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SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission File Number 033-19694

FirstCity Financial Corporation

(254) 751-1750
(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. Yes x No o

     The number of shares of common stock, par value $.01 per share, outstanding at August 14, 2002 was 8,376,500.

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PART I

FINANCIAL INFORMATION

ITEM 1. Financial Statements

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
(Unaudited)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
(Unaudited)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
(Dollars in thousands, except per share data)

(1) Basis of Presentation and Earnings (Loss) per Common Share

     The unaudited consolidated financial statements of FirstCity Financial Corporation (“FirstCity” or the “Company”) reflect, in the opinion of management, all adjustments, consisting only of normal and recurring adjustments, necessary to present fairly FirstCity’s consolidated financial position at June 30, 2002, the results of operations for the three-month and six-month periods ended June 30, 2002 and 2001, and the cash flows for the six-month periods ended June 30, 2002 and 2001.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include the estimation of future collections on purchased portfolio assets used in the calculation of net gain on resolution of portfolio assets, interest rate environments, valuation of the deferred tax asset, and prepayment speeds and collectibility of loans held in inventory, in securitization trusts and held for investment. Actual results could differ materially from those estimates.

     The effects of any common stock equivalents are antidilutive for the three months and six months ended June 30, 2002 and 2001; therefore, diluted earnings (loss) per common share is reported the same as basic earnings (loss) per common share.

(2) Liquidity and Capital Resources

Proposed Recapitalization

     In conjunction with a proposed recapitalization of FirstCity, the Company filed a registration statement in June 2002 with the Securities and Exchange Commission for a proposed exchange offer of its outstanding shares of New Preferred Stock, par value $0.01 per share (“New Preferred Stock”).

     Upon the commencement of the exchange offer, FirstCity will offer to exchange each share of its New Preferred Stock for, at the holder’s election, either:

	(1)		$10.00 cash and 2 shares of FirstCity’s common stock, or
	(2)		$ 8.00 cash and 3 shares of FirstCity’s common stock.

     FirstCity anticipates commencing the exchange offer promptly after its registration statement is declared effective by the Securities and Exchange Commission.

     The exchange offer is a part of a comprehensive recapitalization of FirstCity. Upon its successful completion, the recapitalization will consist of the following:

•		the sale of a 20% interest in Drive Financial Services LP (“Drive”), to BoS(USA), Inc. (“BoS(USA)”), a wholly-owned subsidiary of Bank of Scotland, for $16 million. This sale will provide the cash portion of the consideration of the exchange offer and will leave FirstCity with an 11% interest in Drive after the sale,
•		the exchange offer,
•		the use of the remainder of the cash proceeds from the sale of the 20% interest in Drive to reduce FirstCity’s debt owed to Bank of Scotland,

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•		FirstCity’s purchase of the 20% interest in FirstCity’s indirect subsidiary, FirstCity Holdings Corporation, held by Terry R. DeWitt, G. Stephen Fillip and James C. Holmes (the “FCHC Group”),
•		the refinancing of the remainder of FirstCity’s debt facilities with Bank of Scotland and BoS(USA), with a total commitment by Bank of Scotland and BoS(USA) of up to $47 million, consisting of (a) a cash flow note of up to $35 million and (b) a $12 million subordinated note,
•		Bank of Scotland’s providing new financing to FirstCity, with a total commitment by Bank of Scotland of up to $60 million. The new financing will consist of (a) a $5 million revolving credit loan and (b) an acquisition term loan in an amount up to $55 million. The total commitment by Bank of Scotland and BoS(USA) for the refinancing combined with the new financing will not exceed $77 million,
•		the release of FirstCity from its guaranty of $4 million of Drive’s indebtedness to BoS(USA), and
•		the cancellation of BoS(USA)’s existing option to acquire a warrant to purchase 1,975,000 shares of FirstCity’s non-voting common stock.

     The successful completion of the exchange offer is a condition to all of the items listed above.

     The exchange offer is subject to several conditions. The most significant conditions include:

	(1)		the closing of the sale of a 20% interest in Drive to BoS(USA) (which currently owns a 49% interest in Drive) for $16 million by FirstCity, which will provide the cash proceeds of the exchange offer, and the other transactions contemplated by the recapitalization,
	(2)		the tender of at least 80% of the outstanding shares of New Preferred Stock,
	(3)		the effectiveness of the registration statement relating to the shares of common stock of FirstCity to be issued in connection with the exchange offer, and
	(4)		the lack of any change or development involving a prospective change in or affecting FirstCity’s business or financial affairs that, in the reasonable judgment of FirstCity’s board of directors, would or might prohibit, restrict or delay consummation of the exchange offer or materially impair the contemplated benefits to FirstCity of the exchange offer.

     Because there are multiple conditions to the closing of the transactions contemplated by the recapitalization that are beyond the control of FirstCity, FirstCity cannot provide any assurances that these conditions will be satisfied and that the exchange offer and the recapitalization will close.

     A registration statement relating to the shares of common stock of FirstCity to be issued in connection with the exchange offer has been filed with the Securities and Exchange Commission but has not yet become effective. Once the registration statement is declared effective the exchange offer will commence and appropriate documents will be mailed to holders of the New Preferred Stock.

Other Issues

     Generally, the Company requires liquidity to fund its operations, working capital, payment of debt, equity for acquisition of pools of assets or single assets (collectively referred to as “Portfolio Assets” or “Portfolios”), investments in and advances to entities formed with Cargill Financial Services Corporation (“Cargill”) or one or more other co-investors to acquire Portfolios (each such entity an “Acquisition Partnership”), retirement of and dividends on preferred stock, and other investments by the Company. The potential sources of liquidity are funds generated from operations, equity distributions from the Acquisition Partnerships, interest and principal payments on subordinated intercompany debt and dividends from the Company’s subsidiaries, short-term borrowings from revolving lines of credit, proceeds from equity market transactions, securitizations and other structured finance transactions and other special purpose short-term borrowings.

     BoS(USA) has an option to acquire a warrant for 1,975,000 shares of the Company’s non-voting Common Stock; the option can be exercised after October 31, 2002 if the Company’s $12 million Term Loan B owed to BoS(USA) and Bank of Scotland remains outstanding, but not prior to that date. The strike price is $2.3125 per share. In the event that prior to October 31, 2002 the Company

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either (a) refinances the $12 million Term Loan B with subordinated debt, or (b) pays off the balance of Term Loan B from proceeds of an equity offering, then the option to acquire a warrant for 1,975,000 shares of non-voting Common Stock will terminate. BoS(USA) and the Company have entered into several amendments to this option to acquire a warrant for 1,975,000 shares extending the exercise date from its initial exercise date of August 31, 2001. The most recent amendment extended the date from June 30, 2002 to October 31, 2002 to allow the Company additional time to pursue the proposed recapitalization described above. Under the terms of the proposed recapitalization, the option would be cancelled.

     BoS(USA) also has a warrant to purchase 425,000 shares of the Company’s voting Common Stock at $2.3125 per share. In the event that Term Loan B is terminated prior to October 31, 2002 through a transaction involving the issuance of warrants, BoS(USA) is entitled to additional warrants in connection with this existing warrant for 425,000 shares to retain its ability to acquire approximately 4.86% of the Company’s voting Common Stock. BoS(USA) and the Company have also amended the warrant to extend the exercise date from its initial exercise date of August 31, 2001 to correspond to the extension of the initial exercise date of the option described in the preceding paragraph. The most recent amendment extended the date from June 30, 2002 to October 31, 2002, consistent with the amendment exercise date of the option as discussed above.

     In the third quarter of 1999, dividends on the Company’s redeemable preferred stock (“New Preferred Stock”) were suspended. At June 30, 2002, accumulated dividends in arrears on New Preferred Stock totaled $7.7 million, or $6.30 per share. Since the Company failed to pay quarterly dividends for six consecutive quarters, the holders of New Preferred Stock are entitled to elect two directors to the Company’s Board until cumulative dividends have been paid in full. Dividends on outstanding shares of New Preferred Stock of FirstCity will be restricted until Term Loan B is paid in full. Given the continued high debt levels of the Company, and management’s priority of assuring adequate levels of liquidity, the Company does not anticipate that dividends on New Preferred Stock will be paid in the foreseeable future. The Company believes that the proposed recapitalization plan described above will, if implemented, substantially reduce the number of outstanding shares of New Preferred Stock and the corresponding accrued dividends on the New Preferred Stock, along with eliminating the option of BoS(USA) to acquire a warrant to purchase 1,975,000 shares.

     The Portfolio Asset acquisition and resolution group of FirstCity has a $35 million loan facility (increased from $30 million in August 2002) with CFSC Capital Corp. XXX, a subsidiary of Cargill. This facility is being used exclusively to provide equity in new Portfolio acquisitions in partnerships with Cargill and its affiliates. At June 30, 2002, approximately $25 million was outstanding under this facility.

     On April 29, 2002, BoS(USA) provided a commitment to fund up to $5 million on a Term Loan E to the Company to allow the Company to purchase existing debt under a term credit facility at a purchase price not to exceed 85% of the unpaid principal balance. Term Loan E, secured by assets of the Company, provides for an interest rate of LIBOR plus 6% and matures on March 31, 2004. At June 30, 2002, advances of $2.8 million have been made on this loan and used to purchase existing debt with a balance of $3.5 million, resulting in a gain of $.7 million on early extinguishment of debt included in other income in the consolidated statements of operations. Bosque Asset Corp., a wholly-owned subsidiary of FirstCity (“Bosque”), issued the original notes pursuant to a Note Agreement dated June 6, 1997 in connection with its acquisition of approximately 1,500 loans. A security interest in the acquired loans was granted by Bosque to Banker’s Trust Company of California, N.A., as trustee for the noteholders. The notes issued by Bosque matured according to the original terms on June 5, 2002. FirstCity has not guaranteed payment or performance of Bosque under the notes or the Note Agreement. As of June 30, 2002, FirstCity has acquired notes issued under the Note Agreement that represent 57.94% or $3.4 million of the aggregate outstanding principal balances of the notes under the Note Agreement. The notes acquired by FirstCity were purchased at eighty percent (80%) of the outstanding principal balance of the notes. As of June 30, 2002, the aggregate balance of the outstanding notes held by persons unrelated to FirstCity was $2.5 million. The current trustee under the Note Agreement has not taken any action related to the maturity of the notes. The collections from the notes continue to be distributed to the noteholders, including FirstCity, under the terms of the matured loan facility. Collections for the month of June 2002 resulted in a principal payment of $1.0 million on July 5, 2002, of which $.6 million was paid to FirstCity and $.4 million was paid to noteholders unrelated to FirstCity. As of August 5, 2002, the aggregate outstanding principal balance of the notes under the Note Agreement was $4.9 million, of which $2.8 million was held by FirstCity and $2.1 million was held by persons unrelated to FirstCity FirstCity intends to purchase the notes held by unrelated persons or to obtain their consent to the extension of maturity date for the notes under the Note Agreement.

     The Company has a revolving line of credit facility with BoS(USA) used to fund corporate overhead expenses. On May 1, 2002, the maximum principal balance under this facility was increased from $10 million to $14 million. This facility, secured by assets of the Company, provides for an interest rate of LIBOR plus 2.50% and matures on December 31, 2003. At June 30, 2002, the outstanding balance on this facility was $10 million.

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     Management believes that the BoS(USA) loan facilities along with the liquidity from the Cargill line, the related fees generated from the servicing of assets and equity distributions from existing Acquisition Partnerships and wholly owned portfolios will allow the Company to meet its obligations as they come due during the next twelve months.

(3) New Accounting Pronouncements

     On January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) 142, Goodwill and Other Intangible Assets (“SFAS 142”) and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with the SFAS 121, Accounting for the Impairment of Long-Lived Assets to Be Disposed Of (“SFAS 121”). SFAS 144 supersedes SFAS 121. The adoption of SFAS 142 did not have a material impact on the Company’s consolidated financial statements, as unamortized goodwill at December 31, 2001 was $.1 million.

     SFAS 144 addresses the accounting model for long-lived assets to be disposed of by sale and resulting implementation issues. This statement requires that those long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. It also broadens the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. Additionally, discontinued operations that are not disposed of within one year must be reclassified as assets held and used unless the discontinued segment will be (1) abandoned through the liquidation or run-off of operations because the entity is obligated by regulation or contract to provide services after it ceases accepting all new business and (2) is being reported as a discontinued operation when SFAS 144 is initially applied. The only assets remaining from discontinued operations are the investment securities resulting from the retention of residual interests in securitization transactions. Since the Company is contractually obligated to service the securitized assets, the adoption of SFAS 144 had no impact on the Company’s consolidated financial statements.

     On April 1, 2002, the Company elected early adoption of SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). SFAS 145 updates, clarifies and simplifies existing accounting pronouncements. As it relates to FirstCity, the statement eliminates the extraordinary gain classification on early debt extinguishments. Instead, the gains associated with the early extinguishment of debt have been recorded in other income in the consolidated statements of operations. The Company also reclassified the extraordinary gain incurred in 2000 as other income. The result of this adoption did not modify or adjust net earnings (loss) for any period and does not impact the Company’s compliance with various debt covenants.

     On July 30, 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146"). The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not expect the adoption of SFAS 146 to have a material effect on its consolidated financial position or results of operations.

(4) Discontinued Operations

     The Company recorded a provision of $2.0 million in the first six months of 2002 and $1.0 million in 2001 for additional losses from discontinued operations. The additional provisions primarily relate to a decrease in the estimated future gross cash receipts on residual interests in securitizations. The net assets from discontinued operations consist of the following:

     The only assets remaining from discontinued operations are the investment securities resulting from the retention of residual interests in securitization transactions. Although the liquidation or run-off of these investment securities will last longer than one year, the Company is contractually obligated to service the securitized assets. The Company has considered the estimated future gross cash receipts for such investment securities in the computation of the loss from discontinued operations. The cash flows are collected over a

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period of time and are valued using prepayment assumptions of 25% for fixed rate loans and 40% for variable rate loans. Overall loss rates are estimated from 1.0% to 1.7% of collateral.

(5) Portfolio Assets

     Portfolio Assets are summarized as follows:

     Portfolio Assets are pledged to secure non-recourse notes payable.

(6) Loans Receivable from Acquisition Partnerships Held for Investment

     Loans receivable from Acquisition Partnerships held for investment consist primarily of loans from certain Acquisition Partnerships located in Mexico and are summarized as follows:

     There were no provisions recorded on these loans during the first six months of 2002 and 2001. The loans receivable from the Mexican partnerships are secured by the assets/loans acquired by the Mexican partnerships with purchase money loans provided by the investors to the Mexican partnerships to purchase the asset pools held in those entities and are evaluated for impairment by analyzing the expected future cash flows from the underlying assets within each pool to determine that the cash flows were sufficient to repay these notes. The Company applies the asset valuation methodology consistently in all venues and uses the same proprietary asset management system to evaluate impairment on all asset pools. The results of this evaluation indicated that cash flows from the pools will be sufficient to repay the loans and no allowances for impairment were necessary.

(7) Equity Investments

     The Company has investments in entities formed to acquire Portfolios (“Acquisition Partnerships”) and their general partners and investments in servicing entities that are accounted for under the equity method. The condensed combined financial position and results of operations of the Acquisition Partnerships (excluding servicing entities), which include the domestic and foreign Acquisition Partnerships and their general partners, are summarized below:

CONDENSED COMBINED BALANCE SHEETS

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CONDENSED COMBINED SUMMARY OF OPERATIONS

     The assets and equity of the Acquisition Partnerships and equity investments in the Acquisition Partnerships are summarized by geographic region below. The WAMCO Partnerships represent limited partnerships and limited liability companies in which the Company has a common ownership with Cargill.

     Revenues and earnings (loss) of the Acquisition Partnerships and equity in earnings of the Acquisition Partnerships are summarized by geographic region below.