli, the Company's Chief Executive
Officer, and the Company's agreement to use its best efforts to increase such
policy to $5.0 million within six months of the closing date.
The facilities will also be subject to certain customary and other
on-going conditions pursuant to which the Company will be required (i) to
maintain at all times an effective registration statement with the SEC for the
sale of at least $30.0 million of subordinated debentures; (ii) to maintain the
Company's ability to issue and sell its subordinated debentures, except for the
inability to issue and sell subordinated debentures for a period of time which
shall not exceed three consecutive weeks or two occasions in any 12-month period
irrespective of the length of time of any such occasions; (iii) to satisfy all
requirements for the continued listing of the Company's common stock on the
NASDAQ National Market, with a delisting notification to be considered a default
under the facilities subject to the cure period provided in the applicable
NASDAQ listing standards; and (iv) during the terms of the facilities, to retain
Messrs. Santilli, Ruben and Mandia in their current positions or, if Messrs.
Ruben or Mandia cease to hold their current positions of Executive Vice
President and Chief Financial Officer, respectively, to secure a replacement
employee reasonably satisfactory to the lender.
The facilities will contain additional conditions, representations,
covenants and events of default customary for transactions of this type and
similar to those contained in our $250.0 million credit facility, as well as the
Company's covenant to maintain additional warehouse facilities for an aggregate
of at least $350.0 million. The failure to satisfy any of the initial or
on-going conditions contained in the facilities or the loss of servicing rights
under more than two of the Company's outstanding securitizations or any
warehouse facility will constitute an event of default under the facilities.
While the Company anticipates that it will close on the facilities with
the lender, there can be no assurance that these negotiations will result in
definitive agreements or that these agreements, as negotiated, will contain
terms and conditions acceptable to it.
COMMITMENT LETTER RELATED TO $150.0 MILLION WAREHOUSE FACILITY. The
Company received a commitment letter dated as of November 1, 2004 for a mortgage
warehouse facility from CIT Group/Business Credit, Inc. and Clearwing Capital,
LLC, an affiliate of the lender on the Company's $250.0 million credit facility,
for the purpose of funding home mortgage loan originations. The commitment
letter becomes effective and legally obligates the parties upon the payment of
the fees by the Company, as described below, which fees have not been paid to
date. The commitment letter provides for a $150.0 million senior secured
revolving facility, of which $10.0 million can be utilized to fund newly
originated loans. Of the $150.0 million, CIT Group would provide up to
approximately $132.0 million as the A Facility and Clearwing would provide up to
approximately $18.0 million as the B Facility. The A Facility and B Facility
together are referred to as the $150.0 million facility. The $150.0 million
facility will expire on October 14, 2006, with a one-year extension of the A
Facility after the expiration of the initial term subject to, among other
things, the effectiveness of a committed B Facility in an amount and on terms
and conditions substantially satisfactory to the A facility lender. The A
Facility will have a floating interest rate based upon LIBOR plus a margin,
which decreases over the term of the facility, or prime plus a margin of 1.5%.
The $150.0 million facility will satisfy the option provided to the lender on
the Company's $250.0 million facility which permits this lender to increase the
maximum credit amount to $400.0 million and triggers the payment of additional
fees to such lender as described below.
37
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
- -- (CONTINUED)
The A Facility and the B Facility will each be secured by the home
mortgage loans which are funded by advances under the $150.0 million facility,
as well as all assets, held by a special purpose entity organized to facilitate
this transaction, provided, however, that the B Facility will be subordinate to
the A Facility. The $150.0 million facility will contain representations and
warranties and covenants, events of default and other conditions, which are
customary for a facility of this type. The commitment letter and the closing of
the $150.0 million facility are subject to such other customary and commercially
reasonable terms, including no material adverse condition or change in or
affecting the Company's business, operations, property, condition or prospects
since June 30, 2004, the Company's receipt of a working capital facility or
reverse repurchase line of not less than $23.0 million, cash on hand and
available working capital facilities of not less than $40.0 million, delivery of
2004 audited financial statements with an unqualified audit opinion,
preparation, execution and delivery of definitive loan documents, completion of
due diligence by CIT Group and Clearwing, and execution of a servicing
arrangement satisfactory to CIT Group and Clearwing.
In connection with the execution and effectiveness of the commitment
letter, the Company is obligated to pay the lender on the A Facility a work fee
to offset its costs and expenses incurred in connection with the facility and a
fee of 2.0% of the amount of the A Facility, half of which is due upon the
effective date of the commitment letter and the second half upon the closing of
the facility. The Company agreed to pay annual collateral management fees to
affiliates of the lender on the A Facility over the term of the facility. The
Company also agreed to pay the lender on the B Facility: the increase commitment
fees provided for in the fee agreement related to our $250.0 million facility of
approximately $21.9 million, with approximately $1.4 million payable upon the
termination of the facility and the balance payable in equal monthly
installments over the term of the facility, a work fee to offset the lender's
costs and expenses incurred in connection with the facility, and additional fees
of $4.5 million payable in equal monthly installments over the term of the
facility.
The commitment letter terminates on November 30, 2004 if the execution
and delivery of definitive agreements does not occur on or before such date.
While the Company anticipates that it will close on the $150.0 million facility
with the lenders, there can be no assurance that these negotiations will result
in definitive agreements or that these agreements, as negotiated, will contain
terms and conditions acceptable to it.
Although after December 3, 2004 the Company expects to have mortgage
loan warehouse credit facilities totaling at a minimum $530.0 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, the Company 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. 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
38
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
- -- (CONTINUED)
(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. The 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 recorded in the first quarter of fiscal
2005 and in the 2004 fiscal year, the Company requested and obtained waivers
or amendments to several credit facilities to address its non-compliance with
certain financial covenants.
On September 22, 2003, the lender under the $200.0 million facility agreed
(now $60.0 million) to extend the deadline for the Company's 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 $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 $200.0 million facility was limited to $80.0 million.
The Company entered into two amendments to the sale and servicing agreement with
the lender under its $200.0 million facility which clarified the scope of
particular financial covenants: one amendment dated as of May 12, 2004 clarified
the scope of the financial covenant regarding the maintenance of minimum
adjusted tangible net worth; and one amendment dated as of June 30, 2004
clarified the scope of the financial covenant regarding the maintenance of
minimum cash and cash equivalents. This lender waived its noncompliance with the
minimum net worth requirements at September 30, 2003, October 31, 2003, November
30, 2003, December 31, 2003, March 31, 2004, June 30, 2004 and September 30,
2004. This lender also waived the Company's non-compliance with: the covenant
regarding minimum adjusted tangible net worth, for all monthly compliance
periods commencing with the month ending April 30, 2004 and continuing through
the month ending October 31, 2004; the covenant regarding minimum cash and cash
equivalents, for the compliance periods ending December 31, 2003, April 30,
2004, May 31, 2004 and October 31, 2004; the covenant regarding the ratio of
debt to adjusted tangible net worth, for the compliance periods ending September
30, 2004 and October 31, 2004; and the covenant regarding aggregate cash flow
from all securitization trusts, for the compliance period ending September 30,
2004.
The Company has continued to operate on the basis of waivers granted by the
lender under this facility to each of these events of noncompliance. The
expiration date of this facility was originally September 21, 2004, but
through a series of extensions granted by this lender to facilitate the
Company's closing and implementation of replacement credit facilities, this
facility is now scheduled to expire on December 3, 2004. Consequently, the
Company currently anticipates that it will be out of compliance with one or
more of the
39
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
- -- (CONTINUED)
financial covenants contained in this facility at November 30, 2004 and will
need an additional waiver for this noncompliance from this lender to continue
to operate.
A provision in the Company's $250.0 million credit facility required the
Company to maintain another credit facility for $200.0 million with a $40.0
million sublimit of such facility available for funding newly originated
loans. As a result of the reduction of the Company's $200.0 million facility
to $100.0 million, as described above, the Company entered into an amendment
to the master loan and security agreement governing its $250.0 million
facility which reduced the required amount for another facility to $100.0
million. In the event the Company does not extend the $200.0 million (now
$60.0 million) facility beyond its December 5, 2004 expiration date, or in the
event it does not otherwise enter into definitive agreements with other
lenders by December 5, 2004 which satisfy the above-described requirements in
the $250.0 million facility for $100.0 million in additional credit facilities
and a $40.0 million sublimit for newly originated loans, the Company will need
an additional amendment to the $250.0 million facility or a waiver from the
lender to continue to operate.
Because the Company anticipates incurring losses at least through the second
quarter of fiscal 2005 and as a result of any non-compliance with other
financial covenants, the Company anticipates that it will need to obtain
additional waivers. There can be no assurance as to whether or in what form a
waiver or modification of these agreements would be granted to 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, $77.2 million of debt from this registration statement was
available for future issuance as of September 30, 2004.
On December 1, 2003, the Company mailed an Exchange Offer, referred to as
the first 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 first 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
40
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
8. SUBORDINATED DEBENTURES, SENIOR COLLATERALIZED SUBORDINATED NOTES AND
WAREHOUSE LINES AND OTHER NOTES PAYABLE (CONTINUED)
SUBORDINATED DEBENTURES AND SENIOR COLLATERALIZED SUBORDINATED NOTES --
(CONTINUED)
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.
On May 14, 2004, the Company mailed an Exchange Offer, referred to as the
second 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. The terms of the second exchange offer were similar to the
terms of the first exchange offer, as described above. See Note 9 for the
results of the exchange offers through June 30, 2004.
At September 30, 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 $401.6 million, of which $146.2 million
represented 150% of the principal balance of the senior collateralized
subordinated notes outstanding at September 30, 2004.
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 $8.6 million in the three months ended September
30, 2004 and $23.3 million in the year ended June 30, 2004.
9. STOCKHOLDERS' EQUITY
EXCHANGE OFFERS
On December 1, 2003, the Company mailed the first exchange offer to holders
of eligible subordinated debentures. On May 14, 2004, the Company mailed the
second exchange offer to holders of eligible subordinated debentures. Holders
of eligible 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 Note 8 for a description of the terms
of the senior collateralized subordinated notes issued in both exchange
offers. See below for a description of the terms of the Series A Preferred
Stock.
41
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
9. STOCKHOLDERS' EQUITY (CONTINUED)
EXCHANGE OFFERS -- (CONTINUED)
Under the terms of the exchange offers, the following amounts of
subordinated debentures were exchanged for shares of Series A preferred stock
and senior collateralized subordinated notes (in thousands):
SHARES OF SENIOR
SUBORDINATED SERIES A COLLATERALIZED
DEBENTURES PREFERRED SUBORDINATED
BY CLOSING DATES EXCHANGED STOCK ISSUED NOTES ISSUED
- ---------------- ------------ ------------ --------------
First Exchange Offer:
December 31, 2003............................................................. $ 73,554 39,095 $34,459
February 6, 2004.............................................................. 43,673 22,712 20,961
Second Exchange Offer:
June 30, 2004................................................................. 60,589 31,980 28,609
July 31, 2004................................................................. 25,414 12,908 12,506
August 23, 2004............................................................... 5,418 2,741 2,677
-------- ------- -------
Cumulative results of exchange offers......................................... $208,648 109,436 $99,212
======== ======= =======
TERMS OF THE SERIES A PREFERRED STOCK
General. The Series A Preferred Stock has a par value of $0.001 per share
and may be redeemed at the Company's option after the second anniversary of
the issuance date at a price equal to the liquidation value plus accrued and
unpaid dividends.
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 September 30, 2004, the liquidation value equals $109.4
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 September 30,
2004, the annual dividend requirement equals $10.9 million.
Conversion into Shares of Common Stock. On or after the second anniversary
of the issuance date (or on or after the one year anniversary of the issuance
date if no dividends are paid on the Series A Preferred Stock), each share of
the Series A Preferred Stock is convertible at the option of the holder into a
number of shares of the Company's common stock determined by dividing: (A)
$1.00 plus an amount equal to accrued but unpaid dividends (if the conversion
date is prior to the second anniversary of the issuance date because the
Series A Preferred Stock has become convertible due to a failure to pay
dividends), $1.20 plus an amount equal to accrued but unpaid dividends (if the
conversion date is prior to the third anniversary of the issuance date but on
or after the second anniversary of the issuance date) or $1.30 plus an amount
equal to accrued but unpaid dividends (if the conversion date is on or after
the third anniversary of the issuance date) by (B) the market value of a share
of the Company's common stock (which figure shall not be less than $5.00 per
share regardless of the actual market value on the conversion date).
42
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
9. STOCKHOLDERS' EQUITY (CONTINUED)
TERMS OF THE SERIES A PREFERRED STOCK -- (CONTINUED)
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 and the second exchange
offer converted at the conversion prices listed below, the number of shares of
the Company's common stock which would be issued upon conversion follows
(shares in thousands):
AS OF SEPTEMBER 30,
2004
-----------------------
CONVERTIBLE
NUMBER OF INTO NUMBER
PREFERRED OF COMMON
SHARES SHARES
--------- -----------
Conversion at $1.20 ................................. 109,436 26,265
Conversion at $1.30 ................................. 109,436 28,453
As described above, the conversion ratio of the Series A preferred stock
increases during the first three years following 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. Under guidance issued by the
EITF in issue 98-5, "Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios," this
discount, or beneficial conversion feature, must be valued and amortized to
the income statement as additional non-cash preferred dividends over the
three-year period that the holders of the Series A preferred stock earn the
discount with an offsetting credit to additional paid in capital.
The Company computed the value of the beneficial conversion feature using
the conversion ratio of $1.30 to $5.00, which is the conversion term that is
most beneficial to the investor, and would result in the issuance of 24.5
million shares of common stock based on the shares of Series A preferred stock
that were issued through June 30, 2004. The value of the beneficial conversion
feature equals the excess of the intrinsic value of those 24.5 million shares
of common stock at their closing prices on the dates the preferred stock was
issued, over the value of the Series A preferred stock on the same dates. The
value of the Series A preferred stock was equal to the carrying value of the
subordinated debentures exchanged. For closings under the exchange offers
through September 30, 2004, the value of the beneficial conversion feature was
$11.3 million. During the first three months of fiscal 2005, amortization of
$0.9 million was added to the $2.6 million of cash dividends declared
resulting in a total charge to the income statement of $3.5 million. During
fiscal 2004, amortization of $0.8 million was added to the $2.9 million of
cash dividends declared resulting in a total charge to the income statement of
$3.7 million. The offset to the charge to the income statement for the
amortization of the beneficial conversion feature is recorded to additional
paid in capital. Amortization of the total value of the beneficial conversion
feature will be $3.6 million in fiscal 2005, $3.8 million in fiscal 2006 and
$3.0 million for fiscal 2007.
OTHER
On May 13, 2004, the Board of Directors declared a 10% stock dividend
payable June 8, 2004 to common shareholders of record on May 25, 2004. In
conjunction with the Board's resolution, all outstanding stock options and
related exercise prices were adjusted. Accordingly, all outstanding common
shares, earnings per common share, average common share and stock option
amounts presented have been adjusted to reflect the effect of this stock
dividend.
In December 2003, the Company's shareholders approved an increase in the
number of shares of authorized common stock from 9.0 million shares to 209.0
million shares and authorized preferred stock from 3.0 million shares to 203.0
million shares. In December 2003 and June 2004, the Company's shareholders
also approved the issuance of shares of the Series A preferred stock in
connection with the Company's two exchange offers and shares of common stock
upon the conversion of the Series A preferred stock.
43
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
10. INCOME TAXES
The provision for income taxes consists of the following (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
-------- --------
CURRENT
Federal.............................................. $ 399 $ 873
State................................................ -- 38
-------- --------
399 911
-------- --------
DEFERRED
Federal.............................................. (13,988) (15,679)
State................................................ -- (1,332)
-------- --------
(13,988) (17,011)
-------- --------
Total provision for income tax expense (benefit) ........ $(13,589) $(16,100)
======== ========
There were no tax benefits from the utilization of net operating loss carry
forwards in the quarters ended September 30, 2004 and 2003.
The cumulative temporary differences resulted in net deferred income tax
assets or liabilities consisting primarily of the following (in thousands):
SEPTEMBER 30, JUNE 30,
2004 2004
------------- --------
Deferred income tax assets:
Allowance for credit losses ........................ $ 468 $ 529
Net operating loss carryforwards ................... 157,613 139,088
Other .............................................. 11,290 11,237
-------- --------
169,371 150,854
Less valuation allowance ........................... 36,693 33,394
-------- --------
132,678 117,460
-------- --------
Deferred income tax liabilities:
Interest-only strips and other receivables ......... 66,477 58,327
-------- --------
66,477 58,327
-------- --------
Net deferred income tax asset....................... $ 66,201 $ 59,133
======== ========
The Company's net deferred income tax asset position increased by $7.1
million from $59.1 million at June 30, 2004 to $66.2 million at September 30,
2004. This increase is the result of a federal tax benefit of $13.6 million on
the Company's pre-tax loss of $38.8 million offset by a tax expense of $6.5
million on a write up of $18.6 million on the Company's interest-only strips
which was recorded as a decrease to other comprehensive income, a component of
stockholders' equity. This federal tax benefit increase of $7.1 million will
be realized against future federal taxable income. Factors which were
considered in determining that it is more likely than not the Company will
realize this deferred tax asset included: (i) the circumstances producing the
losses for the fourth quarter of fiscal 2003, the year ended June 30, 2004 and
the first quarter of fiscal 2005; (ii) the Company's historical profitability
prior to the fourth quarter of fiscal 2003; (iii) the anticipated impact that
the Company's adjusted business strategy will have on producing more currently
taxable income than its previous business strategy produced due to higher loan
originations and shifting from securitizations to whole loan sales; (iv) the
achievability of anticipated levels of future taxable income under the
Company's adjusted business strategy; and (v) the likely utilization of its
net operating loss carryforwards. Additionally, the Company considers
44
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
10. INCOME TAXES (CONTINUED)
tax-planning strategies it can use to increase the likelihood that the deferred
income tax asset will be realized.
In determining that it is more likely than not that the Company would realize
its deferred tax asset, adequate funding and liquidity was assumed based on the
status of negotiations with credit facility providers. Credit facilities of at a
minimum $530.0 million and a repurchase facility of $23.0 million were assumed.
In addition to its existing $250.0 million credit facility which has two more
years remaining on its term, on November 5, 2004, the Company closed a new
credit facility totaling $100.0 million (which can be increased up to $175.0
million from month four through month ten of the facility term at the sole
discretion of the lender). As of November 12, 2004, the Company had a commitment
letter for a new $150.0 million credit facility, a firm commitment for a new
$30.0 million credit facility and a $23.0 million repurchase facility. These
facilities are expected to close by November 30, 2004 bringing the Company's
total credit facilities to $530.0 million possibly growing to $605.0 million at
the sole discretion of one of its lenders. The combination of existing financing
and financing scheduled to close before November 30, 2004 provides adequate
funding to determine that it is more likely than not that the Company will
realize its deferred tax asset.
The valuation allowance represents the income tax effect of state net
operating loss carry forwards less an amount of $5.4 million which it has been
determined that it is more likely than not the Company will utilize in the
next three years. This $5.4 million benefit will depend on future taxable
income from operations and the implementation of state tax planning. The
changes in the Company's business strategy from primarily securitizations to a
combination of whole loan sales and smaller securitizations will result in a
quicker recognition and a higher level of taxable income.
The Company's net operating loss federal tax benefit of $115.5 million will
likewise depend on future taxable income from operations in addition to the
reversal of timing differences principally related to existing securitization
assets with full net operating loss utilization primarily within two years.
A reconciliation of income taxes at federal statutory rates to the Company's
tax provision is as follows (in thousands):
SEPTEMBER 30, JUNE 30,
2004 2004
------------- --------
Federal income tax at statutory rates .............. $(13,589) $(62,903)
Nondeductible items ................................ 9 35
Other, net ......................................... (9) (5,426)
-------- --------
$(13,589) $(68,294)
======== ========
For financial tax reporting, the Company had a pre-tax loss of $38.8 million
on which a benefit of $13.6 million was recorded. This is a reduction of $4.1
million from the $17.7 million for the three months ended June 30, 2004 as a
result of an $8.0 million reduction in the Company's pre-tax loss as well as a
decrease in its effective tax rate from 38% in fiscal 2004 to 35% in fiscal
2005. The Company has net Federal operating loss carry forwards aggregating
approximately $324.0 million available to reduce future Federal income taxes
as of September 30, 2004 which will begin to expire in 2019. The Company has
net state operating losses of $146.4 million as of September 30, 2004 which
will expire in 20 years.
45
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
11. COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
As of September 30, 2004, the Company leases property under noncancelable
operating leases requiring minimum annual rentals as follows (in thousands):
YEAR-ENDING SEPTEMBER 30,
---------------------------------------------------------------------
2005................................................................. $ 5,763
2006................................................................. 5,630
2007................................................................. 5,454
2008................................................................. 5,486
2009................................................................. 5,344
Thereafter........................................................... 25,153
-------
$52,830
=======
Rent expense for leased property was $1.4 million and $1.6 million,
respectively, for the quarter-ended September 30, 2004 and 2003.
PERIODIC ADVANCE GUARANTEES
As the servicer of securitized loans, the Company is obligated to advance
interest payments for delinquent loans if it deems 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.
RECOURSE ON WHOLE LOAN SALES
The Company's whole loan sale agreements with purchasers may include
recourse provisions obligating it to repurchase loans at the sales price in
the event of unfavorable delinquency performance on the loans sold or to
refund premiums if a sold loan prepays. The duration of these obligations
typically ranges from 60 days to one year from the date of the loan sale.
Premium refund obligations typically decline monthly over the obligation
period. The Company reserves for these premium obligations at the time of sale
through an expense charge against the gain on sale. The amount of the reserve
is calculated based on the expected near term delinquency and prepayment
performance of the sold loans and the premiums received at the time of sale.
At September 30, 2004, the reserve for repurchase and payoff obligations of
premiums received, included in miscellaneous liabilities on the balance sheet,
was $446 thousand.
46
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
RECOURSE ON WHOLE LOAN SALES -- (CONTINUED)
The following table details as of September 30, 2004, the aggregate
principal balance of loans which the Company has sold with recourse that are
still subject to recourse provisions and the quarter during which its recourse
obligations on those loans mature (dollars in thousands):
QUARTER ENDED PRINCIPAL BALANCE
------------- -----------------
December 31, 2004.......................................... $378,960
March 31, 2005............................................. 150,608
June 30, 2005.............................................. 102,861
September 30, 2005......................................... 148,475
--------
$780,904
========
OTHER
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
some companies in the subprime industry, more commonly referred to as
"predatory lending" practices. State, local and federal governmental agencies
have imposed sanctions for practices including, but not limited to, charging
borrowers excessive fees, imposing higher interest rates than the borrower's
credit risk warrants and failing to adequately disclose the material terms of
loans to the borrowers. For example, the Pennsylvania Attorney General
reviewed certain fees charged to Pennsylvania customers by the Company's
subsidiary, HomeAmerican Credit, Inc., which does business as Upland Mortgage.
Although the Company believes that these fees were fair and in compliance with
applicable federal and state laws, in April 2002, the Company agreed to
reimburse borrowers approximately $221,000 with respect to a particular fee
paid by borrowers from January 1, 1999 to mid-February 2001 and to reimburse
the Commonwealth of Pennsylvania $50,000 for their costs of investigation and
for future public protection purposes. The Company discontinued charging this
particular fee in mid-February 2001. The Company has satisfied the monetary
commitments and obligations to the Pennsylvania Attorney General. The reserve,
which the Company previously established, was adequate to cover the resolution
of this matter. By way of further example, on December 22, 2003, the Company
entered into a Joint Agreement with the Civil Division of the U.S. Attorney's
Office for the Eastern District of Pennsylvania which ended the inquiry by the
U.S. Attorney initiated pursuant to the civil subpoena dated May 14, 2003. The
U.S. Attorney's inquiry focused on the Company's forbearance policies,
primarily on its practice of requesting a borrower who entered into
forbearance agreement to execute a deed in lieu of foreclosure. In response to
the inquiry and as part of the Joint Agreement, the Company, among other
things, adopted a revised forbearance policy, which became effective on
November 19, 2003 and agreed to make an $80 thousand contribution to one or
more housing counseling organizations approved by the U.S. Department of
Housing and Urban Development. $40 thousand of this pledged amount has been
contributed, with the balance being due in 2005. The Company does not believe
that the Joint Agreement with the U.S. Attorney has had a significant impact
on its operations. As a result of these initiatives, the Company is unable to
predict whether state, local or federal authorities will require changes in
the Company's lending practices in the future, including the reimbursement of
borrowers as a result of fees charged or the imposition of fines, or the
impact of those changes on the Company's profitability.
47
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
12. DERIVATIVE FINANCIAL INSTRUMENTS
HEDGE ACCOUNTING
From time to time, the Company utilizes 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 terms and
pricing for a whole loan sale are fixed or the date the fixed interest rate
pass-through certificates to be issued by a securitization trust are priced.
Generally, the period between loan origination and pricing for whole loan
sales is less than 45 days and the period between loan origination and pricing
of the pass-through interest rate is less than three months. The types of
derivative financial instruments the Company uses to mitigate the effects of
changes in fair value of its loans due to interest rate changes may include
interest rate swaps, futures and forward contracts, including forward sale
agreements. 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.
TRADE ACCOUNTING
Generally, the Company does not enter into derivative financial instrument
contracts for trading purposes. However, the Company has entered into
derivative financial instrument contracts, which were not designated or
qualified as accounting hedges in accordance with SFAS No. 133. In these cases
the derivative contracts are recorded as an asset or liability on the balance
sheet at fair value and gains and losses are included in the income statement.
(GAINS) AND LOSSES ON DERIVATIVE FINANCIAL INSTRUMENTS
The following table summarizes gains and (losses) on derivative financial
instruments and gains and losses on hedged loans for the three months ended
September 30, 2004 and 2004 (in thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
----------------
2004 2003
------- ------
Hedge accounting:
Gains (losses) on derivatives ............................. $ (652) $ --
Gains (losses) on hedged loans ............................ 632 --
Trade accounting - gains (losses) on derivatives:
Related to pipeline ....................................... (1,969) --
Related to whole loan sales ............................... -- 5,097
Related to interest-only strips ........................... -- 11
------- ------
Total gains and (losses) $(1,989) $5,108
======= ======
CASH FLOW ON DERIVATIVE FINANCIAL INSTRUMENTS
THREE MONTHS
ENDED
SEPTEMBER 30,
-----------------
2004 2003
------- -------
Amount settled in cash - received (paid):
Hedge accounting ......................................... $ (773) $ --
Trade accounting ......................................... (2,838) (1,378)
------- -------
Total amount settled in cash - received (paid) $(3,611) $(1,378)
======= =======
48
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
12. DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED)
DERIVATIVE FINANCIAL INSTRUMENTS OUTSTANDING
At September 30, 2004 and June 30, 2004, the notional amounts of forward
sale agreements and Eurodollar futures contracts accounted for as hedges and
related unrealized gains and losses recorded as assets or liabilities on the
balance sheet were as follows (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
--------------------- ---------------------
NOTIONAL UNREALIZED NOTIONAL UNREALIZED
AMOUNT GAIN AMOUNT (LOSS)
-------- ---------- -------- ----------
Forward sale agreement .......................................................... $360,358 $ -- $275,000 $ --
Eurodollar futures contracts .................................................... $ -- $ -- $ 27,962 $(103)
At September 30, 2004 and June 30, 2004, outstanding Eurodollar futures
contracts used to manage interest rate risk on loans in our pipeline and
associated unrealized gains and unrealized losses recorded as assets and
liabilities on the balance sheet were as follows (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
--------------------- ---------------------
NOTIONAL UNREALIZED NOTIONAL UNREALIZED
AMOUNT GAIN AMOUNT (LOSS)
-------- ---------- -------- ----------
Eurodollar futures contracts .................................................... $10,000 $ 2 $202,038 $(851)
The sensitivity of the Eurodollar futures contracts held as trading as of
September 30, 2004 to a 0.1% change in market interest rates is $2 thousand.
The Company had an interest rate swap contract, which was 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. This
contract matured in April 2004. Unrealized gains and losses on the interest
rate swap contract were due to changes in the interest rate swap yield curve
during the periods the contract was in place. Net gains and losses on this
interest rate swap contract included 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 months ended September 30, 2003 were as follows
(in thousands):
Unrealized gain on interest rate swap contract ......................... $ 177
Cash interest paid on interest rate swap contract ...................... (166)
-----
Net gain (loss) on interest rate swap contract ......................... $ 11
=====
49
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
13. RECONCILIATION OF BASIC AND DILUTED EARNINGS PER COMMON SHARE
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
-------- --------
(in thousands
except per share
data)
(Numerator)
EARNINGS (LOSS)
Net income (loss) attributable to common shares ......... $(28,712) $(26,268)
======== ========
(Denominator)
Average Common Shares:
Average common shares outstanding ...................... 3,598 3,242
Average potentially dilutive shares .................... (a) (b)
-------- --------
Average common and potentially dilutive shares ......... 3,598 3,242
======== ========
EARNINGS (LOSS) PER COMMON SHARE:
Basic: $ (7.98) $ (8.10)
Diluted: $ (7.98) $ (8.10)
- ---------------
(a) 22,252,297 shares anti-dilutive in the three months ended September 30,
2004 but these shares may become dilutive in future periods.
(b) 58,219 shares anti-dilutive in the three months ended September 30, 2003
but these shares may become dilutive in future periods.
14. SEGMENT INFORMATION
The Company has three operating segments: Loan Origination, Servicing and
Treasury and Funding.
The Loan Origination segment originates business purpose loans secured by
real estate and other business assets, home mortgage loans typically to credit-
impaired borrowers and loans secured by one-to-four family residential real
estate.
The Servicing segment services the loans originated by the Company both
while held as available for sale by the Company and subsequent to
securitization. Servicing activities include billing and collecting payments
from borrowers, transmitting payments to securitization trust investors,
accounting for principal and interest, collections and foreclosure activities
and disposing of real estate owned.
The Treasury and Funding segment offers the Company's subordinated debenture
securities pursuant to a registered public offering and obtains other sources
of funding for the Company's general operating and lending activities.
The All Other caption on the following tables mainly represents segments
that do not meet the SFAS No. 131 "Disclosures about Segments of an Enterprise
and Related Information" defined thresholds for determining reportable
segments, financial assets not related to operating segments and is mainly
comprised of interest-only strips, unallocated overhead and other expenses of
the Company unrelated to the reportable segments identified.
The reporting segments follow the same accounting policies used for the
Company's consolidated financial statements as described in the summary of
significant accounting policies. Management evaluates a segment's performance
based upon profit or loss from operations before income taxes.
Reconciling items represent elimination of inter-segment income and expense
items, and are included to reconcile segment data to the consolidated
financial statements.
50
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
14. SEGMENT INFORMATION (CONTINUED)
THREE MONTHS ENDED SEPTEMBER 30, 2004
---------------------------------------------------------------------------------
LOAN TREASURY AND RECONCILING
ORIGINATION FUNDING SERVICING ALL OTHER ITEMS CONSOLIDATED
----------- ------------ --------- --------- ----------- ------------
(in thousands)
External revenues:
Gain on sale of loans:
Securitizations............................ $ -- $ -- $ -- $ -- $ -- $ --
Whole loan sales........................... 6,119 -- -- -- -- 6,119
Interest income ............................. 4,833 5 (115) 8,678 -- 13,401
Non-interest income ......................... 2,608 1 7,420 -- (6,440) 3,589
Inter-segment revenues ....................... -- 14,501 -- 16,057 (30,558) --
Operating expenses:
Interest expense ............................ 5,650 15,653 100 11,253 (14,501) 18,155
Non-interest expense ........................ 19,797 2,989 6,974 12,539 -- 42,299
Depreciation and amortization ............... 332 20 157 943 -- 1,452
Interest-only strips valuation adjustment ... -- -- -- 29 -- 29
Inter-segment expense ........................ 22,497 -- -- -- (22,497) --
Income tax expense (benefit) ................. (12,151) (1,454) 26 (10) -- (13,589)
-------- -------- ------- -------- --------- ----------
Income (loss) before dividends on preferred
stock....................................... $(22,565) $ (2,701) $ 48 $ (19) $ -- $ (25,237)
======== ======== ======= ======== ========= ==========
Segment assets ............................... $389,486 $178,684 $69,737 $603,108 $(157,619) $1,083,396
======== ======== ======= ======== ========= ==========
THREE MONTHS ENDED SEPTEMBER 30, 2003
---------------------------------------------------------------------------------
LOAN TREASURY AND RECONCILING
ORIGINATION FUNDING SERVICING ALL OTHER ITEMS CONSOLIDATED
----------- ------------ --------- --------- ----------- ------------
(in thousands)
External revenues:
Gain on sale of loans:
Securitizations............................ $ 799 $ -- $ -- $ -- $ -- $ 799
Whole loan sales........................... 2,921 -- -- -- -- 2,921
Interest income ............................. 3,562 7 136 11,318 -- 15,023
Non-interest income ......................... 519 -- 13,219 86 (12,366) 1,458
Inter-segment revenues ....................... -- 18,078 9,553 (27,631) --
Operating expenses:
Interest expense ............................ 6,651 16,106 (272) 12,411 (18,078) 16,818
Non-interest expense ........................ 18,057 (3,582) 11,296 7,423 -- 33,194
Depreciation and amortization ............... 594 16 29 1,123 -- 1,762
Interest-only strips valuation adjustment ... -- -- -- 10,795 -- 10,795
Inter-segment expense ........................ 21,919 -- -- -- (21,919) --
Income tax expense (benefit) ................. (14,980) 2,107 875 (4,102) -- (16,100)
-------- -------- ------- -------- --------- --------
Income (loss) before dividends on preferred
stock....................................... $(24,440) $ 3,438 $ 1,427 $ (6,693) $ -- $(26,268)
======== ======== ======= ======== ========= ========
Segment assets ............................... $214,822 $222,497 $96,277 $535,146 $(118,236) $950,506
======== ======== ======= ======== ========= ========
51
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, 2004.
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. Through our principal direct and indirect
subsidiaries, we originate, sell and service home mortgage loans. We also
process and purchase home mortgage loans through our Bank Alliance Services
program. Additionally, we service business purpose loans, which we had
originated and sold in prior periods. To the extent we obtain a credit facility
to fund business purpose loans, we may originate and sell business purpose loans
in future periods.
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.
52
Prior to our third quarter of fiscal 2004, our loans primarily
consisted of fixed interest rate loans secured by first or second mortgages on
one-to-four family residences. Our business strategy adjustments include
increasing loan originations by offering adjustable rate loans and purchase
money mortgage loans. During the quarter ended September 30, 2004, 63.5% of
loans we originated were adjustable rate and 36.5% were fixed rate. During the
quarter ended September 30, 2004, 37.5% of the loans we originated were purchase
money mortgage loans. During the quarter ended September 30, 2004, 91.0% of the
loans we originated were secured by first mortgages and 9.0% were secured by
second mortgages. See "--Results of Operations -- Overview" for further detail
regarding the characteristics of the loans we originated during the first
quarter of fiscal 2005.
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. This type of borrower is commonly
referred to as a subprime borrower. Loans made to subprime borrowers are
frequently referred to as subprime loans.
We originate loans through a combination of channels including a
national processing center located at our centralized operating office in
Philadelphia, Pennsylvania and a network of mortgage brokers. Our loan servicing
and collection activities are performed at our Philadelphia office.
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 whole loan sales or securitizations, 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 credit 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 in whole loan sales or into securitizations, our
ability to maintain credit and warehouse facilities to fund loan originations,
and our ability to raise capital through the sale of subordinated debentures.
OUR RECENT FINANCIAL DIFFICULTIES AND LIQUIDITY CONCERNS. Several
events and issues, which occurred beginning in the fourth quarter of fiscal
2003, have negatively impacted our short-term liquidity and contributed to our
losses for fiscal 2003, fiscal 2004 and the first quarter of fiscal 2005. These
events included our inability to complete publicly underwritten securitizations
since the fourth quarter of fiscal 2003 (we completed a privately-placed
securitization in the second quarter of fiscal 2004), our inability to draw down
upon and the expiration of several of our credit facilities during the first six
months of fiscal 2004, and our temporary discontinuation of sales of new
subordinated debentures for approximately a six-week period during the first
quarter of fiscal 2004.
53
Our inability to complete a publicly underwritten securitization during
the fourth quarter of fiscal 2003 was the result of our investment bankers'
decision in late June 2003 not to underwrite the contemplated June 2003
securitization transaction. Management believes that a number of factors
contributed to this decision, including a highly publicized lawsuit finding
liability of an underwriter in connection with the securitizations of loans for
another unaffiliated subprime leader, an inquiry by the Civil Division of the
U.S. Attorney's Office in Philadelphia regarding our forbearance practices, an
anonymous letter regarding us received by our investment bankers, the SEC's
enforcement action against another unaffiliated subprime lender related to its
loan restructuring practices and related disclosure, a federal regulatory agency
investigation of practices by another subprime servicer and our investment
bankers' prior experience with securitizations transactions with non-affiliated
originators.
We were unable to complete a publicly underwritten securitization
during fiscal 2004 and the first quarter of fiscal 2005 due to our diminished
capacity to originate loans during the first nine months of fiscal 2004, our
commitment to whole loan sales under our adjusted business strategy, our
financial condition and liquidity issues, and an absence of market demand for
our securitizations. We completed a privately-placed securitization during the
second quarter of fiscal 2004.
As a result of these liquidity issues our loan origination volume
during fiscal 2004 was substantially reduced. From July 1, 2003 through June 30,
2004, we originated $982.7 million of loans, as compared to originations of
$1.67 billion of loans for the same period in fiscal 2003. During the first
three months of fiscal 2005, we originated $629.7 million of loans including
$198.0 million in July 2004, $197.4 million in August 2004 and $234.3 million in
September 2004, as compared to $124.1 million of loans originated during the
quarter ended September 30, 2003.
We anticipate that depending upon the size of our future quarterly
securitizations, if any, we will need to increase our loan originations to
approximately $400.0 million to $500.0 million per month to return to profitable
operations. If we are unable to complete quarterly securitizations, we will need
to increase our loan originations to approximately $500.0 million to $600.0
million per month to return to profitability. Our ability to achieve the levels
of loan originations necessary to achieve profitable operations could be
hampered by our failure to continue to successfully implement our adjusted
business strategy, funding limitations under existing credit facilities and our
ability to obtain new credit facilities and renew existing facilities. Our plan
is to increase loan originations through the continued application of our
business strategy adjustments, particularly as related to building our expanded
broker channel and offering adjustable rate mortgages, purchase money mortgages
and more competitively priced fixed rate mortgages. For a detailed discussion of
our losses, capital resources and commitments, see "-- Liquidity and Capital
Resources."
On November 5, 2004, we entered into a definitive agreement dated as of
November 4, 2004 regarding a one-year $100.0 million credit facility to replace
our $200.0 million facility (reduced to $60.0 million) that expires on December
3, 2004.
On October 27, 2004, we entered into a commitment letter dated October
26, 2004 and are negotiating the terms of a definitive agreement with a
warehouse lender for a three-year $30.0 million mortgage loan warehouse facility
and a two-year $23.0 million residual repurchase facility.
54
On November 1, 2004, we received a commitment letter from a warehouse
lender and an affiliate of the lender on our $250.0 million credit facility for
a two-year $150.0 million mortgage loan warehouse facility. The commitment
letter becomes effective and legally obligates the parties upon our payment of
fees which have not been paid to date.
We cannot assure you that we will succeed in entering into definitive
agreements regarding these facilities or that these agreements will contain the
terms and conditions acceptable to us. See "-- Liquidity and Capital Resources
- -- Credit Facilities" for information regarding the terms of these facilities.
On September 30, 2004, we had unrestricted cash of approximately $19.7
million and up to $70.1 million available under our warehouse credit facilities.
We can only use advances under these 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 may not be sufficient to cover our operating
cash requirements. Our cash position will also be negatively impacted by the
payment of fees to our lenders in connection with entering into the new credit
facilities described above.
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 may be used to fund overcollateralization
requirements, as defined below, in connection with our loan originations and to
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. See
"-- Liquidity and Capital Resources" for a discussion of advance rates under the
terms of our credit facilities." 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.
See "-- Liquidity and Capital Resources -- Remedial Steps Taken to
Address Liquidity Issues" for a discussion of the specific actions we undertook
to address liquidity concerns.
RECENT OPERATING LOSSES AND SALE OF ASSETS. We incurred net losses
attributable to common stock of $28.7 million for the quarter-ended September
30, 2004 and $115.1 million and $29.9 million for the fiscal years ended June
30, 2004 and 2003, respectively. In addition, depending on our ability to reach
a profitable level of loan originations, complete a securitization and recognize
gains, we anticipate incurring a loss at least through the second quarter of
fiscal 2005.
For the first quarter of fiscal 2005, we recorded a net loss
attributable to common stock of $28.7 million. The loss for the first quarter of
fiscal 2005 primarily resulted from our inability to reach the loan origination
levels required under our adjusted business strategy to return to profitability,
which substantially reduced our ability to generate revenues, and our inability
to complete a securitization during the first quarter. Additionally, operating
expenses increased in the first quarter of fiscal 2005 as we began to add loan
processing and marketing support staff to support the future loan origination
levels we expect to achieve under our adjusted business strategy.
During the first quarter of fiscal 2005, we recorded a pre-tax write up
of $18.6 million on our interest-only strips. The $18.6 million write up was
recorded as an increase to other comprehensive income, a component of
stockholders' equity. This write up of interest-only strips resulted from a
reduction to our assumptions for loan prepayments expected to occur beyond 18
months. Management believes that once we move beyond the low interest rate
environment and the impact that environment has on loan prepayments, the long
running and highly unfavorable prepayment experience over the last twelve
quarters will leave us with securitized mortgage pools which will experience
future prepayment speeds substantially lower than originally believed. See "-
Application of Critical Accounting Estimates - Interest-Only Strips" for a
discussion of how valuation adjustments are recorded.
55
The loss for fiscal 2004 primarily resulted from liquidity issues we
had experienced since the fourth quarter of fiscal 2003, including the absence
of credit facilities until the second quarter of fiscal 2004, which
substantially reduced our loan origination volume and our ability to generate
revenues, our inability to complete a publicly underwritten securitization
during fiscal 2004, our shift in business strategy to focus on whole loan sales,
and charges to the income statement of $46.4 million for pre-tax valuation
adjustments on our securitization assets. Additionally, operating expense levels
that would support greater loan origination volume also contributed to the loss
for fiscal 2004.
During fiscal 2004, we recorded total pre-tax valuation adjustments on
our interest-only strips and servicing rights of $63.8 million, of which $46.4
million was charged as expense to the income statement and $17.4 million was
charged to other comprehensive income, a component of stockholders' equity.
These adjustments primarily reflect the impact of higher than anticipated
prepayments on securitized loans experienced in fiscal 2004 due to the low
interest rate environment experienced during fiscal 2004. Additionally, the
fiscal 2004 valuation adjustment included a write down of $5.4 million of the
carrying value of our interest-only strips and servicing rights related to five
of our mortgage securitization trusts to reflect their values under the terms of
a September 27, 2004 sale agreement. The five securitizations were sold for $9.4
million. The $5.4 million write-down was calculated as the difference between
the carrying value of these interest-only strips and servicing rights
immediately prior to the sale, and the $9.4 million proceeds. The sale price for
these five securitizations was not considered in determining the fair value of
our remaining interest-only strips and servicing rights because the sale was
considered a distressed sale undertaken as part of our negotiations to obtain a
new $100.0 million warehouse credit facility and to raise cash to pay fees on
new warehouse credit facilities. The new $100.0 million warehouse credit
facility is described in "-- Liquidity and Capital Resources." See "--
Application of Critical Accounting Estimates -- Interest-Only Strips" for a
discussion of how valuation adjustments are recorded.
EXCHANGE OFFERS. On December 1, 2003, we mailed an offer to exchange,
which we refer to as the first exchange offer, to holders of our subordinated
debentures issued prior to April 1, 2003. On May 14, 2004, we mailed a second
offer to exchange, which we refer to as the second exchange offer, to holders of
our subordinated debentures issued prior to November 1, 2003. See "-- Liquidity
and Capital Resources -- Subordinated Debentures" for more detail on the terms
of the exchange offers, senior collateralized subordinated notes and Series A
preferred stock issued and the results of the exchange offers.
Depending on market conditions and our financial condition, we may
engage in additional exchange offers in the future and we are considering
another exchange offer in our second quarter of fiscal 2005. Our ability to
engage in future exchange offers of this type may be limited by the availability
of collateral to secure the senior collateralized subordinated notes issued in
future exchange offers.
AMOUNT OF OUR INDEBTEDNESS. At September 30, 2004, we had total
indebtedness of approximately $869.0 million, comprised of amounts outstanding
under our credit facilities, senior collateralized subordinated notes issued in
the exchange offers, capitalized leases and subordinated debentures. See "--
Liquidity and Capital Resources -- Secured and Unsecured Indebtedness " for a
comparison at September 30, 2004 of our secured and senior debt obligations and
unsecured subordinated debenture obligations to assets which are available to
repay those obligations.
56
BUSINESS STRATEGY ADJUSTMENTS. In response to our inability to
securitize our loans and the liquidity concerns described above, we adjusted our
business strategy at the beginning of fiscal 2004. 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. Our business strategy also focuses on increasing loan originations by
continuing to expand our broker channel and by offering adjustable rate
mortgages loans, purchase money mortgages and more competitively priced fixed
rate mortgage loans.
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 reasonable terms and to profitably sell or
securitize our loans on a regular basis. Our failure with respect to any of
these factors could impair our ability to successfully implement our strategy,
which could adversely affect our results of operations and financial condition.
If we fail to generate sufficient liquidity through the sales of our
loans, the sale of our subordinated debentures, the maintenance of 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 result in losses and
impair our ability to repay our subordinated debentures and other outstanding
debt. 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. See
"Risk Factors -- We depend upon the availability of financing to fund our
continuing operations. Any failure to obtain adequate funding could hurt our
ability to operate profitably and restrict our ability to repay our outstanding
debt" and " -- If we are unable to obtain additional financing, we may not be
able to restructure our business to permit profitable operations or repay our
outstanding debt."
In addition to the above potential restrictions and changes to our
business strategy, 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 obtaining working capital funding. 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.
57
CREDIT FACILITIES, SERVICING AGREEMENTS AND WAIVERS RELATED TO
FINANCIAL COVENANTS. At various times since June 30, 2003, including at June 30,
2004, July 31, 2004, August 31, 2004, September 30, 2004 and October 31, 2004,
we have been out of compliance with one or more financial covenants contained in
our $200.0 million credit facility (reduced to $60.0 million). We have continued
to operate on the basis of waivers granted by the lender under this facility. We
currently anticipate that we will be out of compliance with one or more of these
financial covenants at November 30, 2004 and will need a waiver from this lender
for this noncompliance to continue to operate. The expiration date of this
facility was originally September 21, 2004, but through a series of extensions
granted by this lender to facilitate our closing and implementation of
replacement credit facilities, this facility is now scheduled to expire on
December 3, 2004.
A provision in our $250.0 million credit facility required us to
maintain another credit facility for $200.0 million with a $40.0 million
sublimit of such facility available for funding newly originated loans. As a
result of the reduction of our $200.0 million facility to $100.0 million, as
described above, we entered into an amendment to the master loan and security
agreement governing our $250.0 million facility which reduced the required
amount for another facility to $100.0 million.
At various times since June 30, 2003, we have also been out of
compliance with the net worth requirement in several of our pooling and
servicing agreements and sale and servicing agreements (collectively referred to
in this document as the servicing agreements). Two of the financial insurers who
provide financial guaranty insurance to certain bond holders and certificate
holders under these servicing agreements (collectively referred to in this
document as bond insurers) required us to amend the servicing agreements in
consideration for granting us waivers from this noncompliance. One bond insurer
granted us a permanent waiver from this noncompliance in consideration for a
term-to-term servicing arrangement. The other bond insurer granted us a one-time
waiver in consideration for a term-to-term servicing arrangement. Since then, we
have had to obtain a waiver of net worth requirements from this bond insurer on
a monthly basis and we currently anticipate that we will need to do so for the
foreseeable future.
Due to our financial results during fiscal 2004, two other bond
insurers required us to amend the servicing agreements related to the
securitizations these bond insurers insured. As a result of the amendments to
our servicing agreements, all of our servicing agreements associated with bond
insurers now provide for term-to-term servicing and, in the case of our
servicing agreements with two bond insurers, our rights as servicer may be
terminated at the expiration of a servicing term in the sole discretion of the
bond insurer.
We cannot assure you that we will continue to receive the waivers and
servicing agreement extensions that we need to operate or that they will not
contain conditions that are unacceptable to us. Because we anticipate incurring
losses through at least the second 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 contained in our credit
facilities and servicing agreements. To the extent we are not able to obtain
waivers under our credit facilities, we may be unable to pay dividends on the
Series A preferred stock. See "-- Liquidity and Capital Resources" for
additional information regarding the waivers obtained.
DELINQUENCIES; FORBEARANCE AND DEFERMENT ARRANGEMENTS. We had total
delinquencies in our managed portfolio of $239.4 million at September 30, 2004
compared to $219.4 million at June 30, 2004 and $228.9 million at June 30, 2003.
The managed total portfolio includes loans on our balance sheet and loans
serviced for others. At September 30, 2004, the total managed portfolio was $1.9
billion compared to $2.1 billion at June 30, 2004 and $3.7 billion at June 30,
2003. 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 12.57% at September 30, 2004 compared to 10.49% at June 30, 2004
and 6.27% at June 30, 2003.
58
As the managed portfolio continues to season and if the economy does
not continue to improve, 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. As
the portfolio seasons, or ages, the likelihood that borrowers will incur credit
problems increases. Additionally, 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 at September 30, 2004 do
not include $184.6 million of previously delinquent loans, 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 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. Since December 2003, we have experienced a
reduction and leveling off in new deferment arrangements and if the improving
economic environment continues, we expect to continue to experience a reduction
in new deferment arrangements.
There was approximately $184.6 million of cumulative unpaid principal
balance of loans under deferment and forbearance arrangements at September 30,
2004, as compared to approximately $216.3 million and $197.7 million of
cumulative unpaid principal balance at June 30, 2004 and 2003, respectively.
Total cumulative unpaid principal balances under deferment or forbearance
arrangements as a percentage of the total managed portfolio were 9.69% at
September 30, 2004, 10.34% at June 30, 2004 and 5.41% at June 30, 2003.
Additionally, there are loans under deferment and forbearance arrangements which
have returned to delinquent status. At September 30, 2004, there was $72.9
million of cumulative unpaid principal balance under deferment arrangements and
$53.7 million of cumulative unpaid principal balance under forbearance
arrangements that are now reported as delinquent 31 days or more. See "-- On
Balance Sheet Portfolio Quality -- Deferment and Forbearance Arrangements," "--
Total Portfolio Quality -- Deferment and Forbearance Arrangements."
LISTING ON THE NASDAQ NATIONAL MARKET SYSTEM. Since our common stock is
listed on the NASDAQ National Market System, we are required to meet certain
requirements established by the NASDAQ Stock Market in order to maintain this
listing. These requirements include, among other things, maintenance of
stockholders' equity of $10.0 million, a minimum bid price of $1.00 and a market
value of publicly held shares of $5.0 million. If we are unable to maintain our
listing on the NASDAQ National Market System, the value of our capital 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.
There can be no assurance that we will be in compliance with the $10.0 million
stockholders' equity requirement on December 31, 2004. We intend to engage in a
new exchange offer in order to maintain compliance with this listing
requirement. Our ability to engage in future exchange offers of this type may be
limited by the availability of collateral to secure the senior collateralized
subordinated notes issued in future exchange offers.
59
LIQUIDITY AND CAPITAL RESOURCES
GENERAL. 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 serviced
portfolio and investments in securitization 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 outstanding. Since the fourth quarter of
fiscal 2003, we have also used our funding sources to cover our operating
losses. Our cash needs change as the mix of loan sales through securitization
shifts to more whole loan sales, as the serviced portfolio changes, as our
interest-only strips mature and release cash, as subordinated debentures and
senior collateralized subordinated notes outstanding 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, repaying
existing subordinated debentures and senior collateralized subordinated notes
outstanding, paying interest expense, preferred dividends and operating
expenses, funding capital expenditures, and in connection with our
securitizations, funding overcollateralization requirements, costs of
repurchasing delinquent loans for trigger management and servicer 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" and "--
Securitizations -- Repurchase Rights" 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
secured credit facilities. These credit facilities are generally revolving lines
of credit that enable us to borrow on a short-term basis against our loans. We
then sell our loans to unrelated third parties on a whole loan basis or
securitize our loans to generate the cash to pay off these revolving credit
facilities.
LIQUIDITY CONCERNS. Several events and issues have negatively impacted
our short-term liquidity. First, our inability to complete a 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. Because there was no securitization, $453.4 million of the $516.1
million in revolving credit and conduit facilities available to us at June 30,
2003 was drawn upon. Our revolving credit facilities and mortgage conduit
facility had only $62.7 million of unused capacity available at June 30, 2003,
which significantly reduced our ability to fund loan originations in fiscal 2004
until we sold existing loans, extended existing credit facilities, or added new
credit facilities.
60
Second, our ability to borrow under credit facilities to fund new loan
originations in the first three months of fiscal 2004 using borrowings under
certain of our credit facilities which carried over into fiscal 2004 was
limited, terminated or expired by October 31, 2003. Further advances under a
non-committed portion of one of these 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 accelerate 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 a $25.0 million warehouse facility
after September 30, 2003, and this $25.0 million facility expired on October 31,
2003.
Third, even though we were successful in obtaining one new credit
facility in September 2003 and a second new credit facility in October 2003, our
ability to finance new loan originations in the second and third quarters of
fiscal 2004 with borrowings under these new facilities was limited. The
limitations resulted from requirements to fund overcollateralization, which is
discussed below, in connection with new loan originations.
Fourth, 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, our loan origination volume in
fiscal 2004 was substantially reduced. In fiscal 2004, we originated $982.7
million of loans, compared to originations of $1.67 billion of loans in fiscal
2003. As a result of the decrease in loan originations and liquidity issues
described above, we incurred losses in fiscal 2003 and 2004. While we increased
loan originations to $629.7 million for the first quarter of fiscal 2005, we
recorded a loss for the first quarter of fiscal 2005 primarily because we did
not reach the loan origination level required under our adjusted business
strategy to return to profitability. Depending on our ability to reach a
profitable level of loan originations and to complete a securitization and
recognize gains, we anticipate incurring a loss at least through the second
quarter of fiscal 2005.
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 may 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.
Because we depend upon the availability of financing to fund our
continuing operations, any failure to obtain adequate financing could hurt our
ability to operate profitably and, therefore, the realization of our deferred
tax asset is dependent on obtaining adequate financing and profitable
operations. See "-- Application of Critical Accounting Estimates -- Deferred Tax
Asset" for a discussion of our deferred tax asset.
61
There can be no assurance that we will be in compliance with the $10.0
million stockholders' equity requirement on December 31, 2004. We intend to
engage in a new exchange offer in order to maintain compliance with this listing
requirement. Our ability to engage in future exchange offers of this type may be
limited by the availability of collateral to secure the senior collateralized
subordinated notes issued in future exchange offers. If we are unable to
maintain our listing on the NASDAQ National Market System, 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.
SECURED AND UNSECURED INDEBTEDNESS. At September 30, 2004, we had total
indebtedness of approximately $869.0 million, comprised of amounts outstanding
under our credit facilities, senior collateralized subordinated notes issued in
the exchange offers, capitalized leases and subordinated debentures. The
following table compares our secured and senior debt obligations and unsecured
subordinated debenture obligations at September 30, 2004 to assets which were
available to repay those obligations. We anticipate that any shortfall in assets
available to repay obligations will be funded through cash received on the sale
of future loan originations:
SECURED AND UNSECURED
SENIOR DEBT SUBORDINATED TOTAL
OBLIGATIONS DEBENTURES DEBT/ASSETS
----------- ------------ -----------
(in thousands)
Outstanding debt obligations (a)........... $ 378,926 (b) $ 490,026 $ 868,952
=========== ========== ===========
Assets available to repay debt:
Cash and cash equivalents.............. $ -- $ 19,673 $ 19,673
Loans.................................. 296,559 (c) 39,952 336,511
Interest-only strips(e)................ 193,744 (a)(b) 255,068 448,812 (d)
Servicing rights....................... -- 66,712 66,712 (d)
----------- ---------- -----------
Total assets available................. $ 490,303 $ 381,405 $ 871,708
=========== ========== ===========
- ------------------
(a) Includes the impact of the exchange of $208.6 million of subordinated
debentures (unsecured subordinated debentures) for $99.2 million of senior
collateralized subordinated notes (secured and senior debt obligations) and
109.4 million shares of Series A preferred stock in the exchange offers. At
September 30, 2004, our interest in the cash flows from the interest-only
strips held in the trust, which secure the senior collateralized
subordinated notes totaled $401.6 million, of which approximately $146.2
million represents 150% of the principal balance of the senior
collateralized subordinated notes outstanding at September 30, 2004. For
presentation purposes, $146.2 million of the interest-only strips balance is
allocated to the secured and senior debt obligations column.
(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, as a first priority, 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
$47.6 million. This amount is included as an allocation of our interest-only
strips to the secured and senior debt obligations column.
(c) Reflects the amount of loans specifically pledged as collateral against our
advances under our credit facilities.
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(d) Reflects the fair value of our interest-only strips and servicing rights at
September 30, 2004.
(e) The grant of a lien on the collateral to secure the senior collateralized
subordinated is not a direct lien on any interest-only strips, but is,
rather, a lien on the right of certain of our subsidiaries to receive
certain cash flows from ABFS Warehouse Trust 2003-1 which is a special
purpose entity which holds the majority of, but not all of, the
interest-only strips directly or indirectly held by us. The interest-only
strips in this trust also secure, as a first priority, obligations in an
amount not to exceed 10% of the outstanding principal balance under our
$250.0 million credit 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 $53.7 million. In addition,
interest-only strips in this trust will also secure certain obligations
under our new $30.0 million credit facility, the definitive terms of which
are being negotiated, which security interest is not reflected in the table
above. Finally, it is intended that approximately $86.0 million of
interest-only strips held by this trust will be transferred to the lender in
connection with the $23.0 million residual repurchase facility, the terms of
which are being negotiated, which transfer of collateral is not reflected in
the table above.
REMEDIAL STEPS TAKEN TO ADDRESS LIQUIDITY ISSUES. Since June 30, 2003,
we undertook specific remedial actions to address liquidity concerns including:
o We adjusted our business strategy beginning in early fiscal 2004.
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. See "-- Overview -- Business Strategy
Adjustments" for more information.
o We solicited bids and commitments from participants in the whole
loan sale market and entered into forward sale agreements and
individual sale transactions. In total, from June 30, 2003 through
June 30, 2004, we sold approximately $1.1 billion (which includes
$222.3 million of loans sold by the expired mortgage conduit
facility described under "-- Credit Facilities") of loans through
whole loan sales. From July 1, 2004 through September 30, 2004, we
sold an additional $586.5 million of loans through whole loan
sales.
o We have entered into an informal arrangement with one recurring
purchaser of our loans whereby the purchaser maintains members of
its loan underwriting staff on our premises to facilitate its
purchase of our loans promptly after we originate them. This
arrangement accelerates our receipt of cash proceeds from the sale
of loans, accelerates the pay down of our advances under our
warehouse credit facilities and adds to our liquidity. This
quicker turnaround time is expected to enable us to operate with
smaller committed warehouse credit facilities than would otherwise
be necessary.
o On October 31, 2003, we completed a privately-placed
securitization, with servicing released, of $173.5 million of
loans.
o We entered into two definitive loan agreements during fiscal 2004
for the purpose of funding our loan originations. These two
agreements replaced those credit facilities, which carried over
into fiscal 2004 but were limited, terminated or expired by
October 31, 2003. We entered into the first agreement on September
22, 2003 with a financial institution for a one-year $200.0
million credit facility. We entered into the second agreement on
October 14, 2003 with a warehouse lender for a three-year
revolving mortgage loan warehouse credit facility of up to $250.0
million. The $200.0 million facility was extended to December 3,
2004, reduced on September 30, 2004 to $100.0 million and on
November 5, 2004, reduced to $60.0 million. This reduction to
$60.0 million will occur at a rate of $10.0 million per week
commencing November 5, 2004. The three-year $250.0 million
warehouse credit facility continues to be available. See "--
Credit Facilities" for information regarding the terms of these
facilities.
63
o On November 5, 2004, we entered into a definitive agreement dated
as of November 4, 2004 with a warehouse lender for a one-year
$100.0 million credit facility to replace the maturing $200.0
million credit facility (reduced to $60.0 million). See "-- Credit
Facilities" for information regarding the terms of this facility.
We also sold the interest-only strips and servicing rights related
to five of our mortgage securitization trusts to an affiliate of
this facility provider under the terms of a September 27, 2004
sale agreement. The sale of these assets was undertaken as part of
our negotiations to obtain the new $100.0 million credit facility
and to raise cash to pay fees on new warehouse credit facilities
and as a result, we did not realize their full value as reflected
on our books. We wrote down the carrying value of these
interest-only strips and servicing rights by $5.4 million at June
30, 2004 to reflect their values under the terms of the sale
agreement. On September 27, 2004, we received proceeds from this
sale of $9.7 million.
o On October 27, 2004, we entered into a commitment letter dated
October 26, 2004 and are negotiating the terms of a definitive
agreement with a warehouse lender for a three-year $30.0 million
mortgage loan warehouse facility and a two-year $23.0 million
residual repurchase facility. We cannot assure you that we will
succeed in entering into a definitive agreement regarding these
facilities or that this agreement will contain the terms and
conditions acceptable to us. See "-- Credit Facilities" for
information regarding the terms of these facilities.
o On November 1, 2004, we received a commitment letter from two
warehouse lenders, including an affiliate of the lender on our
$250.0 million credit facility, for a two-year $150.0 million
mortgage loan warehouse facility. The commitment letter becomes
effective and legally obligates the parties upon our payment of
fees described in the commitment letter which have not been paid
to date. However, we cannot assure you that we will enter into
definitive agreements regarding the $150.0 million credit facility
or that this agreement will contain the terms and conditions
acceptable to us. See "-- Credit Facilities" for information
regarding the terms of this facility.
o We mailed exchange offers on December 1, 2003 and May 14, 2004 to
holders of our subordinated debentures in order to increase our
stockholders' equity and reduce the amount of our outstanding
debt. These exchange offers resulted in the exchange of $208.6
million of our subordinated debentures for 109.4 million shares of
Series A preferred stock and $99.2 million of senior
collateralized subordinated notes. The issuance of 109.4 million
shares of Series A preferred stock results in an annual cash
preferred dividend obligation of $10.9 million. See "--
Subordinated Debentures" for more detail on the terms of the
exchange offers, senior collateralized subordinated notes and
preferred stock issued.
o On January 22, 2004, we executed an agreement to sell our
interests in the remaining leases in our 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. We received the cash from this sale in January 2004 and
recognized a net gain of $0.5 million.
64
o We suspended the payment of quarterly dividends on our common
stock beginning in the first quarter of fiscal 2004.
Although we obtained two warehouse credit facilities totaling $450.0
million in fiscal 2004, and after December 3, 2004 we expect to have warehouse
credit facilities totaling at a minimum $530.0 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 need 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. Additionally, our
warehouse credit facilities have been obtained at high costs, which have a
significant impact on our liquidity. See "-- Credit Facilities" for detail on
the amount of fees we are required to pay under these facilities.
We can provide no assurances that we will be able to sell our loans,
maintain existing credit 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.
SHORT AND LONG TERM CAPITAL RESOURCES AND CONTRACTUAL OBLIGATIONS. The
following table summarizes our short and long-term capital resources and
contractual obligations as of September 30, 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 "--
Overview -- 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 home mortgage 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........................ $ 10,419 $ -- $ -- $ -- $ 10,419
Cash pledged as collateral against
contractual obligation................. 1,000 2,000 1,000 4,000 8,000
Loans available for sale................. 332,710 102 118 3,581 336,511
Interest-only strips (a)................. 103,908 154,339 104,203 344,973 707,423
Servicing rights (a)..................... 17,183 26,132 21,544 66,351 131,210
---------- --------- --------- --------- ---------
465,220 182,573 126,865 418,905 1,193,563
---------- --------- --------- --------- ---------
Contractual Obligations (b)
Subordinated debentures.................. 335,172 133,105 12,089 9,660 490,026
Accrued interest-subordinated 21,095 9,620 1,353 1,399 33,467
debentures (c).........................
Senior collateralized subordinated notes 38,859 53,615 2,801 2,179 97,454
Accrued interest-senior collateralized
subordinated notes (d)................. 1,799 2,137 133 131 4,200
Warehouse lines of credit (e)............ 279,943 -- -- -- 279,943
Convertible promissory note (f).......... 694 433 -- -- 1,127
Capitalized lease (g)................... 376 49 -- -- 425
Operating leases (h)..................... 5,763 11,084 10,830 25,153 52,830
Services and equipment................... 74 -- -- -- 74
---------- --------- --------- --------- ---------
683,775 210,043 27,206 38,522 959,546
---------- --------- --------- --------- ---------
Excess (Shortfall)....................... $ (218,555) $ (27,470) $ 99,659 $ 380,383 $ 234,017
========== ========= ========= ========= =========
65
- ------------------
(a) Reflects projected cash flows utilizing assumptions including prepayment and
credit loss rates. See "-- Application of Critical Accounting Estimates --
Interest-Only Strips" and "Application of Critical Accounting Estimates -
Servicing Rights."
(b) See "-- Contractual Obligations."
(c) This table reflects interest payment terms elected by subordinated debenture
holders as of September 30, 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 September 30, 2004.
(e) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(f) Amount includes principal and accrued interest at September 30, 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.
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 had been negative because
we incur cash expenses as we originate loans, but generally do not recover from
these origination expense cash outflows until we sell or securitize 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 the residual assets retained in a
securitization. However, during the year ended June 30, 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.
66
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 three months ended September 30, 2004
was a negative $14.2 million, compared to a positive $128.4 million for the
first three months of fiscal 2004. The negative cash flow from operations for
the three months ended September 30, 2004 resulted from funding a $32.2 million
increase in loans available for sale. The positive cash flow from operations for
the three months ended September 30, 2003 was due to sales of loans during that
three-month period, which were originated in the 2003 fiscal year and carried on
our balance sheet at June 30, 2003. During the three months ended September 30,
2004, we received cash on whole loan sales of $602.2 million and originated
$629.7 million of loans. During the three months ended September 30, 2003, we
received cash on whole loan sales of $271.0 million and originated $124.1
million of 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 any future quarter depending on the size and frequency of our whole loan
sales, 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.
67
CONTRACTUAL OBLIGATIONS. Following is a summary of future payments
required on our contractual obligations as of September 30, 2004 (in thousands):
PAYMENTS DUE BY PERIOD
--------------------------------------------------------------------
LESS THAN 1 TO 3 3 TO 5 MORE THAN
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS 5 YEARS
- ----------------------------------------- --------- ---------- ---------- --------- ---------
Subordinated debentures.................. $ 490,026 $ 335,172 $ 133,105 $ 12,089 $ 9,660
Accrued interest - subordinated 33,467 21,095 9,620 1,353 1,399
debentures (a).........................
Senior collateralized subordinated notes. 97,454 38,859 53,615 2,801 2,179
Accrued interest - senior 4,200 1,799 2,137 133 131
collateralized subordinated notes (b)
Warehouse lines of credit (c)............ 279,943 279,943 -- -- --
Convertible promissory notes (d)......... 1,127 694 433 -- --
Capitalized lease (e).................... 425 376 49 -- --
Operating leases (f)..................... 52,830 5,763 11,084 10,830 25,153
Services and equipment................... 74 74 -- -- --
--------- ---------- ---------- --------- --------
Total obligations........................ $ 959,546 $ 683,775 $ 210,043 $ 27,206 $ 38,522
========= ========== ========== ========= ========
- -------------
(a) This table reflects interest payment terms elected by subordinated
debenture holders as of September 30, 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 September 30, 2004.
(c) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(d) Amount includes principal and accrued interest at September 30, 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 whole loan sale or securitization
generates the cash proceeds necessary to repay the borrowings under the
warehouse facilities. We periodically review our expected future credit needs
and attempt to negotiate credit commitments for those needs as well as excess
capacity in order to allow us flexibility in implementing our adjusted business
strategy.
The following is a description of the warehouse and operating lines of
credit facilities, which were available to us at September 30, 2004 (in
thousands):
FACILITY AMOUNT AMOUNT
AMOUNT UTILIZED AVAILABLE
----------- ---------- ---------
REVOLVING CREDIT FACILITIES:
Warehouse revolving line of credit, expiring December 2004 (a).... $ 100,000 $ 73,276 $ 26,724
Warehouse revolving line of credit, expiring October 2006 (b)..... 250,000 206,667 43,333
----------- ---------- ---------
Total revolving credit facilities................................. 350,000 279,943 70,057
OTHER FACILITIES:
Capitalized leases, maturing January 2006 (c).................. 404 404 --
----------- ---------- ---------
Total credit facilities........................................... $ 350,404 $ 280,347 $ 70,057
=========== ========== =========
68
- --------------
(a) Originally a $200.0 million warehouse revolving line of credit with JP
Morgan Chase Bank entered into on September 22, 2003 and originally
scheduled to expire September 2004. In September 2004, the maturity date of
this facility was extended to November 5, 2004 and the facility was reduced
to $100.0 million. In November 2004, the maturity date was extended to
December 3, 2004 and the facility amount will reduce to $60.0 million at a
rate of $10.0 million per week commencing on November 5, 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 September 30, 2004. The letter of
credit was collateralized by cash and expires on December 16, 2004.
(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.
CREDIT FACILITIES AVAILABLE AT SEPTEMBER 30, 2004
$200.0 MILLION WAREHOUSE FACILITY. On September 22, 2003, we entered
into definitive agreements with JP Morgan Chase Bank for a $200.0 million credit
facility (subsequently reduced to $60.0 million) 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 had a term of 364 days and by its original terms would
have expired September 21, 2004. This facility 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 September 20, 2004, we entered into an amendment to our $200.0
million credit facility which extended the scheduled expiration date of this
credit facility from September 21, 2004 to September 30, 2004.
On September 30, 2004, we entered into an amendment to our $200.0
million credit facility which extended the expiration date of this credit
facility from September 30, 2004 to November 5, 2004, and decreased this
facility from $200.0 million to $100.0 million. Since entering into this
facility on September 22, 2003, the amount outstanding under this facility at
any given time has not exceeded $100.0 million. In addition, the amendment
included changes which reduce the advance rate if the amount outstanding under
the facility exceeds $75.0 million. The amendment also changed the portfolio
composition requirements to accommodate fluctuations in the pledged loans at the
beginning and end of each month, providing greater flexibility to us. The
purpose of the amendment was to allow us to continue to borrow under this
facility, subject to its terms as described above, while we finalize the
definitive agreement for a new credit facility. In light of this amendment, on
October 1, 2004, we entered into an amendment to the $250.0 million credit
facility described below which decreased the amount of the additional credit
facilities that we must maintain from $200.0 million to $100.0 million, provided
that there continues to be at least $40.0 million available for funding newly
originated loans, as originally required by the facility agreements.
69
On November 5, 2004, we entered into an additional amendment to this
$200.0 million facility (reduced to $100.0 million on September 30, 2004). The
amendment further extended the scheduled expiration date of this facility from
November 5, 2004 to December 3, 2004 and further reduced the maximum amount that
can be borrowed under the facility from $100.0 million to $60.0 million. The
reduction will occur at a rate of $10.0 million per week commencing on November
5, 2004. This amendment also restored portfolio composition requirements to
their original terms except that funding for up to $60.0 million of newly
originated loans, rather than as a percentage of the facility's outstanding
balance, was made available and no loans older than 30 days may be funded. The
purpose of the amendment was to allow us to continue to borrow under this
facility, subject to its terms as described above, while we transition from this
facility to replacement credit facilities.
$250.0 MILLION WAREHOUSE FACILITY. 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 an affiliate of the lender 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. Additional credit support for a portion of the facility
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 to facilitate this transaction. The interest-only
strips and residual interests contributed to this special purpose entity also
secured our fee obligations under this facility to an affiliate of the lender,
as described above. The interest-only strips sold pursuant to the previously
described sale agreement of September 27, 2004 were part of the interest-only
strips contributed to this special purpose entity for the purpose of securing
our fee obligations to this lender affiliate. In consideration for the release
by this lender affiliate of its lien on the interest-only strips involved in the
September 27, 2004 sale, we prepaid $3.5 million of fees owed or to be owed to
the lender affiliate.
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.
70
The definitive agreements for this $250.0 million facility, as amended,
granted the lender an option from the first anniversary of entering into the
definitive agreements up to November 30, 2005 to increase the credit amount to
$400.0 million with additional fees and interest payable by us. This option will
be satisfied upon the completion of the $150.0 million Warehouse Facility.
We amended the security agreements related to the senior collateralized
subordinated notes to accommodate a request from the lender on our $250.0
million credit facility, and its affiliate, dated September 30, 2004, to clarify
an inconsistency between these agreements and the $250.0 million credit facility
documents related to liens on certain assets previously pledged by ABFS
Warehouse Trust 2003-1 to Clearwing, the affiliate of the lender.
DEFINITIVE AGREEMENTS AND COMMITMENTS RELATED TO NEW CREDIT FACILITIES
$100.0 MILLION WAREHOUSE FACILITY. On November 5, 2004, we entered into
definitive agreements, dated as of November 4, 2004, with Fortress Credit Corp.
for a $100.0 million revolving mortgage warehouse credit facility to fund loan
originations, referred to as the $100.0 million facility, including up to $30.0
million for newly originated loans ($40.0 million if the facility is increased
as described below). The $100.0 million facility has a term of one year, with
the right to extend upon mutual written agreement of the parties and our payment
to the lender of a renewal fee equal to a percentage of the maximum amount
available under the facility. The lender may, at any time during the period from
the 121st day through the 300th day from the closing date, in its sole
discretion, increase the maximum amount available under the facility up to
$175.0 million, at which time we are obligated to pay a commitment increase fee
equal to 2.25% of the amount of the increase. Our ability to utilize this
facility for newly originated loans is subject to our satisfaction of such
requirements to be determined by the lender in its sole discretion. We agreed to
pay fees of $2.3 million upon closing and approximately $3.8 million over the
term of the facility (and if the facility is increased to $175.0 million, an
additional $2.6 million in fees), plus a monthly non-usage fee equal to a
percentage of the undrawn portion of the $100.0 million facility. The $100.0
million facility has a floating interest rate based on LIBOR plus a margin of
4.25% (which is increased to 7.5% for newly originated loans) and is secured by
the mortgage loans which are funded by advances under the facility, as well as
all assets, accounts receivable and all related proceeds held by the special
purpose entity organized to facilitate the transaction, referred to as the
borrower.
The $100.0 million facility contains representations, warranties,
conditions and covenants which are customary for facilities of this type,
including provisions which require the borrower to: (1) use the proceeds solely
to fund loan originations as described in the facility; (2) not incur any other
indebtedness except as specified in the facility; (3) not permit any liens,
claims or interests on, or any sale or disposition of, the collateral securing
the facility; and (4) provide the lender with all financial statements,
certificates and notices as specified in the facility. The $100.0 million
facility contains events of default typical for this type of facility, including
but not limited to, if: (1) the borrower fails to make any payment when due to
the lender; (2) the borrower breaches or fails to comply with the
representations, warranties, conditions or covenants under the facility; (3) we
become insolvent or the subject of insolvency proceedings; (4) a material
adverse change or effect as described in the facility occurs; (5) certain
members of management are no longer our executive officers and a satisfactory
replacement has not been found within 60 days; (6) we are unable to sell or
issue subordinated notes for more than three consecutive weeks or on more than
two occasions in any 12-month period irrespective of the length of time of such
occasions; (7) we are delisted from the NASDAQ Stock Market or any other stock
market or securities exchange or trading of our stock is suspended for at least
three consecutive days; (8) any of our servicing agreements, other than a
servicing agreement relating to a securitization in which one of our bond
insurers, or its affiliates have provided bond insurance or similar credit
enhancement, are terminated for cause or an event of default; (9) our net worth
is negative at the end of any calendar month or less than $10.0 million at the
end of any calendar quarter; (10) we fail to maintain cash and cash equivalents
and undrawn borrowing capacity under committed borrowing facilities of less than
$20.0 million after December 30, 2004; or (11) we fail to maintain minimum cash
of at least $10.0 million after December 30, 2004. Subject to certain exceptions
and the expiration of any applicable cure period as described in the $100.0
million facility, upon the occurrence of one or more events of default, the
lender may declare the amount outstanding under the facility immediately due and
payable. We expect to draw down on the full amount of this line to the extent
necessary to fund our loan originations.
71
We also sold the interest-only strips and servicing rights related to
five of our mortgage securitization trusts to an affiliate of this facility
provider under the terms of a September 27, 2004 sale agreement. The sale of
these assets was undertaken as part of our negotiations to obtain the new $100.0
million facility and to raise cash to pay fees on new warehouse credit
facilities and as a result, we did not realize their full value as reflected on
our books. We wrote down the carrying value of these interest-only strips and
servicing rights by $5.4 million at June 30, 2004 to reflect their values under
the terms of the sale agreement. On September 27, 2004, we received proceeds
from this sale of $9.7 million.
COMMITMENT LETTER RELATED TO $30.0 MILLION WAREHOUSE FACILITY AND $23.0
MILLION RESIDUAL REPURCHASE FACILITY. On October 27, 2004, we executed a
commitment letter, dated as of October 26, 2004, with a lender for: (i) a $30.0
million warehouse facility to fund the origination of residential mortgage
loans, including mortgage loans for which the complete documentation will not
have been received by the custodian at the time of funding and closing of such
loans, referred to as newly originated loans in this document; and (ii) a $23.0
million repurchase facility for specified interest-only strips owned by one of
our subsidiaries. Pursuant to the commitment letter, we agreed to organize a
special purpose trust to act as borrower under the warehouse facility, hold the
related newly originated loans and act as seller under the repurchase facility.
We also agreed to form a second trust, referred to as the parent trust, to hold
100% of the ownership interest in the special purpose trust.
The warehouse facility will have a term of three years, although, upon
the termination of the repurchase facility at the close of its two-year term, we
have an option to terminate the warehouse facility on the second anniversary of
the closing date upon payment of a termination fee of $600,000. Pursuant to the
commitment letter, the warehouse facility will have a floating interest rate
based upon LIBOR plus a margin of 2.5% per year.
The warehouse facility will be secured by, among other items, (i) newly
originated loans funded through the facility and proceeds from these loans; (ii)
a pledge of 100% of the common stock of ABFS Consolidated Holdings, Inc., our
subsidiary that will own 97% of the parent trust; (iii) a certificate issued by
the parent trust entitling an entity organized by the lender to a priority
interest in all of the parent trust's assets and distributions, including income
derived from certain of our interest-only strips; (iv) certain servicing
advances owned by American Business Credit, Inc., our subsidiary; and (v) the
value of the interest-only strips in excess of the amount necessary for the
special purpose trust to satisfy its obligations under the repurchase facility.
In connection with the warehouse facility, the lender on our $250.0
million credit facility must consent to certain aspects of the proposed
transaction. In addition, the parent trust will enter into an amendment to
security agreements with the trustee for our outstanding senior collateralized
subordinated notes pursuant to which collateral owned by the parent trust will
be pledged to secure the senior collateralized subordinated notes.
72
In connection with the execution of the commitment letter, we paid fees
of approximately $1.9 million. We also agreed to pay fees on the closing of the
facility and over the term of the warehouse facility totaling approximately $7.1
million, as well as an annual non-use fee equal to a percentage of the undrawn
portion of the warehouse facility.
As described in the commitment letter, under the repurchase facility,
an entity organized by the lender for the purposes of the repurchase facility
transaction, referred to as the purchaser, will acquire specified interest-only
strips for $23.0 million, which amount will be initially adjusted to reflect any
pre-closing adjustments to the value of such interest-only strips that may
result from distributions on the interest-only strips after September 30, 2004,
changes in market conditions or other factors as determined by the purchaser,
and may be reduced after the closing in case of a margin payment paid to the
purchaser, as described in the repurchase facility. The interest-only strips to
be transferred pursuant to this arrangement had an aggregate book value of $86.0
million at September 30, 2004. Subject to certain limitations, the repurchase
price of the specified interest-only strips will be secured by the collateral
under the warehouse facility, other than the specified interest-only strips
necessary for the special purpose trust to satisfy its obligations under the
repurchase facility. The repurchase facility will terminate two years after the
closing date. We have an option to terminate the repurchase facility by
repurchasing the specified interest-only strips in whole, but not in part, and
paying the applicable exit fee equal to 3% of the repurchase facility amount.
Our execution of the definitive agreement related to the repurchase facility
will require the consent of the lender under our $250.0 million credit facility.
The commitment letter is subject to, among other things, (i) the
approval by the lender's investment committee on or prior to November 5, 2004
and (ii) the execution of definitive agreements not later than November 5, 2004.
On November 8, 2004, the lender amended the commitment letter to notify us that
it had obtained the approval of its investment committee and to extend the
deadline for the execution of definitive agreements from November 5, 2004 to
November 22, 2004. We currently anticipate entering into an interim repurchase
facility with this lender which will expire when the definitive agreement
related to the warehouse facility and the permanent repurchase facility is
executed.
The availability of the warehouse facility and the repurchase facility,
referred to as the facilities, is subject to the satisfaction of certain initial
conditions which include, but are not limited to, the following: (i) our receipt
of one or more definitive commitments from one or more other new lenders for
warehouse funding of at least $100.0 million with a minimum of $30.0 million
available for funding newly originated loans; and (ii) our assignment to the
lender of a "key man" life insurance policy equal to at least $2.0 million on
the life of Mr. Santilli, our Chief Executive Officer, and our agreement to use
our best efforts to increase such policy to $5.0 million within six months of
the closing date.
The facilities will also be subject to certain customary and other
on-going conditions pursuant to which we will be required (i) to maintain at all
times an effective registration statement with the SEC for the sale of at least
$30.0 million of subordinated debentures; (ii) to maintain our ability to issue
and sell our subordinated debentures, except for the inability to issue and sell
subordinated debentures for a period of time which shall not exceed three
consecutive weeks or two occasions in any 12-month period irrespective of the
length of time of any such occasions; (iii) to satisfy all requirements for the
continued listing of our common stock on the NASDAQ National Market, with a
delisting notification to be considered a default under the facilities subject
to the cure period provided in the applicable NASDAQ listing standards; and (iv)
during the terms of the facilities, to retain Messrs. Santilli, Ruben and Mandia
in their current positions with us or, if Messrs. Ruben or Mandia cease to hold
their current positions of Executive Vice President and Chief Financial Officer,
respectively, to secure a replacement employee reasonably satisfactory to the
lender.
73
The facilities will contain additional conditions, representations,
covenants and events of default customary for transactions of this type and
similar to those contained in our $250.0 million credit facility, as well as our
covenant to maintain additional warehouse facilities for an aggregate of at
least $350.0 million. The failure to satisfy any of the initial or on-going
conditions contained in the facilities or the loss of servicing rights under
more than two of our outstanding securitizations or any warehouse facility will
constitute an event of default under the facilities.
While we anticipate that we will close on the facilities with the
lender, there can be no assurance that these negotiations will result in
definitive agreements or that these agreements, as negotiated, will contain
terms and conditions acceptable to us.
COMMITMENT LETTER RELATED TO $150.0 MILLION WAREHOUSE FACILITY. We
received a commitment letter dated as of November 1, 2004 for a mortgage
warehouse facility from two warehouse lenders, including an affiliate of the
lender on our $250.0 million credit facility, for the purpose of funding our
home mortgage loan originations. The commitment letter becomes effective and
legally obligates the parties upon the payment of the fees by us, as described
below, which fees have not been paid to date. The commitment letter provides for
a $150.0 million senior secured revolving facility, of which $10.0 million can
be utilized to fund newly originated loans. Of the $150.0 million, one lender
would provide up to approximately $132.0 million as the A Facility and the
affiliate of the lender on our $250.0 million credit facility would provide up
to approximately $18.0 million as the B Facility. The A Facility and B Facility
together are referred to as the $150.0 million facility. The $150.0 million
facility will expire on October 14, 2006, with a one-year extension of the A
Facility after the expiration of the initial term subject to, among other
things, the effectiveness of a committed B Facility in an amount and on terms
and conditions substantially satisfactory to the A facility lender. The A
Facility will have a floating interest rate based upon LIBOR plus a margin,
which decreases over the term of the facility, or prime plus a margin of 1.5%.
The $150.0 million facility will satisfy the option provided to the lender on
our $250.0 million facility which permitted this lender to increase the maximum
credit amount to $400.0 million and triggers the payment of additional fees to
such lender as described below.
The A Facility and the B Facility will each be secured by the home
mortgage loans which are funded by advances under the $150.0 million facility,
as well as all assets, held by a special purpose entity organized to facilitate
this transaction, provided, however, that the B Facility will be subordinate to
the A Facility. The $150.0 million facility will contain representations and
warranties and covenants, events of default and other conditions, which are
customary for a facility of this type. The commitment letter and the closing of
the $150.0 million facility are subject to such other customary and commercially
reasonable terms, including no material adverse condition or change in or
affecting our business, operations, property, condition or prospects since June
30, 2004, our receipt of a working capital facility or reverse repurchase line
of not less than $23.0 million, cash on hand and available working capital
facilities of not less than $40.0 million, delivery of 2004 audited financial
statements with an unqualified audit opinion, preparation, execution and
delivery of definitive loan documents, completion of due diligence by the
lenders, and execution of a servicing arrangement satisfactory to the lenders.
In connection with the execution and effectiveness of the
commitment letter, the Company is obligated to pay the lender on the A Facility
a work fee to offset its costs and expenses incurred in connection with the
facility and a fee of 2.0% of the amount of the A Facility, half of which is due
upon the effective date of the commitment letter and the second half upon the
closing of the facility. The Company agreed to pay annual collateral management
fees to affiliates of the lender on the A Facility over the term of the
facility. The Company also agreed to pay the lender on the B Facility: the
increase commitment fees provided for in the fee agreement related to our $250.0
million facility of approximately $21.9 million, with approximately $1.4 million
payable upon the termination of the facility and the balance payable in equal
monthly installments over the term of the facility, a work fee to offset the
lender's costs and expenses incurred in connection with the facility, and
additional fees of $4.5 million payable in equal monthly installments over the
term of the facility.
74
The commitment letter terminates on November 30, 2004 if the execution
and delivery of definitive agreements does not occur on or before such date.
While we anticipate that we will close on the $150.0 million facility with the
lenders, there can be no assurance that these negotiations will result in
definitive agreements or that these agreements, as negotiated, will contain
terms and conditions acceptable to us.
Although after December 3, 2004 we expect to have mortgage loan
warehouse credit facilities totaling at a minimum $530.0 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 RELATED TO OUR CREDIT
AGREEMENTS AND SERVICING Agreements. Our warehouse credit agreements require
that we comply with one or more financial covenants regarding, for example, net
worth, leverage, net income, liquidity, total debt and debt to equity and other
debt ratios. Each agreement has multiple individualized financial covenant
thresholds and ratio limits that we must meet as a condition to drawing on a
particular line of credit. 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.
In addition, in light of the losses experienced during the first
quarter of fiscal 2005 and the fiscal year 2004, we requested and obtained
waivers or amendments to credit facilities as discussed below 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 were 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.
On September 22, 2003, the lender under the $200.0 million facility
agreed (reduced to $60.0 million) 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 $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 $200.0
million facility was limited to $80.0 million. We entered into two amendments to
the sale and servicing agreement with the lender under our $200.0 million
facility which clarified the scope of particular financial covenants: one
amendment dated as of May 12, 2004 clarified the scope of the financial covenant
regarding the maintenance of minimum adjusted tangible net worth; and one
amendment dated as of June 30, 2004 clarified the scope of the financial
75
covenant regarding the maintenance of minimum cash and cash equivalents. This
lender waived our noncompliance with the minimum net worth requirements at
September 30, 2003, October 31, 2003, November 30, 2003, December 31, 2003,
March 31, 2004, June 30, 2004 and September 30, 2004. This lender also waived
our non-compliance with: the covenant regarding minimum adjusted tangible net
worth for all monthly compliance periods commencing with the month ending April
30, 2004 and continuing through the month ending October 31, 2004; the covenant
regarding minimum cash and cash equivalents for the compliance periods ending
December 31, 2003, April 30, 2004, May 31, 2004 and October 31, 2004; the
covenant regarding the ratio of debt to adjusted tangible net worth for the
compliance periods ending September 30, 2004 and October 31, 2004; and the
covenant regarding aggregate cash flow from all securitization trusts for the
compliance period ending September 30, 2004.
We have continued to operate on the basis of waivers granted by the
lender under this facility to each of these events of noncompliance. The
expiration date of this facility was originally September 21, 2004, but through
a series of extensions granted by this lender to facilitate our closing and
implementation of replacement credit facilities, this facility is now scheduled
to expire December 3, 2004. Consequently, we currently anticipate that we will
be out of compliance with one or more of the financial covenants contained in
this facility at November 30, 2004 and will need an additional waiver for this
noncompliance from this lender to continue to operate.
A provision in our $250.0 million credit facility required us to
maintain another credit facility for $200.0 million with a $40.0 million
sublimit of such facility available for funding loans between the time they are
closed by a title agency or closing attorney and the time documentation for the
loans is received by the collateral agent. As a result of the reduction of our
$200.0 million facility to $100.0 million, as described above, we entered into
an amendment to the master loan and security agreement governing our $250.0
million facility which reduced the required amount for another facility to
$100.0 million.
Additionally, as a result of being out of compliance at various times
since June 30, 2003 with the net worth requirement in several of our servicing
agreements, we requested and obtained waivers of this non-compliance from the
bond insurers associated with each of two separable groups of these servicing
agreements. In connection with the waiver of the net worth covenant granted by
one of these bond insurers, 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. The bond insurer re-appointed us as servicer under these amended
servicing agreements for additional 120-day terms commencing, respectively, on
January 29, 2004, May 27, 2004 and September 23, 2004. The second of these bond
insurers waived our non-compliance with net worth requirements on an oral basis
from September 30, 2003 through March 9, 2004, at which time it executed a
written waiver document which confirmed its prior oral waivers and extended
these waivers through March 14, 2004. Additionally, we entered into an agreement
with this second bond insurer on February 20, 2004 which amended the related
servicing agreements principally to provide for 30-day term-to-term servicing
and which re-appointed 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 for an additional
one-month term under these amended servicing agreements for all relevant periods
since the execution of the amended servicing agreements. Our reappointment as
servicer under these amended servicing agreements occurs in the sole discretion
of the associated bond insurer.
76
Separately, one bond insurer, as a condition to its participation in
our October 31, 2003 privately-placed securitization, required that we amend the
servicing agreement related to a previous public securitization in which the
bond insurer had provided financial guarantee insurance to the Class M
certificate. The resulting amendment to this servicing agreement, dated October
31, 2003, 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 amended again 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. On May 24, 2004, this amended servicing agreement was
further amended principally to provide for minor administrative changes to the
agreement and to re-appoint us as servicer for an additional term expiring June
30, 2004. This bond insurer subsequently has re-appointed us as servicer under
this amended servicing agreement for successive additional terms during all
relevant periods including the current term ending November 30, 2004. Our
re-appointment as servicer under this amended servicing agreement is determined
by reference to its provisions.
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. We were continuously re-appointed as servicer
under these servicing agreements prior to the described amendments and we have
continuously been re-appointed as servicer for all relevant periods subsequent
to the described amendments. Our re-appointment as servicer under these amended
servicing agreements is determined by reference to their provisions.
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.
We amended the security agreements related to the senior collateralized
subordinated notes to accommodate a request from the lender on our $250.0
million credit facility, and its affiliate, dated September 30, 2004, to clarify
an inconsistency between these agreements and the $250.0 million credit facility
documents related to liens on certain assets previously pledged by ABFS
Warehouse Trust 2003-1 to Clearwing, the affiliate of the lender. See "-- Credit
Facilities--Credit Facilities Available at September 30, 2004" for additional
information regarding these amendments.
Because we anticipate incurring losses at least through the second
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. We cannot assure you as to whether or in what form a waiver or
modification of these agreements would be granted to us.
77
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, we utilize
proceeds from the issuance of subordinated debentures to fund
overcollateralization requirements. During the three months ended September 30,
2004, subordinated debentures decreased by $32.8 million compared to a decrease
of $32.0 million in the three months ended September 30, 2003. The reduction in
subordinated debentures outstanding at September 30, 2004 was primarily due to
the closings of the second exchange offer during the quarter and the resulting
conversion of $30.8 million of subordinated debentures into 15.6 million of
shares of Series A preferred stock and $15.2 million of senior collateralized
subordinated notes.
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 first exchange
offer 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 a maturity of 36 months. All other senior
collateralized subordinated notes issued in the first exchange offer have
maturities equal to the subordinated debentures tendered. The senior
collateralized subordinated notes outstanding 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 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 principal balance of the senior collateralized
subordinated notes issued in the first exchange offer, 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.
On May 14, 2004, we mailed the second exchange offer to holders of up
to $120,000,000 of investment notes issued prior to November 1, 2003, which
offered holders of such notes the ability to exchange their investment notes on
substantially the same terms described above.
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Under the terms of the exchange offers, the following amounts of
subordinated dentures were exchanged for shares of Series A preferred stock and
senior collateralized subordinated notes (in thousands):
Shares of Senior
Subordinated Series A Collateralized
Debentures Preferred Subordinated
By Closing Dates Exchanged Stock Issued Notes Issued
- ---------------- ------------ ------------ --------------
First exchange offer:
December 31, 2003............................. $ 73,554 39,095 $ 34,459
February 6, 2004.............................. 43,673 22,712 20,961
--------- --------- ---------
Results of first exchange offer............ 117,227 61,807 55,420
--------- --------- ---------
Second exchange offer:
June 30, 2004................................. 60,589 31,980 28,609
July 31, 2004................................. 25,414 12,908 12,506
August 23, 2004............................... 5,418 2,741 2,677
--------- --------- ---------
Results of second exchange offer........... 91,421 47,629 43,792
--------- --------- ---------
Cumulative results of exchange offers............. $ 208,648 109,436 $ 99,212
========= ========= =========
At September 30, 2004, our interest in the cash flows from the
interest-only strips held in the trust which secure the senior collateralized
subordinated notes totaled $401.6 million of which approximately $146.2 million
represented 150% of the outstanding principal balance of senior collateralized
subordinated notes. See "-- Secured and Unsecured Indebtedness" for a
description of our additional obligations related to the interest-only strips
held in this trust.
Anthony J. Santilli, our Chairman, Chief Executive Officer and
President, Beverly Santilli, President of American Business Credit, Inc. and
Executive Vice President of HomeAmerican Credit, Inc., 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) outstanding: Mr. Santilli: SAPS - 4,691, SCSN -
$4,691; Mrs. Santilli: SAPS - 4,691, SCSN - $4,691; Dr. Miller: SAPS - 30,164,
SCSN - $30,164. Mr. Santilli and Mrs. Santilli subsequently transferred
ownership of the Series A preferred stock acquired on February 6, 2004.
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, $77.2 million of debt from this registration statement was
available for future issuance as of September 30, 2004. On October 22, 2004, we
filed Post-Effective Amendment No. 1 to this registration statement to update
the financial and other information. On June 22, 2004, we filed a registration
statement with the SEC to register $280.0 million of subordinated debentures.
Such registration statement is under review.
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 obtaining working capital funding. No assurance can be given that we will be
able to successfully implement the contingent financial restructuring plan, if
necessary, and repay our outstanding debt when due.
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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 September 2004 was 11.02%, compared to a weighted-average
interest rate of 7.49% for subordinated debentures issued in the month of June
2003. We had reduced the interest rates offered on subordinated debentures
beginning in the fourth quarter of fiscal 2001 and had continued reducing rates
through June 2003 in response to decreases in market interest rates as well as
declining cash needs during that period. However, during fiscal 2004, the
weighted-average interest rate on subordinated debentures we issued had steadily
increased, reflecting 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 weighted average remaining
maturity of our subordinated debentures at September 30, 2004 was 11.5 months
compared to 13.5 months at June 30, 2004 and 19.5 months at June 30, 2003.
TERMS OF THE SERIES A PREFERRED STOCK. The Series A preferred stock has
a par value of $0.001 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. There were 109,435,580 shares of the
Series A preferred stock issued and outstanding at September 30, 2004.
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 September 30,
2004, the liquidation value equals $109.4 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 September 30, 2004, the annual cash
dividend requirement equals $10.9 million.
On or after the second anniversary of the issuance date (or on or after
the one year anniversary of the issuance date if no dividends are paid on the
Series A preferred stock), each share of the Series A preferred stock is
convertible at the option of the holder into a number of shares of our common
stock determined by dividing: (A) $1.00 plus an amount equal to accrued but
unpaid dividends (if the conversion date is prior to the second anniversary of
the issuance date because the Series A preferred stock has become convertible
due to a failure to pay dividends), $1.20 plus an amount equal to accrued but
unpaid dividends (if the conversion date is prior to the third anniversary of
the issuance date but on or after the second anniversary of the issuance date)
or $1.30 plus an amount equal to accrued but unpaid dividends (if the conversion
date is on or after the third anniversary of the issuance date) by (B) the
market value of a share of our common stock (which figure shall not be less than
$5.00 per share regardless of the actual market value on the conversion date).
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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 and the second
exchange offer converted at the conversion prices listed below, the number of
shares of our common stock which would be issued upon conversion follows (shares
in thousands):
As of September 30, 2004
-----------------------------
Convertible
Number of into Number
Preferred of Common
Shares Shares
--------- -----------
Conversion at $1.20.......... 109,436 26,265
Conversion at $1.30.......... 109,436 28,453
As described above, the conversion ratio of the Series A preferred
stock increases during the first three years following 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. Under guidance
issued by the EITF in issue 98-5, "Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,"
this discount, or beneficial conversion feature, must be valued and amortized to
the income statement as additional non-cash preferred dividends over the
three-year period that the holders of the Series A preferred stock earn the
discount.
We computed the value of the beneficial conversion feature using the
conversion ratio of $1.30 to $5.00, which is the conversion term that is most
beneficial to the investor and would result in the issuance of 28.5 million
shares of common stock based on the shares of Series A preferred stock that were
issued through September 30, 2004. The value of the beneficial conversion
feature equals the excess of the intrinsic value of those 28.5 million shares of
common stock at their closing prices on the dates the preferred stock was
issued, over the value of the Series A preferred stock on the same dates. The
value of the Series A preferred stock was equal to the carrying value of the
subordinated debentures exchanged. For closings under the exchange offers
through September 30, 2004, the value of the beneficial conversion feature was
$11.3 million. During the first quarter of fiscal 2005, amortization of $0.9
million was added to the $2.6 million of cash dividends declared on the Series A
preferred stock resulting in a total charge to the income statement of $3.5
million. During fiscal 2004, amortization of $0.8 million was added to the $2.9
million of cash dividends declared on the Series A preferred stock resulting in
a total charge to the income statement of $3.7 million. The offset to the charge
to the income statement for the amortization of the beneficial conversion
feature is recorded to additional paid in capital. Amortization of the total
value of the beneficial conversion feature will be $3.6 million in fiscal 2005,
$3.8 million in fiscal 2006 and $3.0 million for fiscal 2007.
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, although to a lesser extent. 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. See "-- Off-Balance Sheet Arrangements" for further detail
of our securitization activity and effect of securitizations on our liquidity
and capital resources.
OTHER LIQUIDITY CONSIDERATIONS. 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 our first exchange offer and the common stock issuable
upon the conversion of the Series A preferred stock.
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At a special meeting of stockholders held on June 29, 2004, our
shareholders approved a proposal to authorize the issuance of shares of Series A
preferred stock in connection with our second 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. In addition to meeting the
requirements of the exchange offers, 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
Servicemembers Civil Relief Act, 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.
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.
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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. Prior to its
preclusion in July 2003, we 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 on new loans in some of the states where we originate loans. Prior to this
rule becoming effective, 80% to 85% of the home mortgage loans we originated
contained prepayment fees. The origination of a high percentage of loans with
prepayment fees impacts our securitization gains and securitization assets by
helping to reduce the likelihood of a borrower prepaying their loan, thereby
prolonging the life of a securitization, and increasing the amounts of residual
cash flow, servicing fees and prepayment fees we can expect to collect over the
life of a securitization. We currently expect that the percentage of loans that
we will originate in the future containing prepayment fees will decrease to
approximately 65% to 70%. During the first quarter of fiscal 2005 and fiscal
2004, approximately 78% and 72%, respectively, of the loans we originated
contained prepayment fees. This decrease in prepayment fee penetration will
potentially reduce the amount of gains and securitization assets we will record
on any future securitizations. Because there are many other variables including
market conditions, which will also impact securitizations, we are unable to
quantify the impact of this rule on any future securitization assets and related
gains until we complete a publicly-placed securitization of loans which we
originated since this rule became effective. Additionally, in an earlier
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 were applicable to
loans made in New Jersey, including alternative mortgage transactions. On May
26, 2004, the New Jersey Supreme Court reversed the decision of the Appellate
Division of the Superior Court of New Jersey and held that the Parity Act had
preempted the New Jersey Prepayment Law, which prohibited housing lenders from
imposing prepayment penalties. However, the plaintiff has petitioned the United
States Supreme Court for certiorari in this matter.
Although we are licensed or otherwise qualified to originate loans in
46 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.
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We are also subject, from time to time, to private litigation resulting
from alleged "predatory lending" practices. 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.
On May 20, 2004, the purported consumer class action lawsuit captioned
Moore v. American Business Financial Services, Inc. et al, No. 003237 was filed
against us, our lending subsidiaries and an unrelated party in the Philadelphia
Court of Common Pleas. The lawsuit was brought on behalf of residential mortgage
consumers and challenges the validity of our deed in lieu of foreclosure and
force-placed insurance practices as well as certain mortgage service fees
charged by us. This lawsuit relates, in part, to the same subject matter as the
U.S. Attorney's inquiry concluded in December 2003 with no findings of
wrongdoing as discussed below. The lawsuit seeks actual and treble damages,
statutory damages, punitive damages, costs and expenses of the litigation and
injunctive relief. Procedurally, this lawsuit is in a very preliminary stage. We
believe the complaint contains fundamental factual inaccuracies and that we have
numerous defenses to these allegations. We intend to vigorously defend this
lawsuit. Due to the inherent uncertainties in litigation and because the
ultimate resolution of this proceeding is influenced by factors outside of 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.
SECURITIES CLASS ACTION LAWSUITS AND SHAREHOLDER DERIVATIVE ACTION. In
January and February of 2004, four class action lawsuits were filed against us
and certain of our officers and directors. Lead plaintiffs and counsel were
appointed on June 3, 2004. A consolidated amended class action complaint that
supersedes these four complaints was filed on August 19, 2004 in the United
States District Court for the Eastern District of Pennsylvania.
The consolidated amended class action complaint brings claims on behalf
of a class of all purchasers of our common stock for a proposed class period of
January 27, 2000 through June 26, 2003. The consolidated complaint names us, our
director and Chief Executive Officer, Anthony Santilli, our Chief Financial
Officer, Albert Mandia, and former director, Richard Kaufman, as defendants and
alleges that we and the named directors and officers violated Sections 10(b) and
20(a) of the Exchange Act. The consolidated complaint alleges that, during the
applicable class period, our forbearance and deferment practices enabled us to,
among other things, lower our delinquency rates to facilitate the securitization
of our loans which purportedly allowed us to collect interest income from our
securitized loans and inflate our financial results and market price of our
common stock. The consolidated amended class action complaint seeks unspecified
compensatory damages, costs and expenses related to bringing the action, and
other unspecified relief. We filed a motion to dismiss this class action on
October 21, 2004.
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 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 the motion to dismiss the consolidated
amended complaint filed in the putative consolidated securities class action.
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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 is
influenced by factors outside of our control, we are currently unable to predict
the ultimate outcome of this litigation or its impact on our financial position,
results of operations or cash flows.
JOINT AGREEMENT WITH THE U.S. ATTORNEY'S OFFICE. 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 ended the inquiry by the
U.S. Attorney initiated pursuant to the civil subpoena dated May 14, 2003. The
U.S. Attorney's inquiry focused on our forbearance policies, primarily on our
practice of requesting a borrower who entered into forbearance agreement to
execute a deed in lieu of foreclosure. In response to the inquiry and as part of
the Joint Agreement, we, among other things, adopted a revised forbearance
policy, which became effective on November 19, 2003 and agreed to make an $80
thousand contribution to a housing counseling organization approved by the U.S.
Department of Housing and Urban Development, of which $40 thousand was
contributed with the balance being due in 2005. We do not believe that the Joint
Agreement with the U.S. Attorney has had a significant impact on our operations.
See "Legal Proceedings."
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
Our consolidated financial statements are prepared in accordance with
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. When we securitize loans, 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 loan securitizations. While we completed no securitization in the three
months ended September 30, 2004 and recorded minimal gains for the three months
ended September 30, 2003, 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. 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. 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.
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INTEREST-ONLY STRIPS. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 41.4% of our
total assets at September 30, 2004 and 44.0% of our total assets at June 30,
2004 and are carried at their fair values. Interest-only strips are initially
recorded at their allocated cost basis at the time of recording a securitization
gain and in accordance with SFAS No. 115 "Accounting for Certain Investments in
Debt and Equity Securities," referred to as SFAS No. 115 in this document, are
then written up to their fair value through other comprehensive income, a
component of stockholders' equity.
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. 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 for impairment.
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, decreases in the fair value of
interest-only strips that are deemed to be other than temporary adjustments to
fair value are recorded through the income statement, which would adversely
affect our income in the period of adjustment. Additionally, to the extent any
individual interest-only strip has a portion of its initial write up to fair
value still remaining in other comprehensive income, other than temporary
decreases in its fair value would first be recorded as a reduction to other
comprehensive income, which would adversely affect our stockholders' equity in
the period of adjustment.
During the first quarter of fiscal 2005, we recorded a pre-tax write up
of $18.6 million on our interest-only strips. The $18.6 million write up was
recorded as an increase to other comprehensive income, a component of
stockholders' equity. This write up of interest-only strips resulted from a
reduction to our assumptions for loan prepayments expected to occur beyond 18
months. Management believes that once we move beyond the low interest rate
environment and the impact that environment has on loan prepayments, the long
running and highly unfavorable prepayment experience over the last twelve
quarters will leave us with securitized mortgage pools which will experience
future prepayment speeds substantially lower than originally believed.
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During fiscal 2004, we recorded total pre-tax other than temporary
valuation adjustments on our interest-only strips of $57.0 million, of which in
accordance with EITF 99-20, $39.6 million was charged as expense to the income
statement and $17.4 million was charged to other comprehensive income. The
valuation adjustments primarily reflect the impact of higher than anticipated
prepayments on securitized loans experienced during the fiscal year ended June
30, 2004 due to the continuing low interest rate environment. Additionally, on
June 30, 2004, we wrote down the carrying value of our interest-only strips
related to five of our mortgage securitization trusts by $4.1 million to reflect
their values under the terms of a September 27, 2004 sale agreement. The sale of
these assets is described in "-- Liquidity and Capital Resources." See "--
Securitizations" for more detail on the estimation of the fair value of
interest-only strips and the sensitivities of these balances to changes in
assumptions and the impact on our financial statements of changes in
assumptions.
Interest accretion income represents the yield component of cash flows
received on interest-only strips. We use a prospective approach to estimate
interest accretion. As previously discussed, we update estimates of residual
cash flow from our securitizations on a quarterly basis. Under the prospective
approach, when it is probable that there is a favorable or unfavorable change in
estimated residual cash flow from the cash flow previously projected, we
recognize a larger or smaller percentage of the cash flow as interest accretion.
Any change in value of the underlying interest-only strip could impact our
current estimate of residual cash flow earned from the securitizations. For
example, a significant change in market interest rates could increase or
decrease the level of prepayments, thereby changing the size of the total
managed loan portfolio and related projected cash flows. The managed portfolio
includes loans held as available for sale on our balance sheet and loans
serviced for others.
SERVICING RIGHTS. Servicing rights, which represent the rights to
receive contractual servicing fees from securitization trusts and ancillary fees
from borrowers, net of adequate compensation that would be required by a
substitute servicer, represented 6.2% of our total assets at September 30, 2004
and 7.1% of our total assets at June 30, 2004. 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 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
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.
A review for impairment is performed on a quarterly basis by
stratifying the serviced loans by loan type, home mortgage or business purpose
loans, which we consider to be the predominant risk characteristic in the
portfolio of loans we service. In establishing loan type as the predominant risk
characteristic, we considered the following additional loan characteristics and
determined these characteristics as mostly uniform within our two types of
serviced loans and not predominant for risk stratification:
o Fixed versus floating rate loans - All loans we service in our
securitizations are fixed-rate loans.
o Conforming versus non-conforming loans - All loans we service are
sub-prime (non-conforming) loans, with over 80% of the loans
serviced having credit grades of A or B.
o Interest rate on serviced loans - The serviced loan portfolio has
a high penetration rate of prepayment fees. Sub-prime borrowers,
in general, are not as influenced by movement in market interest
rates as conforming borrowers. A sub-prime borrower's ability to
'rate shop' is generally limited due to personal credit
circumstances that are not market driven.
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o Loan collateral - All loans we service are secured by real estate,
with approximately 85% secured with first liens on residential
property.
o Individual loan size - The average loan size in our managed
portfolio is $71 thousand. The managed portfolio is approximately
$1.6 billion at September 30, 2004 with approximately 22 thousand
loans. There are no significant defining groupings with respect to
loan size. No loans are greater than $1.0 million, only $9.1
million of loans have principal balances greater than $500
thousand, and only $30.3 million of loans have principal balances
greater than $350 thousand.
o Geographic location of loans - The largest percentage of loans we
service are geographically located in the mid-Atlantic and
northeast sections of the United States.
o Original loan term - Home equity loan terms are primarily 180, 240
or 360 months. Business purpose loan terms are primarily 120 or
180 months.
If our quarterly 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.
Our valuation analyses indicated that no adjustment was required in the quarter
ended September 30, 2004 and $5.5 million was required in fiscal 2004. The
fiscal 2004 valuation adjustment for impairment of servicing rights was due to
higher than expected prepayment experience. Additionally, on June 30, 2004, we
wrote down the carrying value of our servicing rights related to five of our
mortgage securitization trusts by $1.3 million to reflect their values under the
terms of a September 27, 2004 sale agreement. The sale of these assets is
described in "-- Liquidity and Capital Resources." In accordance with SFAS No.
140, the write downs were recorded as a charge to the income statement.
Impairment is measured as the excess of carrying value over fair value. See "--
Securitizations" for more detail on the estimation of the fair value of
servicing rights and the sensitivities of these balances to changes in
assumptions and the estimated impact on our financial statements of changes in
assumptions.
Amortization of the servicing rights asset for securitized loans is
calculated individually for each securitized loan pool and is recognized in
proportion to, and over the period of, estimated future servicing income on that
particular pool of loans.
DEFERRED TAX ASSET. Estimates of deferred tax assets and deferred tax
liabilities make up the deferred income tax asset on our balance sheet. These
estimates involve significant judgments and estimates by management, which may
have a material impact on the carrying value of the deferred income tax asset.
We periodically review the deferred income tax asset to determine if it is more
likely than not that we will realize this deferred tax asset.
Our net deferred income tax increased from $59.1 million at June 30,
2004 to $66.2 million at September 30, 2004. For more detail on this net
deferred income tax asset, see Note 10 of the September 30, 2004 Consolidated
Financial Statements. This increase results primarily from recording $13.6
million of federal income tax benefits on our prior loss for the quarter ended
September 30, 2004, partially offset by the deferred tax credit recorded on
September 30, 2004 write-up of our interest-only strips. In fiscal 2004, we
recorded $68.3 million of federal and state income tax benefits on our pre-tax
loss for the fiscal year ended June 30, 2004. These federal and state income tax
benefits 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: (i) the circumstances
producing the losses for the fourth quarter of fiscal 2003, the fiscal year
ended June 30, 2004 and first quarter of fiscal 2005; (ii) our historical
profitability prior to the fourth quarter of fiscal 2003; (iii) the anticipated
impact that our adjusted business strategy will have on producing more currently
taxable income than our previous business strategy produced due to higher loan
originations and shifting from securitizations to whole loan sales; (iv) the
achievability of anticipated levels of future taxable income under our adjusted
business strategy; and (v) the likely utilization of our net operating loss
carryforwards. Additionally, we consider tax-planning strategies we can use to
increase the likelihood that the deferred income tax asset will be realized.
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Our adjusted business strategy will more likely than not produce the
level of loan originations that we need to achieve taxable income. In the month
of September 2004 under our adjusted business strategy, we originated $234.0
million of loans and management believes that amount would have been higher if
not for the impact of hurricanes in some of the states in which we originate
loans. Once our adjusted business strategy is fully implemented, we anticipate
increasing our loan originations to approximately $400.0 million to $600.0
million per month, which will return us to profitable operations. We have
significantly expanded our geographic reach and established a strong presence on
the west coast in fiscal 2004, and are continuing to apply our adjusted business
strategy, particularly as it relates to expanding our broker channel and
offering adjustable rate mortgages, purchase money mortgages and more
competitively priced fixed rate mortgages. Additionally, economic conditions are
favorable for loan originations with growing GDP and employment, high real
estate values and moderate increases in interest rates.
In determining that it is more likely than not that we would realize
our deferred tax asset, adequate funding and liquidity was assumed based on the
current status of negotiations with credit facility providers. Credit facilities
of at a minimum $530.0 million and a working capital line of $23.0 million were
assumed. In addition to our existing $250.0 million credit facility which has
two more years remaining on its term, on November 5, 2004, we closed a new
credit facility totaling $100.0 million (which can be increased to $175.0
million from month four through month ten of the facility term at the sole
discretion of the lender). As of November 12, 2004, we had a commitment letter
for a new $150.0 million credit facility, a firm commitment for a new $30.0
million credit facility and a $23.0 million repurchase facility. These
facilities are expected to close by November 30, 2004 bringing our total credit
facilities to $530.0 million possibly growing to $605.0 million at the sole
discretion of one of our lenders. The combination of existing financing and
financing scheduled to close before November 30, 2004 provides adequate funding
to determine that it is more likely than not that we will realize our deferred
tax asset.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is maintained
on non-accrual loans to account for delinquent loans and leases and delinquent
loans that have been repurchased from securitization trusts. The allowance is
maintained at a level that management determines is adequate to absorb estimated
probable losses. 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 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. Delinquent loans are charged
off against the allowance in the period in which a loan is deemed fully
uncollectable or when liquidated in a payoff or sale. 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.
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DERIVATIVE FINANCIAL INSTRUMENTS. We utilize derivative financial
instruments to manage the effect of changes in interest rates on the fair value
of our loans between the date loans are originated at fixed interest rates and
the date the terms and pricing for a whole loan sale are fixed or the date the
fixed interest rate pass-through certificates to be issued by a securitization
trust are priced. See "-- Quantitative and Qualitative Disclosures About Market
Risk -- Strategies for Use of Derivative Financial Instruments" for more detail.
Derivative contracts receive hedge accounting only if they are
designated as a hedge and are expected to be, and are, highly effective in
substantially reducing interest rate risk arising from the pools of mortgage
loans exposing us to risk. Under hedge accounting, the gain or loss derived from
these derivative financial instruments, which are designated as fair value
hedges, is reported in the Statement of Income (included in the caption "gains
and losses on derivative financial instruments") as it occurs with an offsetting
adjustment to the hedged loans attributable to the risk being hedged also
reported in the Statement of Income. The fair value of derivative financial
instruments is determined based on quoted market prices. The fair value of the
hedged loans is determined based on current pricing of these assets in a whole
loan sale or securitization. Cash flows resulting from fair value hedges are
reported in the period they occur.
Assuming a hedge relationship continues to be highly effective,
determined as described below, the relationship continues until the mortgage
loan pool is sold in a whole loan sale, is committed to a forward sale agreement
or is sold in a securitization. When a hedge relationship is terminated, the
derivative financial instrument may be re-designated as a hedge of a new
mortgage pool.
The effectiveness of our fair value hedges is periodically assessed.
Fair value hedges must meet specific effectiveness tests to be considered highly
effective. Over time the change in the fair values of the derivative financial
instrument must be within 80 to 120 percent of the change in the fair value of
the hedged loans due to the designated risk. If highly effective correlation
does not exist, we discontinue hedge accounting prospectively.
DEVELOPMENT OF CRITICAL ACCOUNTING ESTIMATES. On a quarterly basis,
senior management reviews the estimates used in our critical accounting
policies. As a group, senior management discusses the development and selection
of the assumptions used to perform its estimates described above. Management has
discussed the development and selection of the estimates used in our critical
accounting policies as of September 30, 2004 and June 30, 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 quarter ended September 30,
2004 and the fiscal years ended June 30, 2004, 2003 and 2002, see "--
Securitizations."
INITIAL ADOPTION OF ACCOUNTING POLICIES. In conjunction with the
relocation of our corporate headquarters to new leased office space, we entered
into a lease agreement and certain governmental grant agreements, which provided
us with reimbursement for certain expenditures related to our office relocation.
The reimbursable expenditures included 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 are 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 were initially recorded as a liability. Grant
funds received to offset expenditures for capitalizable items are classified 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 were recognized in the income statement
as an offset to the expense item.
90
IMPACT OF CHANGES IN CRITICAL ACCOUNTING ESTIMATES IN PRIOR FISCAL YEARS
During fiscal 2004 and fiscal 2003, we recorded valuation adjustments
on our securitization assets of $63.8 million and $63.3 million, respectively.
The breakout of the total pre-tax adjustments recorded in fiscal 2004 and fiscal
2003 between interest-only strips and servicing rights, and the amounts charged
as expense to the income statement or to other comprehensive income were as
follows (in thousands):
YEAR ENDED JUNE 30, 2004 YEAR ENDED JUNE 30, 2003
-------------------------------------- ----------------------------------------
INCOME OTHER INCOME OTHER
TOTAL STATEMENT COMPREHENSIVE TOTAL STATEMENT COMPREHENSIVE
WRITE DOWN IMPACT INCOME IMPACT WRITE DOWN IMPACT INCOME IMPACT
---------- --------- ------------- ---------- --------- -------------
Interest-only strips.......... $ 57,031 $ 39,659 $ 17,372 $ 57,973 $ 39,900 $ 18,073
Servicing rights.............. 6,791 6,791 -- 5,282 5,282 --
------------------------------------ -------------------------------------
Total securitization assets... $ 63,822 $ 46,450 $ 17,372 $ 63,255 $ 45,182 $ 18,073
==================================== =====================================
The amounts of the valuation adjustments recorded in fiscal 2004 and
fiscal 2003 related to changes in critical accounting estimates are discussed
below. See "- Application of Critical Accounting Estimates - Interest-Only
Strips" and "- Application of Critical Accounting Estimates - Servicing Rights"
for a discussion of how valuation adjustments are recorded.
DISCOUNT RATES. The amounts of the valuation adjustments recorded in
fiscal 2004 and fiscal 2003 related to changes in discount rates were as follows
(in thousands):
YEAR ENDED JUNE 30, 2004 YEAR ENDED JUNE 30, 2003
---------------------------------------- ----------------------------------------
INCOME INCOME
TOTAL STATEMENT OTHER TOTAL STATEMENT OTHER
WRITE WRITE COMPREHENSIVE WRITE WRITE COMPREHENSIVE
DOWN/ DOWN/(WRITE INCOME WRITE DOWN/ DOWN/(WRITE INCOME WRITE
RELATED TO DISCOUNT RATE (WRITE UP) UP) DOWN/(WRITE UP) (WRITE UP) UP) DOWN/(WRITE UP)
- ------------------------ ---------- ----------- --------------- ---------- ----------- ---------------
Interest-only strips.......... $ (16) $ (553) $ 537 $ (20,904) $ (10,756) $ (10,148)
Servicing rights.............. -- -- -- (7,118) (7,118) --
----------------------------------- -------------------------------------
Total securitization assets... $ (16) $ (553) $ 537 $ (28,022) $ (17,874) $ (10,148)
=================================== =====================================
The valuation adjustment on interest-only strips for fiscal 2004
included the net impact of a December 31, 2003 reduction in the discount rate
applied to value the residual cash flows from interest-only strips from 11% to
10%, and a subsequent increase in that discount rate at June 30, 2004 back to
11%. 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. The increase in the discount rate to
11% at June 30, 2004 was made to reflect an increase in market interest rates
that had occurred since the end of the March 2004 quarter. The December 31, 2003
reduction in the discount rate had a favorable impact of $8.4 million on that
quarter's valuation adjustment. The June 30, 2004 increase in discount rate had
an unfavorable impact of $8.4 million on that quarter's valuation adjustment.
There was no change in the discount rate applied to value the cash flows from
servicing rights.
91
During fiscal 2003, we reduced the discount rates applied to value the
residual cash flows from interest-only strips and the cash flows from servicing
rights. 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 for fiscal 2003 are discussed in more detail below.
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 426 basis points, from 8.04% in the 2000-2 securitization
to 3.78% in the 2003-1 securitization.
o The weighted average interest rate on loans securitized had
declined from a high of 12.01% in the 2000-3 securitization to
10.23% in the 2003-1 securitization.
o Market factors and the economy favored the continuation of low
interest rates for the foreseeable future.
o Economic analysis of interest rates and data released at the time
of the June 30, 2003 evaluation supported declining mortgage
refinancings even though predicting the continuation of low
interest rates for the foreseeable future.
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%.
92
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. From the second quarter of fiscal 2002 through the
first quarter of fiscal 2005, we revised the prepayment rate assumptions used to
value our securitization assets, thereby impacting the fair value of these
assets. See "-- Securitizations" for discussion of the impacts of these
revisions in prepayment rate assumptions.
OFF-BALANCE SHEET ARRANGEMENTS
We use off-balance sheet arrangements extensively in our business
activities. The types of off-balance sheet arrangements we use include special
purpose entities for the securitization of loans, obligations we incur as the
servicer of securitized loans and other contractual obligations such as
operating leases for corporate office space. See "-- Liquidity and Capital
Resources" for additional information regarding our off-balance sheet
contractual obligations.
We have used special purpose entities and off-balance sheet facilities
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. We expect to use off-balance sheet
facilities in any future securitizations.
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.
When we securitize loans, 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.
93
We may retain the rights to service the loans we sell through
securitizations. If we retain the servicing rights, as the servicer of
securitized loans, we are obligated to advance interest payments for delinquent
loans if we deem that the advances will ultimately be recoverable. These
advances can first be made out of funds available in a trust's collection
account. If the funds available from the collection account are insufficient to
make the required interest advances, then we are required to make the advance
from our operating cash. The advances made from a trust's collection account, if
not recovered from the borrower or proceeds from the liquidation of the loan,
require reimbursement from us. These advances may require funding from our
capital resources and may create greater demands on our cash flow than either
selling loans with servicing released or maintaining a portfolio of loans on our
balance sheet. However, any advances we make on a mortgage loan from our
operating cash can be recovered from the subsequent mortgage loan payments to
the applicable trust prior to any distributions to the certificate holders.
At September 30, 2004 and June 30, 2004, the mortgage securitization
trusts held loans with an aggregate principal balance due of $1.6 billion and
$1.9 billion as assets and owed $1.5 billion and $1.7 billion to third party
investors, respectively. There were no revenues from the sale of loans to
securitization trusts for the three months ended September 30, 2004. The
revenues for the three months ended September 30, 2003 were $0.8 million. We
have interest-only strips and servicing rights with fair values of $448.8
million and $66.7 million, respectively at September 30, 2004, which combined
represent 48% of our total assets. Net cash flows received from interest-only
strips and servicing rights were $35.7 million for the three months ended
September 30, 2004 and $61.6 million for the three months ended September 30,
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."
94
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.
In a declining interest rate environment, such as experienced during
fiscal 2003, securitization pass-through interest rates generally decline, which
can lead to higher interest rate spreads. Increased interest rate spreads result
in increases in the residual cash flow we expect to receive on securitized
loans, the amount of cash we receive at the closing of a securitization from the
sale of notional bonds or premiums on investor certificates and corresponding
increases in the gains we recognize on the sale of loans in a securitization. In
our fiscal 2003 securitizations, we experienced improved interest rate spreads.
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. No
assurances can be made that market interest rates will remain at current levels
or that we can complete securitizations in the future. 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 "-- Quantitative and Qualitative
Disclosures About Market Risk -- Strategies for Use of Derivative Financial
Instruments" for a discussion of our hedging strategies.
While a declining interest rate environment can lead to higher interest
rate spreads, a declining interest rate environment could also 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. This has been our
experience since fiscal 2002.
Declining interest rates and resulting high prepayment rates over the
last twelve quarters have required revisions to our estimates of the value of
our securitization assets. 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 twelve
quarters we have recorded cumulative pre-tax write downs to our interest-only
strips in the aggregate amount of $140.4 million and pre-tax adjustments to the
value of servicing rights of $12.1 million, for total adjustments of $152.5
million, mainly due to the higher than expected prepayment experience. On June
30, 2004, we wrote down the carrying value of our interest-only strips and
servicing rights related to five of our mortgage securitization trusts by $5.4
million to reflect their values under the terms of a September 27, 2004 sale
agreement. The sale of these assets is described in "-- Liquidity and Capital
Resources." The following table summarizes the net cumulative write downs
recorded on our securitization assets over the last twelve quarters (in
thousands):
95
TOTAL INCOME OTHER
WRITE DOWN STATEMENT COMPREHENSIVE
(WRITE UP) IMPACT INCOME IMPACT
---------- --------- -------------
PRE-TAX ADJUSTMENT RESULTING FROM:
Prepayments.............................. $ 177,396 $ 128,697 $ 48,699
Discount rate............................ (30,305) (18,427) (11,878)
Loss on sale............................. 5,452 3,446 2,006
--------- --------- --------
Net cumulative write down................ $ 152,543 $ 113,716 $ 38,827
========= ========= ========
See "- Application of Critical Accounting Estimates - Interest-Only
Strips" for a discussion of how valuation adjustments are recorded in the income
statement or other comprehensive income.
During the quarter ended September 30, 2004, we recorded a pre-tax
write up of $18.6 million on our interest-only strips. The $18.6 million write
up was recorded as an increase to other comprehensive income, a component of
stockholders' equity. This write up in the value of our interest-only strips
resulted from a reduction to our assumptions for loan prepayments expected to
occur beyond 18 months. Management believes that once we move beyond the low
interest rate environment and the impact that environment has on loan
prepayments, the long running and highly unfavorable prepayment experience over
the last twelve quarters will leave us with securitized mortgage pools which
will experience future prepayment speeds substantially lower than originally
believed. No adjustments were recorded to our servicing rights at September 30,
2004.
The breakout of the total securitization assets adjustments recorded in
fiscal 2004 and 2003 between interest-only strips and servicing rights was as
follows (in thousands):
YEAR ENDED JUNE 30, 2004 YEAR ENDED JUNE 30, 2003
-------------------------------------- ----------------------------------------
INCOME OTHER INCOME OTHER
TOTAL STATEMENT COMPREHENSIVE TOTAL STATEMENT COMPREHENSIVE
WRITE DOWN IMPACT INCOME IMPACT WRITE DOWN IMPACT INCOME IMPACT
---------- --------- ------------- ---------- --------- -------------
Interest-only strips.......... $ 57,031 $ 39,659 $ 17,372 $ 57,973 $ 39,900 $ 18,073
Servicing rights.............. 6,791 6,791 -- 5,282 5,282 --
---------------------------------- ------------------------------------
Total securitization assets... $ 63,822 $ 46,450 $ 17,372 $ 63,255 $ 45,182 $ 18,073
================================== ====================================
The long duration of historically low interest rates, combined with
increasing home values and high consumer debt levels has given borrowers an
extended opportunity to engage in mortgage refinancing activities, which
resulted in elevated prepayment experience. Low interest rates and increasing
home values provide incentive to borrowers to convert high cost consumer debt
into lower rate tax deductible loans. As home values have increased, lenders
have been highly successful in educating borrowers that they have the ability to
access the cash value in their homes.
96
The persistence of historically low interest rate levels, unprecedented
in the last 40 years, has made the forecasting of prepayment levels difficult.
We assumed for each quarter end valuation that the decline in interest rates had
stopped and a rise in interest rates would occur in the near term. This
assumption was supported by published data. Consistent with this view that
interest rates would rise, 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. We believe that once we are beyond the low interest rate
environment and its impact on prepayments, the long recurring and highly
unfavorable prepayment experience over the last eleven quarters will subside.
Also, the rate of increase in home values has slowed considerably, which we
expect will mean that fewer borrowers will have excess value in their homes to
access. The Mortgage Bankers Association of America has forecast as of September
17, 2004 that mortgage refinancings as a percentage share of total mortgage
originations will decline from 49% in the second quarter of calendar 2004 to 24%
in the second quarter of calendar 2005. The Mortgage Bankers Association of
America has also projected in its September 2004 economic forecast that the
10-year treasury rate (which generally affects mortgage rates) will increase
steadily each quarter in their forecast. As a result of our analysis of these
factors, we believe prepayments will continue to remain at higher than normal
levels for the near term before declining to historical prepayment levels and
then further declining in the future. See the table "-- Summary of Material
Mortgage Loan Securitization Valuation Assumptions and Actual Experience at
September 30, 2004" for our current prepayment assumptions. See "-- Prepayment
Rates" for more detail regarding prepayment assumptions. 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 net pre-tax write-up of the
interest-only strips for the first quarter of fiscal 2005 and the net pre-tax
write downs of the securitization assets by quarter for fiscal years 2004, 2003
and 2002 and detail 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 2005:
INCOME OTHER
TOTAL STATEMENT COMPREHENSIVE
QUARTER ENDED (WRITE UP) IMPACT INCOME IMPACT
- ----------------------------------------- --------- --------- -------------
September 30, 2004....................... $ (18,614) $ 29 $ (18,643)
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
June 30, 2004............................ 9,249 8,602 647
--------- --------- ----------
Total Fiscal 2004........................ $ 63,822 $ 46,450 $ 17,372
========= ========= ==========
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
========= ========= ==========
97
FISCAL YEAR 2002:
INCOME OTHER
TOTAL STATEMENT COMPREHENSIVE
QUARTER ENDED WRITE DOWN IMPACT INCOME IMPACT
- ----------------------------------------- ---------- --------- ------------
December 31, 2001........................ $ 11,322 $ 4,462 $ 6,860
March 31, 2002........................... 15,513 8,691 6,822
June 30, 2002............................ 17,244 8,900 8,344
--------- --------- ----------
Total Fiscal 2002........................ $ 44,079 $ 22,053 $ 22,026
========= ========= ==========
Note: The impacts of prepayments on our securitization assets in the quarter
ended September 30, 2001 were not significant.
The following table summarizes the volume of loan securitizations and
whole loan sales for the three months ended September 30, 2004 and 2003 (dollars
in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------------
SECURITIZATIONS: 2004 2003
--------- ----------
Business loans.................................. $ -- $ 1,207
Home equity loans............................... -- 4,245
--------- ----------
Total........................................... $ -- $ 5,452 (a)
========= ===========
Gain on sale of loans through securitization.... $ -- $ 799
Securitization gains as a percentage of total
revenue....................................... -- 4.0%
(a) - These loans were sold into an off-balance sheet mortgage conduit facility
prior to its expiration on July 15, 2003.
WHOLE LOAN SALES:
Whole loan sales................................ $ 602,222 $ 270,979
Premiums on whole loan sales.................... $ 6,119 $ 2,921
As demonstrated in the fourth quarter of fiscal 2003 and the fiscal
year ended June 30, 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 whole loan
sales and securitizations requires building an inventory of loans over time,
during which time we incur costs and expenses. Since a gain on sale is not
recognized until a whole loan sale is settled or securitization is closed, which
may not occur until a subsequent quarter, operating results for a given quarter
can fluctuate significantly. If whole loan sales or securitizations do not close
when expected, we could experience a material adverse effect on our results of
operations for a quarter. See "-- Liquidity and Capital Resources" for a
discussion of the impact of whole loan sales and securitizations on our cash
flow.
Several factors affect the level of profitability realized on a
securitization. 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.
98
INTEREST-ONLY STRIPS. As the holder of interest-only strips, we are
entitled to receive excess (or residual) cash flows and cash flows from the
release of 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 bond fees. In
most of our securitizations, surety bond fees are paid to an unrelated insurance
entity to provide credit enhancement for the trust investors. The use of bond
insurers and our relationships with them impact the gain on sale of loans from
securitizations and the amount of residual cash flows we receive from our
securitization trusts. The forms of credit enhancement in our securitizations
are described below.
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.
Our securitizations provide credit enhancement to the trust investors
through the use of overcollateralization, a surety bond and/or subordinate bond
structures. The terms and conditions of credit enhancements are specific to each
securitization and are determined at inception for the life of the trust. All of
our securitizations require overcollateralization as the primary credit
enhancement for the benefit of the trust investors. Overcollateralization levels
are generally established by bond rating agencies. A second form of credit
enhancement is provided from a third party surety bond provider, the use of
subordinate investor bond structures, or a combination of both. Subordinate
investor bonds receive a higher rate of interest for the higher risk associated
with their investment and typically have a defined principal amortization, which
maintains a specified ratio of subordinate bonds to senior bonds. Third party
surety bond providers receive monthly fees, which are deducted from the excess
interest cash flow from the trust and in return the surety bond provider
guarantees the repayment of principal to the trust investors. The surety bond
fee amount is specific to each applicable securitization and generally ranges
from 0.19% to 0.45% annually on the applicable investor notes outstanding. The
surety bond provider establishes their annual surety bond fee based on the
levels of overcollateralization set for each securitization trust and their
assessment of credit risk in each pool of securitized loans.
The fair value of our interest-only strips is a combination of the fair
values of our residual cash flows and our overcollateralization cash flows. At
September 30, 2004, investments in interest-only strips totaled $448.8 million,
including the fair value of overcollateralization related cash flows of $202.2
million.
OVERCOLLATERALIZATION REQUIREMENTS. Overcollateralization requirements
are specific to each securitization. The amount of required
overcollateralization, often referred to as specified overcollateralization,
varies during the life of the trust. The requirements for overcollateralization
typically include:
o 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.
o 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. All residual cash flows are initially retained by the
trust until the final target is reached. The final target is maintained
until the stepdown date. 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.
99
o 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 final target levels when delinquencies fall below the
specified limits. See "- Trigger Management" for a discussion of
securitization trusts holding excess overcollateralization.
o The stepdown requirement is a percentage of the remaining unpaid
principal balance of securitized loans. The step-down target percentage
is typically twice the percentage of the final target and is applied
each period to the current unpaid principal balance of the remaining
loans in the securitized pool. During the stepdown period, the
overcollateralization amount is reduced through cash payments to us
until the overcollateralization balance declines to a specific floor.
The floor percentage is typically 0.50% to 1.00% of the original
principal balance of the loans in the securitized pool and provides for
a minimum constant amount of overcollateralization for the remaining
life of the trust. The ability to stepdown may be precluded during
periods in which delinquencies exceed specified limits. The
overcollateralization levels return to the target levels when
delinquencies fall below the specified limits.
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 not the
obligation, to repurchase a limited amount of delinquent loans from
securitization trusts. See "-- Repurchase Rights" for a summary of the amount of
delinquent loans which we have the right, but not obligation, to repurchase from
securitization trusts. In addition, we may elect to repurchase delinquent 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. The related REO writedown for REO repurchased is recorded through
general and administrative expense in the period of repurchase. Our ability to
repurchase these loans does not disqualify us for sale accounting under SFAS No.
140 or other relevant accounting literature because we are not required to
repurchase any loan and our ability to repurchase a loan is limited by contract.
At September 30, 2004, one of our twenty mortgage securitization trusts
were under a triggering event as a result of delinquencies exceeding specified
levels. There were no securitization trusts exceeding specified loss levels at
September 30, 2004. At June 30, 2004, four of our mortgage securitization trusts
were under a triggering event. Approximately $5.0 million of excess
overcollateralization is being held by the trust as of September 30, 2004. For
the three months ended September 30, 2004, we repurchased delinquent loans with
an aggregate unpaid principal balance of $2.7 million from securitization trusts
primarily for trigger management. We cannot predict when the trust currently
exceeding triggers will be below trigger limits and release the excess
overcollateralization. In order for the trust to release the excess
overcollateralization, delinquent loans would need to decline, or we would need
to repurchase delinquent loans of up to $4.8 million as of September 30, 2004.
If delinquencies increase and we cannot cure the delinquency or liquidate the
loans in the mortgage securitization trust 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 "-- Prepayment Rates" for more detail regarding prepayment
assumptions. 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.
100
The following table presents the securitization trust under a
triggering event at September 30, 2004, its related specified limit on
delinquencies, actual delinquencies at September 30, 2004, the related amounts
of actual excess overcollateralization and the maximum target amounts of excess
overcollateralization. The amount by which the maximum target amounts of excess
overcollateralization exceeds current excess overcollateralization amounts will
be withheld by the trust from future residual cash flows, as long as the actual
delinquency levels continue to exceed the specified limit, until the maximum
amount is reached.
SUMMARY OF SECURITIZATION TRUSTS UNDER TRIGGERING EVENTS
(dollars in thousands)
ACTUAL SEPTEMBER 30, 2004
DELINQUENCIES ACTUAL
--------------------------- SEPTEMBER 30,
SPECIFIED AMOUNT ABOVE 2004 MAXIMUM TARGET
SECURITIZATION TRIGGER SPECIFIED LIMIT EXCESS OVER- EXCESS OVER-
TRUST TRIGGER EXCEEDED LIMIT % (A) COLLATERALIZATION COLLATERALIZATION
-------------- ---------------- --------- -------- --------------- ----------------- -----------------
2001-4 Rolling 3 month 90+
day delinquency rate 12.50% 13.21% $4,835 $4,992 $4,992 (b)
- ---------------
(a) In order for this trust to release the excess overcollateralization,
delinquent loans would need to decline, or we would need to repurchase
delinquent loans of up to $4.8 million as of September 30, 2004.
(b) Residual cash flows will be retained by the securitization trust until this
maximum is reached or the actual delinquency level returns to the specified
limit.
The following table summarizes the principal balances of loans and REO
we have repurchased from the mortgage loan securitization trusts, the valuation
adjustments recorded through the provision for loan losses for loans repurchased
and the REO writedown recorded through general and administrative expense for
REO repurchased during the quarter ended September 30, 2004 and the fiscal years
ended June 30, 2004, 2003 and 2002. We received $1.8 million, $40.9 million,
$37.6 million and $19.2 million of proceeds from the liquidation of repurchased
loans and REO for the quarter ended September 30, 2004, and for the fiscal years
2004, 2003 and 2002, respectively. We carried as assets on our balance sheet,
repurchased loans and REO in the amounts of $5.9 million, $5.2 million and $9.2
million at September 30, 2004, and June 30, 2004 and 2003 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.
101
SUMMARY OF LOANS AND REO REPURCHASED FROM MORTGAGE LOAN SECURITIZATION TRUSTS
(DOLLARS IN THOUSANDS)
2001-3 2000-2 1998-3 1997(C) TOTAL
------ ------ ------ ------- -------
THREE MONTHS ENDED SEPTEMBER 30,
2004:
Repurchases by original loan type:
Business purpose loans.............. $ 1,127 $ -- $ -- $ 875 $ 2,002
Home equity loans................... 464 34 45 158 701
------- ------ ------ ------- -------
Total............................. $ 1,591 $ 34 $ 45 $ 1,033 $ 2,703
======= ====== ====== ======= =======
% of Original balance of
loans securitized................. 0.53% 0.01% 0.02% 0.59%
Number of loans and REO
repurchased....................... 10 1 1 8 20
Repurchases by loan or REO:
Loans repurchased................... $ 1,591 $ 34 $ 45 $ 937 $ 2,607
REO repurchased..................... -- -- -- 96 96
------- ------ ------ ------- -------
Total............................. $ 1,591 $ 34 $ 45 $ 1,033 $ 2,703
======= ====== ====== ======= =======
Valuation adjustment at
repurchase:
Loans repurchased (a)............... $ 304 $ -- $ 13 $ 281 $ 598
REO repurchased (b)................. -- -- -- -- --
------- ------ ------ ------- -------
Total............................. $ 304 $ -- $ 13 $ 281 $ 598
======= ====== ====== ======= =======
- --------------
(a) The valuation adjustment for loans repurchased is recorded through the
provision for loan losses.
(b) The valuation adjustment for REO repurchased is recorded through general
and administrative expense.
102
SUMMARY OF LOANS AND REO REPURCHASED FROM MORTGAGE LOAN SECURITIZATION TRUSTS
(CONTINUED)
(DOLLARS IN THOUSANDS)
2003-1 2002-1 2001-3 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1 1999-4
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
YEAR ENDED JUNE 30, 2004:
- -------------------------
Repurchases by original loan type:
Business purpose loans............ $ 219 $ -- $ 592 $ 1,713 $ 1,008 $ 2,252 $ 631 $ 1,386 $ 925 $ 1,324
Home equity loans................. -- 35 1,129 2,937 4,152 3,493 2,145 2,699 2,702 4,864
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 219 $ 35 $ 1,721 $ 4,650 $ 5,160 $ 5,745 $ 2,776 $ 4,085 $ 3,627 $ 6,188
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original balance of
loans securitized............... 0.05% 0.01% 0.57% 1.31% 1.88% 2.09% 1.85% 1.35% 1.53% 2.79%
Number of loans and REO
repurchased..................... 1 1 23 40 64 63 28 53 54 102
Repurchases by loan or REO:
Loans repurchased................. $ 219 $ 35 $ 1,121 $ 3,818 $ 4,593 $ 4,464 $ 2,159 $ 3,428 $ 2,280 $ 4,596
REO repurchased................... -- -- 600 832 567 1,281 617 657 1,347 1,592
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 219 $ 35 $ 1,721 $ 4,650 $ 5,160 $ 5,745 $ 2,776 $ 4,085 $ 3,627 $ 6,188
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Valuation adjustment at repurchase:
Loans repurchased (a)............. $ 55 $ 11 $ 409 $ 774 $ 1,456 $ 1,195 $ 515 $ 938 $ 784 $ 1,753
REO repurchased (b)............... -- -- 140 202 179 472 230 215 480 611
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 55 $ 11 $ 549 $ 976 $ 1,635 $ 1,667 $ 745 $ 1,153 $ 1,264 $ 2,364
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
YEAR ENDED JUNE 30, 2003:
- --------------------------
Repurchases by original loan type:
Business purpose loans............ $ -- $ -- $ 349 $ -- $ 543 $ 223 $ 144 $ 2,065 $ 1,573 $ 2,719
Home equity loans................. -- -- 853 -- 4,522 520 839 4,322 4,783 5,175
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ -- $ -- $ 1,202 $ -- $ 5,065 $ 743 $ 983 $ 6,387 $ 6,356 $ 7,894
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original Balance of Loans
Securitized....................... -- -- 0.40% -- 1.84% 0.27% 0.66% 2.11% 2.68% 3.56%
Number of loans and REO
repurchased..................... -- -- 11 -- 51 9 11 59 65 97
Repurchases by loan or REO:
Loans repurchased................. $ -- $ -- $ 560 $ -- $ 2,957 $ 46 $ 393 $ 1,688 $ 1,868 $ 3,382
REO repurchased................... -- -- 642 -- 2,108 697 590 4,699 4,488 4,512
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ -- $ -- $ 1,202 $ -- $ 5,065 $ 743 $ 983 $ 6,387 $ 6,356 $ 7,894
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Valuation adjustment at repurchase:
Loans repurchased (a)............. $ -- $ -- $ 112 $ -- $ 603 $ 9 $ 78 $ 442 $ 386 $ 817
REO repurchased (b)............... -- -- 87 -- 667 250 147 1,557 1,235 1,770
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ -- $ -- $ 199 $ -- $ 1,270 $ 259 $ 225 $ 1,999 $ 1,621 $ 2,587
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
YEAR ENDED JUNE 30, 2002:
- --------------------------
Repurchases by original loan type:
Business purpose loans............ $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 194
Home equity loans................. -- -- -- -- -- -- -- -- 84 944
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 84 $ 1,138
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original Balance of Loans
Securitized....................... -- -- -- -- -- -- -- -- 0.04% 0.51%
Number of loans and REO
repurchased..................... -- -- -- -- -- -- -- -- 2 18
Repurchases by loan or REO:
Loans repurchased................. $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 84 $ 228
REO repurchased................... -- -- -- -- -- -- -- -- -- 910
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 84 $ 1,138
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Valuation adjustment at repurchase:
Loans repurchased (a)............. $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 75 $ 123
REO repurchased (b)............... -- -- -- -- -- -- -- -- -- 459
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 75 $ 582
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
- ----------
(a) The valuation adjustment for loans repurchased is recorded through the
provision for loan losses.
(b) The valuation adjustment for REO repurchased is recorded through general and
administrative expense.
103
SUMMARY OF LOANS AND REO REPURCHASED FROM MORTGAGE LOAN SECURITIZATION TRUSTS
(CONTINUED)
(DOLLARS IN THOUSANDS)
1999-3 1999-2 1999-1 1998-4 1998-3 1998-2 1998-1 1997(C) 1996(C) TOTAL
------ ------ ------ ------ ------ ------ ------ ------- ------- -------
YEAR ENDED JUNE 30, 2004:
- --------------------------
Repurchases by original loan type:
Business loans.................... $ 915 $ 1,014 $ 696 $ 497 $ 456 $ -- $ 350 $ 781 $ -- $14,759
Home equity loans................. 2,228 3,472 3,223 1,354 2,825 399 875 579 100 39,211
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 3,143 $ 4,486 $ 3,919 $ 1,851 $ 3,281 $ 399 $ 1,225 $ 1,360 $ 100 $53,970
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original Balance of Loans
Securitized....................... 1.42% 2.04% 2.12% 2.31% 1.64% 0.33% 1.17% 0.78% 0.16%
Number of loans and REO
repurchased..................... 47 58 52 24 33 4 17 19 1 684
Repurchases by loan or REO:
Loans repurchased................. $ 2,185 $ 3,324 $ 2,106 $ 1,687 $ 2,865 $ 355 $ 532 $ 1,295 $ 100 $41,162
REO repurchased................... 958 1,162 1,813 164 416 44 693 65 -- 12,808
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 3,143 $ 4,486 $ 3,919 $ 1,851 $ 3,281 $ 399 $ 1,225 $ 1,360 $ 100 $53,970
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Valuation adjustment at repurchase:
Loans repurchased (a)............. $ 914 $ 995 $ 511 $ 435 $ 771 $ 51 $ 140 $ 405 $ 30 $12,142
REO repurchased (b)............... 317 434 651 44 125 17 115 -- -- 4,232
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 1,231 $ 1,429 $ 1,162 $ 479 $ 896 $ 68 $ 255 $ 405 $ 30 $16,374
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
YEAR ENDED JUNE 30, 2003:
- --------------------------
Repurchases by original loan type:
Business loans.................... $ 2,138 $ 1,977 $ 1,199 $ 72 $ 1,455 $ 205 $ 395 $ 744 $ 451 $16,252
Home equity loans................. 3,697 3,140 4,432 549 3,211 1,386 610 381 355 38,775
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 5,835 $ 5,117 $ 5,631 $ 621 $ 4,666 $ 1,591 $ 1,005 $ 1,125 $ 806 $55,027
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original Balance of Loans
Securitized..................... 2.63% 2.33% 3.04% 0.78% 2.33% 1.33% 0.96% 0.64% 1.30%
Number of loans and REO
repurchased..................... 83 59 60 7 60 23 13 16 13 637
Repurchases by loan or REO:
Loans repurchased................. $ 1,692 $ 2,263 $ 3,484 $ 309 $ 2,553 $ 686 $ 598 $ 817 $ 513 $23,809
REO repurchased................... 4,143 2,854 2,147 312 2,113 905 407 308 293 31,218
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 5,835 $ 5,117 $ 5,631 $ 621 $ 4,666 $ 1,591 $ 1,005 $ 1,125 $ 806 $55,027
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Valuation adjustment at repurchase:
Loans repurchased (a)............. $ 385 $ 336 $ 797 $ 62 $ 503 $ 144 $ 22 $ 160 $ 157 $ 5,013
REO repurchased (b)............... 1,674 739 375 54 344 87 97 69 69 9,221
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 2,059 $ 1,075 $ 1,172 $ 116 $ 847 $ 231 $ 119 $ 229 $ 226 $14,234
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
YEAR ENDED JUNE 30, 2002:
- --------------------------
Repurchases by original loan type:
Business loans.................... $ 1,006 $ 341 $ 438 $ 632 $ 260 $ 516 $ 1,266 $ 1,912 $ 104 $ 6,669
Home equity loans................. 3,249 2,688 2,419 4,649 5,575 1,548 1,770 462 183 23,571
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 4,255 $ 3,029 $ 2,857 $ 5,281 $ 5,835 $ 2,064 $ 3,036 $ 2,374 $ 287 $30,240
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
% of Original Balance of Loans
Securitized....................... 1.92% 1.38% 1.54% 6.60% 2.92% 1.72% 2.89% 1.36% 0.46%
Number of loans and REO
repurchased..................... 47 31 33 58 61 24 37 26 4 341
Repurchases by loan or REO:
Loans repurchased................. $ 1,221 1,375 1,437 2,535 2,702 818 1,611 1,641 -- 13,652
REO repurchased................... 3,034 1,654 1,420 2,746 3,133 1,246 1,425 733 287 16,588
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 4,255 $ 3,029 $ 2,857 $ 5,281 $ 5,835 $ 2,064 $ 3,036 $ 2,374 $ 287 $30,240
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Valuation adjustment at repurchase:
Loans repurchased (a)............. $ 235 $ 132 $ 222 $ 528 $ 557 $ 149 $ 747 $ 244 $ -- $ 3,012
REO repurchased (b)............... 899 508 606 851 633 370 490 426 110 5,352
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total........................... $ 1,134 $ 640 $ 828 $ 1,379 $ 1,190 $ 519 $ 1,237 $ 670 $ 110 $ 8,364
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
- ------------
(a) The valuation adjustment for loans repurchased is recorded through the
provision for loan losses.
(b) The valuation adjustment for REO repurchased is recorded through general and
administrative expense.
(c) Amounts represent combined repurchases and percentages for two 1997
securitization pools and two 1996 securitization pools.
104
REPURCHASE RIGHTS. SFAS No. 140 was effective on a prospective basis
for transfers of financial assets occurring after March 31, 2001. For
securitizations recorded under SFAS No. 140 which have removal of accounts
provisions providing us with a contractual right to repurchase delinquent loans,
SFAS No. 140 requires that we recognize the loans which are subject to these
rights as assets on our balance sheet and record a liability to reflect the
repurchase cost. SFAS No. 140 requires this accounting treatment because the
default by the borrower has given us effective control over the loan whether or
not we actually repurchase these loans. We do not record a loss on our retained
interests or on the loans that have been re-recognized under removal of accounts
provisions of SFAS No. 140. We do record a loss and an allowance for loan losses
at the time we exercise our contractual rights to repurchase these loans. For
securitization trusts 2001-2 through 2003-2, to which this rule applies, we have
the contractual right to repurchase a limited amount of loans greater than 180
days past due, but no obligation to do so. As delinquent loans in securitization
trusts 2001-2 through 2003-2 age greater than 180 days past due, we record an
asset reflecting the estimated fair value of the loans and a liability to
reflect the repurchase cost. In accordance with the provisions of SFAS No. 140,
we have recorded on our September 30, 2004 balance sheet an asset of $40.7
million and a liability of $47.9 million for delinquent loans subject to the
removal of accounts provisions under securitization trusts 2001-2 through
2003-2.
For securitization trusts 1998-3 through 2001-1, we also have rights to
repurchase a limited amount of delinquent loans, but are not obligated to do so.
No liabilities or assets have been recorded on our balance sheet related to
these rights.
We have not changed the accounting for our retained interests related
to any loans we re-recognize under SFAS No. 140 removal of accounts provision.
The following table summarizes the amount of delinquent loans in
securitization trusts, which we have the right, but not obligation, to
repurchase as of September 30, 2004 (in thousands):
REPURCHASE RIGHTS NOT REQUIRED TO BE REPURCHASE RIGHTS ACCOUNTED FOR
ACCOUNTED FOR UNDER SFAS 140 UNDER SFAS 140 (B)
- ----------------------------------------- -------------------------------------
AMOUNT OF AMOUNT OF
TRUST LOANS TRUST LOANS
- ----- --------- ----- ---------
1998 (a) $2,579 2001-2 $2,125
1999-1 3,133 2001-3 1,485
1999-2 3,073 2001-4 6,320
1999-3 4,013 2002-1 6,400
1999-4 4,061 2002-2 7,600
2000-1 1,458 2002-3 7,400
2000-2 4,232 2002-4 7,600
2000-3 10,104 2003-1 6,526
2000-4 7,713 2003-2 2,469
-------
2001-1 7,240 Sub-total $47,925
------- -------
Sub-total $47,606
-------
Total $95,531
=======
- -----------
(a) Amounts represent combined repurchase rights for two 1998 securitization
pools.
(b) The liability for loans subject to repurchase rights under SFAS No. 140 of
$47.9 million is recorded on our balance sheet.
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.
105
SUMMARY OF SELECTED MORTGAGE LOAN SECURITIZATION TRUST INFORMATION
CURRENT BALANCES AS OF SEPTEMBER 30, 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............................. $ 21 $ 22 $ 22 $ 22 $ 20 $ 17 $ 16
Home equity loans.......................... 100 200 151 129 121 90 80
------- ------- ------- ------- ------- ------- -------
Total.................................... $ 121 $ 222 $ 173 $ 151 $ 141 $ 107 $ 96
======= ======= ======= ======= ======= ======= =======
WEIGHTED-AVERAGE INTEREST RATE ON LOANS
- ---------------------------------------
SECURITIZED:
- ------------
Business loans............................. 15.66% 15.94% 16.04% 15.94% 15.97% 15.89% 15.77%
Home equity loans.......................... 8.80% 9.70% 10.54% 10.88% 10.90% 10.92% 10.74%
Total.................................... 10.00% 10.32% 11.23% 11.63% 11.61% 11.69% 11.58%
Percentage of first mortgage loans............ 88% 87% 87% 88% 89% 91% 90%
Weighted-average loan-to-value................ 76% 76% 76% 77% 76% 75% 76%
Weighted-average remaining term (months) on
loans securitized.......................... 261 246 236 231 217 211 208
Original balance of Trust Certificates........ $ 173 $ 450 $ 376 $ 370 $ 380 $ 320 $ 322
Current balance of Trust Certificates......... $ 115 $ 198 $ 152 $ 138 $ 128 $ 97 $ 83
Weighted-average pass-through interest rate
to Trust Certificate holders(a)............ 3.81% 6.09% 6.73% 7.63% 8.31% 6.09% 5.35%
Highest Trust Certificate pass-through
interest rate................................. 8.00% 3.78% 8.61% 6.86% 7.39% 6.51% 5.35%
OVERCOLLATERALIZATION REQUIREMENTS(D):
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....................................... $ -- $ -- $ -- $ -- $ -- $ -- $ --
Final target.................................. $ 7 $ 25 $ 22 $ 13 $ 13 $ 14 $ 13
CURRENT STATUS:
Overcollateralization amount............... $ 6 $ 24 $ 22 $ 13 $ 13 $ 10 $ 14
Final target reached or anticipated date
to reach.................................. 1/2005 12/2004 Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach..................................... 11/2006 4/2006 1/2006 10/2005 7/2005 10/2004 Yes(c)
ANNUAL SURETY FEE(D) ......................... 0.50% 0.20% (b) (b) (b) 0.21% 0.20%
SERVICING RIGHTS:
Original balance........................... $ -- $ 16 $ 14 $ 13 $ 15 $ 13 $ 13
Current balance............................ $ -- $ 9 $ 7 $ 6 $ 7 $ 5 $ 5
- --------------
(a) Rates for securitizations 2002-1 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. (c) Although the final target has been reached, this trust is
exceeding delinquency limits, and the trust is
retaining additional overcollateralization. We cannot predict when normal
residual cash flow will resume. See "-- Trigger Management" for further
detail.
(d) See "- Interest-Only Strips" for a discussion of credit enhancements in our
securitizations and "- Overcollateralization Requirements" for further
detail on overcollateralization.
106
SUMMARY OF SELECTED MORTGAGE LOAN SECURITIZATION TRUST INFORMATION (CONTINUED)
CURRENT BALANCES AS OF SEPTEMBER 30, 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............................. $ 15 $ 17 $ 11 $ 8 $ 4 $ 9 $ 8
Home equity loans.......................... 69 71 49 49 24 52 36
------ ------- ------- ------- ------ ------ ------
Total.................................... $ 84 $ 88 $ 60 $ 57 $ 28 $ 61 $ 44
WEIGHTED-AVERAGE INTEREST RATE ON LOANS
SECURITIZED:
- ---------------------------------------
Business loans............................. 15.89% 16.06% 16.01% 16.07% 16.17% 16.00% 16.16%
Home equity loans.......................... 11.13% 11.27% 11.48% 11.61% 11.50% 11.44% 11.41%
Total.................................... 11.97% 12.21% 12.31% 12.22% 12.21% 12.11% 12.23%
Percentage of first mortgage loans............ 90% 90% 89% 88% 91% 85% 81%
Weighted-average loan-to-value................ 75% 75% 74% 75% 76% 76% 75%
Weighted-average remaining term (months)
on loans securitized......................... 204 197 198 188 184 195 180
Original balance of Trust Certificates........ $ 306 $ 355 $ 275 $ 275 $ 150 $ 300 $ 235
Current balance of Trust Certificates......... $ 82 $ 79 $ 55 $ 52 $ 26 $ 54 $ 38
Weighted-average pass-through interest rate to
Trust Certificate holders ................. 5.76% 6.51% 6.28% 7.05% 7.61% 7.14% 7.15%
Highest Trust Certificate pass-through
interest rate................................ 6.17% 6.99% 6.28% 7.05% 7.61% 8.04% 7.93%
OVERCOLLATERALIZATION REQUIREMENTS(B):
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............... $ 8 $ 8 $ 5 $ 5 $ 3 $ 7 $ 5
Final target reached or anticipated date to
reach...................................... Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date
to reach ................................ Yes(a) Yes Yes Yes Yes Yes Yes
ANNUAL SURETY FEE(B) ......................... 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 $ 5 $ 3 $ 4 $ 1 $ 3 $ 2
- ---------
(a) 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.
(b) See "- Interest-Only Strips" for a discussion of credit enhancements in
our securitizations and "- Overcollateralization Requirements" for
further detail on overcollateralization.
107
SUMMARY OF SELECTED MORTGAGE LOAN SECURITIZATION TRUST INFORMATION (CONTINUED)
CURRENT BALANCES AS OF SEPTEMBER 30, 2004
(dollars in millions)
1999-4 1999-3 1999-2 1999-1 1998(a)
------ ------ ------ ------ ------
ORIGINAL BALANCE OF LOANS SECURITIZED:
- --------------------------------------
Business loans.................................. $ 25 $ 28 $ 30 $ 16 $ 26
Home equity loans............................... 197 194 190 169 254
------ ------ ------ ------ ------
Total........................................... $ 222 $ 222 $ 220 $ 185 $ 280
====== ====== ====== ====== ======
CURRENT BALANCE OF LOANS SECURITIZED:
Business loans.................................. $ 8 $ 7 $ 6 $ 4 $ 4
Home equity loans............................... 37 38 38 31 34
------ ------ ------ ------ ------
Total........................................... $ 45 $ 45 $ 44 $ 35 $ 38
====== ====== ====== ====== ======
WEIGHTED-AVERAGE INTEREST RATE ON LOANS
SECURITIZED:
- ---------------------------------------
Business loans.................................. 16.08% 15.88% 15.70% 15.95% 15.70%
Home equity loans............................... 11.01% 10.81% 10.50% 10.66% 10.70%
Total........................................... 85% 11.61% 11.22% 11.27% 11.26%
Percentage of first mortgage loans................. 86% 87% 89% 93% 90%
Weighted-average loan-to-value..................... 75% 76% 76% 77% 76%
Weighted-average remaining term (months) on
loans securitized................................. 178 183 189 185 187
Original balance of Trust Certificates............. $ 220 $ 219 $ 219 $ 184 $ 498
Current balance of Trust Certificates.............. $ 40 $ 40 $ 39 $ 31 $ 35
Weighted-average pass-through interest rate to
Trust Certificate holders......................... 7.16% 6.96% 6.78% 6.56% 6.06%
Highest Trust Certificate pass-through interest
rate ............................................ 7.68% 7.49% 7.13% 6.58% 6.35%
OVERCOLLATERALIZATION REQUIREMENTS(B):
REQUIRED PERCENTAGES:
- ---------------------------------------
Initial......................................... 1.00% 1.00% 0.50% 0.50% 1.50%
Final target.................................... 5.50% 5.00% 5.00% 5.00% 5.10%
Stepdown overcollateralization.................. 11.00% 10.00% 10.00% 10.00% 10.21%
REQUIRED DOLLAR AMOUNTS:
Initial....................................... $ 2 $ 2 $ 1 $ 1 $ 7
Final target.................................. $ 12 $ 11 $ 11 $ 9 $ 26
CURRENT STATUS:
Overcollateralization amount................... $ 5 $ 4 $ 4 $ 3 $ 4
Final target reached or anticipated date to
reach ...................................... Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to reach.. Yes Yes Yes Yes Yes
ANNUAL SURETY FEE (B)............................. .0.21% 0.21% 0.19% 0.19% 0.20%
SERVICING RIGHTS:
- -----------------
Original balance................................ $ 10 $ 10 $ 10 $ 8 $ 18
Current balance................................. $ 2 $ 2 $ 2 $ 1 $ 1
(a) Amounts represent combined balances and weighted-average percentages for
two 1998 securitization pools.
(b) See "- Interest-Only Strips" for a discussion of credit enhancements in
our securitizations and "- Overcollateralization Requirements" for further
detail on overcollateralization.
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.
108
DISCOUNT RATES. We use discount rates, which we believe are
commensurate with the risks involved in our securitization assets. While quoted
market prices on comparable interest-only strips are not available, we have
performed comparisons of our valuation assumptions and performance experience to
others in the non-conforming mortgage industry. We quantify the risks in our
securitization assets by comparing the asset quality and performance experience
of the underlying securitized mortgage pools to comparable industry performance.
At September 30, 2004, we applied a discount rate of 11% to the
estimated residual cash flows. 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 further reduced
that discount rate to 10% to reflect the impact of sustained decreases in market
interest rates. On June 30, 2004, we increased the discount rate to 11% to
reflect an increase in market interest rates that had occurred since the end of
the March 2004 quarter. 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.
Our interest-only strips are financed by our subordinated debentures,
senior collateralized subordinated notes and Series A preferred stock. The costs
of these instruments are considered in determining the discount rate used to
value interest-only strips. In fact, the increase in interest rates paid on
newly issued subordinated debentures was a major factor in our decision to
increase the discount rate on interest-only strips at June 30, 2004 from 10% to
11%. At June 30, 2004, the weighted average yield of our subordinated debentures
outstanding was 9.91%. The increase in the rates paid on newly issued
subordinated debentures and the total portfolio yield were significantly
impacted by our recent liquidity issues and current financial conditions.
Consequently, we have been paying up for risk and to raise cash. We expect to
begin a reduction in interest rates offered as our financial condition improves.
The weighted average yield on senior collateralized subordinated notes was 9.92%
at June 30, 2004. Our Series A preferred stock yields a 10% dividend rate. The
weighted average rate of the financing of our retained interest was 9.92% at
June 30, 2004.
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 11% discount rate that we
apply to our residual cash flow portion of our interest-only strips also
reflects the other characteristics of our securitized loans described below:
o Underlying loan collateral with fixed interest rates, which are
higher than others in the non-conforming mortgage industry. Average
interest rate of securitized loans exceeds the industry average by
100 basis points or more. All of the securitized loans have fixed
interest rates, which are more predictable than adjustable rate
loans.
109
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 September 30,
2004 in our total portfolio, approximately 50% to 55% of securitized
business purpose loans had prepayment fees and approximately 50% to
55% 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 September 30, 2004, only one of our
securitizations was using the 5.0% floor and that floor was removed for the
September 30, 2004 valuation. At September 30, 2004 and June 30, 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 9% at September 30, 2004 and
June 30, 2004.
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 to an average of the actual
experience of other similar pools of mortgage loans at the same age. Current
economic conditions, current interest rates, loans repurchased from
securitization trusts and other factors are considered in our analysis of
prepayment experience and in forecasting future prepayment levels.
110
Our analysis of prepayment experience and our forecast of prepayments
consider that prepayments on securitized loans may be initiated by the borrower,
such as a refinancing for a lower interest rate, initiated by the servicer in
the collection process for delinquent loans, or as a result of our repurchase of
delinquent loans from the securitization trusts for trigger management. See "--
Trigger Management" for a discussion of our loan repurchase activities and the
amount of loans we have repurchased from securitization trusts. Prepayments
initiated by the borrower are viewed as voluntary prepayments. Voluntary
prepayments are the most significant component of our prepayment experience,
generally representing approximately 91% of total prepayments, and are full cash
payoffs of a securitized loan. Prepayments initiated by the servicer are viewed
as involuntary prepayments, generally representing approximately 4% of our total
prepayment experience and are the result of delinquent loan bulk sales, REO
liquidations and settlements on delinquent loans. Losses on these involuntary
prepayments are absorbed by the securitization trusts. See "-- Credit Loss
Rates." Prepayments as a result of our repurchase of delinquent loans from the
securitization trusts are also viewed as involuntary and generally represent
approximately 5% of our total prepayment experience. Losses on the liquidation
of repurchased loans are absorbed on our books. See "-- Credit Loss Rates." Both
voluntary and involuntary loan prepayments are incorporated in our prepayment
assumption forecasts.
Our practice in forecasting prepayment assumptions had been to use an
average historical prepayment rate of similar pools for the expected constant
prepayment rate assumption while a pool of mortgage loans was less than a year
old even though actual experience may be different. During that period, before a
pool of mortgage loans reached its expected constant prepayment rate, actual
experience both quantitatively and qualitatively was generally not considered
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 was 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.
As was previously discussed, for the past eleven quarters, our actual
prepayment experience was generally higher, most significantly on home equity
loans, than our historical averages for prepayments prior to that eleven-quarter
period. The long duration of historically low interest rates, combined with
increasing home values and high consumer debt levels has given borrowers an
extended opportunity to engage in mortgage refinancing activities, which
resulted in elevated prepayment experience. Low interest rates and increasing
home values provide incentive to borrowers to convert high cost consumer debt
into lower rate tax deductible loans. As home values have increased, lenders
have been highly successful in educating borrowers that they have the ability to
access the cash value in their homes.
The persistence of historically low interest rate levels, unprecedented
in the last 40 years, has made the forecasting of prepayment levels difficult.
We assumed for each quarter end valuation that the decline in interest rates had
stopped and a rise in interest rates would occur in the near term. Economic
conditions and published mortgage industry surveys supported our assumption. We
believe that once we move beyond the low interest rate environment and the
impact that environment has had on prepayments, the long recurring and highly
unfavorable prepayment experience over the last twelve quarters will leave us
with securitized mortgage loan pools which will experience future prepayment
speeds substantially lower than originally believed. Also, the rate of increase
in home values has slowed considerably, which we expect will mean that fewer
borrowers will have excess value in their homes to access. As a result of our
analysis of these factors, we believe prepayments will continue to remain at
higher than normal levels for the near term before declining to historical
prepayment levels and then further declining in the future. See the table "--
Summary of Material Mortgage Loan Securitization Valuation Assumptions and
Actual Experience at September 30, 2004" for our current prepayment assumptions.
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. See "-- Securitizations" for
further detail regarding the impact of our recent prepayment experience and
published information available from the Mortgage Bankers Association of
America.
111
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, such as our customer
retention incentive program, 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 for individual mortgage loan pools and averages for similar mortgage
loan pools. Delinquency trends, economic conditions, loans repurchased from
securitization trusts and other factors are also considered. If our analysis
indicates that loss experience may be different from our assumptions, we would
adjust our assumptions as necessary. See the table "-- Summary of Material
Mortgage Loan Securitization Valuation Assumptions and Actual Experience at
September 30, 2004" for our current credit loss assumptions and actual credit
loss experience. However, we cannot predict with certainty what credit loss
experience will be in the future. Any unfavorable difference between the
assumptions used to value securitization assets and actual experience may have a
significant adverse impact on the value of these assets.
We may elect to repurchase delinquent loans from securitization trusts
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. See "-- Trigger Management" for a discussion of our loan
repurchase activities and the amount of loans we have repurchased from
securitization trusts. Once a loan has been included in a pool of securitized
loans, its performance, including historical loss experience if the loan has
been repurchased, is reflected in the performance of that pool of mortgage
loans.
We may enter into deferment and forbearance arrangements with borrowers
in our managed portfolio who experience financial hardships. See "-- On Balance
Sheet Portfolio Quality -- Deferment and Forbearance Arrangements" and "-- Total
Portfolio Quality -- Deferment and Forbearance Arrangements" for more detail
regarding these arrangements. Any credit losses ultimately realized on these
arrangements are included in total historical losses of the loans' original pool
of securitized loans, which are used in developing credit loss assumptions.
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 "-- Quantitative and Qualitative Disclosures About
Market Risk" for further detail of our management of the risk of changes in
interest rates paid on floating interest rate certificates.
112
SENSITIVITY ANALYSIS. The table below summarizes at September 30, 2004
the amount of securitized loans in our securitization trusts, the carry value of
our securitization assets and the weighted-average life of our securitized
loans:
Securitized collateral balance.................................................. $ 1,639,889
Balance sheet carrying value of retained interests (a).......................... $ 515,524
Weighted-average collateral life (in years)..................................... 6.45
- ----------
(a) Amount includes interest-only strips and servicing rights.
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):
IMPACT OF ADVERSE CHANGE
----------------------------
10% CHANGE 20% CHANGE
---------- ----------
Prepayment speed....................................................... $ 17,312 $ 35,373
Credit loss rate....................................................... 3,616 7,231
Floating interest rate certificates (a)................................ 1,070 2,140
Discount rate.......................................................... 19,277 37,168
- -------
(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."
113
The following tables provide information regarding the initial and
current assumptions applied in determining the fair values of mortgage loan
related interest-only strips and servicing rights for each securitization trust.
SUMMARY OF MATERIAL MORTGAGE LOAN SECURITIZATION
VALUATION ASSUMPTIONS AND ACTUAL EXPERIENCE AT SEPTEMBER 30, 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.......................... 11% 11% 11% 11% 11% 11% 11%
Interest-only strip overcollateralization
discount rate:
- -------------------------------------------
Initial valuation.......................... 8% 7% 9% 7% 7% 7% 7%
Current valuation.......................... 8% 4% 9% 7% 7% 7% 5%
Servicing rights discount rate:
- -------------------------------
Initial valuation.......................... (e) 11% 11% 11% 11% 11% 11%
Current valuation.......................... (e) 9% 9% 9% 9% 9% 9%
Prepayment rates(a):
- --------------------
INITIAL ASSUMPTION (B):
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 EXPERIENCE (C):
Business loans.......................... 24% 25% 15% 18% 37% 28% 18%
Home equity loans....................... 41% 53% 47% 42% 44% 41% 42%
CURRENT ASSUMPTION(D):
Business loans
Months 1 through 3.................... 13% 19% 21% 22% 20% 17% 14%
Months 4 through 9.................... 17% 22% 22% 19% 15% 12% 10%
Months thereafter..................... 12% 11% 10% 10% 10% 10% 10%
Home equity loans
Months 1 through 3.................... 38% 38% 38% 38% 38% 38% 38%
Months 4 through 9.................... 25% 25% 25% 25% 25% 25% 25%
Months 10 through 12.................. 18% 18% 18% 18% 18% 18% 18%
Months 13 through 15.................. 13% 13% 13% 13% 13% 13% 13%
Months 16 through 27.................. 8% 8% 8% 8% 8% 8% 8%
Months thereafter..................... 6% 6% 6% 6% 6% 6% 6%
Annual credit loss rates:
- -------------------------
Initial assumption......................... 0.52% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Actual experience.......................... 0.05% 0.02% 0.05% 0.10% 0.14% 0.14% 0.22%
Current assumption......................... 0.52% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Servicing fees:
- ---------------
Contractual fees........................... (e) 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%
Ancillary fees............................. (e) 1.25% 1.25% 1.25% 1.25% 1.25% 1.25%
- -------
(a) Prepayment rates are expressed as Constant Prepayment Rate (CPR).
(b) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected CPR. 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.
(c) Current experience is a six-month historical average.
(d) Current assumption is a blended average projected during the time period
described.
(e) Servicing rights for the 2003-2 loans were sold to a third party servicer.
114
SUMMARY OF MATERIAL MORTGAGE LOAN SECURITIZATION
VALUATION ASSUMPTIONS AND ACTUAL EXPERIENCE AT SEPTEMBER 30, 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..................... 11% 11% 11% 11% 11% 11% 11%
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 (a):
- ---------------------
INITIAL ASSUMPTION (B):
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 EXPERIENCE (C):
Business loans...................... 18% 23% 22% 26% 36% 33% 23%
Home equity loans................... 43% 43% 40% 33% 41% 35% 35%
CURRENT ASSUMPTION (D):
Business loans
Months 1 through 3................ 11% 10% 14% 14% 17% 11% 14%
Months 4 through 9................ 10% 10% 10% 10% 10% 10% 10%
Months thereafter................. 10% 10% 10% 10% 10% 10% 10%
Home equity loans
Months 1 through 3................ 38% 38% 38% 38% 38% 38% 38%
Months 4 through 9................ 25% 25% 25% 25% 25% 25% 25%
Months 10 through 12.............. 18% 18% 18% 18% 18% 18% 18%
Months 13 through 15.............. 13% 13% 13% 13% 13% 13% 13%
Months 16 through 17.............. 8% 8% 8% 8% 8% 8% 8%
Months thereafter................. 6% 6% 6% 6% 6% 6% 6%
Annual credit loss rates:
- -------------------------
Initial assumption.................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40%
Actual experience..................... 0.52% 0.49% 0.80% 0.48% 0.50% 0.54% 0.68%
Current assumption.................... 0.50% 0.50% 0.55% 0.50% 0.50% 0.55% 0.70%
Servicing fees:
- ---------------
Contractual fees....................... 0.50% 0.50% 0.50% 0.70% 0.50% 0.50% 0.50%
Ancillary fees......................... 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25%
- ----------
(a) Prepayment rates are expressed as Constant Prepayment Rate (CPR).
(b) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected CPR. 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.
(c) Current experience is a six-month historical average.
(d) Current assumption rates are a blended average during the projected time
period described.
115
SUMMARY OF MATERIAL MORTGAGE LOAN SECURITIZATION
VALUATION ASSUMPTIONS AND ACTUAL EXPERIENCE AT SEPTEMBER 30, 2004 (CONTINUED)
1999-4 1999-3 1999-2 1999-1 1998(e)
------ ------ ------ ------ -------
Interest-only strip residual discount rate:
- -------------------------------------------
Initial valuation............................ 11% 11% 11% 11% 11%
Current valuation............................ 11% 11% 11% 11% 11%
Interest-only strip overcollateralization
discount rate:
- -----------------------------------------
Initial valuation............................ 8% 7% 7% 7% 7%
Current valuation............................ 8% 7% 7% 7% 7%
Servicing rights discount rate:
- -------------------------------
Initial valuation............................ 11% 11% 11% 11% 11%
Current valuation............................ 9% 9% 9% 9% 9%
Prepayment rates(a):
INITIAL ASSUMPTION (B):
Business loans ............................ 10% 10% 10% 10% 13%
Home equity loans.......................... 24% 24% 24% 24% 24%
Ramp period (months):
Business loans............................. 24 24 24 24 24
Home equity loans.......................... 18 18 18 18 12
CURRENT EXPERIENCE (C):
Business loans............................. 12% 29% 27% 13% 10%
Home equity loans.......................... 36% 32% 35% 34% 32%
CURRENT ASSUMPTION (D):
Business loans
Months 1 through 3..................... 13% 13% 15% 11% 14%
Months 4 through 9..................... 10% 10% 10% 10% 10%
Months thereafter...................... 10% 10% 10% 10% 10%
Home equity loans
Months 1 through 3..................... 38% 38% 38% 38% 38%
Months 4 through 9..................... 25% 25% 25% 25% 25%
Months 10 through 12................... 18% 18% 18% 18% 18%
Months 13 through 15................... 13% 13% 13% 13% 13%
Months 16 through 27................... 8% 8% 8% 8% 8%
Months thereafter...................... 6% 6% 6% 6% 6%
Annual credit loss rates:
- -------------------------
Initial assumption........................... 0.30% 0.25% 0.25% 0.25% 0.25%
Actual experience............................ 0.76% 0.66% 0.45% 0.54% 0.59%
Current assumption........................... 0.85% 0.65% 0.45% 0.55% 0.65%
Servicing fees:
- ---------------
Contractual fees............................. 0.50% 0.50% 0.50% 0.50% 0.50%
Ancillary fees............................... 1.25% 1.25% 1.25% 1.25% 1.25%
- -------------------
(a) Prepayment rates are expressed as Constant Prepayment Rate (CPR).
(b) The prepayment ramp is the length of time before a pool of mortgage loans
reaches its expected CPR. 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.
(c) Current experience is a six-month historical average.
(d) Current assumption is a blended average during the projected time period
described.
(e) Amounts represent weighted-average percentages for two 1998 securitization
pools.
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.
116
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. Our valuation
analyses at September 30, 2004 indicated that no adjustment was required in the
first quarter of fiscal 2005. See "-- Application of Critical Accounting
Estimates -- Servicing Rights" for a discussion of the $6.8 million write down
of servicing rights recorded in fiscal 2004 including the impact of our sale of
servicing rights related to five of our securitization trusts under the terms of
a September 27, 2004 sale agreement.
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
September 30, 2004 and June 30, 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 help 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.
117
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 twelve 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 "-- 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 " -- Securitizations" for information on the
volume of whole loan sales and premiums recorded for the three months ended
September 30, 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. See "--
Overview -- Business Strategy Adjustments" 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.
Many of our whole loan sale agreements with purchasers include recourse
provisions, which are customary in the mortgage industry, obligating us to
repurchase loans at the sales price in the event of unfavorable delinquency
performance of the loans sold or to refund premiums if a sold loan prepays
within a specified period. The duration of these obligations typically ranges
from 60 days to one year from the date of the loan sale. Delinquency performance
generally relates to borrower first payment default. Premium refund obligations
typically decline monthly over the obligation period. We reserve for these
premium obligations at the time of sale through an expense charge against the
gain on sale. The amount of the reserve is calculated based on the expected
first payment defaults and prepayment performance of the sold loans and the
premiums received at the time of sale. Based on our experience, first payment
defaults make up an immaterial portion of the reserve. In determining our
reserve for premium obligation on prepayments, we refer to our prepayment
experience within the various recourse timeframes that are dictated by the whole
loan sale agreements with the purchasers. The reserve for repurchase and payoff
obligations of premiums received, which is included in miscellaneous liabilities
on the balance sheet, was $446 thousand at September 30, 2004 and $307 thousand
at June 30, 2004. Because we have no retained interests in loans sold under
these agreements and we are able to estimate our liability under the agreements'
recourse provisions, sale accounting is appropriate.
118
The following table summarizes as of September 30, 2004, the aggregate
principal balance of loans which we have sold with recourse that are still
subject to recourse provisions and the quarter during which our recourse
obligations on those loans terminate (in thousands):
PRINCIPAL
QUARTER ENDED BALANCE
------------- --------
December 31, 2004............ 378,960
March 31, 2005............... 150,608
June 30, 2005................ 102,861
September 30, 2005........... 148,475
-----------
$780,904
===========
RESULTS OF OPERATIONS
SUMMARY FINANCIAL RESULTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED PERCENTAGE
SEPTEMBER 30, CHANGE
-----------------------------------
2004 2003
---------- --------- ---------
Total revenues................ $ 23,109 $ 20,201 14.4%
Total expenses................ $ 61,935 $ 62,569 (1.0)%
Income (loss) before dividends
on preferred stock.......... $(25,237) $ (26,268) 3.9%
Dividends on preferred stock.. $ 3,475 $ -
Net income (loss) attributable
to common stock............. $(28,712) $ (26,268) 9.3%
Return on average assets...... (10.71)% (9.88)%
Return on average equity...... (958.29)% (386.77)%
Earnings (loss) per common share:
Basic...................... $ (7.98) $ (8.10) 1.5%
Diluted.................... $ (7.98) $ (8.10) 1.5%
Common dividends declared per
share ...........................$ - $ -
OVERVIEW
For the three months ended September 30, 2004, we recorded a net loss
attributable to common stock of $28.7 million compared to a net loss of $26.3
million in the three months ended September 30, 2003. During the three months
ended September 30, 2004, preferred dividends of $3.5 million were recorded on
the Series A preferred stock, which was issued in the exchange offers. There
were no preferred dividends in the three months ended September 30, 2003.
The loss for the three months ended September 30, 2004 primarily
resulted from our inability to reach the loan origination levels required under
our adjusted business strategy to return to profitability, which substantially
reduced our ability to generate revenues, and our inability to complete a
securitization during the three months ended September 30, 2004. Additionally,
operating expenses increased in the three months ended September 30, 2004 as we
began to add loan processing and marketing support staff to support the future
loan origination levels we expect to achieve under our adjusted business
strategy. Loan origination volume increased to $629.7 million in the three
months ended September 30, 2004, compared to origination volume of $514.1
million in the three months ended June 30, 2004 and $124.1 million in the three
months ended September 30, 2003.
See discussions below for more detail on loan originations, gains on
sale of loans, securitization assets valuation adjustments, and other revenues
and expenses.
119
Total stockholders' equity at September 30, 2004 totaled $11.9 million
and was substantially unchanged from June 30, 2004 as the $28.7 million net loss
attributable to common stock was offset by the 15.6 million shares of Series A
preferred stock issued during the three months ended September 30, 2004 in the
exchange offers and the $12.1 million pre-tax increase to other comprehensive
income for adjustments on our interest-only strips at September 30, 2004.
The loss per common share for the three months ended September 30, 2004
was $7.98 on average common shares of 3,598,000 compared to a loss per common
share of $8.10 on average common shares of 3,242,000 for the three months ended
September 30, 2003. No common dividends were paid in fiscal 2005 or 2004.
On May 13, 2004, our Board of Directors declared a 10% stock dividend
payable June 8, 2004 to common shareholders of record on May 25, 2004. All
outstanding stock options and related exercise prices were adjusted as a result
of the stock dividend. Accordingly, all outstanding common shares, earnings per
common share, average common share and stock option amounts presented have been
adjusted to reflect the effect of this stock dividend.
The following schedule details our loan originations during the three
months ended September 30, 2004 and 2003, by loan type (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2004 2003
------- -------
Home mortgage loans......................................... $629,579 $124,052
Business purpose loans...................................... 151 -
-------- --------
Total loan originations................................. $629,730 $124,052
======== ========
Home mortgage loans are originated by our subsidiaries, HomeAmerican
Credit, Inc., doing business as Upland Mortgage, and American Business Mortgage
Services, Inc., and purchased through the Bank Alliance Services program. Total
home mortgage loan originations increased $505.5 million, or 407%, for the three
months ended September 30, 2004 to $629.6 million from $124.1 million for the
three months ended September 30, 2003. Liquidity issues had substantially
reduced our ability to originate home mortgage loans during the three months
ended September 30, 2003. Our adjusted business strategy emphasizes whole loan
sales, and if market conditions permit, smaller publicly underwritten or
privately-placed securitizations and reducing costs. Based on our adjusted
business strategy, we no longer originate loans through retail branches, which
were a high cost origination channel, and plan to continue increasing our broker
channel origination sources. Our home mortgage 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, during fiscal 2004 we acquired broker operations located
in West Hills, California and Austin, Texas, opened new offices in Irvine,
California and Edgewater, Maryland to support our broker operations and have
expanded the broker business within HomeAmerican Credit, Inc.
120
The following schedule details our home mortgage loan originations by
source, including through the Bank Alliance Services program, for the three
months ended September 30, 2004 and 2003. Loans originated under the Bank
Alliance Services program are originated through substantially the same process
as all other loans we originate (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-----------------------
2004 2003
-------- -------
Direct channel..................................... $200,484 $ 70,657
Retail branches.................................... - 649
Broker channel..................................... 414,392 10,014
Bank Alliance Services program .................... 14,703 42,732
-------- --------
Total home mortgage loans...................... $629,579 $124,052
======== ========
The following table presents the amounts of home mortgage loans we
originated in the three months ended September 30, 2004 in our direct and broker
operations channels and in our Bank Alliance Services program by loan
characteristic (in thousands):
Bank
Retail Broker Alliance
Channel Channel Services Total
------------- ------------ ----------- --------------
ORIGINATIONS BY TYPE OF LOAN:
-----------------------------
Purchase Money Mortgage Loans:
Fixed rate $ 341 $ 41,548 $ 54 $ 41,943
Adjustable rate 933 193,212 - 194,145
--------- --------- -------- ---------
Total $ 1,274 $ 234,760 $ 54 $ 236,088
========= ========= ======== =========
Average WAC 7.85% 7.49% 8.70% 7.49%
Average LTV 88.94% 85.32% 98.18% 85.34%
Home Equity Loans:
Fixed rate $ 139,921 $ 38,174 $ 9,265 $ 187,360
Adjustable rate 59,289 141,458 5,384 206,131
--------- --------- -------- ---------
Total $ 199,210 $ 179,632 $ 14,649 $ 393,491
========= ========= ======== =========
Average WAC 8.40% 7.04% 7.89% 7.76%
Average LTV 81.38% 80.15% 75.41% 80.60%
Total Home Mortgage Loans:
Fixed rate $ 140,262 $ 79,722 $ 9,319 $ 229,303
Adjustable rate 60,222 334,670 5,384 400,276
--------- --------- -------- ---------
Total $ 200,484 $ 414,392 $ 14,703 $ 629,579
========= ========= ======== =========
Average WAC 8.40% 7.29% 7.89% 7.66%
Average LTV 81.43% 83.08% 75.50% 82.38%
ORIGINATIONS BY LIEN:
---------------------
1st Lien:
Loans originated $ 182,480 $377,147 $13,099 $572,726
Average WAC 8.00% 6.95% 7.47% 7.30%
2nd Lien:
Loans originated $ 18,004 $ 37,245 $1,604 $56,853
Average WAC 12.39% 10.77% 11.37% 11.30%
During the three months ended September 30, 2004, our subsidiary,
American Business Credit, Inc., originated $151 thousand in business purpose
loans. During the three months ended September 30, 2003, American Business
Credit, Inc. did not originate any business purpose loans. 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.
REVENUES
TOTAL REVENUES. For the three months ended September 30, 2004, total
revenues increased $2.9 million, or 14.4%, to $23.1 million from $20.2 million
for the three months ended September 30, 2003. Increases during the three months
ended September 30, 2004 in gains on whole loan sales and interest and fees on
loans originated were partially offset by a reduction in interest accretion on
interest-only strips. Our ability in the first three months of fiscal 2005 to
originate and sell more loans than we did during the first three months of
121
fiscal 2004, when our ability to borrow under credit facilities to finance new
loan originations was limited, accounted for the increases in gains on whole
loan sales and interest and fees. While we currently believe we will continue to
have credit facilities available to finance new loan obligations and therefore
anticipate further increases in total revenues, we cannot assure you that we
will be successful in maintaining existing credit facilities, or replacing or
obtaining alternative credit facilities.
GAIN ON SALE OF LOANS - SECURITIZATIONS. For the three months ended
September 30, 2004, we did not complete a securitization and no gains were
recorded. In the three months ended September 30, 2003, we recorded gains of
$0.8 million on 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 $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 $6.1 million for the three months ended September 30, 2004 from
gains of $2.9 million for the three months ended September 30, 2003. The volume
of whole loan sales increased $331.2 million to $602.2 million for the three
months ended September 30, 2004 from $271.0 million for the three months ended
September 30, 2003. The increase in the volume of whole loan sales for the three
months ended September 30, 2004 resulted from increased loan origination volume
and our adjusted business strategy which emphasizes more whole loan sales. Due
to our adjusted business strategy, we anticipate further increases in gains on
whole loan sales.
INTEREST AND FEES. For the three months ended September 30, 2004,
interest and fee income increased $3.0 million, or 65.4%, to $7.7 million
compared to $4.7 million in the three months ended September 30, 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 for the three months
ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------------------
2004 2003
-------------- --------------
Interest on loans and invested cash................ $ 4,954 $ 3,914
Other fees......................................... 2,742 739
---------- ----------
Total interest and fees............................ $ 7,696 $ 4,653
========== ==========
During the three months ended September 30, 2004, interest income
increased $1.1 million, or 26.6%, to $5.0 million from $3.9 million for the
three months ended September 30, 2003. The increase for the three-month period
resulted from our carrying a higher average loan balance during the three months
ended September 30, 2004 as compared to the first quarter of 2004 due to higher
loan originations in the first quarter of 2005. Investment interest income in
the three months ended September 30, 2004 was level with investment interest
income in the three months ended September 30, 2003.
Other fees increased $2.0 million during the three months ended
September 30, 2004 or 271.0%, to $2.7 million from $0.7 million for the three
months ended September 30, 2003. This increase was mainly due to higher loan
originations in the three months ended September 30, 2004. While we currently
believe we will continue to have credit facilities available to finance new loan
obligations and therefore anticipate further increases in other fees, we cannot
assure you that we will be successful in maintaining existing credit facilities,
122
or replacing or obtaining alternative credit facilities. Additionally, 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 $8.4
million was earned in the three months ended September 30, 2004 compared to
$11.1 million in the three months ended September 30, 2003. The decrease
reflects the decline in the balance of our interest-only strips of $96.8
million, or 17.7%, to $448.8 million at September 30, 2004 from $545.6 million
at September 30, 2003. We expect to experience continued declines in the amount
of interest accretion on our interest-only strips until we can resume selling
our loans into quarterly securitizations.
SERVICING INCOME. Servicing income is comprised of contractual and
ancillary fees collected on securitized loans serviced for others, less
amortization of the servicing rights assets that are recorded at the time loans
are securitized. Ancillary fees include prepayment fees, late fees and other
servicing fee compensation. For the three months ended September 30, 2004,
servicing income increased $0.1 million, or 17.7%, to $0.8 million from $0.7
million for the three months ended September 30, 2003. Contractual fees
decreased during the three months ended September 30, 2004 compared to the three
months ended September 30, 2003 due to the decline in our managed portfolio
resulting primarily from our inability to complete securitizations in four of
the five quarters from June 2003 to September 2004. In addition, there were
decreases in loan prepayment fees received in the three months ended September
30, 2004. The decreases in fees were more than offset by a decrease in the
amortization of servicing rights due to lower fees received as well as a
reduction in the rate of amortization. Amortization is recognized in proportion
to contractual and ancillary fees collected.
The following table summarizes the components of servicing income for
the three months ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------------------
2004 2003
-------------- -------------
Contractual fees......................................... $ 2,120 $ 3,792
Prepayment fees.......................................... 3,707 6,973
Other ancillary fees..................................... 1,458 2,328
Amortization of servicing rights......................... (6,440) (12,375)
---------- ---------
Net servicing income..................................... $ 845 $ 718
========== =========
On September 27, 2004, we sold the servicing rights related to five of
our mortgage securitization trusts. This sale will not have a significant impact
on our future net servicing income. During the three months ended September 30,
2004, we recognized $20 thousand for servicing these five securitization trusts
and for the fiscal year 2004, we recognized net servicing income of $170
thousand.
EXPENSES
TOTAL EXPENSES. Total expenses decreased $0.6 million, or 1.0%, to
$61.9 million for the three months ended September 30, 2004 compared to $62.6
million for the three months ended September 30, 2003. The decrease for the
period was mainly a result of decreases in securitization assets valuation
adjustments, provision for credit losses and employee related costs during the
three months ended September 30, 2004, partially offset by increases in losses
on derivative financial instruments, general and administrative expenses, sales
and marketing expenses and interest expense.
123
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 three months ended September 30, 2004, interest expense increased $1.3
million, or 7.9%, to $18.2 million, compared to $16.8 million for the three
months ended September 30, 2003. In addition, as a result of the exchange
offers, we recorded preferred dividends of $3.5 million in the three months
ended September 30, 2004 on the Series A preferred stock issued in exchange for
subordinated debentures. In fiscal 2005, we anticipate preferred dividends will
exceed $14 million.
The increases in interest expense to fund loans due to higher average
outstanding balances under warehouse lines of credit and interest expense on
senior collateralized subordinated notes issued in the exchange offers were
offset by a decrease in interest expense on subordinated debentures due to the
decline in average subordinated debentures outstanding as a result of the
exchange offers.
The following schedule details interest expense for the three months
ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-----------------------------
2004 2003
------------- -----------
Interest on subordinated debentures......................... $ 13,284 $ 16,093
Interest to fund loans...................................... 2,489 696
Interest on senior collateralized subordinated notes ....... 2,343 -
Other interest.............................................. 39 29
---------- ---------
Total interest expense...................................... $ 18,155 $ 16,818
========== =========
Average subordinated debentures outstanding during the three months
ended September 30, 2004 were $501.1 million compared to $704.7 million during
the three months ended September 30, 2003. The decrease was primarily the result
of the exchange offers. Average interest rates paid on subordinated debentures
were 10.12% during the three months ended September 30, 2004 compared to 8.75%
during the three months ended September 30, 2003.
We had reduced the interest rates offered on subordinated debentures
beginning in the fourth quarter of fiscal 2001 and had continued reducing rates
through June 2003 in response to decreases in market interest rates as well as
declining cash needs during that period. The weighted-average interest rate of
subordinated debentures issued in the month of September 2004, was 11.02%,
compared to the average interest rate of 7.49% on subordinated debentures issued
in the month of June 2003. However, during fiscal 2004, the weighted-average
interest rate on subordinated debentures we issued had steadily increased,
reflecting 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
$240.6 million during the three months ended September 30, 2004, compared to
$131.9 million during the three months ended September 30, 2003. The increase in
the average balance on warehouse lines was due to a higher volume of loans held
on the balance sheet during the three months ended September 30, 2004 as a
result of higher originations and our adjusted business strategy. Interest rates
124
paid on warehouse lines during the three months ended September 30, 2004 were
generally based on one-month LIBOR plus an interest rate spread ranging from
2.00% to 2.50%. One-month LIBOR has increased from approximately 1.12% at
September 30, 2003 to 1.84% at September 30, 2004. Due to our adjusted business
strategy, we anticipate further increases in both average outstanding balances
under warehouse lines of credit and the resulting interest expense to fund
loans. While we currently believe we will continue to have credit facilities
available to finance new loan obligations, we cannot assure you that we will be
successful in maintaining existing credit facilities, or replacing or obtaining
alternative credit facilities.
The average outstanding balance on senior collateralized subordinated
notes was $93.4 million during the three months ended September 30, 2004. The
senior collateralized subordinated notes were issued in the exchange offers. The
average rate paid on senior collateralized subordinated notes was 9.86% during
the three months ended September 30, 2004.
PROVISION FOR CREDIT LOSSES. The provision for credit losses for the
three months ended September 30, 2004 decreased $4.0 million, or 97.2%, to $117
thousand, compared to $4.2 million for the three months ended September 30,
2003. The decrease in the provision for loan losses for the three months ended
September 30, 2004 was primarily due to lower loan charge-offs resulting from
the decreased amounts of delinquent loans repurchased from securitization
trusts. In addition, a related allowance for loan losses on repurchased loans is
included in our provision for credit losses in the period of repurchase. During
the three months ended September 30, 2004, we repurchased $2.6 million of loans
from securitization trusts and recorded a provision for credit losses of $0.6
million on those repurchases, compared to loan repurchases of $9.8 million and a
provision of $2.8 million in the three months ended September 30, 2003.
Principal loss severity on loans generally ranged from 20% to 30% in the three
months ended September 30, 2004 and from 15% to 35% in the three months ended
September 30, 2003. See "-- Securitizations -- Trigger Management" for further
discussion and information regarding repurchases from securitization trusts. The
provision for credit losses also includes adjustments to the carrying value of
loans available for sale, which are delinquent and expected to be sold at a
loss.
The following schedule details the provision for credit losses for the
three months ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
---------------------------------
2004 2003
--------------- ------------
Loans available for sale ................................ $ 58 $ 363
Non-accrual loans........................................ 59 3,823
Leases .................................................. - (30)
-------- ----------
Total Provision for Credit Losses........................ $ 117 $ 4,156
======== ==========
The allowance for credit losses was $1.2 million, or 27.2% of
non-accrual loans at September 30, 2004, compared to $3.8 million, or 24.6%, of
non-accrual loans and leases at September 30, 2003. Non-accrual loans were $4.6
million at September 30, 2004, compared to $11.9 million at September 30, 2003.
See "-- On Balance Sheet Portfolio Quality" for information on 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.
125
The following table summarizes changes in the allowance for credit
losses for the three months ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
------------------------------
2004 2003
------------- -------------
Balance at beginning of period...................... $ 1,469 $ 1,529
Provision for credit losses......................... 59 3,793
Charge-offs......................................... (394) (1,660)
Recoveries.......................................... 104 126
------- ---------
Balance at end of period.............................. $ 1,238 $ 3,788
======= =========
The following tables summarize the changes in the allowance for credit
losses by loan type for the three months ended September 30, 2004 and September
30, 2003 (in thousands):
BUSINESS HOME
PURPOSE MORTGAGE
THREE MONTHS ENDED SEPTEMBER 30, 2004 LOANS LOANS TOTAL
------------------------------------- -------- --------- --------
Balance at beginning of period........... $ 350 $ 1,119 $ 1,469
Provision for credit losses.............. 146 (87) 59
Charge-offs.............................. (66) (328) (394)
Recoveries............................... 70 34 104
------ -------- --------
Balance at end of period................. $ 500 $ 738 $ 1,238
====== ======== ========
BUSINESS HOME
PURPOSE MORTGAGE
THREE MONTHS ENDED SEPTEMBER 30, 2003 LOANS LOANS LEASES TOTAL
- ----------------------------------------- --------- -------- ------- --------
Balance at beginning of period........... $ 503 $ 856 $ 170 $ 1,529
Provision for credit losses.............. 1,129 2,694 (30) 3,793
Charge-offs.............................. (352) (1,198) (110) (1,660)
Recoveries............................... 4 14 108 126
--------- ------- ------- --------
Balance at end of period................. $ 1,284 $ 2,366 $ 138 $ 3,788
========= ======= ======= ========
The following table summarizes net charge-off experience by loan type
for the three months ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
------------------------------
2004 2003
------------- -------------
Business purpose loans........................ $ (4) $ 349
Home mortgage loans........................... 294 1,183
Equipment leases.............................. - 2
------- -------
Total......................................... $ 290 $ 1,534
======= =======
EMPLOYEE RELATED COSTS. For the three months ended September 30, 2004,
employee related costs decreased $1.9 million, or 13.8%, to $11.9 million from
$13.9 million in the three months ended September 30, 2003. The decrease in
employee related costs for the three months ended September 30, 2004 was
primarily attributable to a increase 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 increase in loan originations and
the ability to defer costs of loan origination personnel under SFAS No. 91. The
increase in SFAS No. 91 deferrals was $3.3 million during the three months ended
September 30, 2004. Increases in bonuses, salaries and cost of benefits
partially offset the effect of increased SFAS No. 91 cost deferrals.
126
Total employees at September 30, 2004 were 1,053 compared to 1,119 at
June 30, 2003. Since June 30, 2003, we have been implementing our adjusted
business strategy and our workforce has experienced a net reduction of 66
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. However, we expect to increase our sales,
servicing and support positions as necessary in the future to handle higher
levels of loan originations. In the process of implementing our adjusted
business strategy, since June 30, 2003 we reduced our workforce by approximately
255 employees and experienced a net loss of approximately 90 additional
employees who have resigned. Partially offsetting this workforce reduction, we
have added 275 loan origination employees in our broker channel as part of our
business strategy's focus on expanding our broker operations.
Factors affecting the level of future employee related costs include
future staffing decisions related to our business strategy, our loan origination
levels, and our ability or inability to defer loan originations costs under SFAS
No. 91.
SALES AND MARKETING EXPENSES. For the three months ended September 30,
2004, sales and marketing expenses increased $3.6 million, or 125.0%, to $6.4
million from $2.8 million for the first quarter of fiscal 2004. The increase was
primarily due to increases in direct mail and internet advertising for direct
channel loan originations. The increase in direct mail and internet advertising
costs of $2.5 million in the three months ended September 30, 2004 was mainly
due to the increase in home mortgage loan originations in our direct channel.
While we expect to continue streamlining our direct mail costs in the future by
offering a wider array of loan products and targeting customer segments that we
believe will enable us to increase our loan origination conversion rates, we
expect direct mail expense to increase over the fiscal 2004 expense level as
direct channel originations increase. By increasing our conversion rates, we
expect to be able to lower our overall sales and marketing costs per dollar
originated. In addition, in the three months ended September 30, 2004, print
media advertising costs related to subordinated debentures increased $1.1
million.
(GAINS) AND LOSSES ON DERIVATIVE FINANCIAL INSTRUMENTS. The following
table summarizes (gains) and losses on derivative financial instruments and
gains and losses on hedged loans for the three months ended September 30, 2004
and 2004 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-----------------------------
2004 2003
------------- ------------
Hedge accounting:
(Gains) losses on derivatives..................... $ 652 $ -
(Gains) losses on hedged loans.................... (632) -
Trade accounting:
Related to pipeline.............................. 1,969 -
Related to whole loan sales...................... - (5,097)
Related to interest-only strips.................. - (11)
------- --------
Total (gains) and losses..................... $ 1,989 $ (5,108)
======= ========
127
For more detail on our hedging and trading activities see "--
Quantitative and Qualitative Disclosures About Market Risk -- Strategies for Use
of Derivative Financial Instruments."
GENERAL AND ADMINISTRATIVE EXPENSES. For the three months ended
September 30, 2004, general and administrative expenses increased $4.1 million,
or 21.3%, to $23.3 million from $19.2 million for the three months ended
September 30, 2003. The increase was primarily attributable to $4.5 million in
fees on new credit facilities and a write-off of $1.5 million of fee receivables
and deferment and forbearance advances related to collateral in trusts whose
servicing we sold on September 27, 2004 partially offset by a decrease of $1.8
million in costs associated with servicing and collecting our total managed
portfolio including expenses associated with REO and delinquent loans, and a
$0.2 million decrease in costs associated with customer retention incentives.
The following table summarizes general and administrative expenses for
the three months ended September 30, 2003 and 2004 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------------
2004 2003
-------------- ----------
Expenses associated with servicing
and collecting loans:
Fees and advances on serviced loans. $ 5,932 $ 1,501
Interest on repurchases from trusts. 565 3,339
REO expenses........................ 281 1,460
Valuation adjustment on
repurchased REO .................. - 2,293
REO revaluation losses and (gains)
losses on sales................. 174 132
---------- --------
Total Expenses associated with
servicing and collecting loans.. 6,952 8,725
Fees on credit facilities................ 4,658 -
Professional fees........................ 2,695 2,017
Depreciation and amortization ........... 1,451 1,762
Occupancy expenses....................... 1,386 1,626
Business insurance....................... 1,003 899
Expenses associated with customer
retention incentives................... 767 934
Other, net 4,399 3,252
---------- ---------
Total general and administrative
expenses........................ $ 23,311 $ 19,215
========== =========
Beginning in the fourth quarter of fiscal 2002, we offered customer
retention incentives to borrowers who were exploring loan refinancing
opportunities for the purpose of lowering their monthly loan payments. In an
attempt to retain the loans we were servicing for these borrowers, we offered
the borrowers the opportunity to receive a monthly cash rebate equal to a
percentage of their scheduled monthly loan payments for periods of six to twelve
months. We do not initiate any outbound activity to identify borrowers who are
interested in refinancing loans. Eligible borrowers for the cash rebate program
are identified when they contact us inquiring about refinancing opportunities.
When we were successful in retaining these loans, we reduced the level of loan
prepayments in our managed portfolio of securitized loans. To initially qualify
for this program, a borrower has to be current on his or her loan principal and
interest payments. To be eligible for the cash rebate payment, a borrower must
make his or her monthly loan payment on a timely basis (within 15 days of the
payment due date) and has to remain on a current basis. The rebate amount is a
128
percentage of the scheduled monthly loan payment, principal plus interest. The
percentage of rebates on scheduled loan payments offered to participants ranged
from 15% to 20%. Our policy is to forward a rebate payment to the borrower
within six weeks of receiving the monthly loan payment from the borrower.
For those borrowers who elected to participate in customer retention
incentives, we recorded a liability for the amount of future cash payments that
we expected to make under this program. The liability we recorded for this
program was determined based on an analysis of our two-year experience on the
number of borrowers who remain for the full term of the incentive program. Some
borrowers are dropped from this program because they fail to make timely monthly
loan payments and others leave the program when they payoff their loans. Factors
which have contributed to the fluctuation in the expense charges for the rebate
program include the reduction in our managed portfolio, loan refinancing
activities, shortening of the term of the incentive program offered from 12
months to 6 months and, finally, our ultimate payment experience as the program
seasoned. The following table summarizes the activity for customer retention
incentives and the related balance sheet liability at September 30, 2004 and
2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------------------
2004 2003
-------------- --------------
Balance at beginning period..................... $ 1,277 $ 5,231
Liability accrued for new participants.......... 1,148 2,556
Participants leaving the program:
Loan became delinquent....................... (114) (238)
Loans paid off............................... (267) (1,384)
-------- --------
Net charge to income statement............ 767 934
Cash payments made to participants............. (768) (1,843)
-------- --------
Balance at end of year......................... $ 1,276 $ 4,322
======== ========
Principal amount outstanding on loans
participating at period end (a)............... $374,766 $578,360
======== ========
- ---------------------
(a) These are loans included in mortgage securitization trusts, which are
serviced by us.
Factors affecting future general and administrative expense levels
include the size of our total managed portfolio, which decreased 35.9% in the
three months ended September 30, 2004 from the three months ended September 30,
2003, the amount of future loan originations and the costs associated with
obtaining new or increasing existing credit facilities.
SECURITIZATION ASSETS VALUATION ADJUSTMENT. During the three months
ended September 30, 2004, we recorded a pre-tax write up of $18.6 million on our
interest-only strips. The $18.6 million write up was recorded as an increase to
other comprehensive income, a component of stockholders' equity. This write up
of interest-only strips resulted from a reduction to our assumptions for loan
prepayments expected to occur beyond 18 months. Management believes that once we
move beyond the low interest rate environment and the impact that environment
has on loan prepayments, the long running and highly unfavorable prepayment
experience over the last twelve quarters will leave us with securitized mortgage
pools which will experience future prepayment speeds substantially lower than
originally believed. No adjustments were recorded to our servicing rights at
September 30, 2004. During the three months ended September 30, 2003, we
recorded valuation adjustments on our securitization assets of $16.7 million.
The breakout of the total pre-tax adjustments recorded in the three months ended
September 30, 2004 and 2003 between interest-only strips and servicing rights,
129
and the amounts charged as expense to the income statement or added to or
charged to other comprehensive income were as follows (in thousands):
THREE MONTHS ENDED SEPTEMBER 30, 2004 THREE MONTHS ENDED SEPTEMBER 30, 2003
----------------------------------------- -------------------------------------------
TOTAL INCOME OTHER INCOME OTHER
(WRITE UP)/ STATEMENT COMPREHENSIVE TOTAL STATEMENT COMPREHENSIVE
WRITE DOWN IMPACT INCOME IMPACT WRITE DOWN IMPACT INCOME IMPACT
------------- ---------- ---------------- -------------- ------------ ---------------
Interest-only strips.......... $(18,614) $ 29 $ (18,643) $ 15,814 $ 9,951 $ 5,863
Servicing rights.............. -- -- -- 844 844 --
----------------------------------------- -------------------------------------------
Total securitization assets... $(18,614) $ 29 $ (18,643) $ 16,658 $ 10,795 $ 5,863
========================================= ===========================================
See "- Application of Critical Accounting Estimates - Interest-Only
Strips" for a discussion of how valuation adjustments are recorded and "--
Off-Balance Sheet Arrangements" and "-- Securitizations" for more detail on
securitization assets valuations.
PROVISION FOR INCOME TAX EXPENSE (BENEFIT). In the three months ended
September 30, 2004, our tax benefit decreased $2.5 million from $16.1 million
for the three months ended September 30, 2003, to $13.6 million as a result of a
$3.6 million reduction in pre-tax loss as well as a decrease in our effective
tax rate from 38% in fiscal 2004 to 35% in fiscal 2005. The utilization of our
net operating loss carry forwards are dependent on future taxable income from
operations and it is more likely than not we will be able to primarily utilize
all benefits within two years. Our adjusted business strategy of shifting to
primarily whole loan sales will result in a quicker recognition and a higher
level of taxable income. Our previous business strategy of using primarily
securitizations allowed for the deferral of taxable income. See "-- Application
of Critical Accounting Estimates -- Deferred Tax Asset" for a discussion of the
factors we considered in determining that it is more likely than not we will
realize these benefits.
SEGMENT REPORTING
We have three operating segments: Loan Origination, Servicing and
Treasury and Funding. The Loan Origination segment originates home mortgage
loans. The Servicing segment services the loans originated by us both while held
as available for sale by us and subsequent to securitization. The Treasury and
Funding segment offers our subordinated debenture securities pursuant to a
registered public offering and obtains other sources of funding for our general
operating and lending activities. All Other is mainly comprised of interest-only
strips, unallocated overhead and other expenses unrelated to the reportable
segments identified. Refer to Note 14 to the September 30, 2004 Consolidated
Financial Statements for comparative data for the three months ended September
30, 2004 and 2003.
LOAN ORIGINATION SEGMENT
TOTAL REVENUES. For the three months ended September 30, 2004, total
revenues increased $5.7 million, or 173.8% to $13.5 million from $7.8 million
for the three months ended September 30, 2003. Gains on whole loan sales
increased to $6.1 million for the first quarter of fiscal 2005 from gains of
$2.9 million for the first quarter of fiscal 2004. The volume of whole loan
sales increased $331.2 million, to $602.2 million for the three months ended
September 30, 2004 from $271.0 million for the three months ended September 30,
2003. In the three months ended September 30, 2003, we recorded gains of $0.8
million on the sale of $5.5 million of loans into an off-balance sheet facility
130
before its expiration on July 5, 2003 and additional gains realized from our
residual interests in $35.0 million of loans remaining in the off-balance sheet
facility from June 30, 2003.
TOTAL EXPENSES. Total expenses increased $5.8 million, or 13.6%, to
$48.3 million for the three months ended September 30, 2004 compared to $42.5
million for the three months ended September 30, 2003. Interest expense for the
loan origination segment consists primarily of interest expense on warehouse
lines of credit used to fund loans. During the three months ended September 30,
2004, interest expense decreased $1.0 million, or 15.1%, to $5.6 million
compared to $6.7 million for the three months ended September 30, 2003.
Non-interest expense for the loan origination segment consists of a
provision for credit losses, employee related costs, sales and marketing
expenses and general and administrative expenses. The provision for credit
losses for the three months ended September 30, 2004 decreased $4.1 million, or
96.0%, to $117 thousand, compared to $4.2 million for the three months ended
September 30, 2003. The decrease was primarily due to lower loan charge-offs
resulting from the decreased amounts of delinquent loans repurchased from
securitization trusts. Employee related costs decreased $3.2 million, or 44.8%,
to $4.0 million for the first quarter of fiscal 2005 from $7.2 million for the
first quarter of fiscal 2004. The decrease in employee related costs was
primarily attributable to the increase in loan originations and the ability to
defer costs of loan origination personnel under SFAS No. 91. Sales and marketing
expenses increased $2.5 million, or 99.1%, to $5.0 million for the period ended
September 30, 2004, from $2.5 million for the period ended September 30, 2003
due to increases in direct mail and internet advertising for direct channel loan
originations. For the three months ended September 30, 2004, general and
administrative expenses increased $12.3 million to $10.6 million from a credit
of $1.7 million for the three months ended September 30, 2003. The increase was
primarily attributable to a $7.1 million increase in losses on derivative
financial instruments and a $4.7 million increase in fees on new credit
facilities
TREASURY AND FUNDING SEGMENT
TOTAL REVENUES. For the three months ended September 30, 2004, total
revenues decreased $3.6 million, or 19.8%, to $14.5 million from $18.1 million
for the three months ended September 30, 2003. The reduction in total revenues
is primarily attributed to a decrease in intercompany revenues earned on the
allocation of capital. For the first quarter of fiscal 2005, the capital
provided by the Treasury and Funding Segment decreased $152.2 million, or 25.8%,
to $438.1 million compared to $590.3 million in the first quarter of fiscal
2004.
TOTAL EXPENSES. Total expenses for the three months ended September 30,
2004 increased $1.2 million, or 6.9%, to $18.6 million from $17.4 million for
the three months ended September 30, 2003 primarily due to a $1.1 million
increase in advertising costs related to subordinated debentures.
SERVICING SEGMENT
TOTAL REVENUES. For the three months ended September 30, 2004, total
revenues decreased $6.1 million, or 45.3%, to $7.3 million from $13.4 million
for the three months ended September 30, 2003. For the period ended September
30, 2004, contractual fee income decreased $5.8 million, or 44.4%, to $7.3
million from $13.1 million for the period ended September 30, 2003 due to the
decrease in our managed portfolio.
131
TOTAL EXPENSES. Total expenses decreased $3.6 million, or 33.3%, to
$7.2 million for the three months ended September 30, 2004 compared to $10.8
million for the three months ended September 30, 2003. The decrease is due
primarily to a reduction in professional fees and REO expenses.
ALL OTHER SEGMENTS
TOTAL REVENUES. For the three months ended September 30 2004, total
revenues increased $2.7 million, or 12.3%, to $24.7 million from $22.0 million
for the three months ended September 30, 2003. An increase of $5.4 million in
inter-segment revenues was partially offset by a $2.7 million decrease in
interest accretion on interest-only strips. Interest accretion of $8.4 million
was earned in the three months ended September 30, 2004 compared to $11.1
million in the three months ended September 30, 2003.
TOTAL EXPENSES. Total expenses decreased $8.0 million, or 24.5%, to
$24.8 million for the three months ended September 30, 2004 compared to $32.8
million for the three months ended September 30, 2003. The decrease for the
period was principally due to a decline in the valuation adjustment for the
securitization assets recorded in the income statement. For the three months
ended September 30, 2004, the valuation adjustment decreased $10.8 million, or
99.7%, to $29 thousand from $10.8 million for the three months ended September
30, 2003.
132
BALANCE SHEET INFORMATION
BALANCE SHEET DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, JUNE 30,
2004 2004
------------ ----------
Cash and cash equivalents.............................. $ 19,673 $ 910
Restricted cash........................................ 10,419 13,307
Loan and lease receivables:
Loans available for sale........................... 336,511 304,275
Non-accrual loans.................................. 3,314 1,993
Interest and fees receivable........................... 15,304 18,089
Deferment and forbearance advances receivable.......... 5,839 6,249
Loans subject to repurchase rights..................... 40,736 38,984
Interest-only strips................................... 448,812 459,086
Servicing rights....................................... 66,712 73,738
Deferred income tax asset.............................. 66,201 59,133
Total assets........................................... 1,083,396 1,042,870
Subordinated debentures................................ 490,026 522,609
Senior collateralized subordinated notes............... 97,454 83,639
Warehouse lines and other notes payable................ 281,472 241,200
Accrued interest payable............................... 38,324 37,675
Total liabilities...................................... 1,071,537 1,030,955
Total stockholders' equity............................. 11,859 11,915
Book value per common share ......................... $ 3.30 $ 3.31
SEPTEMBER 30, 2004 COMPARED TO JUNE 30, 2004
Total assets increased $40.5 million, or 3.9%, to $1,083.4 million at
September 30, 2004 from $1,042.9 million at June 30, 2004 primarily due to
increases in loans available for sale, cash and cash equivalents and deferred
income tax assets. Decreases in interest-only strips and servicing rights
partially offset these increases.
Cash and cash equivalents increased $18.8 million, to $19.7 million at
September 30, 2004 from $0.9 million at June 30, 2004 due to remedial actions
taken to address liquidity issues described in "- Liquidity and Capital
Resources."
Loans available for sale increased $32.2 million, or 10.6% to $336.5
million. Loans available for sale at September 30, 2004 were at a historically
high level due to our business strategy adjustments.
Interest and fees receivable decreased $2.8 million, or 15.4%, to $15.3
million at September 30, 2004 from $18.1 million at June 30, 2004. This decrease
is mainly due to decreases in receivables for tax and insurance payments
advanced on behalf of borrowers whose loans we service and first lien buyouts
and the write-off of $1.2 million of fee receivables related to loan collateral
in trusts whose servicing we sold on September 27, 2004.
Loans subject to repurchase rights increased $1.8 million, or 4.5%, due
to increases in the amount of delinquent loans eligible for repurchase from
securitization trusts. See "- Securitizations - Repurchase Rights" for a more
information on loans subject to repurchase rights.
133
Interest-only strips at September 30, 2004 decreased $10.3 million, or
2.2%, from June 30, 2004 as a result of cash flow received, partially offset by
interest accretion and a write up of interest-only strips recorded through other
comprehensive income. See "-- Securitizations" for a discussion of valuation
adjustments recorded on our interest-only strips. Activity in our interest-only
strips for the three months ended September 30, 2004 and 2003 was as follows (in
thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------
2004 2003
--------- ---------
Balance at beginning of period $ 459,086 $ 598,278
Initial recognition of interest-only strips, including initial
overcollateralization of $0......................................... - 950
Cash flow from interest-only strips..................................... (33,141) (56,222)
Required purchases of additional overcollateralization.................. 4,615 7,660
Interest accretion...................................................... 8,448 10,828
Adjustment for loans subject to repurchase rights....................... 309 162
Proceeds from sale of interest-only strips.............................. (9,120) -
Adjustments to fair value recorded through other comprehensive income (a) 18,644 (6,122)
Other than temporary fair value adjustment (b).......................... (29) (9,951)
--------- ---------
Balance at end of period................................................ $ 448,812 $ 545,583
========= =========
(a) Adjustments to the carrying value of interest-only strips for the initial
write up to fair value are recorded through other comprehensive income at
the time of impairment, which is a component of stockholders' equity.
Additionally, to the extent any individual interest-only strip has a portion
of its initial write up to fair value still remaining in other comprehensive
income, other than temporary decreases in its fair value would first be
recorded as a reduction to other comprehensive income.
(b) Recorded through the income statement.
The following table summarizes our purchases of overcollateralization
by securitization trust for the three months ended September 30, 2004 and the
fiscal years ended June 30, 2004, 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
"-- Securitizations" for a discussion of overcollateralization requirements.
134
SUMMARY OF MORTGAGE LOAN SECURITIZATION OVERCOLLATERALIZATION PURCHASES
(IN THOUSANDS)
2003-2 2003-1 TOTAL
------- ------- ------
THREE MONTHS ENDED
SEPTEMBER 30, 2004:
Required purchases of additional
overcollateralization ........ $ 1,719 $ 2,534 $ 4,253
======= ======= =======
2003-2 2003-1 2002-4 2002-3 OTHER (A) TOTAL
------- ------- ------- ------- -------- --------
YEAR ENDED JUNE 30, 2004:
Required purchases of additional
overcollateralization.......... $ 3,872 $16,587 $ 9,323 $ 1,978 $(4,426) $ 27,334
======= ======= ======= ======= ======= ========
(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
======= ======= ======= ======= ======= ======== ======= ======= ======= ====== =======
Servicing rights decreased $7.0 million, or 9.5%, to $66.7 million at
September 30, 2004 from $73.7 million at June 30, 2004, primarily due to the
amortization of servicing rights.
Our net deferred income tax increased from $59.1 million at June 30,
2004 to $66.2 million at September 30, 2004. For more detail on this net
deferred income tax asset, see Note 10 of the September 30, 2004 Consolidated
Financial Statements. This increase results primarily from recording $13.6
million of federal income tax benefits on our prior loss for the three months
ended September 30, 2004, partially offset by the deferred tax credit recorded
on September 30, 2004 write-up of our interest-only strips. See "-- Application
of Critical Accounting Estimates -- Deferred Tax Asset" for more information
regarding our deferred tax asset.
Total liabilities increased $40.6 million, or 3.9% to $1,071.5 million
at September 30, 2004 from $1,030.9 million at June 30, 2004 primarily due to
increases in warehouse lines and notes payable, senior collateralized
subordinated notes as a result of the second exchange offer, accounts payable
and accrued expenses and other liabilities. Partially offsetting these increases
were decreases in subordinated debentures as a results of the second exchange
offer.
During the three months ended September 30, 2004, subordinated
debentures decreased $32.6 million, or 6.2%, to $490.0 million primarily due to
the conversion of $30.8 million of subordinated debentures into 15.6 million
shares of Series A preferred stock and $15.2 million of senior collateralized
subordinated notes. See "-- Liquidity and Capital Resources" for further
information regarding outstanding debt.
Warehouse lines and other notes payable increased $40.3 million at
September 30, 2004, or 16.7%, primarily due to the increase in loans available
for sale.
135
Other liabilities increased $8.6 million, or 12.0%, to $80.5 million at
September 30, 2004 from $71.9 million at June 30, 2004 due to an increase of
$10.4 million in our liability to fund closed loans partially offset by a $1.0
reduction in liabilities recorded for derivative financial instruments.
ON BALANCE SHEET PORTFOLIO QUALITY
The following table provides data concerning delinquency experience,
non-accrual loans, real estate owned and loss experience for loans on our
balance sheet (dollars in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004 MARCH 31, 2004
-------------------- -------------------- ---------------------
AMOUNT % AMOUNT % AMOUNT %
--------- ------ ---------- ------ ----------- ------
DELINQUENCY BY TYPE:
BUSINESS PURPOSE LOANS (A)
Total portfolio................. $ 2,597 $ 1,210 $ 1,757
========= ========== ===========
Period of delinquency:
31-60 days.................... $ - -% $ - -% $ - -%
61-90 days.................... - -% - -% - -%
Over 90 days.................. 2,314 89.10% 1,125 92.98% 1,401 79.74%
--------- ------ ---------- ------ ----------- ------
Total delinquencies .......... $ 2,314 89.10% $ 1,125 92.98% $ 1,401 79.74%
========= ====== ========== ====== =========== ======
Amount of loans in non-accrual
status (b) ................... 2,360 1,125 1,401
========= ========== ===========
REO............................. $ 676 $ 900 $ 1,076
========= ========== ===========
HOME MORTGAGE LOANS (A)
Total portfolio................. $ 331,286 $ 302,393 $ 118,804
========= ========== ===========
Period of delinquency:
31-60 days.................... $ 812 0.25% $ 69 0.02% $ 207 0.17%
61-90 days.................... 50 0.02% 201 0.07% 221 0.19%
Over 90 days.................. 2,073 0.63% 2,204 0.73% 3,932 3.31%
--------- ------ ---------- ------ ----------- ------
Total delinquencies........... $ 2,935 0.89% $ 2,474 0.82% $ 4,360 3.67%
========= ====== ========== ====== =========== ======
Amount of loans in non-accrual
status(b) .................... 2,192 2,337 4,305
========= ========== ===========
REO............................. $ 834 $ 1,020 $ 1,432
========= ========== ===========
TOTAL ON BALANCE SHEET LOANS (A)
Total loans and leases.......... $ 333,883 $ 303,603 $ 120,561
========= ========== ===========
Period of delinquency:
31-60 days.................... $ 812 0.24% $ 69 0.02% $ 207 0.17%
61-90 days.................... 50 0.01% 201 0.07% 221 0.18%
Over 90 days.................. 4,387 1.31% 3,329 1.10% 5,137 4.26%
--------- ------ ---------- ------ ----------- ------
Total delinquencies........... $ 5,249 1.57% $ 3,599 1.19% $ 5,565 4.62%
========= ===== ========== ====== =========== ======
Amount of loans in non-accrual
status(b) .................... 4,552 1.36% 3,462 1.14% 5,706 4.73%
========= ===== ========== ====== =========== ======
REO............................. $ 1,510 0.45% $ 1,920 0.63% $ 2,508 2.08%
========= ===== ========== ====== =========== ======
NET LOSSES EXPERIENCED DURING THE
THREE MONTH PERIOD (C):
On Loans:
Non-accrual loans.......... $ 289 0.38% $ 6,217 11.23% $ 5,784 14.46%
Loans available for sale... - -% - -% - -%
On Leases....................... - -% - -% - -%
On REO.......................... 569 0.7% 1,051 1.90% 1,876 4.69%
--------- ---------- -----------
Total net losses............... $ 858 1.12% $ 7,268 13.13% $ 7,660 19.02%
========= ===== ========== ====== =========== ======
(a) Includes loans carried on our balance sheet as available for sale,
non-accrual loans. Excludes deferred direct origination costs and allowance
for loan losses. Non-accrual loans consist primarily of loans repurchased
from securitization trusts.
(b) Non-accrual loans are included in total delinquencies in the "On Balance
Sheet Portfolio Quality" table.
(c) Percentage based on annualized losses and average loans available for sale
and non-accrual loans.
DELINQUENT LOANS AVAILABLE FOR SALE. Total delinquent loans available
for sale (loans with payments past due greater than 30 days) were $862 thousand
at September 30, 2004, compared to $245 thousand and $231 thousand at June 30,
2004 and March 31, 2004, respectively. Total delinquent loans available for sale
136
as a percentage of loans available for sale were 0.26% at September 30, 2004
compared to 0.08% and 0.20% at June 30, 2004 and March 31, 2004, respectively.
If a loan available for sale becomes contractually delinquent for 90 days or
more, it is placed on non-accrual status and transferred to non-accrual loans.
We do not anticipate significant increases in the amount of delinquent loans
available for sale because our adjusted business strategy focuses on whole loan
sales, which result in loans being held on our books for short periods. The
amount of loans available for sale which were transferred to non-accrual loans
was $271 thousand for the three months ended September 30, 2004, $154 thousand
for the three months ended June 30, 2004 and $985 thousand for the three months
ended March 31, 2004. The following table summarizes delinquent loans available
for sale (dollars in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004 MARCH 31, 2004
-------------------- ------------------- -------------------
AMOUNT % AMOUNT % AMOUNT %
----------- ----- ---------- ----- ---------- -----
Total loans available for
sale..................... $ 329,331 $ 300,141 $ 114,847
=========== ========== ==========
Period of delinquency:
31-60 days.............. $ 812 0.24% $ 69 0.02% $ 73 0.06%
61-90 days.............. 50 0.02 176 0.06 158 0.14
Over 90 days............ - - - - - -
----------- ----- ---------- ----- ---------- -----
Total delinquencies..... $ 862 0.26% $ 245 0.08% $ 231 0.20%
=========== ===== ========== ===== ========== =====
NON-ACCRUAL LOANS. 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 consist primarily of loans repurchased from securitization trusts, but
also include loans previously carried as available for sale when they become
contractually delinquent for 90 days or more. The following table summarizes
non-accrual loans by source at September 30, 2004 and 2003 (in thousands):
SEPTEMBER 30,
-------------------------
2004 2003
-------- ---------
Repurchased from securitization trusts............... $ 4,392 $ 9,836
Transferred from loans available from sale........... 80 2,105
Other ............................................... 80 -
--------- ---------
Total non-accrual loans.............................. $ 4,552 $ 11,941
========= =========
DEFERMENT AND FORBEARANCE ARRANGEMENTS. From time to time, borrowers in
the portfolio of loans which we manage are confronted with events, usually
involving hardship circumstances or temporary financial setbacks that adversely
affect their ability to continue payments on their loan. To assist borrowers, we
may agree to enter into a deferment or forbearance arrangement. Prevailing
economic conditions, which may affect the borrower's ability to make their
regular payments, may also have an impact on the value of the real estate or
other collateral securing the loans, resulting in a change to the loan-to-value
ratios. We may take these conditions into account when we evaluate a borrower's
request for assistance for relief from the borrower's financial hardship.
Our policies and practices regarding deferment and forbearance
arrangements, like all of our collections policies and practices, are designed
to manage customer relationships, maximize collections and avoid foreclosure (or
repossession of other collateral, as applicable) if reasonably possible. We
review and regularly revise these policies and procedures in order to enhance
their effectiveness in achieving these goals.
In a deferment arrangement, we make advances on behalf of the borrower
in amounts equal to the delinquent loan payments, which include principal and
interest. Additionally, we may pay taxes, insurance and other fees on behalf of
the borrower. Based on our review of the borrower's current financial
circumstances, the borrower must repay the advances and other payments and fees
we make on the borrower's behalf either at the termination of the loan or on a
137
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 ranging from approximately 12 to 42 months, depending on
the period for which deferment is requested, 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 at least two
senior vice presidents.
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 two senior
vice presidents. 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.
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.
138
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.
Information regarding the principal amounts of loans in our managed
portfolio under deferment and forbearance arrangements and the principal amounts
of loans which entered into deferment and forbearance arrangements during the
years ended June 30, 2004 and 2003 is presented in "-- Total Portfolio Quality
- -- Deferment and Forbearance Arrangements."
Advances made under deferment and forbearance arrangements result from
a new credit decision regarding the borrower's ability to repay the advance, as
well as perform under the original terms of the original loan, and do not
involve any modification of the terms of the original loan. These arrangements
are considered a new lending activity and do not qualify as troubled debt
restructurings under SFAS No. 15, "Accounting by Debtors and Creditors for
Troubled Debt Restructurings." We record the advances that we make under
deferment and forbearance arrangements with borrowers as receivables on our
balance sheet. We carry these receivables at their estimated recoverable
amounts. If the original loan returns to a delinquency status of 90 days or more
past due, we write the receivable off to expense.
During the three months ended September 30, 2004 and 2003 and fiscal
year ended June 30, 2004, we did not record any fee income on these arrangements
while we recorded $100 thousand and $59 thousand during fiscal years ended June
30, 2003 and 2002, respectively. We view deferment and forbearance arrangements
as loss mitigation actions available to assist borrowers who have reached out
for help to prevent their loans from becoming more delinquent and going into a
default status. We believe that in order to assist these borrowers, "best
practice" lending would suggest mitigating the cost to the borrowers related to
entering into these arrangements. We had charged fees where permitted by state
lending laws for entering into this type of arrangement, however, starting in
fiscal 2004, we decided to discontinue the practice of charging fees to
borrowers who entered into deferment and forbearance arrangements.
The following table presents information regarding our on balance sheet
receivables for advances to borrowers related to deferment and forbearance
arrangements for the three months ended September 30, 2004 and 2003 (in
thousands):
139
ADVANCES RECEIVABLE
---------------------------------------------------
UNDER UNDER
DEFERMENT FORBEARANCE TOTAL
-------------- -------------- --------------
THREE MONTHS ENDED SEPTEMBER 30, 2004:
Balance June 30, 2004.............. $ 3,311 $ 2,938 $ 6,249
Advances on new arrangements....... 880 68 948
Payments received.................. (511) (473) (984)
Receivables written off............ (236) (138) (374)
-------------- --------------- ---------------
Balance September 30, 2004......... $ 3,444 $ 2,395 $ 5,839
============== =============== ===============
THREE MONTHS ENDED SEPTEMBER 30, 2003:
Balance June 30, 2003.............. $ 1,286 $ 3,055 $ 4,341
Advances on new arrangements....... 1,511 1,320 2,831
Payments received.................. (287) (576) (863)
Receivables written off............ (218) (147) (365)
-------------- --------------- ---------------
Balance September 30, 2003......... $ 2,292 $ 3,652 $ 5,944
============== =============== ===============
REAL ESTATE OWNED. REO, comprising foreclosed properties and deeds
acquired in lieu of foreclosure, decreased to $1.5 million at September 30,
2004, compared to $1.9 million at June 30, 2004. The decrease in the amount of
REO on our balance sheet at September 30, 2004 was mainly due to lower REO
repurchases from the securitization trusts and liquidation of REO during the
three months ended September 30, 2004.
The activity in REO carried on our balance sheet during the three
months ended September 30, 2004 and 2003 was as follows. For total REO purchased
from securitization trusts and the valuation loss recorded at the time of
purchase, see the table "Summary of Loans and REO Repurchased from Mortgage Loan
Securitization Trusts" in "-- Securitizations -- Trigger Management." (in
thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------------
2004 2003
------------ -------------
Balance at beginning of period....................... $ 1,920 $ 4,776
Properties acquired through foreclosure (a).......... 101 676
Properties purchased from securitization trusts (a).. 96 4,202
Sales/liquidation proceeds........................... (433) (4,956)
Property revaluation losses.......................... - (145)
(Loss) Gain on sale/liquidation...................... (174) 13
------- -------
Balance at end of period............................. $ 1,510 $ 4,566
======= =======
- --------------------
(a) At lower of cost or net realizable value.
140
LOSS EXPERIENCE. During the three months ended September 30, 2004, we
experienced net loan, lease and REO charge-offs of $0.9 million or 1.12% on an
annualized basis. During the three months ended June 30, 2004, we experienced
net charge-offs of $7.3 million or 13.13% on an annualized basis. During the
three months ended March 31, 2004, we experienced net charge-offs of $7.7
million, or 19.02% on an annualized basis. Principal loss severity experience on
delinquent loans generally has ranged from 20% to 30% of principal and loss
severity experience on REO generally has ranged from 20% to 40% of principal.
The increase in net charge-offs from the prior periods was mainly due to the
larger volume of loans that became delinquent, were repurchased from
securitization trusts and/or, were liquidated during the period, as well as
economic conditions and the seasoning of the total portfolio. See the table
"Summary of Loans and REO Repurchased from Mortgage Loan Securitization Trusts"
for further detail of loan repurchase activity.
141
TOTAL PORTFOLIO QUALITY
The following table provides data concerning delinquency experience,
real estate owned and loss experience for the total loan portfolio in which we
have interests, either because the loans 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):
SEPTEMBER 30, 2004 JUNE 30, 2004 MARCH 31, 2004
------------------------- ---------------------- ----------------------
AMOUNT % AMOUNT % AMOUNT %
-------------- ---------- ----------- --------- ------------- ---------
DELINQUENCY BY TYPE:
MANAGED BY ABFS:
BUSINESS PURPOSE LOANS
Total portfolio......... $ 233,221 $ 255,200 $ 278,608
============== ============ =============
Period of delinquency:
31-60 days............. $ 12,849 5.51% $ 4,847 1.90% $ 4,864 1.75%
61-90 days............. 6,608 2.83 4,241 1.66 5,798 2.08
Over 90 days........... 44,926 19.26 51,625 20.23 52,434 18.82
-------------- ---------- ----------- --------- ------------- ---------
Total delinquencies.... $ 64,383 27.61% $ 60,713 23.79% $ 63,096 22.65%
============= ========== =========== ========= ============= =========
REO...................... $ 5,662 $ 3,725 $ 4,441
============== ============ =============
HOME MORTGAGE LOANS
Total portfolio.......... $ 1,671,205 $ 1,836.678 $ 1,914,165
============== ============ =============
Period of delinquency:
31-60 days............. $ 49,624 2.97% $ 35,301 1.92% $ 36,885 1.93%
61-90 days............. 25,083 1.50 18,961 1.03 21,964 1.15
Over 90 days........... 100,317 6.00 104,441 5.69 121,999 6.37
-------------- ---------- ----------- --------- ------------- ---------
Total delinquencies.... $ 175,024 10.47% $ 158,703 8.64% $ 180,848 9.45%
============= ========== =========== ========= ============= =========
REO...................... $ 31,562 $ 30,675 $ 21,778
============== ============ =============
TOTAL MANAGED BY ABFS
Total loans and leases... $ 1,904,426 $ 2,091,878 $ 2,192,773
============== ============ =============
Period of delinquency:
31-60 days............. $ 62,473 3.28% $ 40,148 1.92% $ 41,749 1.90%
61-90 days............. 31,691 1.66 23,202 1.11 27,762 1.27
Over 90 days........... 145,243 7.63 156,066 7.46 174,433 7.95
-------------- ---------- ----------- --------- ------------- ---------
Total delinquencies (b) $ 239,407 12.57% $ 219,416 10.49% $ 243,944 11.12%
============== ========== =========== ========= ============= =========
REO...................... $ 37,224 1.95% $ 34,400 1.64% $ 26,189 1.19%
============== ========== =========== ========= ============= =========
SERVICED BY OTHERS (C):
Total portfolio serviced by
others................... $ 120,605 $ 139,811 $ 156,644
============== ============ =============
Period of delinquency:
31-60 days............. $ 9,332 7.74% $ 6,976 4.99% $ 8,649 5.52%
61-90 days............. 3,737 3.10 3,636 2.60 3,529 2.25
Over 90 days........... 10,124 8.39 8,105 5.80 5,804 3.71
-------------- ---------- ----------- --------- ------------- ---------
Total delinquencies.... $ 23,193 19.23% $ 18,717 13.39% $ 17,982 11.48%
============== ========== =========== ========= ============= =========
142
TOTAL PORTFOLIO QUALITY (CONTINUED)
SEPTEMBER 30, 2004 JUNE 30, 2004 MARCH 31, 2004
-------------------- ------------------- ---------------------
AMOUNT % AMOUNT % AMOUNT %
----------- ---- ----------- ----- ----------- -----
TOTAL PORTFOLIO.............. $ 2,025,031 $ 2,231,689 $ 2,349,417
=========== =========== ===========
Period of delinquency:
31-60 days............... $ 71,805 3.55% $ 47,124 2.11% $ 50,398 2.15%
61-90 days............... 35,428 1.75 26,838 1.20 31,291 1.33
Over 90 days............. 155,367 7.67 164,171 7.36 180,237 7.67
----------- ----- ----------- ----- ----------- -----
Total delinquencies...... $ 262,600 12.97% $ 238,133 10.67% $ 261,926 11.15%
=========== ===== =========== ===== =========== =====
REO.......................... $ 37,224 1.84% $ 34,400 1.54% $ 26,189 1.11%
=========== ===== =========== ===== =========== =====
NET LOSSES EXPERIENCED
DURING THE THREE MONTH
PERIOD (B):
On Loans:
Absorbed by securitization
trusts.................. $ 1,129 0.21% $ 1,691 0.29% $ 1,646 0.26%
Non-accrual loans.......... 1,658 0.31 6,217 1.08 5,784 0.91
Loans available for sale... - - - - - -
On Leases.................. - - - - - -
On REO:
Absorbed by securitization
trusts..................... 288 0.05 216 0.04 1,617 0.25
REO on balance sheet........ 643 0.12 1,051 0.18 1,876 0.29
----------- ----------- -----------
Total net losses............. $ 3,718 0.70% $ 9,175 1.60% $ 10,923 1.71%
=========== ===== =========== ===== =========== =====
- -------------------
(a) We do not service the mortgage loans in the 2003-2 securitization trust, our
most recent securitization, which closed in October 2003.
(b) Including previously delinquent loans under deferment and forbearance
arrangements (which are reported as current loans if borrowers are current
under the terms of the original note), total delinquency for the managed
portfolio would be 22.26%, 20.83%, 11.68% and 10.11% at September 30, 2004,
June 30, 2004, 2003 and 2002, respectively.
(c) Percentage based on annualized losses and average total portfolio.
We do not service the mortgage loans in the 2003-2 securitization
trust, our most recent securitization, which closed in October 2003. A third
party services the $120.6 million of mortgage loans in that trust. Those loans
and their delinquency status are included in the above Total Portfolio Quality
table because we have retained securitization interests in the form of
interest-only strips on our balance sheet. Due to different servicing practices,
which may be followed by other loan servicers, loans serviced by others may
perform less favorably and incur higher delinquencies and losses than the loans
in the portfolio managed by us. We adjusted the initial loss assumption applied
in valuing our interest-only strip from the 2003-2 securitization to account for
this risk. No mortgage loans in the total portfolio were serviced by third
parties prior to October 2003.
DEFERMENT AND FORBEARANCE ARRANGEMENTS. See "-- On Balance Sheet
Portfolio Quality -- Deferment and Forbearance Arrangements" for a discussion of
how these arrangements arise and our policies and practices regarding deferment
and forbearance arrangements.
The following table presents, as of the end of our last ten 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):
143
CUMULATIVE UNPAID PRINCIPAL BALANCE
-----------------------------------------------------------------
% OF
PORTFOLIO
UNDER UNDER MANAGED BY
DEFERMENT FORBEARANCE TOTAL(A) 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
June 30, 2004...................... 160,572 55,776 216,348 10.34
September 30, 2004................. 145,314 39,283 184,597 9.69
(a) Included in cumulative unpaid principal balance are loans with arrangements
that were entered into longer than twelve months ago. At September 30, 2004,
there was $63.6 million of cumulative unpaid principal balance under
deferment arrangements and $31.2 million of cumulative unpaid principal
balance under forbearance arrangements that were entered into prior to July
2003.
Additionally, there are loans under deferment and forbearance
arrangements, which have returned to delinquent status. At September 30, 2004
there was $72.9 million of cumulative unpaid principal balance under deferment
arrangements and $53.7 million of cumulative unpaid principal balance under
forbearance arrangements that are now reported as delinquent 31 days or more.
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. The economic conditions that contributed
most to the greater use of deferment arrangements during this period related to
increased unemployment, loss of one job in two income households, and reductions
and leveling off in normal working hours and overtime. Since December 2003, we
have experienced a reduction in new deferment arrangements due to improving
economic conditions and if the improving economic environment continues, we
expect to continue to experience a reduction in new deferment arrangements.
144
The following table presents the amount of unpaid principal balance of
loans that entered into a deferment or forbearance arrangement in each quarter
(dollars in thousands):
UNPAID PRINCIPAL BALANCE IMPACTED BY
ARRANGEMENTS ENTERED INTO
DURING THE QUARTER
----------------------------------------------------------------
% OF
PORTFOLIO
UNDER UNDER MANAGED BY
QUARTER ENDED: DEFERMENT FORBEARANCE TOTAL 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
June 30, 2004............................ 32,332 982 33,314 1.59
September 30, 2004....................... 36,571 435 37,006 1.94
The following table presents a summary of the activity, in terms of the
principal balance, of loans under these arrangements for the three months ended
September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
-------------------------------- -------------------------------
UNDER UNDER UNDER UNDER
DEFERMENT FORBEARANCE DEFERMENT FORBEARANCE
------------- --------------- ------------- --------------
Principal balance beginning of period.. $ 160,572 $ 55,776 $ 110,487 $ 87,199
Plus loans entering arrangements:
First time arrangements............. 30,502 435 56,762 14,678
Repeat arrangements................. 6,069 -- 1,657 1,277
Plus/Less loans that changed status:
Loans returned to current status..... 23,728 12,010 6,950 5,286
Loans returned to delinquent
status(a)........................... (57,826) (23,662) (22,593) (22,682)
Less loans exiting the program:
Loans charged off.................... -- -- (6) (18)
Loans paid off....................... (11,734) (3,022) (9,156) (4,521)
Loans servicing released............. (28) --
Loan principal payments received..... (232) (31) (99) (111)
Loans that completed program......... (5,737) (2,223) (2,455) (641)
---------- ----------- ------------ -----------
Principal balance end of period.......... $ 145,314 $ 39,283 $ 141,547 $ 80,467
========== =========== ============ ===========
- ------------------------
(a) During the three months ended September 30, 2004, $1.2 million and $2.3
million of loans previously under forbearance and deferment arrangements,
respectively, which had returned to delinquent status, were foreclosed.
From June 30, 2002 through the quarter ended September 30, 2004, we
entered into deferment and forbearance arrangements with borrowers with loan
principal outstanding totaling $1.9 billion at the time of those arrangements.
Of the total loans under deferment or forbearance arrangements, $425.2 million,
or 23%, returned to delinquent status during fiscal years ended June 30, 2004
and 2003 and the three months ended September 30, 2004. Once these loans ceased
145
to be current they were reported in our loan portfolio delinquency statistics.
Since loans under deferment and forbearance arrangements are held within the
securitization trusts loans, their return to delinquency status would be
reflected in all trust delinquency and loss statistics and would be considered
in delinquency and loss triggers for the respective securitization trusts. Any
credit losses realized on loans under these arrangements are included in total
portfolio historical losses, which are used in developing credit loss
assumptions.
DELINQUENT LOANS AND LEASES. Total delinquencies (loans with payments
past due greater than 30 days, excluding REO) in the total portfolio were $262.6
million at September 30, 2004 compared to $238.1 million and $261.9 million at
June 30, 2004 and March 31, 2004, respectively. Total delinquencies as a
percentage of the total portfolio were 12.97% at September 30, 2004 compared to
10.67% and 11.15% at June 30, 2004 and March 31, 2004, respectively. The
increase in delinquencies and delinquency percentage in fiscal 2005 were mainly
due to the impact on our borrowers of weak and uncertain economic conditions,
which may include the reduction in other sources of credit to our borrowers, and
the seasoning of the total portfolio. As the total portfolio seasons, or ages,
more borrowers can be expected to incur credit problems. These factors have
resulted in a significant usage of deferment and forbearance arrangements. In
addition, the delinquency percentage has increased due to high loan prepayment
experience resulting from borrowers' 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 managed by us also contributed to the increase in the delinquency
percentage at September 30, 2004 from June 30, 2004. As the total portfolio
continues to season, and if our economy does not continue to improve, the
delinquency rate may increase.
REAL ESTATE OWNED. Total REO, comprising foreclosed properties and
deeds acquired in lieu of foreclosure, increased to $37.2 million, or 1.84% of
the total portfolio at September 30, 2004 compared to $34.4 million, or 1.54% at
June 30, 2004 and $26.2 million, or 1.11% at March 31, 2004. The increase in REO
resulted from actions taken during the fourth quarter of fiscal 2004 to slow
down the sales and liquidations of REO properties in the total portfolio and to
implement a program to identify REO properties whose values may be maximized
through rehabilitation. We intend to put greater effort into rehabilitating
those REO properties and renting the properties to create sales value. It is too
early in this program to predict how successful the program may be. As the total
portfolio continues to season and if our economy does not continue to improve,
the REO balance may increase.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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, Treasury yields and one-month LIBOR yields. Changes in these
interest rates impact the interest rate spread between the effective rate of
interest received on loans available for sale or securitized loans (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 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.
146
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
long-term and short-term liquidity.
INTEREST RATE SENSITIVITY. The following table provides information
about financial instruments that are sensitive to changes in interest rates. For
interest-only strips and servicing rights, the table presents projected
principal cash flows utilizing assumptions including prepayment and credit loss
rates. See "-- Securitizations" for more information on these assumptions. For
debt obligations, the table presents principal cash flows and related average
interest rates by expected maturity dates (dollars in thousands):
AMOUNT MATURING AFTER SEPTEMBER 30, 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).... $ 332,709 $ 49 $ 53 $ 57 $ 62 $ 3,581 $336,511 $345,953
Interest-only strips............ 103,908 90,057 64,282 54,660 49,543 344,973 707,423 448,812
Servicing rights................ 17,183 13,767 12,365 11,274 10,270 66,351 131,210 66,712
RATE SENSITIVE LIABILITIES:
Fixed interest rate borrowings.. $ 374,226 $155,704 $32,241 $ 7,507 $ 7,492 $ 11,839 $589,009 $587,898
Average interest rate........... 10.29% 9.87% 10.17% 9.63% 11.76% 11.93% 10.22%
Variable interest rate
borrowings.................... $ 279,943 $ -- $ -- $ -- $ -- $ -- $279,943 $279,943
Average interest rate........... 4.21% -- -- -- -- -- 4.21%
- -------------------------
(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.
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
147
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 0.2%. 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 September 30, 2004, $195.5 million of debt issued by loan
securitization trusts was floating interest rate certificates based on one-month
LIBOR, representing 13.2% of total debt issued by loan securitization trusts. In
accordance with accounting principles generally accepted in the United States of
America, the changes in fair value are generally recognized as part of net
adjustments to other comprehensive income, which is a component of stockholders'
equity. As of September 30, 2004, the interest rate sensitivity for $170.6
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 $107.6 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 June 30, 2004, approximately 50-55% of business loans and
50-55% 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 "-- Securitizations"
for further information regarding these assumptions and the impact of
prepayments during this period.
148
SUBORDINATED DEBENTURES AND SENIOR COLLATERALIZED SUBORDINATED NOTES.
We also experience interest rate risk to the extent that as of September 30,
2004 approximately $213.4 million of our liabilities were comprised of fixed
interest rate subordinated debentures and senior collateralized subordinated
notes outstanding 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.
In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
Financial Instruments and Hedging Activities," referred to as SFAS No. 133 in
this document. SFAS No. 133 establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives), and for hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure those
instruments at fair value. If certain criteria are met, a derivative may be
specifically designated as (a) a hedge of the exposure to changes in the fair
value of a recognized asset or liability or an unrecognized firm commitment
(fair value hedge), (b) a hedge of the exposure to variable cash flows of a
forecasted transaction (cash flow hedge), or (c) a hedge of the foreign currency
exposure of a net investment in a foreign operation. If a derivative is a hedge,
depending on the nature of the hedge designation, changes in the fair value of a
derivative are either offset against the change in the fair value of assets,
liabilities, or firm commitments through earnings or recognized in other
comprehensive income until the hedged item is recognized in earnings. The
ineffective portion of a derivative's change in fair value will be recognized in
earnings immediately. If a derivative is trading, changes in its fair value are
recognized in earnings.
The value of a derivative financial instrument is based on 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.
HEDGE ACCOUNTING
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 terms and pricing
for a whole loan sale are fixed or the date the fixed interest rate pass-through
certificates to be issued by a securitization trust are priced. Generally, the
period between loan origination and pricing for whole loan sales is less than 45
days and the period between loan origination and pricing of the pass-through
interest rate is less than three months. The types of derivative financial
instruments we use to mitigate the effects of changes in fair value of our loans
due to interest rate changes may include interest rate swaps, futures and
149
forward contracts, including forward sale agreements. 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.
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. Derivative contracts may be specifically designated
as hedges of mortgage loans, which we would expect to include in a whole loan
sale transaction at a future date. We may hedge the effect of changes in market
interest rates with forward sale agreements, Eurodollar futures, forward
starting interest rate swaps, forward treasury sales or derivative contracts of
similar underlying securities. We also enter into forward sale agreements to
manage this risk.
SUMMARY OF HEDGE ACCOUNTING. We recorded the following gains and losses
on the fair value of derivative financial instruments accounted for as hedging
transactions for the three months ended September 30, 2004. There were no
derivative financial instruments accounted for as hedging transactions for the
three months ended September 30, 2003. Ineffectiveness related to qualified
hedging relationships 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 SEPTEMBER 30, 2004
Recorded in gains and losses on derivative financial
instruments:
Gains (losses) on derivative financial instruments....... $ (652)
Gains (losses) on hedged loans........................... $ 632
Amount settled in cash - received (paid)................. $ (773)
At September 30, 2004 and June 30, 2004, the notional amounts of
forward sale agreements and Eurodollar futures contracts accounted for as hedges
and related unrealized gains and losses recorded as assets or liabilities on the
balance sheet were as follows (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
-------------------------- ------------------------
NOTIONAL UNREALIZED NOTIONAL UNREALIZED
AMOUNT (LOSS) AMOUNT (LOSS)
----------- ------------ ----------- -----------
Forward sale agreement.................. $ 360,358 $ -- $ 275,000 $ --
Eurodollar futures contracts............ $ -- $ -- $ 27,962 $ (103)
TRADE ACCOUNTING
Generally, we do not enter into derivative financial instrument
contracts for trading purposes. However, we have entered into derivative
financial instrument contracts, which were not designated or qualified as
accounting hedges in accordance with SFAS No. 133. In these cases the derivative
contracts are recorded as an asset or liability on the balance sheet at fair
value and gains and losses are included in the income statement.
RELATED TO LOANS EXPECTED TO BE SOLD THROUGH WHOLE LOAN SALE
TRANSACTIONS. During fiscal 2005 and 2004, we used Eurodollar futures contracts
or interest rate swap contracts to manage interest rate risk on loans in our
pipeline or loans expected to be sold in whole loan sale transactions.
150
Forward starting interest rate swap contracts with a notional amount of
$170.0 million were carried over from a fiscal 2003 disqualified hedging
relationship. These forward starting interest rate swap contracts were used to
manage the effect of changes in market interest rates on the fair value of
fixed-rate mortgage loans that were sold in the three months ended September 30,
2003 and the contracts were closed in that quarter. We had elected not to
designate these derivative contracts as an accounting hedge.
We recorded the following gains and losses on the fair value of
derivative financial instruments classified as trading for the three months
ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-----------------------------
2004 2003
------------ -----------
Trading Gains/(Losses) on Eurodollar futures contracts:
Related to loan pipeline................................................ $ (1,969) $ --
Amount settled in cash - (paid)......................................... $ (2,838) $ --
Trading Gains/(Losses) on forward starting interest rate swaps:
Related to whole loan sales............................................. $ -- $ 5,097
Amount settled in cash - (paid)......................................... $ -- $ (1,212)
At September 30, 2004 and June 30, 2004, outstanding Eurodollar futures
contracts used to manage interest rate risk on loans in our pipeline or expected
to be sold in whole loan sale transactions and associated unrealized gains and
unrealized losses recorded as assets and liabilities on the balance sheet were
as follows (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
-------------------------- ----------------------------
NOTIONAL UNREALIZED NOTIONAL UNREALIZED
AMOUNT GAIN AMOUNT (LOSS)
---------- ----------- ------------- ----------
Eurodollar futures contracts............ $10,000 $ 2 $202,038 $ (851)
The sensitivity of the Eurodollar futures contracts held as trading as
of September 30, 2004 to a 0.1% change in market interest rates is $2 thousand.
RELATED TO INTEREST-ONLY STRIPS. We had an interest rate swap contract,
which was 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. This contract matured in April 2004. Unrealized gains and
losses on the interest rate swap contract were due to changes in the interest
rate swap yield curve during the periods the contract was in place. Net gains
and losses on this interest rate swap contract included 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 months ended September 30, 2003
were as follows (in thousands):
Unrealized gain (loss) on interest rate swap
contract......................................... $ 177
Cash interest paid on interest rate swap contract.... (166)
-------
Net gain (loss) on interest rate swap contract....... $ 11
=======
151
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 whole loan sales or 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.
RELATED PARTY TRANSACTIONS
We have a non-recourse 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 (272,264 shares
after the effect of stock dividends) 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 non-recourse loan is secured by 247,513 shares (272,264
shares after the effect of stock dividends) of our common stock, and is shown as
a reduction of stockholders' equity in our financial statements. Mr. Santilli is
current in all payments required by the loan agreement. Our only recourse in the
event of non-payment is to the shares securing the loan.
In February 2003, we awarded 2,000 shares (2,200 shares after the
effect of a subsequent stock dividend) 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 an
Executive Vice President, 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
of Directors on February 20, 2004. Mr. Steinberg received the consulting fees
for assisting us during these two fiscal quarters with the implementation of the
adjusted business strategy, including the expansion of our broker network into
California, Texas and Maryland. Mr. Steinberg was instrumental in negotiating
agreements to purchase broker assets in these states and in quickly organizing
these assets into loan production facilities. Mr. Steinberg's compensation was
determined by reference to the fees charged by finders and brokers, including
investment bankers, for efforts to find and purchase loan production assets.
Barry Epstein, Managing Director of the National Wholesale Residential
Mortgage Division, received 200,000 shares (220,000 shares after giving effect
to subsequent stock dividends) of common stock on December 24, 2003 under the
terms of his employment agreement, subject to the transfer restrictions and
forfeiture provisions provided for in a restricted stock agreement until
achievement of certain performance goals stipulated in both agreements. The
shares were issued by us as a material inducement for Mr. Epstein's employment.
The performance goals have been met, and the transfer and forfeiture provisions
have been terminated, with respect to 100,000 shares (110,000 shares after
giving effect to a subsequent stock dividend).
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.
152
In fiscal 2003, Lanard & Axilbund, Inc. ("L&A"), a real estate
brokerage and management firm in which our Director, Mr. Sussman, was a
shareholder until December 31, 2002 and is now Chairman Emeritus, acted as our
agent in connection with the lease of our current corporate office space. As a
result of this transaction, L&A received a commission of $978,439 from the
landlord of the leased office space during fiscal 2003 and is currently entitled
to receive an additional commission of the same amount. We believe this
commission in the aggregate to be consistent with market and industry standards.
Pursuant to an exit agreement between L&A and Mr. Sussman, Mr. Sussman received
a distribution from L&A during fiscal 2003 on account of the first commission
payment consistent with his percentage stock ownership of L&A in the amount of
$59,212 and is entitled to receive the same amount upon L&A's receipt of the
second commission payment. As part of our agreement with L&A, L&A reimbursed us
in the amount of $229,214 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. Mr. Santilli and Mrs. Santilli subsequently transferred ownership of
the Series A preferred stock acquired on February 6, 2004.
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):
153
SEPTEMBER 30, 2004: DELINQUENCIES
------------------------------------------------------------------------------------------------
AMOUNT %
------------ ----------
On-balance sheet loan receivables:
Loans available for sale...................... $ 329,331 $ 862
Non-accrual loans............................. 4,552 4,387
------------- ------------
Total on-balance sheet loan receivables... 333,883 5,249 1.57%
Securitized loan receivables..................... 1,691,148 257,351 15.22%
------------- ------------
Total Portfolio............................... $ 2,025,031 $ 262,600 12.97%
============= ============
On-balance sheet REO............................. $ 1,510
Securitized REO.................................. 35,714
-------------
Total REO........................................ $ 37,224
=============
JUNE 30, 2004: DELINQUENCIES
------------------------------------------------------------------------------------------------
AMOUNT %
------------ ------------
On-balance sheet loan receivables:
Loans available for sale...................... $ 300,141 $ 245
Non-accrual loans............................. 3,462 3,354
------------- ------------
Total on-balance sheet loan receivables... 303,603 3,599 1.19%
Securitized loan and lease receivables........ 1,928,086 234,534 12.16%
------------- ------------
Total Portfolio............................... $ 2,231,689 $ 238,133 10.67%
============= ============
On-balance sheet REO.......................... $ 1,920
Securitized REO............................... 32,480
-------------
Total REO..................................... $ 34,400
=============
MARCH 31, 2004: DELINQUENCIES
----------------------------------------------------------------------------------------------
AMOUNT %
-----------------------------
On-balance sheet loan receivables:
Loans available for sale.................... $ 114,855 $ 231
Non-accrual loans........................... 5,706 5,334
------------- -------------
Total on-balance sheet loan receivables. 120,561 5,565 4.62%
Securitized loan and lease receivables......... 11.50%
2,228,856 256,361
------------- -------------
Total Portfolio................................ $ 2,349,417 $ 261,926 11.15%
============= =============
On-balance sheet REO........................... $ 2,508
Securitized REO................................ 23,681
-------------
Total REO...................................... $ 26,189
=============
OFFICE FACILITIES
We presently lease office space for our corporate headquarters in
Philadelphia, Pennsylvania. 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 provided 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.
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 performed loan servicing and collection activities at this office,
but relocated these activities to our Philadelphia office on July 12, 2004. The
expenses and cash outlay related to the relocation were not material to our
operations.
154
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.
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 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.
In connection with the acquisition of the Texas broker operation, we
entered into a sublease on June 11, 2004 for approximately 6,000 square feet of
space in Austin, Texas. The term of the sublease is 10 1/2 months, expiring
April 28, 2005 at an annual rental of approximately $0.1 million.
RECENT ACCOUNTING PRONOUNCEMENTS
No new accounting pronouncements affecting us have been issued since
the filing of our June 30, 2004 Form 10-K.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Quantitative and Qualitative Disclosures About
Market Risk."
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.
155
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
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 were
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.
On May 20, 2004, the purported consumer class action lawsuit captioned
Moore v. American Business Financial Services, Inc. et al, No. 003237 was filed
against us, our lending subsidiaries and an unrelated party in the Philadelphia
Court of Common Pleas. The lawsuit was brought on behalf of residential mortgage
consumers and challenges the validity of our deed in lieu of foreclosure and
force-placed insurance practices as well as certain mortgage service fees
charged by us. This lawsuit relates, in part, to the same subject matter as the
U.S. Attorney's inquiry concluded in December 2003 with no findings of
wrongdoing as discussed below. The lawsuit seeks actual and treble damages,
statutory damages, punitive damages, costs and expenses of the litigation and
injunctive relief. Procedurally, this lawsuit is in a very preliminary stage. We
believe the complaint contains fundamental factual inaccuracies and that we have
numerous defenses to these allegations. We intend to vigorously defend this
lawsuit. Due to the inherent uncertainties in litigation and because the
ultimate resolution of this proceeding is influenced by factors outside of 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.
156
In addition, our lending subsidiaries, including HomeAmerican Credit,
Inc., which does business as Upland Mortgage, and American Business Mortgage
Services, Inc., 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. For example,
in July 2004, we received a document request in the form of an administrative
subpoena from the New Jersey Attorney General's Office, acting as counsel for
the Office of Consumer Protection, in connection with American Business Mortgage
Services, Inc. It seeks the loan files of two borrowers and includes a broader
request for a list of loans solicited or closed by a former loan officer from
January 1, 1999 to the present. The loan officer's employment was terminated in
2001. While it would appear that the request does not raise material issues,
since this matter is in the preliminary stages, communications from the Attorney
General's Office have not been sufficient to confirm the extent of their
interest. 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 is
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. On May 26,
2004, the New Jersey Supreme Court reversed the decision of the Appellate
Division of the Superior Court of New Jersey and held that the Parity Act had
preempted the New Jersey Prepayment Law, which prohibited housing lenders from
imposing prepayment penalties. However, the plaintiff has petitioned the United
States Supreme Court for certiorari in this matter.
We expect that, as a result of the publicity surrounding predatory
lending practices, we may be subject to other class action suits in the future.
In addition, from time to time, we are involved as plaintiff or defendant in
various other legal proceedings arising in the normal course of our business.
While we cannot predict the ultimate outcome of these various legal proceedings,
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. 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 this inquiry. We do not believe that
the Joint Agreement with the U.S. Attorney's Office has had a significant impact
on our operations.
157
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 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 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 thousand, and made this
contribution as required, to a U.S. Department of Housing and Urban Development
(HUD) approved housing counseling organization providing housing counseling in
states in which we originate home mortgage loans. 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 and 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
reinstitute 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. KPMG LLP, which we engaged to
perform an independent compliance audit required at the end of the 9-month
period, determined that we had complied with our policy requirements entered
into as a result of the Joint Agreement with the U.S. Attorney's Office.
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 are 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.
In January and February of 2004, four class action lawsuits were filed
against us and certain of our officers and directors. Lead plaintiffs and
counsel were appointed on June 3, 2004. A consolidated amended class action
complaint that supersedes these four complaints was filed on August 19, 2004 in
the United States District Court for the Eastern District of Pennsylvania. The
consolidated class action case is American Business Financial Services, Inc.
Securities Litigation, Civil Action No. 04-0265.
The consolidated amended class action complaint brings claims on behalf
of a class of all purchasers of our common stock for a proposed class period of
January 27, 2000 through June 26, 2003. The consolidated complaint names us, our
director and Chief Executive Officer, Anthony J. Santilli, our Chief Financial
Officer, Albert Mandia, and former director, Richard Kaufman, as defendants and
alleges that, among other things, we and the named directors and officers
violated Sections 10(b) and 20(a) of the Exchange Act. The consolidated
complaint alleges that, during the applicable class period, our forbearance and
deferment practices enabled us to, among other things, lower our delinquency
rates to facilitate the securitization of our loans which purportedly allowed us
158
to collect interest income from our securitized loans and inflate our financial
results and market price of our common stock. The consolidated amended class
action complaint seeks unspecified compensatory damages, costs and expenses
related to bringing the action, and other unspecified relief. We filed a motion
to dismiss this class action on October 21, 2004.
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony J. 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, Kaufman,
Mandia, Becker, DeLuca and Sussman, 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 consolidated amended complaint filed in
the putative consolidated securities class action.
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 is
influenced by factors outside of 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. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Securities Issued in Non-Public Offerings. As of August 23, 2004, in
connection with the exchange offers, we issued $99.2 million in the aggregate
principal amount of senior collateralized subordinated notes and 109.4 million
shares of Series A preferred stock in exchange for $208.6 million in the
aggregate principal amount of subordinated debentures. We issued the foregoing
senior collateralized subordinated notes and shares of the Series A preferred
stock in reliance on the exemption from the registration under Section 3(a)(9)
of the Securities Act. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" for a
description of the terms of the conversion of the Series A preferred stock into
our common stock.
Dilutive and Other Effects of Issuance of Series A Convertible
Preferred Stock. As of August 23, 2004, in connection with the exchange offers,
we issued 109.4 million shares of Series A preferred stock in exchange for
investment notes. 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 109.4 million shares of the Series A Preferred Stock issued in connection
with the exchange offers can be converted is 28.5 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 28.5 million shares of common stock upon conversion of
the Series A Preferred Stock outstanding as of August 23, 2004 and the potential
issuance of shares of common stock if we issue additional shares of Series A
Convertible Preferred Stock could result in the dilution of the equity interests
of current holders of our common stock. The rights and preferences of holders of
the Series A Convertible Preferred Stock are senior to the rights and
preferences of the holders of our common stock. If our Board of Directors issues
another series of preferred stock, the rights and preferences of such series may
be senior to the rights and preferences of the shares of the Series A
Convertible Preferred Stock and would be also senior to the rights and
preferences of the common stock.
159
We believe that the exchange offers met all of the requirements of the
exemption provided by Section 3(a)(9) of the Securities Act because (i) we were
the issuer of both (a) the senior collateralized subordinated notes and the
Series A preferred stock issued in the exchange offers and (b) the subordinated
debentures exchanged; (ii) the exchange offers involved 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 subordinated debentures to
participate in the exchange offers.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES - NONE
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - NONE
ITEM 5. OTHER INFORMATION
(a) None.
(b) On September 29, 2004, the Company adopted procedures, as described
below, by which its stockholders may recommend nominees to the Company's board
of directors as required by Item 7(d)(2)(ii)(G) of Schedule 14A under the
Exchange Act. The Nominating Committee of the Company's Board of Directors will
consider properly submitted stockholder recommendations for director candidates.
A stockholder who wishes to recommend a prospective director nominee should send
a signed and dated letter to the Nominating Committee, c/o Stephen M. Giroux,
Corporate Secretary, American Business Financial Services, Inc., 100 Penn Square
East, Philadelphia, PA 19107. The letter must include the following information:
o name and address of the stockholder making the recommendation;
o proof that the stockholder was the stockholder of record, and/or
beneficial owner, of the Company's common stock as of the date of
the letter;
o the name, address and resume of the recommended nominee; and
o the written consent of the recommended nominee to serve as a
director of the Company if so nominated and elected.
160
ITEM 6. EXHIBITS
EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
-------- ---------------------------------------------------------------------------------------------
10.1 Amendment No. 2, dated as of June 24, 2004, to Sale and Servicing Agreement, among ABFS
Balapointe, Inc., as depositor, HomeAmerican Credit, Inc., d/b/a Upland Mortgage ("Upland"),
American Business Mortgage Services, Inc. ("ABMS" together with Upland, the "Originators"),
and American Business Credit, Inc., as servicer, ABFS Mortgage Loan Warehouse Trust 2003-1, as
trust, American Business Financial Services, Inc., as sponsor, JPMorgan Chase Bank, as
indenture trustee, JPMorgan Chase Bank, as collateral agent, and JPMorgan Chase Bank, as note
purchaser.
10.2 Amendment No. 3, dated as of June 30, 2004, to Sale and Servicing Agreement, among ABFS
Balapointe, Inc., as depositor, HomeAmerican Credit, Inc., d/b/a Upland Mortgage ("Upland"),
American Business Mortgage Services, Inc. ("ABMS" together with Upland, the "Originators"),
and American Business Credit, Inc., as servicer, ABFS Mortgage Loan Warehouse Trust 2003-1, as
trust, American Business Financial Services, Inc., as sponsor, JPMorgan Chase Bank, as
indenture trustee, JPMorgan Chase Bank, as collateral agent, and JPMorgan Chase Bank, as note
purchaser.
10.3 Seventh Waiver Letter, dated as of October 31, 2004, from JPMorgan Chase Bank regarding (i)
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.
10.4 Amendment No. 6, dated as of November 5, 2004, to Sale and Servicing Agreement, among ABFS
Balapointe, Inc., as depositor, HomeAmerican Credit, Inc., d/b/a Upland Mortgage ("Upland"),
American Business Mortgage Services, Inc. ("ABMS" together with Upland, the "Originators"),
and American Business Credit, Inc., as servicer, ABFS Mortgage Loan Warehouse Trust 2003-1, as
trust, American Business Financial Services, Inc., as sponsor, JPMorgan Chase Bank, as
indenture trustee, JPMorgan Chase Bank, as collateral agent, and JPMorgan Chase Bank, as note
purchaser.
10.5 Master Loan and Security Agreement, dated as of November 4, 2004, by and between Penn Square
East Funding, LLC, as Borrower, and Fortress Credit Corp., as Lender.
161
EXHIBIT
NUMBER DESCRIPTION
-------- ---------------------------------------------------------------------------------------------
10.6 Asset Purchase Agreement, dated as of November 4, 2004, between HomeAmerican Credit, Inc. and
American Business Mortgage Services, Inc., jointly and severally, as Sellers, and Penn Square
East Funding, LLC, as Purchaser.
10.7 Servicing Agreement, dated as of November 4, 2004, between Penn Square East Funding, LLC, as
Owner, Fortress Credit Corp., as Lender, American Business Mortgage Services, Inc. and
HomeAmerican Credit, Inc., jointly and severally, as Servicer, and Countrywide Home Loans
Servicing LP, as Backup Servicer.
10.8 Pledge and Security Agreement, dated as of November 4, 2004, made and given by HomeAmerican
Credit, Inc. and American Business Mortgage Services, Inc., each a Grantor and, collectively,
Grantors, in favor of Fortress Credit Corp., as Secured Party.
10.9 Commitment Letter, dated as of October 26, 2004, from The Patriot Group, LLC to American
Business Financial Services, Inc.
10.10 Letter, dated November 8, 2004, amending Commitment Letter, dated October 26, 2004, from
The Patriot Group, LLC to American Business Financial Services, Inc.
10.11 Consents and Amendment to Fee Letter, dated October 26, 2004, from Clearwing Capital, LLC
to ABFS Consolidated Holdings, Inc.
10.12 Commitment Letter, dated as of November 1, 2004, from The CIT Group/Business Credit, Inc. and
Clearwing Capital, LLC to American Business Financial Services, Inc.
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.
162
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: November 12, 2004 By: /s/ Albert W. Mandia
-------------------------------
Albert W. Mandia
Executive Vice President and
Chief Financial Officer
(principal financial officer)
163
EXHIBIT
NUMBER DESCRIPTION
-------- ---------------------------------------------------------------------------------------------
10.1 Amendment No. 2, dated as of June 24, 2004, to Sale and Servicing Agreement, among ABFS
Balapointe, Inc., as depositor, HomeAmerican Credit, Inc., d/b/a Upland Mortgage ("Upland"),
American Business Mortgage Services, Inc. ("ABMS" together with Upland, the "Originators"),
and American Business Credit, Inc., as servicer, ABFS Mortgage Loan Warehouse Trust 2003-1, as
trust, American Business Financial Services, Inc., as sponsor, JPMorgan Chase Bank, as
indenture trustee, JPMorgan Chase Bank, as collateral agent, and JPMorgan Chase Bank, as note
purchaser.
10.2 Amendment No. 3, dated as of June 30, 2004, to Sale and Servicing Agreement, among ABFS
Balapointe, Inc., as depositor, HomeAmerican Credit, Inc., d/b/a Upland Mortgage ("Upland"),
American Business Mortgage Services, Inc. ("ABMS" together with Upland, the "Originators"),
and American Business Credit, Inc., as servicer, ABFS Mortgage Loan Warehouse Trust 2003-1, as
trust, American Business Financial Services, Inc., as sponsor, JPMorgan Chase Bank, as
indenture trustee, JPMorgan Chase Bank, as collateral agent, and JPMorgan Chase Bank, as note
purchaser.
10.3 Seventh Waiver Letter, dated as of October 31, 2004, from JPMorgan Chase Bank regarding (i)
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.
10.4 Amendment No. 6, dated as of November 5, 2004, to Sale and Servicing Agreement, among ABFS
Balapointe, Inc., as depositor, HomeAmerican Credit, Inc., d/b/a Upland Mortgage ("Upland"),
American Business Mortgage Services, Inc. ("ABMS" together with Upland, the "Originators"),
and American Business Credit, Inc., as servicer, ABFS Mortgage Loan Warehouse Trust 2003-1, as
trust, American Business Financial Services, Inc., as sponsor, JPMorgan Chase Bank, as
indenture trustee, JPMorgan Chase Bank, as collateral agent, and JPMorgan Chase Bank, as note
purchaser.
10.5 Master Loan and Security Agreement, dated as of November 4, 2004, by and between Penn Square
East Funding, LLC, as Borrower, and Fortress Credit Corp., as Lender.
10.6 Asset Purchase Agreement, dated as of November 4, 2004, between HomeAmerican Credit, Inc. and
American Business Mortgage Services, Inc., jointly and severally, as Sellers, and Penn Square
East Funding, LLC, as Purchaser.
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EXHIBIT
NUMBER DESCRIPTION
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10.7 Servicing Agreement, dated as of November 4, 2004, between Penn Square East Funding, LLC, as
Owner, Fortress Credit Corp., as Lender, American Business Mortgage Services, Inc. and
HomeAmerican Credit, Inc., jointly and severally, as Servicer, and Countrywide Home Loans
Servicing LP, as Backup Servicer.
10.8 Pledge and Security Agreement, dated as of November 4, 2004, made and given by HomeAmerican
Credit, Inc. and American Business Mortgage Services, Inc., each a Grantor and, collectively,
Grantors, in favor of Fortress Credit Corp., as Secured Party.
10.9 Commitment Letter, dated as of October 26, 2004, from The Patriot Group, LLC to American
Business Financial Services, Inc.
10.10 Letter, dated November 8, 2004, amending Commitment Letter,
dated October 26, 2004, from The Patriot Group, LLC to
American Business Financial Services, Inc.
10.11 Consents and Amendment to Fee Letter, dated October 26,
2004, from Clearwing Capital, LLC to ABFS Consolidated
Holdings, Inc.
10.12 Commitment Letter, dated as of November 1, 2004, from The CIT Group/Business Credit, Inc. and
Clearwing Capital, LLC to American Business Financial Services, Inc.
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.
165