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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 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 NUMBER 1-7614
FIRSTCITY FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 76-0243729
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
6400 IMPERIAL DRIVE, WACO, TX 76712
(Address of Principal Executive Offices) (Zip Code)
(254) 751-1750
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
TITLE OF EACH CLASS
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Common Stock, par value $.01
Special Preferred Stock, par value $.01
Adjusting Rate Preferred Stock, par value $.01
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13, or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [ ]
The number of shares of common stock outstanding at March 24, 1998 was
6,570,081. As of such date, the aggregate market value of the voting and
non-voting common equity held by non-affiliates, based upon the closing price of
the common stock on the NASDAQ National Market System, was approximately
$91,674,437.
DOCUMENTS INCORPORATED BY REFERENCE
PART OF FORM 10-K
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Notice of Annual Meeting and Proxy Statement for the 1998
Annual Meeting of Shareholders............................ III
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FIRSTCITY FINANCIAL CORPORATION
TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 32
Item 3. Legal Proceedings........................................... 32
Item 4. Submission of Matters to a Vote of Security Holders......... 33
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters....................................... 33
Item 6. Selected Financial Data..................................... 33
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 34
Item 8. Financial Statements and Supplementary Data................. 66
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 101
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 101
Item 11. Executive Compensation...................................... 101
Item 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 101
Item 13. Certain Relationships and Related Transactions.............. 101
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K....................................................... 102
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FORWARD LOOKING INFORMATION
This Annual Report on Form 10-K may contain forward-looking statements. The
factors identified under "Risk Factors" are important factors (but not
necessarily all of the important factors) that could cause actual results to
differ materially from those expressed in any forward-looking statement made by,
or on behalf of, the Company.
When any such forward-looking statement includes a statement of the
assumptions or bases underlying such forward-looking statement, the Company
cautions that, while such assumptions or bases are believed to be reasonable and
are made in good faith, assumed facts or bases almost always vary from actual
results, and the differences between assumed facts or bases and actual results
can be material, depending upon the circumstances. When, in any forward-looking
statement, the Company, or its management, expresses an expectation or belief as
to future results, such expectation or belief is expressed in good faith and is
believed to have a reasonable basis, but there can be no assurance that the
statement of expectation or belief will result or be achieved or accomplished.
The words "believe," "expect," "estimate," "project," "anticipate" and similar
expressions identify forward-looking statements.
PART I
ITEM 1. BUSINESS.
GENERAL
The Company is a diversified financial services company headquartered in
Waco, Texas with over 90 offices throughout the United States and a presence in
France and Mexico. The Company began operating in 1986 as a specialty financial
services company focused on acquiring and resolving distressed loans and other
assets purchased at a discount relative to the aggregate unpaid principal
balance of the loans or the appraised value of the other assets ("Face Value").
To date the Company has acquired, for its own account and through various
affiliated partnerships, pools of assets of single assets (collectively referred
to as "Portfolio Assets" or "Portfolios") with a Face Value of approximately
$3.0 billion. In 1996, the Company adopted a growth strategy to diversify and
expand its financial services business. To implement its growth strategy, the
Company has acquired or established several businesses in the financial services
industry, building upon its core strength and expertise as one of the earliest
participants in the business of acquiring and resolving distressed financial
assets and other assets. The Company's servicing expertise, which it has
developed largely through the resolution of distressed assets, is a cornerstone
of its growth strategy. Today the Company is engaged in three principal
businesses: (i) residential and commercial mortgage banking; (ii) Portfolio
Asset acquisition and resolution; and (iii) consumer lending.
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The following chart depicts the business conducted by the Company and the
principal entities through which such businesses are conducted.
[Organizational Chart]
The Company is consolidating all of its servicing capabilities into a
single subsidiary, FirstCity Servicing Corporation ("Servicing Corp."). This
process is designed to combine all servicing activities under a single
management group in an effort to achieve further operating efficiencies, enhance
the quality of asset servicing and coordinate and improve the technology support
for all of the Company's businesses. When this consolidation is complete,
Servicing Corp. will have responsibility for the management of all of the
Company's activities related to servicing mortgage loans, Home Equity Loans,
Portfolio Assets and automobile and other consumer loans.
BUSINESS STRATEGY
The Company's business strategy is to continue to broaden and expand its
business within the financial services industry while building on its core
servicing strengths and credit expertise. The following principles are key
elements to the execution of the Company's business strategy:
- Expand the financial products and services offered by existing
businesses.
- Broaden its sources of revenue and operating earnings by developing or
acquiring additional businesses that leverage its core strengths and
management expertise.
- Cross-sell between the Company's businesses.
- Invest in fragmented or underdeveloped markets in which the Company has
the investment and servicing expertise to achieve attractive risk
adjusted rates of return.
- Pursue new business opportunities through joint ventures, thereby
capitalizing on the expertise of partners whose skills complement those
of the Company.
- Maximize growth in earnings, thereby permitting the utilization of the
Company's net operating loss carryforwards ("NOLs").
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BACKGROUND
The Company began operating in the financial service business in 1986 as a
purchaser of distressed assets from the Federal Deposit Insurance Corporation
("FDIC"). From its original office in Waco, Texas, with a staff of four
professionals, the Company's asset acquisition and resolution business grew to
become a significant participant in an industry fueled by the problems
experienced by banks and thrifts throughout the United States. In the late
1980s, the Company also began acquiring assets from healthy financial
institutions interested in eliminating nonperforming assets from their
portfolios. The Company began its relationship with Cargill Financial Services
Corporation ("Cargill Financial") in 1991. Since that time, the Company and
Cargill Financial have formed a series of Acquisition Partnerships through which
they have jointly acquired over $2.2 billion in Face Value of distressed assets.
By the end of 1994, the Company had grown to nine offices with over 180
professionals and had acquired portfolios with assets in virtually every state.
In July 1995, the Company acquired by merger (the "Merger") First City
Bancorporation of Texas, Inc. ("FCBOT"), a former bank holding company that had
been engaged in a proceeding under Chapter 11 of the Bankruptcy Code since
November 1992. As a result of the Merger, the Common Stock of the Company became
publicly held and the Company received $20 million of additional equity capital
and entered into an incentive-based servicing agreement to manage approximately
$300 million in assets for the benefit of the former equity holders of FCBOT. In
addition, as a result of the Merger, the Company retained FCBOT's rights to
approximately $596 million in NOLs, which the Company believes it can use to
offset taxable income generated by the Company and its consolidated
subsidiaries.
Following the Merger, the Company adopted a growth and diversification
strategy designed to capitalize on its servicing and credit expertise to expand
into additional financial service businesses with management partners that have
distinguished themselves among competitors. To that end, in July 1997 the
Company acquired Harbor Financial Group, Inc., a company engaged in the
residential and commercial mortgage banking business since 1983. The Company has
also expanded into related niche financial services markets, such as consumer
finance and mortgage conduit banking.
MORTGAGE BANKING
General
The Company engages in the mortgage banking business through two principal
subsidiaries, FirstCity Financial Mortgage Corporation ("Mortgage Corp.") and FC
Capital Corporation ("Capital Corp."). Mortgage Corp. is a direct retail and
broker retail mortgage bank, which originates, purchases, sells and services
residential and commercial mortgage loans through more than 80 offices
throughout the United States. The Company acquired Mortgage Corp. (then named
Harbor Financial Group, Inc.) by merger in July 1997 (the "Harbor Merger").
Mortgage Corp.'s senior management team has extensive experience with all
aspects of the residential, construction and commercial mortgage banking
business, including the direct retail, broker retail, secondary marketing,
servicing, financial and operating expertise necessary to manage a growing
business. This management team formed Mortgage Corp. as a subsidiary of a
savings and loan association in 1983, completed a management led buy-out of the
ownership of Mortgage Corp. in 1987 and continued to expand through acquisitions
and internal growth. Many of Mortgage Corp.'s acquisitions represented
opportunistic situations whereby it was able to acquire origination capability
or servicing portfolios from the FDIC, the Resolution Trust Corporation ("RTC")
or other sellers of distressed assets. Mortgage Corp. conducts its residential
and commercial mortgage banking and servicing business through its subsidiaries
Harbor Financial Mortgage Corporation ("Harbor") and New America Financial, Inc.
("New America"). Mortgage Corp. ranks among the 50 largest mortgage banks in the
United States.
Capital Corp. was formed in 1997 to acquire, originate, warehouse,
securitize and service residential mortgage loans to borrowers who have
significant equity in their homes and who generally do not satisfy the more
rigid underwriting standards of the traditional residential mortgage lending
market (referred to herein as "Home Equity Loans"). These loans are extended to
borrowers who demonstrate an ability and willingness to repay credit, but who
might have experienced an adverse event, such as job loss, illness or divorce,
or have had past credit problems such as delinquency, bankruptcy, repossession
or charge-offs. Such an event normally will
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temporarily impair a borrower's credit rating such that the borrower will not
qualify as a prime borrower from a traditional mortgage lender that concentrates
on prime credit quality conventional conforming loans.
The Company owns 80% of the outstanding stock of Capital Corp. and Capital
Corp.'s senior management owns the remaining 20%. This ownership structure
aligns the interests of the key management team of Capital Corp. with those of
the Company. The Company became acquainted with Capital Corp.'s management team
during their tenure as senior management for a Wall Street firm's mortgage
conduit and structured finance division. This team has demonstrated to the
Company a disciplined approach to growing a business where the emphasis is on
credit quality and sound operating standards. The Company and the management
shareholders of Capital Corp. entered into a shareholders' agreement in
connection with the formation of Capital Corp. in August 1997. Commencing on the
fifth anniversary of such agreement, the Company and the management shareholders
have put and call options with respect to the stock of Capital Corp. held by the
other party at a mutually agreed upon fair market value.
Residential Mortgage Banking
Products and Services
Mortgage Corp. originates and purchases both fixed rate and adjustable rate
mortgage loans, primarily secured by first liens on single family residences.
The majority of the residential loans originated by Mortgage Corp. are
conventional conforming loans that qualify for sale to, or conversion into
securities issued by, Federal National Mortgage Association ("FNMA") and Federal
Home Loan Mortgage Corporation ("FHLMC"). Additionally, Mortgage Corp.
originates loans insured by the Federal Housing Administration ("FHA") and the
Farmers Home Administration ("FMHA") and loans guaranteed by the Veterans
Administration ("VA"). These loans qualify for inclusion in guarantee programs
sponsored by the Government National Mortgage Association ("GNMA").
Substantially all the conventional conforming loans are originated with
loan-to-value ratios at or below 80% unless the borrower obtains private
mortgage insurance. The Company also originates a number of other mortgage loan
products to respond to a variety of customer needs. These products include:
- First lien residential mortgage loans that meet the specific underwriting
standards of private investors, issuers of mortgage backed securities,
and other conduits seeking to purchase loans originated by Mortgage Corp.
These loans do not meet the established standards of FNMA or FHLMC and
are generally referred to as non-conforming mortgage loans. The loans may
be non-conforming because, among other reasons, they exceed the dollar
limitations established by FNMA or FHLMC, are originated with an original
loan-to-value ratio in excess of 80%, or are made to a borrower who is
self-employed.
- First and second lien residential mortgage Home Equity Loans to borrowers
who have some level of impaired credit.
- First and second lien residential home improvement loans.
Mortgage Corp. offers its customers a range of choices with respect to
repayment plans and interest rates on the loans that it originates. Most loans
originated by Mortgage Corp. have either 15 or 30 year terms and accrue interest
at fixed or variable rates. Quoted interest rates are a function of the current
interest rate environment and generally may be reduced at the option of the
customer by paying additional discount points at the time the loan is
originated. The adjustable rate mortgage ("ARM") products offered by Mortgage
Corp. reflect the current offerings of its agency or private investors. A basic
ARM loan could have an interest rate that adjusts on an annual basis throughout
its term with limits on the amount of the annual and aggregate lifetime
adjustments. A more complicated ARM loan could have a fixed rate of interest for
a stipulated period of time (for example, five years) with the annual adjustment
rate option commencing on an annual basis after the expiration of the initial
fixed term. Mortgage Corp. continuously monitors and adjusts its product
offerings and pricing so that it is able to sell the loans that it originates in
the secondary markets. To that end, price quotes and product descriptions are
distributed throughout its origination network on a daily basis.
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In 1996, Mortgage Corp. implemented a program to supplement its
conventional conforming loans by offering Home Equity Loans. Mortgage Corp.'s
customers use the proceeds of Home Equity Loans to finance home purchases and
improvements, debt consolidation, education and other consumer needs.
Approximately 74% of the Home Equity Loans originated by Mortgage Corp. in 1997
were secured by first mortgages. In addition to originating Home Equity Loans,
as a result of the formation of Capital Corp. in the third quarter of 1997, the
Company also operates a mortgage conduit business, which acquires Home Equity
Loans individually and in bulk from several independent loan origination
sources.
The Home Equity Loans originated and acquired by Mortgage Corp. and Capital
Corp. are similar in nature. Home Equity Loans have repayment options and
interest rate options that are similar to the options available for conventional
conforming loans. The primary difference between Home Equity Loans and
conventional conforming loans is the underwriting guidelines that govern the two
types of loans. Various underwriting criteria are evaluated to establish
guidelines as to the amount and type of credit for which the prospective
borrower is eligible. These factors also determine the interest rate and
repayment terms to be offered to the borrower. Interest rates on Home Equity
Loans are generally in excess of rates of interest charged on agency or
conforming residential loans. The underwriting guidelines and interest rates
charged for Home Equity Loans are revised as necessary to address market
conditions, the interest rate environment, general economic conditions and other
factors. See "-- Underwriting."
Through various other subsidiaries and affiliates, Mortgage Corp. conducts
business in a number of areas related to its principal mortgage business. Harbor
Financial Property Management, Inc. manages residential properties throughout
the United States for institutional investors. Dungey and Associates, Inc. is a
property appraisal and inspection company that provides services to Mortgage
Corp. and third parties in the Texas market. Hamilton, Carter, Smith & Co. is a
financial advisory firm that provides services to the mortgage industry in the
areas of portfolio/corporate evaluations, risk management and hedging advisory
services, marketing of loan servicing portfolios, and mergers and acquisitions
advisory services. Under management contracts, an affiliate of Mortgage Corp.
provides management and administrative services to Harbor Financial Insurance
Agency, which offers complete lines of personal, commercial and property
insurance products, and to JMC Title, Inc., which provides outside services for
title escrow and insurance services. None of these businesses contributes a
significant portion of the Company's earnings.
Loan Origination
General. Mortgage Corp. originates and acquires mortgage loans through a
direct retail group ("Direct Retail") that operates principally within Harbor,
and a broker retail group ("Broker Retail") whose activities are conducted
through New America. Mortgage Corp. believes that the Direct Retail and Broker
Retail origination channels offer distinct advantages and seeks to expand the
operations of both channels. A customer of the Direct Retail business works with
an employee of Mortgage Corp. throughout the entire loan origination process.
Direct Retail loan origination offers the advantage of greater fee retention to
compensate for higher fixed operating costs. It also facilitates the formation
of direct relationships with customers, which tends to create a more sustainable
loan origination franchise and results in increased control over the lending
process and the refinance activity that is becoming more prevalent in the
mortgage industry. As of December 31, 1997, Direct Retail employed 125 loan
officers, who were supported by 65 loan processing staff and 10 loan
underwriting staff, all of whom are employees of Mortgage Corp. The Direct
Retail group operates through 37 branches located in 11 states.
In the Broker Retail business, customers conduct a substantial portion of
their business with an independent broker who will present a relatively complete
loan application to the Broker Retail account executives for consideration.
Broker Retail mortgage loan origination is cost effective because it does not
involve fixed overhead costs for items such as offices, furniture, computer
equipment and telephones, or additional personnel costs, such as loan officers
and loan processors. By limiting the number of offices and personnel needed to
generate production, Mortgage Corp.'s Broker Retail business transfers the
overhead burden of mortgage origination to the independent mortgage loan
brokers. As a result, through its Broker Retail network Mortgage Corp. is able
to match its loan origination costs more closely with loan origination volume so
that a substantial portion of its loan origination costs are variable rather
than fixed. In addition,
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Broker Retail affords management the flexibility to expand or contract
production capacity as market conditions warrant. As of December 31, 1997,
Broker Retail employed 82 account executives working in 23 offices and operating
in 42 states. Broker Retail account executives work with and through a group of
approximately 6,500 independent mortgage loan brokers, approximately 2,700 of
whom closed loans through the Broker Retail network in 1997.
As a complement to its Direct Retail and Broker Retail businesses, the
Company operates a mortgage conduit business through Capital Corp. Capital Corp.
acquires Home Equity Loans from third-party origination sources for
securitization. Capital Corp. was formed in August 1997 and, as of February 28,
1998, had 19 employees.
Direct Retail. The Direct Retail group originates mortgage loans using
direct contact with consumers and operates through a network of 37 branches
located in Texas, Oklahoma, Pennsylvania, Virginia, West Virginia, Maryland,
Florida, Washington, Arizona, Colorado and Illinois. The marketing efforts of
the Direct Retail group are focused on the loan origination activities of retail
loan officers located in the branch offices. These loan officers identify
prospective customers through contacts within their local markets by developing
relationships with real estate agents, large employers, home builders,
commercial bankers, accountants, attorneys and others who would have contact
with prospective home owners seeking financing or refinancing. Over time,
successful loan officers develop a reputation for being able to provide quick
and accurate service to the customer and often generate new customers through
referrals from existing customers. The marketing efforts of the loan officers
are supported by print media advertising in selected local markets to target
prospects with featured product types or to highlight Mortgage Corp.'s broad
range of service capabilities. Mortgage Corp. has expanded its Direct Retail
network of loan officers by hiring experienced lenders in targeted markets and
by acquiring successful retail mortgage origination businesses.
The following table presents the number and dollar amount of loan
originations through Direct Retail for the periods indicated.
DIRECT RETAIL RESIDENTIAL MORTGAGE LOAN ORIGINATIONS
FISCAL YEAR(1)
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1997 1996 1995
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(DOLLARS IN THOUSANDS)
Conventional Loans:
Volume of loans...................................... $182,640 $162,117 $145,398
Number of loans...................................... 1,425 1,374 1,354
FHA/VA/FMHA Loans:
Volume of loans...................................... $319,667 $184,098 $108,074
Number of loans...................................... 3,300 2,073 1,474
Home Improvement Loans:(2)
Volume of loans...................................... $ 631 $ 211 $ 141
Number of loans...................................... 14 12 7
Brokered Loans:(3)
Volume of loans...................................... $ 62,524 $ 19,851 $ 32,799
Number of loans...................................... 532 99 133
Total Originations:
Volume of loans...................................... $565,462 $366,277 $286,412
Number of loans...................................... 5,271 3,558 2,968
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(1) 1997 data is for the 12 months ended December 31; data for all other years
is for the 12 months ended September 30, which was the fiscal year end for
Mortgage Corp. prior to the Harbor Merger.
(2) Home Improvement Loans are loans that are used by borrowers to finance
various home improvement projects and are generally secured by second liens.
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(3) Brokered Loans are originated through the Direct Retail process but are
closed and funded by a third-party correspondent.
Broker Retail. Mortgage Corp. entered into the Broker Retail business
through the acquisition of New America in July 1994. At the time of the
acquisition, New America had offices in Dallas, Texas and Fort Lauderdale,
Florida. Since becoming a part of Mortgage Corp., New America has expanded to
its present complement of 23 offices. Broker Retail account executives work with
and through independent mortgage loan brokers to identify lending opportunities
for the various loan products offered by Mortgage Corp.
In arranging mortgage loans, independent mortgage loan brokers act as
intermediaries between prospective borrowers and Mortgage Corp. Mortgage Corp.
is an approved FHMA, FHLMC and GNMA seller/servicer and has access to private
investors as well, which provides brokers access to the secondary market for the
sale of mortgage loans that they otherwise could not access because they do not
meet the applicable seller/servicer net worth requirements. Mortgage Corp.
attracts and maintains relationships with mortgage brokers by offering a variety
of competitive and responsive services as well as a variety of mortgage loan
products at competitive prices. Mortgage Corp.'s relationship with these
independent mortgage brokers differs from traditional wholesale purchases in
that Mortgage Corp. underwrites and funds substantially all of the loans funded
through the Broker Retail channel in its own name.
Separately, the Broker Retail channel conducts a whole loan pool
acquisition business. In most cases, the loans purchased in bulk are
underwritten by the seller-originator to FHA, FMHA, VA, FNMA or FHLMC
underwriting standards, with the seller warranting that such loans comply with
such standards. Mortgage Corp. employs quality review procedures prior to
purchase in an effort to ensure that the loans acquired in bulk purchases meet
such standards. See "-- Underwriting." During 1997, bulk acquisitions of loans
constituted less than 1% of Broker Retail production.
The following table presents the number and dollar amount of Broker Retail
production, including bulk acquisitions, for the periods indicated.
BROKER RETAIL RESIDENTIAL MORTGAGE LOAN PRODUCTION
FISCAL YEAR(1)
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1997 1996 1995
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(DOLLARS IN THOUSANDS)
Conventional Loans:
Volume of loans....................................... $2,222,232 $1,270,497 $364,049
Number of loans....................................... 18,332 11,665 3,506
FHA/VA/FMHA Loans:
Volume of loans....................................... $ 273,336 $ 55,917 $ 24,085
Number of loans....................................... 2,741 632 315
Home Equity Loans:
Volume of loans....................................... $ 178,492 $ 6,583 --
Number of loans....................................... 2,423 183 --
Total Production:
Volume of loans....................................... $2,674,060 $1,332,997 $388,134
Number of loans....................................... 23,496 12,480 3,821
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(1) 1997 data is for the 12 months ended December 31; data for all other years
is for the 12 months ended September 30, which was the fiscal year end for
Mortgage Corp. prior to the Harbor Merger.
Characteristics of Retail Loan Production. As a result of Mortgage Corp.'s
extensive Direct Retail and Broker Retail origination networks, the portfolio of
retail mortgage loans originated by Mortgage Corp. on an annual basis is
comprised of loans with a variety of characteristics that are offered to
borrowers who are geographically dispersed. Based upon production data
maintained by Mortgage Corp., the following table sets forth, as a percentage of
aggregate principal balance, the geographic distribution and other data for the
loans
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originated through the retail network of Mortgage Corp. for the 12 month periods
ended December 31, 1997 and September 30, 1996.
DECEMBER 31, 1997 SEPTEMBER 30, 1996
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Production by State:
California............................................... 23% 9%
Texas.................................................... 13 25
Florida.................................................. 7 7
Oregon................................................... 7 --
Washington............................................... 7 5
Georgia.................................................. 6 9
Arizona.................................................. 5 7
All others............................................... 32 38
--- ---
Total............................................ 100% 100%
Interest rate characteristics:
Fixed rate loans......................................... 93% 93%
Variable rate loans...................................... 7 7
--- ---
Total............................................ 100% 100%
Loan purpose:
Purchase transactions.................................... 61% 69%
Refinance transactions................................... 39 31
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Total............................................ 100% 100%
Substantially all of the retail mortgage production of Mortgage Corp. represents
loans secured by first liens on the underlying collateral.
Mortgage Conduit. The Company organized Capital Corp. in August 1997 to
acquire Home Equity Loans from third-party origination sources for
securitization. Capital Corp. acquires existing pools of Home Equity Loans in
individually negotiated transactions from several loan origination sources. From
its inception through December 31, 1997, Capital Corp. acquired 480 Home Equity
Loans in nine pools with principal balances totaling $53.6 million from four
different sellers, including one pool for $35.1 million purchased from the
former employer of Capital Corp.'s management. In addition to acquiring pools of
Home Equity Loans from third-party origination sources for securitization,
Capital Corp. intends to acquire loans originated by New America's extensive
Broker Retail network.
In addition to the acquisition of Home Equity Loans, Capital Corp. intends
to originate Home Equity Loans on a retail basis or through broker referrals.
Capital Corp. recently signed a letter of intent to acquire three existing
retail branch offices. In selected instances, Capital Corp. will seek
opportunities to extend secured warehouse lines of credit to certain approved
sellers of Home Equity Loans and will consider originating mezzanine loans to,
or making equity investments in, selected sellers. The objectives of such loans
and investments are to diversify and solidify the flow of product from selected
mortgage banks who provide Home Equity Loans to Capital Corp.
Characteristics of Mortgage Conduit Production. The loans acquired by
Capital Corp. have been acquired from Home Equity Loan originators who originate
loans throughout the United States. The following table sets forth, as a
percentage of aggregate principal balance, the geographic distribution and other
data for the portfolio of loans acquired by Capital Corp. from its first
acquisition of loans in October 1997 through December 31, 1997.
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Production by state:
Georgia................................................... 29%
New York.................................................. 22
Florida................................................... 15
Illinois.................................................. 11
North Carolina............................................ 5
All others (27 states).................................... 18
---
Total............................................. 100%
Interest rate characteristics:
Fixed rate loans.......................................... 43%
Variable rate loans....................................... 57
---
Total............................................. 100%
Lien status:
First liens............................................... 96%
Subordinate liens......................................... 4
---
Total............................................. 100%
Underwriting
Direct Retail and Broker Retail. Loan underwriting in both the Direct
Retail and Broker Retail groups is performed on a regional basis in larger
branch locations. Substantially all Direct Retail and Broker Retail loans are
processed and individually underwritten by Mortgage Corp. personnel and are
directly funded by Mortgage Corp. Mortgage Corp. believes that having
underwriters in each market area enables these personnel to remain abreast of
changing conditions in property values, employment conditions and various other
conditions in each market. Furthermore, in order to ensure compliance with
Mortgage Corp.'s underwriting guidelines, the underwriters operate independently
of origination personnel.
Mortgage Corp.'s guidelines for underwriting conventional conforming loans
comply with the criteria employed by FHLMC and FNMA, as applicable. Mortgage
Corp.'s guidelines for underwriting FHA and FMHA insured loans and VA guaranteed
loans comply with the criteria established by these agencies. Mortgage Corp.'s
guidelines for underwriting conventional non-conforming loans are based on the
underwriting standards employed by private mortgage insurers and private
investors that purchase such loans. Mortgage Corp.'s guidelines for underwriting
Home Equity Loans are based on the underwriting standards employed by the
private and conduit investors that purchase such loans and are similar to the
underwriting standards employed by Capital Corp. for acquired Home Equity Loans.
Such private investors (i) have given Mortgage Corp. delegated underwriting
authority for approval to close and sell such loans based on policy and
guidelines established by the investor, (ii) require that the loan be
underwritten on a contract basis for the closing and sale of such loans by an
independent third party approved by the investor, typically a mortgage insurance
company, or (iii) are approved directly by the investor before closing and sale
of such loans.
Mortgage Corp. performs a quality control review of loans originated by
having approximately 10% of its loans re-underwritten by independent third
parties that contract with Mortgage Corp. to perform this service. This practice
is designed to ensure that the loan origination practices and decisions are
acceptable to Mortgage Corp.'s loan pool investors and are in compliance with
regulatory requirements. Mortgage Corp. believes that its quality control review
meets or exceeds the review requirements of FNMA, FHLMC and applicable laws and
regulations.
Home Equity Loans are extended to borrowers who, for some reason, do not
qualify for an agency or conventional mortgage loan. In most cases, borrowers
seeking Home Equity Loans have experienced some level of historical credit
difficulty. Through a tiered underwriting system, Mortgage Corp. subjects
borrowers seeking Home Equity Loans to limits based, among other things, on the
loan-to-value ratio applicable to the particular transaction. The maximum
allowed loan-to-value ratio varies depending upon whether the collateral is
classified as a primary, secondary or investor residence. Maximum loan amounts
established for each classification of collateral generally do not exceed
$500,000 for a primary residence with a loan-to-value ratio
10
12
of less than 80%. At the low end of the credit spectrum for qualified Home
Equity Loan borrowers, the maximum loan-to-value ratios cannot exceed 65%, with
security limited to a primary residence and the loan amount limited to $100,000.
Sub-limits within the underwriting guidelines also place loan-to-value and
borrowing amount limitations on the Home Equity Loan based upon whether the loan
is a purchase money or cash-out refinance loan. Through December 31, 1997,
Mortgage Corp. has sold, on a servicing released basis, substantially all of its
Home Equity Loan production.
Mortgage Conduit. Capital Corp. acquires existing Home Equity Loans from
several loan origination sources under a tiered underwriting system. Capital
Corp. acquires each loan pool in an individually negotiated transaction from the
seller after a full underwriting review by Capital Corp. prior to the offer to
purchase. The underwriting review is performed to determine that the loans to be
acquired meet the various underwriting criteria for each credit grade.
Generally, the underwriting grade is a function of the prospective borrower's
credit history, which, in turn, will drive the loan-to-value relationship, the
debt to income ratio, and other credit criteria to be applied by Capital Corp.
in evaluating a loan.
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13
Capital Corp.'s categories and general criteria for grading the credit
history of potential Home Equity Loan borrowers are set forth in the table
below.
UNDERWRITING GUIDELINES(1)
A1 PROGRAM A2 PROGRAM B PROGRAM C PROGRAM
-------------------- -------------------- -------------------- --------------------
Existing mortgage
history.............. Maximum one 30-day Maximum two 30-day Maximum three 30-day Maximum five 30-day
late payment within late payments and no late payments and no and two 60-day late
last 12 months and 60-day late payments 60-day late payments payments within last
two 30-day late within last 12 within last 12 12 months: must be
payments in last 24 months; must be months; must be current at
months; must be current at current at application time
current at application time application time
application time
Other credit
history.............. No more than one No more than two Over 12 month prior Significant prior
30-day late payment 30-day late payments defaults acceptable; defaults acceptable
in last 12 months or in last 12 months. not more than $5,000 if over two years
two 30-day late Minor derogatory in open collection old; generally, not
payments in last 24 items allowed; no accounts or charge- more than $5,000 in
months; must be more than $2,500 in offs open after open collection
current at open collection funding; some 30- accounts or
application time accounts or and 60-day charge-offs open
charge-offs open delinquencies after funding; some
after funding, all 60- and 90-day
current credit must delinquencies
be current
Bankruptcy filings.... Generally, no notice Generally, no Generally, no Generally, no
of default filings bankruptcy or notice bankruptcy or notice bankruptcy or notice
in last two years of default filings of default filings of default filings
in last three years in last two years in last two years
and credit has been and credit has been
reestablished reestablished
subsequent to subsequent to
bankruptcy bankruptcy
Employment history.... Two years stable Two years stable Two years stable Two years stable
Debt service to income
ratio................ 45% or less 45% or less 50% or less 50% or less
Maximum loan-to-value
ratio:
Owner occupied;
single family...... 85% 85% 80% 75%
condo/two-to-four
unit............. 85% 80% 75% 75%
Non-owner occupied... 75% 75% 70% 70%
D PROGRAM
--------------------
Existing mortgage
history.............. No more than three
months delinquent at
closing
Other credit
history.............. Significant defaults
acceptable; not more
than $5,000 in open
charge-offs or
collection amounts
may remain open
after funding;
applicant has
sporadic payment
history
Bankruptcy filings.... Bankruptcy, notice
of sale filing,
notice of default
filing or
foreclosure
permitted if over 12
months old
Employment history.... One year stable
Debt service to income
ratio................ 50% or less
Maximum loan-to-value
ratio:
Owner occupied;
single family...... 65%
condo/two-to-four
unit............. 60%
Non-owner occupied... N.A.
- ---------------
(1) The letter grades applied to each risk classification reflect Capital
Corp.'s internal standards and do not necessarily correspond to the
classifications used by other home equity lenders. The data presented are
for first lien mortgages. More stringent requirements apply to mortgages
secured by second liens.
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The following table presents, for each of Capital Corp.'s underwriting
grades, for the period from Capital Corp.'s formation in August 1997 to December
31, 1997, the aggregate principal balance of loans acquired, the aggregate
number of loans acquired, the weighted average coupon rate of loans acquired,
and the relationship of amount financed to the estimated appraised value of the
mortgaged collateral. Because of the short time period reflected in the
following table, the characteristics of the loans reflected therein are not
necessarily indicative of future loans that may be acquired or originated by
Capital Corp.
CAPITAL CORP.'S LOAN PRODUCTION
WEIGHTED AVERAGE
AGGREGATE LOAN NUMBER OF WEIGHTED AVERAGE LOAN-TO-VALUE
CAPITAL CORP.'S GRADE BALANCE LOANS COUPON RATIO
--------------------- -------------- --------- ---------------- ----------------
(DOLLARS IN
THOUSANDS)
A1...................................... $17,582 131 9.6% 79.1%
A2...................................... 20,077 176 10.3 80.3
B....................................... 8,434 92 10.8 76.0
C....................................... 5,086 52 10.9 73.8
D....................................... 2,445 29 11.6 68.6
------- --- ---- ----
Total or Weighted Average..... $53,624 480 10.3% 78.2%
======= === ==== ====
Financing Strategy
Direct Retail and Broker Retail. Mortgage Corp. finances originated
mortgage loans primarily through its warehouse credit facilities provided by a
group of commercial bank lenders. Loans are generally held in inventory by
Mortgage Corp. for up to 45 days pending their sale to investors or agencies.
From the stage of initial application by the borrower through the final sale of
the loan, Mortgage Corp. bears interest rate risk.
In order to offset the risk that a change in interest rates will result in
a decrease in the value of Mortgage Corp.'s current mortgage loan inventory or
its commitments to purchase or originate mortgage loans ("Committed Pipeline"),
Mortgage Corp. enters into hedging transactions. Mortgage Corp.'s hedging
policies generally require that substantially all of its inventory of
conventional conforming and agency loans and the maximum portion of the
Committed Pipeline that Mortgage Corp. believes may close be hedged with forward
contracts for the delivery of mortgage-backed securities ("MBS") or options on
MBS. The inventory is then used to form the MBS that will fill the forward
delivery contracts and options. Mortgage Corp. hedges its inventory and
Committed Pipeline of jumbo (generally loans in excess of $227,200) and other
non-conforming mortgage loans, by using whole-loan sale commitments to ultimate
buyers or, because such loans are ultimately sold based on a market spread to
MBS, by selling a like amount of MBS. Because the market value of the loan and
the MBS are both subject to interest rate fluctuations, Mortgage Corp. is not
exposed to significant risk and will not derive any significant benefit from
changes in interest rates on the price of the inventory net of gains or losses
in associated hedge positions.
The correlation between price performance of the hedging instruments and
the inventory being hedged is very high as a result of the similarity of the
asset and the related hedge instrument. Mortgage Corp. is exposed to
interest-rate risk to the extent that the portion of loans from the Committed
Pipeline that actually closes at the committed price is different from the
portion expected to close and hedged in the manner described. Mortgage Corp.
determines the portion of its Committed Pipeline that it will hedge based on
numerous assumptions, including composition of the Committed Pipeline, the
portion of such Committed Pipeline likely to close, the timing of such closings
and anticipated changes in interest rates. See Notes 15 and 18 to the Company's
Consolidated Financial Statements.
Mortgage Corp. customarily sells all loans that it originates or purchases.
Conventional conforming and agency loans are generally sold servicing retained
and non-conforming loans are generally sold servicing released. Mortgage Corp.
packages substantially all of its FHA- and FMHA-insured and VA-guaranteed
mortgage loans into pools of loans. It sells these pools to national or regional
broker-dealers in the form of
13
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modified pass-through MBS guaranteed by GNMA. With respect to loans securitized
through GNMA programs, Mortgage Corp. is insured against foreclosure loss by the
FHA or FMHA or partially guaranteed against foreclosure loss by the VA (at
present, generally 25% to 50% of the loan, up to a maximum amount of $50,750,
depending upon the amount of the loan). Conventional conforming loans are also
pooled by Mortgage Corp. and exchanged for securities guaranteed by FNMA or
FHLMC, which securities are then sold to national or regional broker-dealers.
Loans securitized through FNMA or FHLMC are sold on a nonrecourse basis whereby
foreclosure losses are generally the responsibility of FNMA and FHLMC, and not
Mortgage Corp. Alternatively, Mortgage Corp. may sell FHA- and FMHA-insured and
VA-guaranteed mortgage loans and conventional conforming loans, and consistently
sells its jumbo loan production to large buyers in the secondary market (which
can include national or regional broker-dealers) on a nonrecourse basis. These
loans can be sold either on a whole-loan basis or in the form of pools backing
securities which are not guaranteed by any governmental instrumentality but
which generally have the benefit of some form of external credit enhancement,
such as insurance, letter of credit, payment guarantees or senior/subordinated
structures. Substantially all loans sold by Mortgage Corp. are sold without
recourse, subject, in the case of VA loans, to the limits of the VA guaranty
described above. To date, losses on VA loans in excess of the VA guaranty have
not been material to Mortgage Corp.
Mortgage Conduit. Capital Corp. currently finances the purchase of Home
Equity Loans with cash flow from the Company, a sub-line under Mortgage Corp.'s
warehouse credit facility and other short-term credit facilities. Typically,
under these credit facilities, Capital Corp. is only permitted to finance a
portion of the purchase price of loans, which are generally purchased at prices
that exceed their par value. Capital Corp. is in the process of negotiating
nonrecourse warehouse credit facilities in its own name for an aggregate amount
of $500 million. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."
Capital Corp. intends to securitize substantially all of the Home Equity
Loans it acquires or originates. The securitization transactions are expected to
be consummated through the creation of special purpose trusts. The Home Equity
Loans will be transferred to a trust in exchange for certificates representing
the senior interest in the securitized loans held by the trust and, if
applicable, a subordinated interest in the securitized loans. The subordinated
interests generally consist of the excess spread between the interest and
principal paid by the borrowers on the loans pooled in the securitization and
the interest and principal of the senior interests issued in the securitization,
and other unrated interests issued in the securitization. The senior interests
are subsequently sold to investors for cash. Capital Corp. may elect to retain
the subordinated interests or may sell all or some portion of the subordinated
interests to investors for cash. Capital Corp. anticipates that it will retain
the rights to the excess spreads.
Upon the sale of Home Equity Loans in securitization transactions, the sum
of the cash proceeds received, and the estimated present values of the
subordinated interests less the costs of origination and securitization and, the
basis in the Home Equity Loans sold results in the gain recognized at the time
of the securitization transaction. The present values of the subordinated
interests to be recognized by Capital Corp. are to be determined based upon
prepayment, loss and discount rate assumptions that will be determined in
accordance with the unique underlying characteristics of the Home Equity Loans
comprising each securitization.
Servicing
Direct Retail and Broker Retail. Generally, it is Mortgage Corp.'s strategy
to build and retain its servicing portfolio. With the exception of Home Equity
Loans, Mortgage Corp. services substantially all of the mortgage loans that it
originates. In addition, Mortgage Corp. may, from time to time, purchase bulk
servicing contracts for servicing of single family residential mortgage loans
originated by other lenders. Following Mortgage Corp.'s acquisition by the
Company in July 1997, it has retained substantially all of the newly originated
mortgage servicing rights when the option to retain such rights existed.
Mortgage Corp. has been able to retain such rights as a result of the capital
support available from the Company to fund the cash investment required to grow
the servicing portfolio.
14
16
The servicing of mortgage loans generally includes collecting and remitting
loan payments, making advances when required, accounting for principal and
interest, holding custodial (escrow) funds for payment of property taxes and
hazard insurance, making necessary physical inspections of the property,
counseling delinquent mortgagors, supervising foreclosures and property
dispositions in the event of unremedied defaults, and generally administering
the loans. Mortgage Corp. receives a fee for servicing mortgage loans ranging
generally from 1/4% to 1/2% per annum on the declining principal balances of
the loans. The servicing fee is collected by Mortgage Corp. out of monthly
mortgage payments.
Currently, a large portion of Mortgage Corp.'s costs of servicing loans are
incurred as a result of the labor intensive data entry process required in
connection with each new loan. Mortgage Corp. is currently implementing a system
that will automate a large portion of the data entry process for serviced loans.
Mortgage Corp. expects that this system will be fully implemented by the third
quarter of 1998 and will significantly decrease the variable costs associated
with servicing loans.
Mortgage Corp.'s servicing portfolio is subject to reduction by scheduled
amortization or by prepayment or foreclosure of outstanding loans. In addition,
Mortgage Corp. has sold, and may sell in the future, a portion of its portfolio
of loan servicing rights to other mortgage servicers. In general, the decision
to sell servicing rights is based on management's assessment of the market value
of servicing rights and other factors.
The following table presents certain information regarding Mortgage Corp.'s
residential servicing portfolio, including loans held for sale as of the dates
indicated.
RESIDENTIAL SERVICING PORTFOLIO BALANCES
FISCAL YEAR(1)
--------------------------------------
1997 1996 1995
---------- ---------- ----------
(DOLLARS IN THOUSANDS)
FHA-insured mortgage loans............................. $ 429,216 $ 342,694 $ 240,217
VA-guaranteed mortgage loans........................... 266,294 178,943 149,830
Conventional mortgage loans............................ 4,280,315 3,234,197 894,840
Other.................................................. 20,688 66,815 68,802
---------- ---------- ----------
Total residential servicing portfolio........ $4,996,513 $3,822,649 $1,353,689
- ---------------
(1) 1997 data is as of December 31; data for all other years is as of September
30, which was the fiscal year end for Mortgage Corp. prior to the Harbor
Merger.
Mortgage Corp.'s contractual right to subservice approximately $707 million
of residential mortgages at December 31, 1997 is included in the data presented
in the preceding table. Of the total subservicing portfolio, approximately $624
million (88.2%) represents subservicing for loans in California. No other state
accounts for more than 5% of Mortgage Corp.'s subservicing portfolio. These
subservicing rights represent Mortgage Corp.'s right to service loans as to
which third parties own the servicing rights. Such parties have contracted with
Mortgage Corp. to service the portfolio of loans under short-term contracts
(generally for original terms of less than five years) for a fixed dollar amount
of servicing fee per year (generally approximately $75.00 per loan per year).
15
17
Mortgage Corp.'s residential servicing portfolio (excluding subserviced
loans), stratified by interest rate, was as follows as of the dates indicated:
RESIDENTIAL SERVICING PORTFOLIO
INTEREST RATE STRATIFICATION
PERCENTAGE OF PRINCIPAL
BALANCE SERVICED
------------------------
FISCAL YEAR(1)
------------------------
1997 1996
--------- ---------
Under 7.0%.................................................. 7.9% 9.8%
7.0 to 7.49................................................. 15.2 14.7
7.5 to 7.99................................................. 28.1 21.1
8.0 to 8.49................................................. 22.4 18.0
8.5 to 8.99................................................. 15.0 15.8
9.0 to 9.49................................................. 3.4 6.7
9.5 to 9.99................................................. 4.0 6.9
10% and over................................................ 4.0 7.0
------ ------
Total residential servicing portfolio............. 100.0% 100.0%
====== ======
- ---------------
(1) 1997 data is as of December 31; 1996 data is as of September 30, which was
the fiscal year end for Mortgage Corp. prior to the Harbor Merger.
At December 31, 1997, 92% of the principal balance of loans in the
servicing portfolio bore interest at fixed rates and 8% bore interest at
adjustable rates. The weighted average servicing fee of the portfolio was 0.34%
of the principal balance of serviced loans at December 31, 1997.
The following table presents the geographic distribution of Mortgage
Corp.'s residential servicing portfolio (excluding subserviced loans), as of the
dates indicated.
RESIDENTIAL SERVICING PORTFOLIO GEOGRAPHIC DISTRIBUTION
PERCENTAGE OF PRINCIPAL
BALANCE SERVICED
------------------------
FISCAL YEAR(1)
------------------------
1997 1996
--------- ---------
California.................................................. 27.8% 29.5%
Texas....................................................... 17.3 40.3
Florida..................................................... 7.1 4.2
Washington.................................................. 6.7 2.4
Maryland.................................................... 5.2 3.4
Other states (none more than 5%)............................ 35.9 20.2
------ ------
Total residential servicing portfolio............. 100.0% 100.0%
====== ======
- ---------------
(1) 1997 data is as of December 31; 1996 data is as of September 30, which was
the fiscal year end for Mortgage Corp. prior to the Harbor Merger.
16
18
The following table presents, as a percentage of aggregate principal
balance, the delinquency statistics of Mortgage Corp.'s residential servicing
portfolio (excluding subserviced loans) as of the dates indicated.
RESIDENTIAL SERVICING PORTFOLIO DELINQUENCY STATISTICS
FISCAL YEAR(1)
--------------
1997 1996
----- -----
Delinquencies at period end:
30 days................................................ 2.4% 2.1%
60 days................................................ 0.5 0.6
90 days or more........................................ 0.2 0.3
--- ---
Total delinquencies......................................... 3.1% 3.0%
=== ===
Foreclosures pending........................................ 0.7% 0.9%
=== ===
- ---------------
(1) 1997 data is as of December 31; 1996 data is as of September 30, which was
the fiscal year end for Mortgage Corp. prior to the Harbor Merger.
The delinquency data included in the preceding table include the results of
three distressed servicing portfolios acquired by Mortgage Corp. At December 31,
1997, the distressed portfolios totaled approximately $172.3 million of
servicing, of which approximately 7.1% represented delinquent principal
balances. In addition, approximately 4.9% of the principal balance of these
distressed portfolios was in foreclosure at year end 1997.
Mortgage Corp. has increased its servicing portfolio by retaining the
servicing rights on the loans it originates and by acquiring servicing rights
from other mortgage banks. In particular, Mortgage Corp. has sought to acquire
servicing rights from other mortgage banks at a substantial discount to the
market value of currently originated servicing. Such servicing is available at
discounts because of high delinquency levels or other characteristics deemed
unattractive to other servicers seeking more traditional servicing portfolios.
Mortgage Corp. has been able to acquire these servicing portfolios at prices
that, in its view, are attractive compared to the market value of currently
originated servicing. Mortgage Corp. has devoted substantial attention to
improving the overall quality of these distressed servicing portfolios and, as a
result, has developed particular expertise in servicing loans evidencing some
level of distress.
To capitalize further on its distressed servicing expertise, Mortgage Corp.
has initiated a trial program whereby it will acquire delinquent FHA and VA
loans from other mortgage bankers' GNMA securitizations. Mortgage Corp. believes
that a financial and business incentive exists for some mortgage banks to sell
the targeted loans and, therefore, a significant amount of such loans are
available for sale. The GNMA seller-servicers are required to pass through to
the holder of the GNMA security the scheduled principal and interest payments on
all loans in the security pool, even though the borrower may not be making such
payments. The mortgage banker is, therefore, making corporate advances to the
security holder from its own funds. By removing the delinquent loans from the
securitization by a sale to Mortgage Corp., the selling mortgage banker is
relieved from further obligations to make such advances to the GNMA security
holder. Through December 31, 1997, Mortgage Corp. has acquired approximately $16
million of such loans.
Residential mortgage loans are serviced from facilities located in Houston,
Texas and Scottsbluff, Nebraska. The Scottsbluff center, a newly renovated
21,000 square foot facility, was acquired as part of Mortgage Corp.'s 1996
acquisition of Hamilton. This service center has advantageous lease terms and an
efficient cost structure as compared to metropolitan servicing centers. The
addition of Hamilton's servicing and subservicing portfolios almost doubled
Mortgage Corp.'s consolidated servicing portfolio.
In order to track information on its mortgage servicing portfolio, Mortgage
Corp. utilizes a data processing system provided by Alltel Information Systems,
Inc. ("Alltel"). Alltel is one of the largest mortgage banking service bureaus
in the United States. Management believes that this system gives Mortgage
17
19
Corp. sufficient capacity to support the anticipated expansion of its
residential mortgage loan servicing portfolio. See "Risk Factors -- Reliance on
Systems; Year 2000 Issues."
Mortgage Conduit. The loans acquired by Capital Corp. to date are being
subserviced by Advanta Mortgage Corp. USA. Capital Corp. owns the servicing
rights to its loans as master servicer and intends to assign collection and
resolution responsibilities to a subsidiary of the Company as special servicer
when its loans reach certain stages of delinquency, thus placing the final
decisions as to collection management under the control of the Company. Having
acquired and managed consumer portfolios totaling in excess of $580 million in
Face Value in its Portfolio Asset acquisition and resolution business, the
Company believes that the servicing experience and skills it has gained are
valuable to support the unique collection and resolution needs of a Home Equity
Loan portfolio. Capital Corp. intends to ultimately replace Advanta Mortgage
Corp. USA with the combined capabilities of Mortgage Corp. and the Company to
service Capital Corp.'s portfolio of Home Equity Loans and the loans within its
securitized pools. The Company and Mortgage Corp. are in the process of seeking
the approval of the servicer rating agencies as a preliminary step in the
process of retaining the servicing of all new Home Equity Loans in-house.
Strategy
Direct Retail and Broker Retail. Mortgage Corp. intends to pursue the
following strategies in an effort to continue growth in earnings in all aspects
of its residential mortgage business:
- Maintain steady growth in earnings by increasing the size of Mortgage
Corp.'s servicing portfolio.
- Continue opportunistic geographic expansion.
- Increase the range of mortgage products offered.
- Expand the Direct Retail and Broker Retail origination channels.
- Acquire distressed servicing portfolios and delinquent FHA, FMHA and VA
loans from other seller-servicers' GNMA securitizations.
Mortgage Conduit. Capital Corp. intends to implement the following
strategies as it continues to develop and grow its mortgage conduit business:
- Capitalize on the existing Home Equity Loan origination network of
Mortgage Corp. to generate loans for securitization.
- Form strategic relationships with selected small originators of Home
Equity Loans by extending secured warehouse lines of credit or mezzanine
loans to, or making equity investments in, such entities.
- Capitalize on the distressed asset collection experience of Commercial
Corp. to address the collection and resolution challenges inherent in
Home Equity Loan servicing.
- Establish an internal servicing platform to service the Home Equity Loans
originated or acquired by Capital Corp.
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20
Commercial Mortgage Banking
Mortgage Corp.'s commercial mortgage banking business consists of
commercial loans secured by commercial real estate properties and single family
residential construction loans. The following table presents the number and
dollar amount of Mortgage Corp.'s commercial loan production for the periods
indicated.
COMMERCIAL MORTGAGE LOAN ORIGINATIONS
FISCAL YEAR(1)
------------------------------
1997 1996 1995
-------- ------- -------
(DOLLARS IN THOUSANDS)
Correspondent Loans:
Volume of loans........................................ $348,060 $35,600 $53,405
Number of loans........................................ 86 3 9
Construction Loans:
Volume of loans........................................ $ 65,740 $28,780 --
Number of loans........................................ 466 263 --
Total Loans:
Volume of loans........................................ $413,800 $64,380 $53,405
======== ======= =======
Number of loans........................................ 552 266 9
======== ======= =======
- ---------------
(1) 1997 data is for the 12 months ended December 31; data for all other years
is for the 12 months ended September 30, which was Mortgage Corp.'s fiscal
year end prior to the Harbor Merger.
Correspondent Loan Business
Through eight offices located in California, Texas and Colorado, Mortgage
Corp. originates commercial loans that are funded by third parties for which
Mortgage Corp. serves as the correspondent. The loans are secured by
multi-family residential projects, office buildings, shopping centers and other
income producing properties. Revenues derived from Mortgage Corp.'s commercial
lending business are principally origination fees based on a percentage of the
loan amount and, in certain instances, application fees assessed at the time a
loan application is processed by Mortgage Corp. During 1997, Mortgage Corp.
generated $2.7 million in origination fees from its commercial mortgage
origination business. Mortgage Corp.'s commercial lending offices are staffed by
20 loan officers and nine servicing personnel.
Mortgage Corp. originates commercial loans in accordance with the
underwriting guidelines of its investors. These investors include life insurance
companies, commercial mortgage conduits, real estate investment trusts, and
others. Commercial loans are funded by investors at closing. Mortgage Corp.
originated a substantial portion of its 1997 commercial production for a single
large insurance company. In addition, a substantial portion of its commercial
servicing portfolio consists of servicing for such company.
At December 31, 1997, Mortgage Corp. serviced a portfolio of commercial
loans for 36 investors totaling approximately $1.7 billion representing 543
loans (compared to approximately $129 million representing 93 loans at September
30, 1996). At December 31, 1997, the commercial servicing portfolio represented
loans in 23 states with California (65%), Texas (12%), Colorado (7%) and Arizona
(4%) representing the largest concentrations of the principal balance of loans
serviced. The significant increase in the commercial servicing portfolio as
compared to the prior year is the result of Mortgage Corp.'s acquisition of a
large commercial servicing portfolio in 1997.
Commercial loans are serviced in a servicing center located in Walnut
Creek, California. Mortgage Corp. owns the rights to service its correspondent's
loans, with termination rights by the correspondent on a 30-day notice basis.
Servicing fees for such loans range from five to eight basis points per annum of
the principal balance of the loans.
19
21
Construction Loans
In 1995, Mortgage Corp. began originating for its own account and servicing
single-family residential construction loans through a construction loan
department headquartered in Houston, Texas. Mortgage Corp. serves customers in
nine states with construction loan products tailored to its builder and
individual customers. Mortgage Corp. extends construction lines of credit to
approximately 30 builders for the construction of custom and speculative homes.
Generally, builders are limited to no more than 50% of the committed line for
speculative homes. Total commitments outstanding at December 31, 1997 were
approximately $25 million with a maximum extended to any one builder of
approximately $2.5 million. During 1997, approximately 70% of total construction
loan volume was conducted with builder borrowers.
In addition to its builder customer base, Mortgage Corp. offers a
construction-to-permanent loan package to individual customers who are building
or remodeling their own home. Under this program, the customer has one
application and loan approval process to provide for both the interim
construction and permanent financing. During 1997, approximately 30% of total
construction loan volume was conducted with individual borrowers.
The underwriting and servicing of the construction loans is conducted in
Houston, Texas with the construction progress inspection support provided by the
branch office personnel or outside vendors specializing in property inspections
for construction lenders. Construction loans are extended for up to 90% of the
cost of construction for a period of up to nine months with one three month
renewal option on the part of the builder. If the loan remains unpaid after the
first renewal, amortization of at least 10% of the principal balance is required
for any further renewals. Substantially all construction loans bear interest at
variable rates of interest at margins over a base lending rate.
Mortgage Corp. solicits construction loan builder and individual customers
through its major Direct Retail offices and, as a result, conducts most of its
business in Texas (72% in 1997), Maryland (8% in 1997), Virginia (5% in 1997)
and Tennessee (5% in 1997).
Strategy
In its commercial mortgage banking business, Mortgage Corp. intends to
continue to serve its correspondent clients by sourcing opportunities through
its retail offices and its home builder clients. It is the Company's intention
to explore and develop cross-selling opportunities between the commercial
mortgage capability of Mortgage Corp. and the commercial lending business of
Commercial Corp.
In its construction lending business, Mortgage Corp. intends to expand its
customer base by continuing to emphasize the construction-to-permanent loan
product. To that end, a regional construction loan product specialist resides in
the mid-Atlantic regional retail office to introduce the construction loan
product to borrowers in the region. The balance of Mortgage Corp.'s expansion
efforts in the construction lending business are focused on providing a larger
volume of construction loan products to Mortgage Corp.'s existing builder
customers.
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
The Company engages in the Portfolio Asset acquisition and resolution
business and is beginning to originate commercial loans through its wholly owned
subsidiary, FirstCity Commercial Corporation, and its subsidiaries ("Commercial
Corp."). In the Portfolio Asset acquisition and resolution business Commercial
Corp. acquires and resolves portfolios of performing and nonperforming
commercial and consumer loans and other assets, which are generally acquired at
a discount to Face Value. Purchases may be in the form of pools of assets or
single assets. Performing assets are those as to which debt service payments are
being made in accordance with the original or restructured terms of such assets.
Nonperforming assets are those as to which debt service payments are not being
made in accordance with the original or restructured terms of such assets, or as
to which no debt service payments are being made. Portfolios are designated as
nonperforming unless substantially all of the assets comprising the Portfolio
are performing. Once a Portfolio has been designated as either performing or
nonperforming, such designation is not changed regardless of the performance of
the
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assets comprising the Portfolio. Portfolios are either acquired for Commercial
Corp.'s own account or through investment entities formed with Cargill Financial
or one or more other co-investors (each such entity, an "Acquisition
Partnership"). See "-- Portfolio Asset Acquisition and Resolution
Business -- Relationship with Cargill Financial." To date, Commercial Corp. and
the Acquisition Partnerships have acquired over $3.0 billion in Face Value of
assets.
The Company's development of a niche commercial lending business is a
logical extension of its extensive experience with the resolution of distressed
assets. In many cases, the resolution of such assets involves the modification
of an existing debt into a new or modified extension of credit more suited to
the borrower's needs, ability to pay and value of the underlying collateral. The
Company intends to use such experience as the foundation upon which Commercial
Corp. will seek niche commercial lending opportunities.
Portfolio Asset Acquisition and Resolution Business
Background
In the early 1990s large quantities of nonperforming assets were available
for acquisition from the RTC and the FDIC. Since 1993, most sellers of
nonperforming assets have been private sellers, rather than government agencies.
These private sellers include financial institutions and other institutional
lenders, both in the United States and in various foreign countries, and, to a
lesser extent, insurance companies in the United States. As a result of mergers,
acquisitions and corporate downsizing efforts, other business entities
frequently access the market served by the Company to dispose of excess real
estate property or other financial assets not meeting the strategic needs of a
seller. Sales of such assets improve the seller's balance sheet, reduce overhead
costs, reduce staffing requirements and avoid management and personnel
distractions associated with the intensive and time-consuming task of resolving
loans and disposing of real estate. Consolidations within a broad range of
industries, especially banking, have augmented the trend of financial
institutions and other sellers packaging and selling asset portfolios to
investors as a means of disposing of nonperforming loans or other surplus
assets.
Portfolio Assets
Commercial Corp. acquires and manages Portfolio Assets, which are generally
purchased at a discount to Face Value by Commercial Corp. or through Acquisition
Partnerships. The Portfolio Assets are generally nonhomogeneous assets,
including loans of varying qualities that are secured by diverse collateral
types and foreclosed properties. Some Portfolio Assets are loans for which
resolution is tied primarily to the real estate securing the loan, while others
may be collateralized business loans, the resolution of which may be based
either on business or real estate or other collateral cash flow. Consumer loans
may be secured (by real or personal property) or unsecured. Portfolio Assets may
be designated as performing or nonperforming. Commercial Corp. generally expects
to resolve Portfolio Assets within three to five years after purchase.
To date, a substantial majority of the Portfolio Assets acquired by
Commercial Corp. have been designated as nonperforming. Commercial Corp. seeks
to resolve nonperforming Portfolio Assets through (i) a negotiated settlement
with the borrower in which the borrower pays all or a discounted amount of the
loan, (ii) conversion of the loan into a performing asset through extensive
servicing efforts followed by either a sale of the loan to a third party or
retention of the loan by Commercial Corp. or (iii) foreclosure of the loan and
sale of the collateral securing the loan. Commercial Corp. generally retains
Portfolio Assets that are designated as performing for the life of the loans
comprising the Portfolio.
Commercial Corp. has substantial experience acquiring, managing and
resolving a wide variety of asset types and classes. As a result, it does not
limit itself as to the types of Portfolios it will evaluate and purchase. The
main factors determining Commercial Corp.'s willingness to acquire Portfolio
Assets include the information that is available regarding the assets in a
portfolio, the price at which such portfolio can be acquired and the expected
net cash flows from the resolution of such assets. Commercial Corp. has acquired
Portfolio Assets in virtually all 50 states, the Virgin Islands, Puerto Rico and
France. Commercial Corp. believes that its willingness to acquire nonhomogeneous
Portfolio Assets without regard to geographical location provides it with an
advantage over certain competitors that limit their activities to either a
specific
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asset type or geographical location. Although Commercial Corp. imposes no
constraints on geographic locations of Portfolio Assets, the majority of assets
acquired to date have been in the Northeastern and Southern areas of the United
States.
Commercial Corp. also seeks to capitalize on emerging opportunities in
foreign markets where the market for nonperforming loans of the type generally
purchased by Commercial Corp. is less efficient than the market for such assets
in the United States. Through December 31, 1997, Commercial Corp. has acquired,
with Cargill Financial and a local French partner, three Portfolios in France,
consisting of approximately 6,500 assets, for an aggregate purchase price of
approximately $142 million. Such assets had a Face Value of approximately $513
million. Commercial Corp.'s share of the equity interest in the Portfolios
acquired in France ranges from 10% to 33 1/3% and Commercial Corp. has made a
total equity investment therein of approximately $10 million. The underlying
assets and debt are denominated in French francs and Commercial Corp.'s equity
investments are funded with a French franc line of credit, thereby mitigating
against foreign currency translation risks. Commercial Corp. does not otherwise
attempt to hedge any profits that might be derived from its equity investments.
Commercial Corp. has an established presence in Paris, France and is actively
pursuing opportunities to purchase additional pools of distressed assets in
France and other areas of Western Europe. In addition, Commercial Corp. has
established an office in Mexico City, Mexico to explore asset acquisition
opportunities in Mexico.
The following table presents, for each of the years in the three-year
period ended December 31, 1997, selected data for the Portfolio Assets acquired
by Commercial Corp.
PORTFOLIO ASSETS
YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
(DOLLARS IN THOUSANDS)
Face Value......................................... $504,891 $413,844 $699,662
Total purchase price............................... 183,229 205,524 213,187
Total equity invested.............................. 54,764 92,937 26,534
Commercial Corp. equity invested................... $ 37,109 $ 35,973 $ 24,603
Total number of Portfolio Assets................... 5,503 5,921 19,031
Sources of Portfolio Assets
Commercial Corp. develops its Portfolio Asset opportunities through a
variety of sources. The activities or contemplated activities of expected
sellers are publicized in industry publications and through other similar
sources. Commercial Corp. also maintains relationships with a variety of parties
involved as sellers or as brokers or agents for sellers. Many of the brokers and
agents concentrate by asset type and have become familiar with Commercial
Corp.'s acquisition criteria and periodically approach Commercial Corp. with
identified opportunities. In addition, repeat business referrals from Cargill
Financial or other co-investors in Acquisition Partnerships, repeat business
from previous sellers, focused marketing by Commercial Corp. and the nationwide
presence of Commercial Corp. and the Company are important sources of business.
Commercial Corp. has identified and seeks to continue to identify foreign
partners that have contacts within each foreign market and can bring Portfolio
Asset opportunities to Commercial Corp. Commercial Corp. expects that it will
only pursue acquisitions in foreign markets in conjunction with a local foreign
partner. Commercial Corp. has in the past pursued, and expects in the
foreseeable future to pursue, foreign acquisition opportunities in markets where
Cargill Financial has a presence.
Asset Analysis and Underwriting
Prior to making an offer to acquire any Portfolio, Commercial Corp.
performs an extensive evaluation of the assets that comprise the Portfolio. If,
as is often the case, the Portfolio Assets are nonhomogeneous, Commercial Corp.
will evaluate all individual assets determined to be significant to the total of
the proposed purchase. If the Portfolio Assets are homogenous in nature, a
sample of the assets comprising the Portfolio is
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selected for evaluation. The evaluation of an individual asset generally
includes analyzing the credit and collateral file or other due diligence
information supplied by the seller. Based upon such seller-provided information,
Commercial Corp. will undertake additional evaluations of the asset which, to
the extent permitted by the seller, will include site visits to and
environmental reviews of the property securing the loan or the asset proposed to
be purchased. Commercial Corp. will also analyze relevant local economic and
market conditions based on information obtained from its prior experience in the
market or from other sources, such as local appraisers, real estate principals,
realtors and brokers.
The evaluation further includes an analysis of an asset's projected cash
flow and sources of repayment, including the availability of third party
guarantees. Commercial Corp. values loans (and other assets included in a
portfolio) on the basis of its estimate of the present value of estimated cash
flow to be derived in the resolution process. Once the cash flow estimates for a
proposed purchase and the financing and partnership structure, if any, are
finalized, Commercial Corp. can complete the determination of its proposed
purchase price for the targeted Portfolio Assets. Purchases are subject to
purchase and sale agreements between the seller and the purchasing affiliate of
Commercial Corp.
Servicing
After a Portfolio is acquired, Commercial Corp. assigns it to an account
servicing officer who is independent of the officer that performed the due
diligence evaluation in connection with the purchase of the Portfolio. Portfolio
Assets are serviced either at the Company's headquarters or in one of Commercial
Corp.'s other offices. Commercial Corp. generally establishes servicing
operations in locations in close proximity to significant concentrations of
Portfolio Assets. Most of such offices are considered temporary and are reviewed
for closing after the assets in the geographic region surrounding the office are
substantially resolved. The assigned account servicing officer develops a
business plan and budget for each asset based upon an independent review of the
cash flow projections developed during the investment evaluation, a physical
inspection of each asset or the collateral underlying the related loan, local
market conditions and discussions with the relevant borrower. Budgets are
periodically reviewed and revised as necessary. Commercial Corp. employs loan
tracking software and other operational systems that are generally similar to
systems used by commercial banks, but which have been enhanced to track both the
collected and the projected cash flows from Portfolio Assets.
To date, the net present value of Commercial Corp.'s cash flows from
serviced assets has exceeded initial projections. Because of this success,
Commercial Corp. has been able to structure securitization and structured
financing transactions based upon cash flow projections expected to be derived
from Portfolio Assets. The basis for such transactions differs from traditional
securitization structures in which the execution levels are predicated upon the
existence of an underlying contractual stream of cash flows from periodic
payments on underlying loans. Transactions completed by Commercial Corp. to date
have been based not only on the cash flow from performing assets but also the
projected cash flows from nonperforming assets such as unoccupied real estate
and raw land parcels. Commercial Corp. believes that its success in predicting
cash flows from Portfolio Assets has permitted it to access the securitization
markets on attractive terms.
Commercial Corp. services all of the Portfolio Assets owned for its own
account, all of the Portfolio Assets owned by the Acquisition Partnerships and,
to a very limited extent, Portfolio Assets owned by related third parties. In
connection with the Acquisition Partnerships, Commercial Corp. earns a servicing
fee of between 3% and 8% of gross cash collections generated in the Acquisition
Partnerships rather than a periodic management fee based on the Face Value of
the asset being serviced. The rate of servicing fee charged is a function of the
average Face Value of the assets within each pool being serviced (the larger the
average Face Value of the assets in a Portfolio, the lower the fee percentage
within the prescribed range).
Structure and Financing of Portfolio Asset Purchases
Portfolio Assets are acquired for the account of a subsidiary of Commercial
Corp. and through the Acquisition Partnerships. Portfolio Assets owned directly
by a subsidiary of Commercial Corp. are financed with cash contributed by
Commercial Corp. and secured senior debt that is recourse only to such
subsidiary.
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Each Acquisition Partnership is a separate legal entity, generally formed
as a limited partnership. Commercial Corp. and an investor typically form a
corporation to serve as the corporate general partner of each Acquisition
Partnership. Generally, Commercial Corp. and the investor each own 50% of the
general partner and a 49% limited partnership interest in the Acquisition
Partnership (the general partner owns the other 2% interest). Cargill Financial
or its affiliates are the investor in the vast majority of the Acquisition
Partnerships currently in existence. See "-- Relationship with Cargill
Financial." Certain institutional investors have also held limited partnership
interests in the Acquisition Partnerships and may hold interests in the related
corporate general partners. Acquisition Partnerships may also be formed as a
trust, corporation or other type of entity.
The Acquisition Partnerships generally are financed by debt secured only by
the assets of the individual entity and are nonrecourse to the Company,
Commercial Corp., its co-investors and the other Acquisition Partnerships.
Commercial Corp. believes that such legal structure insulates it, the Company
and the other Acquisition Partnerships from certain potential risks, while
permitting Commercial Corp. to share in the economic benefits of each
Acquisition Partnership. Prior to the Merger, a significant portion of the
funding for each Acquisition Partnership was provided in the form of
subordinated debt provided by Cargill Financial. Because the Merger increased
the capital available to Commercial Corp., the need for subordinated debt has
been substantially eliminated, enabling Commercial Corp. to commit a larger
portion of its own funds to the Acquisition Partnerships. In addition, the
Merger has enhanced Commercial Corp.'s capacity to invest in Portfolios without
the participation of an investment partner.
Senior secured acquisition financing currently provides the majority of the
funding for the purchase of Portfolios. Commercial Corp. and the Acquisition
Partnerships have relationships with a number of senior lenders including Nomura
Securities, Inc. ("Nomura"), Cargill Financial and others. Senior acquisition
financing is obtained at variable interest rates ranging from LIBOR to prime
based pricing with negotiated spreads to the base rates. The final maturity of
the senior secured acquisition debt is normally two years from the date of
funding of each advance under the facility. The terms of the senior acquisition
debt of the Acquisition Partnerships generally allow, under certain conditions,
distributions to equity partners before the debt is repaid in full.
Prior to maturity of the senior acquisition debt, the Acquisition
Partnerships typically refinance the senior acquisition debt with long-term debt
secured by the assets of partnerships or transfer assets from the Portfolios to
special purpose entities to effect structured financings or securitization
transactions. Such long-term debt generally accrues interest at a lower rate
than the senior acquisition debt, has collateral terms similar to the senior
acquisition debt, and permits distributions of excess cash flow generated by the
partnership to the equity partners so long as the partnership is in compliance
with applicable financial covenants.
Relationship with Cargill Financial
Cargill Financial, a diversified financial services company, is a wholly
owned subsidiary of Cargill, Incorporated, which is generally regarded as one of
the world's largest privately-held corporations and has offices worldwide.
Cargill Financial and its affiliates provide significant debt and equity
financing to the Acquisition Partnerships. In addition, Commercial Corp.
believes its relationship with Cargill Financial significantly enhances
Commercial Corp.'s credibility as a purchaser of Portfolio Assets and
facilitates its ability to expand into other businesses and foreign markets.
Under a Right of First Refusal Agreement and Due Diligence Reimbursement
Agreement effective as of January 1, 1998 (the "Right of First Refusal
Agreement") among the Company, FirstCity Servicing Corporation, Cargill
Financial and its wholly owned subsidiary CFSC Capital Corp. II ("CFSC"), if the
Company receives an invitation to bid on or otherwise obtains an opportunity to
acquire interests in domestic loans, receivables, real estate or other assets in
which the aggregate amount to be bid exceeds $4 million, the Company is required
to follow a prescribed notice procedure pursuant to which CFSC has the option to
participate in the proposed purchase by requiring that such purchase or
acquisition be effected through an Acquisition Partnership formed by the Company
and Cargill Financial (or an affiliate). The Right of First Refusal Agreement
does not prohibit the Company from holding discussions with entities other than
CFSC
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regarding potential joint purchases of interests in loans, receivables, real
estate or other assets, provided that any such purchase is subject to CFSC's
right to participate in the Company's share of the investment. The Right of
First Refusal Agreement further provides that, subject to certain conditions,
CFSC will bear 50% of the due diligence expenses incurred by the Company in
connection with proposed asset purchases. The Right of First Refusal Agreement
is an amendment and extension of a similar agreement entered into among the
Company, certain members of the Company's management and Cargill Financial in
1992. The Right of First Refusal Agreement terminates on January 1, 2000.
Business Strategy
Historically, Commercial Corp. has leveraged its expertise in asset
resolution and servicing by investing in a wide variety of asset types across a
broad geographic scope. Commercial Corp. continues to follow this investment
strategy and seeks expansion opportunities into new asset classes and geographic
areas when it believes it can achieve attractive risk adjusted returns. The
following are the key elements of Commercial Corp.'s business strategy in the
portfolio acquisition and resolution business:
- Niche markets. Commercial Corp. will continue to pursue profitable
private market niches in which to invest. The niche investment
opportunities that Commercial Corp. has pursued to date include (i) the
acquisition of improved or unimproved real estate, including excess
retail sites, (ii) periodic purchases of single financial or real estate
assets from banks and other financial institutions with which Commercial
Corp. has established relationships, and from a variety of other sellers
that are familiar with the Company's reputation for acting quickly and
efficiently and (iii) the purchase of charged-off credit card
receivables.
- Emphasis on smaller Portfolios. Generally, Commercial Corp. seeks
purchases of Portfolio Assets with a purchase price of less than $100
million in order to avoid large portfolio offerings that attract larger
institutional purchasers and hedge funds, which have lower threshold
return requirements and lower funding costs than Commercial Corp.
- Foreign markets. Commercial Corp. believes that the foreign markets for
distressed assets are less developed than the U.S. market, and therefore
provide a greater opportunity to achieve attractive risk adjusted
returns. Commercial Corp. has purchased Portfolio Assets in France and
expects to continue to seek purchase opportunities outside of the United
States.
Commercial Lending Opportunities
Commercial Corp.'s extensive experience in the asset acquisition and
resolution business has led to numerous opportunities to originate commercial
loans. In most cases, the prospective borrower was unwilling or unable to meet a
traditional lenders' requirements or found that a traditional lender could not
or would not be responsive within a short time frame. In some cases, the
prospective borrower was already aware of Commercial Corp.'s familiarity and
comfort with a particular type of collateral, such as lodging properties, small
commercial real estate developments, franchisee properties or small multi-family
projects. In Commercial Corp.'s view, its extensive experience in servicing
difficult distressed asset credits qualifies it to originate, and service,
commercial loans. To that end, Commercial Corp. is currently evaluating the
possibility of making debtor-in-possession loans to borrowers in bankruptcy
reorganization proceedings, mezzanine loans or venture capital investments in
emerging growth company situations and commercial loans meeting the underwriting
and other standards of qualification for a Small Business Administration
guarantee. Commercial Corp. is also analyzing the special funding needs of
borrowers who are franchisees, and is considering the factoring of receivables.
Commercial Corp. expects that it will analyze other commercial lending
opportunities as they arise. In some cases, the opportunity might be a unique
and defined lending opportunity. In others, an attractive opportunity would be
characterized by a flow of lending opportunities, such as in the factoring
business. Commercial Corp. will also entertain the opportunity to joint venture
with businesses already in the targeted business activity but which need
additional capital or funding and the servicing expertise of Commercial Corp.
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CONSUMER LENDING
The Company conducts all of its consumer receivable origination activities
through FirstCity Consumer Lending Corporation and its subsidiaries ("Consumer
Corp."). Consumer Corp.'s current focus is on the origination and servicing of
sub-prime consumer loans. Such loans are extended to borrowers who evidence an
ability and willingness to repay credit, but have experienced an adverse event,
such as a job loss, illness or divorce, or have had past credit problems, such
as delinquency, bankruptcy, repossession or charge-offs. The significant
majority of Consumer Corp.'s current business is focused on the sub-prime
automobile sector, with each loan funded after individual underwriting and
pricing of each proposed extension of credit.
Market Background
The sub-prime automobile finance business has been characterized by several
factors that the Company believes increase its likelihood of being able to build
a successful sub-prime automobile finance business. Within the past several
years, significant amounts of new capital have become available, thereby
allowing a large number of new market participants to originate loans to
sub-prime automobile borrowers. This increase in competition led to reduced
credit underwriting standards and lower dealer discounts as lenders sought to
maintain earnings by increasing loan origination levels. In the Company's view,
too little attention was paid to both the importance of matching the discount to
the expected loss per occurrence and the special effort required to service a
sub-prime automobile loan. Because of many notable failures, especially among
mono-line automobile finance businesses, the Company believes that the
opportunity now exists to increase market share by providing a fully
underwritten loan product that utilizes risk-adjusted pricing to franchised
automobile dealerships that seek a steady source of funding supported by
meaningful and responsive service.
Consumer Corp. Background
Through its Portfolio Asset acquisition and resolution business, the
Company has acquired approximately $580 million in Face Value of distressed
consumer loans. In addition, through its wholly owned subsidiary, FirstCity
Servicing Corporation of California ("Consumer Servicing") the Company has
extensive experience in the servicing of distressed sub-prime automobile loans.
The Company's initial venture into the sub-prime automobile market involved
the acquisition of a distressed sub-prime automobile loan portfolio from a
secured lender. In addition to acquiring the distressed loans, the Company
acquired the equity of the company that operated the program through which the
loans had been originated. This program involved the indirect acquisition of
automobile loans from financial intermediaries that had direct contact with
automobile dealerships. The Company was required to purchase loans that
satisfied minimum contractual underwriting standards and was not permitted to
negotiate purchase discounts for a loan based on the individual risk profile of
the loan and the borrower. After operating this program for approximately 15
months, the Company concluded that the contractual underwriting standards and
purchase discounts on which the program was based were insufficient to generate
sub-prime automobile loans of acceptable quality to the Company. As a result,
the Company terminated its obligations with the financial institutions
participating in such origination program effective as of January 31, 1998.
With the benefit of the experience gained by the Company through its
initial attempt at originating acceptable sub-prime automobile loans, the
Company began, in early 1997, to explore other business models that it felt
would be successful in the current market environment. This investigation and
research resulted in the formation, during the third quarter of 1997, of
FirstCity Funding Corporation ("Funding Corp."), 80% of which is owned by the
Company and 20% of which is owned by Funding Corp.'s management team. Funding
Corp.'s management team is experienced in the automobile finance business, with
significant prior experience in the sales and finance activities of franchised
dealerships. Funding Corp.'s business model is predicated upon the acquisition
of newly originated sub-prime automobile finance contracts at a price that is
adjusted to reflect the expected loss per occurrence on defaulted contracts. The
approach emphasizes service to the dealership and a steady source of funding for
contracts that meet Funding Corp.'s underwriting and pricing criteria. In
addition, all loans are serviced by Consumer Servicing, which is dedicated
exclusively to the servicing of consumer loans originated or acquired by
Consumer Corp.
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Consumer Corp. and the management shareholders of Funding Corp. entered
into a shareholders' agreement in connection with the formation of Funding Corp.
in September 1997. Commencing on the fifth anniversary of such agreement,
Consumer Corp. and the management shareholders have put and call options with
respect to the stock of Funding Corp. held by the other party, which will be
priced at a mutually agreed upon fair market value.
Product Description
Consumer Corp. currently acquires and originates loans, secured by
automobiles, to borrowers who have had past credit problems or have little or no
credit experience. Such loans are individually underwritten to Consumer Corp.'s
underwriting and credit guidelines. See "-- Loan Acquisition and Underwriting."
The collateral for the loan generally is a used automobile purchased from a
franchised automobile dealership. The loans generally have a term of no more
than 60 months and generally accrue interest at the maximum rate allowed by
applicable state law.
Origination Channels
Through a sales staff managed by professionals with an extensive automobile
dealership background, Funding Corp. markets its loan products and dealership
services directly to participating franchised automobile dealerships. Funding
Corp. currently maintains approximately 250 automobile dealership relationships
in Texas, Missouri and Oklahoma. Near term plans call for expansion into other
states as staffing levels, licensing and training permit. Funding Corp. is
targeting expansion into states that offer attractive opportunities due to
population growth, attractive consumer lending rate environments and
lender-friendly repossession and collection remedies with respect to defaulting
borrowers.
The dealership servicing and marketing staff of Funding Corp. consists of
eight marketing representatives who work with dealers that submit funding
applications to Funding Corp. These marketing representatives call upon new
dealership prospects within the current marketing territories and work with
existing dealerships to solicit additional loan acquisition opportunities. All
of the marketing staff are full time employees of Funding Corp. and have
completed an extensive training program. In addition to the initial training,
weekly updates with the marketing representatives and monthly meetings for the
entire staff are held to maintain current knowledge of the dealership programs
and product offerings.
Participating dealerships submit funding applications for each prospective
loan to Funding Corp.'s home office in Dallas, Texas. Applications are reviewed
and checked for completeness and all complete applications are forwarded to a
credit analyst for review. Within two hours after receipt of an application, a
representative of Funding Corp. will notify the dealership of the terms on which
it would acquire the loan, subject to confirmation of the application data. See
"-- Loan Acquisition and Underwriting."
In addition to Funding Corp.'s operations, FirstCity Consumer Finance
Corporation ("Consumer Finance"), a wholly owned subsidiary of Consumer Corp.,
originates loans with borrowers who have established payment records on recently
originated automobile receivables through direct marketing to the consumer.
Through contractual relationships with third parties, Consumer Finance
identifies loan prospects for underwriting, documentation and funding upon final
approval of a request for credit. The activities of Consumer Finance are not
significant to date, with 20 loans having an aggregate principal balance of
approximately $200,000 outstanding at December 31, 1997.
Loan Acquisition and Underwriting
Funding Corp. acquires sub-prime automobile loans originated by franchised
dealerships under a tiered pricing system. Under its pricing and underwriting
guidelines, each loan is purchased in an individually negotiated transaction
from the selling dealership only after it has been fully underwritten and
independently verified by Funding Corp. A staff of 22 credit and compliance
personnel in Funding Corp.'s home office completes the underwriting and due
diligence for each funding application. During the compliance phase of the
underwriting review, Funding Corp. verifies all pertinent information on a
borrower's credit application, including verification of landlord information
for borrowers without a mortgage. As an additional check on the
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quality of the prospective loan, each borrower is personally contacted by
Funding Corp. prior to the acquisition of the loan. At such time, all of the
details of the proposed transaction are confirmed with the borrower, including
the borrower's level of satisfaction with the purchased vehicle.
Each transaction is individually priced to achieve a risk-adjusted target
purchase price, which is expressed as a percentage of the par value of the loan.
The tiered pricing structure of Funding Corp. is designed as a guideline for
establishing minimum underwriting and pricing standards for the loans to be
acquired. The minimum amount of the discount from par for the four tiers ranges
from no discount for tier 1 loans to a 10% discount for tier 4 loans. Funding
Corp.'s underwriting standards do not permit the purchase of a loan for more
than its par value. Other factors impacting the tier level of a loan include,
but are not limited to, prior credit history, repossession and bankruptcy
history, open credit account status, income minimums, down payment requirements,
payment ratio tests and the contract advance amount as a percentage of the
wholesale value of the collateral vehicle. The purpose of the tiered
underwriting and pricing structure is to acquire loans that are priced in
accordance with risk characteristics and the underlying value of the collateral.
The process is designed to approve loan applications for borrowers who are
likely to pay as agreed, and to minimize the risk of loss on the disposition of
the underlying collateral in the event that a default occurs.
Funding Corp. seeks to acquire loans that have the following
characteristics:
- Loans originated by a new automobile franchised dealership
- Loans secured by automobiles that have established resale values and a
targeted age of approximately two years
- The borrower has made a substantial down payment on the automobile, which
evidences a significant equity commitment
- The loan is underwritten to provide a debt to income ratio permitting the
borrower to comfortably afford the monthly payments
- The borrower evidences a tendency toward repairing impaired credit
- Funding Corp.'s purchase price of the contract from the dealership is
less than the published wholesale value of the automobile
From its inception in September 1997 through December 31, 1997, Funding
Corp. acquired a total of 502 automobile loans representing an aggregate of
approximately $7.1 million in Face Value. The loans had a weighted average
coupon rate of 19.1%. The average Face Value of the loans acquired was $14,209,
which on average represented approximately 104.3% of the published wholesale
value of the financed automobile. Funding Corp. acquired the loans from
dealerships at an average discount of approximately 11.4% from their Face Value.
As a result, the average amount advanced by Funding Corp. for a particular loan
was equal to approximately 92.4% of the published wholesale value of the
financed automobile.
The average automobile financed by Funding Corp. through December 31, 1997
was two and one half years old with approximately 32,000 miles. The average
contractual repayment term for the loans acquired by Funding Corp. was 52
months. The ratio of the borrower's monthly debt service amount to the
borrower's monthly gross income was, on average, equal to 12.1%.
Financing Strategy
Funding Corp. finances its operations with a warehouse credit facility
provided by ContiTrade Services L.L.C. ("ContiTrade"), in connection with which
ContiFinancial Services Corporation, an affiliate of ContiTrade, has the right
to provide advisory and placement services to Funding Corp. for the
securitization of acquired loans. Funding Corp. plans to provide permanent
financing for its acquired consumer loans through securitizations of pools of
loans totaling between $40 and $50 million.
The securitization transactions are expected to be consummated through the
creation of special purpose trusts. The loans will be transferred to a trust in
exchange for certificates representing the senior interest in the
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securitized loans held by the trust and, if applicable, a subordinated interest
in the securitized loans. The subordinated interests generally consist of the
excess spread between the interest and principal paid by the borrowers on the
loans pooled in the securitization and the interest and principal of the senior
interests issued in the securitization, and other unrated interests issued in
the securitization. The senior interests are subsequently sold to investors for
cash. Consumer Corp. may elect to retain the subordinated interests or may sell
all or some portion of the subordinated interests to investors for cash.
Consumer Corp. anticipates that it will retain the rights to the excess spreads.
Upon the sale of loans in securitization transactions, the sum of the cash
proceeds received and the estimated present values of the subordinated interests
less the costs of origination and securitization and the basis in the loans sold
results in the gain recognized at the time of the securitization transaction.
The present values of the subordinated interests to be recognized by Consumer
Corp. are to be determined based upon prepayment, loss and discount rate
assumptions that will be determined in accordance with the unique underlying
characteristics of the loans comprising each securitization.
Servicing
Consumer Servicing, an indirect wholly owned subsidiary of the Company, is
responsible for the loan accounting, collection, payment processing, skip
tracing and recovery activities associated with the Company's consumer lending
activities. Consumer Servicing has extensive experience in servicing automobile
loans and the Company believes that Consumer Servicing is a critical element to
the Company's ultimate success in the consumer loan business. Consumer
Servicing's activities are closely integrated with the activities of Consumer
Corp. This enables Consumer Servicing to take advantage of the information
regarding the quality of originated credit that is available from a servicer in
order to assist in the evaluation and modification of product design and
underwriting criteria.
The staffing of Consumer Servicing consists of 61 personnel, including 34
assigned to customer service and collections and 10 assigned to the special
recovery activities associated with assignments for repossession through the
liquidation of the collateral (in addition to two individuals at Funding Corp.
who work in asset liquidation). This group also coordinates any contract
reinstatements, notices of intent to dispose of collateral and recovery of any
insurance, warranty or other premium payments subject to recovery in the event
of cancellation. An additional staff of seven personnel is dedicated to asset
recovery, which includes tracing of individuals who cannot be located, seeking
to collect on deficiencies, managing the storage of repossessed vehicles prior
to their disposition and physical damage claims on collateral vehicles. An
administrative staff handles the special issues associated with borrowers in
bankruptcy and the more complicated issues associated with contracts involved in
other legal disputes.
The servicing practices associated with sub-prime loans are extensive. For
example, Consumer Servicing personnel contact each borrower three days prior to
the payment due date during each of the first three months of the contract. This
process assists in avoiding first payment defaults and confirms that the
customer can be located. If a borrower is delinquent in payment, an attempt to
contact the borrower is made on the first day of delinquency. Continual contact
is attempted until the borrower is located and payment is made, or a commitment
is made to bring the contract current. If the borrower cannot be contacted, the
account may be assigned to Consumer Servicing's asset recovery staff.
If the borrower does not meet a payment commitment and has not indicated a
verifiable and reasonable intention to bring the loan current, the account is
assigned to outside agents for repossession at the thirty-third day of
delinquency. At such time, the borrower has missed two payments and has not
indicated a willingness to enter into a repayment plan. After the collateral is
repossessed, the borrower has a limited opportunity to reinstate the obligation
under applicable state law by bringing the payment current and reimbursing
Consumer Servicing for its repossession expenses. If the loan is not reinstated
within the reinstatement period, the collateral is sold by the asset liquidation
group. Funding Corp. disposes of repossessed automobiles at auction after a
thorough inspection and detailing. A representative of Funding Corp. generally
will attend the auction to represent Funding Corp. and ensure that the
automobile is properly represented by the auction firm.
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Strategy
The Company continues to evaluate a number of business opportunities in the
consumer sector, which have the capability of generating or acquiring consumer
loans that represent identifiable and predictable credit quality and whose
return thresholds match or exceed those targeted by the Company. These include
secured consumer loan products and certain aspects of direct and indirect
unsecured consumer lending. Through contacts with investment banks, business
brokers and others in the consumer lending field, the Company seeks acquisition
or merger candidates or qualified management teams with which to associate in
start-up ventures. As with other aspects of its business, the Company seeks to
be opportunistic in targeting additional consumer lending opportunities.
GOVERNMENT REGULATION
Many aspects of the Company's business are subject to regulation,
examination and licensing under various federal, state and local statutes and
regulations that impose requirements and restrictions affecting, among other
things, the Company's loan originations, credit activities, maximum interest
rates, finance and other charges, disclosures to customers, the terms of secured
transactions, collection repossession and claims handling procedures, multiple
qualification and licensing requirements for doing business in various
jurisdictions, and other trade practices.
Mortgage Banking. The Company's mortgage banking business is subject to
extensive and complex rules and regulations of, and examinations by, various
federal, state and local government authorities. These rules and regulations
impose obligations and restrictions on loan originations, credit activities and
secured transactions. In addition, these rules limit the interest rates, finance
charges and other fees that Mortgage Corp. and Capital Corp. may assess, mandate
extensive disclosure to their customers, prohibit discrimination and impose
multiple qualification and licensing obligations. Failure to comply with these
requirements may result in, among other things, demands for indemnification or
mortgage loan repurchases, certain rights of rescission for mortgage loans,
class action lawsuits, administrative enforcement actions and civil and criminal
liability. The Company believes that its mortgage banking business is in
compliance with these rules and regulations in all material respects.
Loan origination activities are subject to the laws and regulations in each
of the states in which those activities are conducted. For example, state usury
laws limit the interest rates that can be charged on loans. Lending activities
are also subject to various federal laws, including those described below.
Mortgage Corp. and Capital Corp. are subject to certain disclosure requirements
under the Federal Truth-In-Lending Act ("TILA") and the Federal Reserve Board's
Regulation Z promulgated thereunder. TILA is designed to provide consumers with
uniform, understandable information with respect to the terms and conditions of
loan and credit transactions. TILA also guarantees consumers a three day right
to cancel certain credit transactions, including loans of the type originated by
Mortgage Corp. and Capital Corp. Such three day right to rescind may remain
unexpired for up to three years if the lender fails to provide the requisite
disclosures to the consumer.
Mortgage Corp. and Capital Corp. are also subject to the High Cost Mortgage
Act ("HCMA"), which amends TILA. The HCMA generally applies to consumer credit
transactions secured by the consumer's principal residence, other than
residential mortgage transactions, reverse mortgage transactions or transactions
under an open-end credit plan, in which the loan has either (i) total points and
fees upon origination in excess of the greater of eight percent of the loan
amount or $400 or (ii) an annual percentage rate of more than ten percentage
points higher than United States Treasury securities of comparable maturity
("Covered Loans"). The HCMA imposes additional disclosure requirements on
lenders originating Covered Loans. In addition, it prohibits lenders from, among
other things, (i) originating Covered Loans that are underwritten solely on the
basis of the borrower's home equity without regard to the borrower's ability to
repay the loan and (ii) including prepayment fee clauses in Covered Loans to
borrowers with a debt-to-income ratio in excess of 50% or Covered Loans used to
refinance existing loans originated by the same lender. The HCMA also restricts,
among other things, certain balloon payments and negative amortization features.
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Mortgage Corp. and Capital Corp. are also required to comply with the Equal
Credit Opportunity Act ("ECOA") and the Federal Reserve Board's Regulation B
promulgated thereunder, the Fair Credit Reporting Act ("FCRA"), the Real Estate
Settlement Procedures Act of 1974 ("RESPA"), the Home Mortgage Disclosure Act
("HMDA") and the Federal Fair Debt Collection Procedures Act. Regulation B
restricts creditors from requesting certain types of information from loan
applicants. FCRA requires lenders, among other things, to supply an applicant
with certain disclosures concerning settlement fees and charges and mortgage
servicing transfer practices. It also prohibits the payment or receipt of
kickbacks or referral fees in connection with the performance of settlement
services. In addition, beginning with loans originated in 1994, an annual report
must be filed with the Department of Housing and Urban Development pursuant to
HMDA, which requires the collection and reporting of statistical data concerning
loan transactions.
Regulation of Sub-prime Automobile Lending. Consumer Corp.'s automobile
lending activities are subject to various federal and state consumer protection
laws, including TILA, ECOA, FCRA, the Federal Fair Debt Collection Practices
Act, the Federal Trade Commission Act, the Federal Reserve Board's Regulations B
and Z, and state motor vehicle retail installment sales acts and other similar
laws that regulate the origination and collection of consumer receivables and
impact Consumer Corp.'s business. These laws, among other things, (i) require
Consumer Corp. to obtain and maintain certain licenses and qualifications, (ii)
limit the finance charges, fees and other charges on the contracts purchased,
(iii) require Consumer Corp. to provide specific disclosures to consumers, (iv)
limit the terms of the contracts, (v) regulate the credit application and
evaluation process, (vi) regulate certain servicing and collection practices,
and (vii) regulate the repossession and sale of collateral. These laws impose
specific statutory liabilities upon creditors who fail to comply with their
provisions and may give rise to defenses to the payment of the consumer's
obligation. In addition, certain of the laws make the assignee of a consumer
installment contract liable for the violations of the assignor.
Each dealer agreement contains representations and warranties by the dealer
that, as of the date of assignment, the dealer has complied with all applicable
laws and regulations with respect to each contract. The dealer is obligated to
indemnify Consumer Corp. for any breach of any of the representations and
warranties and to repurchase any non-conforming contracts. Consumer Corp.
generally verifies dealer compliance with usury laws, but does not audit a
dealer's full compliance with applicable laws. There can be no assurance that
Consumer Corp. will detect all dealer violations or that individual dealers will
have the financial ability and resources either to repurchase contracts or
indemnify Consumer Corp. against losses. Accordingly, failure by dealers to
comply with applicable laws, or with their representations and warranties under
the dealer agreement, could have a material adverse effect on Consumer Corp.
If a borrower defaults on a contract, Consumer Corp., as the servicer of
the contract, is entitled to exercise the remedies of a secured party under the
Uniform Commercial Code (the "UCC"), which typically includes the right to
repossession by self-help unless such means would constitute a breach of peace.
The UCC and other state laws regulate repossession and sales of collateral by
requiring reasonable notice to the borrower of the date, time and place of any
public sale of collateral, the date after which any private sale of the
collateral may be held and the borrower's right to redeem the financed vehicle
prior to any such sale, and by providing that any such sale must be conducted in
a commercially reasonable manner.
COMPETITION
All of the business lines in which the Company operates are highly
competitive. Some of the Company's principal competitors in certain of its
businesses are substantially larger and better capitalized than the Company.
Because of these resources, these companies may be better able than the Company
to obtain new customers for mortgage or other loan production, to acquire
Portfolio Assets, to pursue new business opportunities or to survive periods of
industry consolidation.
The Company encounters significant competition in its mortgage banking
business. Mortgage Corp. competes with other mortgage banking companies,
mortgage and servicing brokers, commercial banks, savings associations, credit
unions, other financial institutions and various other lenders. A number of
these competitors have substantially greater financial resources and greater
operating efficiencies. Customers
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distinguish between product and service providers in the industries in which
Mortgage Corp. operates for various reasons, including convenience in obtaining
the product or service, overall customer service, marketing and distribution
channels and pricing (primarily in the form of prevailing interest rates).
Competition for Mortgage Corp. is particularly affected by fluctuations in
interest rates. During periods of rising interest rates, competitors of Mortgage
Corp. who have locked into lower borrowing costs may have a competitive
advantage. During periods of declining rates, competitors may solicit Mortgage
Corp.'s customers to refinance their loans.
The Company believes that it is one of the largest, independent,
full-service companies in the distressed asset business. There are, however, no
published rankings available, because many of the transactions that would be
used for ranking purposes are with private parties. Generally, there are three
aspects of the distressed asset business: due diligence, principal activities,
and servicing. The Company is a major participant in all three areas, whereas
certain of its competitors (including certain securities and banking firms) have
historically competed primarily as portfolio purchasers, as they have
customarily engaged other parties to conduct due diligence on potential
portfolio purchases and to service acquired assets, and certain other
competitors (including certain banking and other firms) have historically
competed primarily as servicing companies.
The Company believes that its ability to acquire Portfolios for its own
account and through Acquisition Partnerships will be an important aspect of the
Company's overall future growth. Acquisitions of Portfolios are often based on
competitive bidding, which involves the danger of bidding too low (which
generates no business), or bidding too high (which could win the Portfolio at an
economically unattractive price).
The sub-prime automobile finance market is highly fragmented and very
competitive. There are numerous financial services companies serving, or capable
of serving, this market, including traditional financial institutions such as
banks, savings and loans, credit unions, and captive finance companies owned by
automobile manufacturers, and other non-traditional consumer finance companies,
many of which have significantly greater financial and other resources than the
Company.
The Company also encounters significant competition in its other
businesses. Within the Home Equity Loan securitization businesses, access to and
the cost of capital are critical to the Company's ability to compete. Many of
the Company's competitors have superior access to capital sources and can
arrange or obtain lower cost of capital for customers.
EMPLOYEES
The Company had 1,186 employees as of December 31, 1997. No employee is a
member of a labor union or party to a collective bargaining agreement. The
Company believes that its employee relations are good.
ITEM 2. PROPERTIES.
FirstCity leases all its office locations. FirstCity leases its current
headquarters building from a related party under a noncancellable operating
lease which expires December 2001. All leases of the other offices of FirstCity
and subsidiaries expire prior to 2005.
ITEM 3. LEGAL PROCEEDINGS.
Periodically, FirstCity, its subsidiaries, its affiliates and the
Acquisition Partnerships are parties to or otherwise involved in legal
proceedings arising in the normal course of business. FirstCity does not believe
that there is any proceeding threatened or pending against it, its subsidiaries,
its affiliates or the Acquisition Partnerships which, if determined adversely,
would have a material adverse effect on the consolidated financial position,
results of operations or liquidity of FirstCity, its subsidiaries, its
affiliates or the Acquisition Partnerships.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth
quarter ended December 31, 1997.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
COMMON AND PREFERRED STOCK DATA
FirstCity's common stock, $.01 par value per share (the "Common Stock")
(FCFC), and its special preferred (FCFCP) and adjusting rate preferred (FCFCO)
stock are listed on the Nasdaq National Market System. The number of common
stockholders of record on March 24, 1998 was approximately 515. High and low
stock prices and dividends in 1997 and 1996 are displayed in the following
table:
1997 1996
--------------------------- ---------------------------
MARKET PRICE CASH MARKET PRICE CASH
--------------- DIVIDENDS --------------- DIVIDENDS
QUARTER ENDED HIGH LOW PAID HIGH LOW PAID
------------- ------ ------ --------- ------ ------ ---------
Common Stock:
March 31.................... $29.50 $23.00 $ -- $22.88 $18.25 $ --
June 30..................... 27.75 20.00 -- 29.00 18.75 --
September 30................ 29.00 23.88 -- 29.50 24.63 --
December 31................. 30.75 25.25 -- 31.88 27.75 --
Special Preferred Stock:
March 31.................... $23.88 $22.88 $.7875 $24.75 $23.13 $ --
June 30..................... 24.38 22.88 .7875 25.75 24.13 --
September 30................ 24.00 21.88 .7875 26.50 25.31 --
December 31................. 23.00 21.88 .7875 26.50 22.00 3.92(1)
Adjusting Rate Preferred
Stock:
March 31.................... $ -- $ -- $ -- $ -- $ -- $ --
June 30..................... -- -- -- -- --
September 30(2)............. 23.50 22.00 -- -- -- --
December 31................. 23.00 21.00 .7875 -- -- --
- ---------------
(1) Accrued dividend from July 3, 1995 through September 30, 1996.
(2) Beginning August 13, 1997.
The Company has never declared or paid a dividend on the Common Stock. The
Company currently intends to retain future earnings to finance its growth and
development and therefore does not anticipate that it will declare or pay any
dividends on the Common Stock in the foreseeable future. Any future
determination as to payment of dividends will be made at the discretion of the
Board of Directors of the Company and will depend upon the Company's operating
results, financial condition, capital requirements, general business conditions
and such other factors that the Board of Directors deems relevant. The Company
Credit Facility and substantially all of the credit facilities to which the
Company's subsidiaries and the Acquisition Partnerships are parties contain
restrictions relating to the payment of dividends and other distributions.
ITEM 6. SELECTED FINANCIAL DATA.
The Harbor Merger, which occurred in July 1997, was accounted for as a
pooling of interests. The Company's historical financial statements have
therefore been retroactively restated to include the financial position and
results of operations of Mortgage Corp. for all periods presented. Earnings per
share has been calculated in conformity with SFAS No. 128, Earnings Per Share,
and all prior periods have been restated.
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The Selected Financial Data presented below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" under Item 7 of this Report and with the related Consolidated
Financial Statements and Notes thereto under Item 8 of this Report.
SELECTED FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1997 1996 1995 1994 1993
-------- -------- -------- -------- -------
Income................................ $129,622 $ 99,089 $ 59,965 $ 40,865 $39,030
Expenses.............................. 109,322 73,709 43,521 32,649 28,801
Net earnings before minority interest,
preferred dividends and income
taxes............................... 20,300 25,380 16,444 8,216 10,189
Net earnings before minority interest
and preferred dividends(1).......... 35,785 39,129 15,244 5,445 6,799
Redeemable preferred dividends........ 6,203 7,709 3,876 -- --
Net earnings to common
shareholders(1)..................... 29,425 31,420 11,368 5,445 6,799
Net earnings per common
share -- Basic(1)................... 4.51 4.83 2.18 1.32 1.65
Net earnings per common share --
Diluted(1).......................... 4.46 4.79 2.18 1.32 1.65
Dividends per common share............ -- -- -- -- --
At year end:
Total assets........................ 940,119 425,189 439,051 105,812 92,872
Total notes payable................. 750,781 266,166 317,189 72,843 66,420
Preferred stock..................... 41,908 53,617 55,555 -- --
Total common equity................... 112,758 84,802 52,788 27,122 19,359
- ---------------
(1) Includes $15.5 million and $13.7 million, respectively, of deferred tax
benefits in 1997 and 1996
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company is a diversified financial services company engaged in
residential and commercial mortgage banking, Portfolio Asset acquisition and
resolution and consumer lending. The mortgage banking business involves the
origination, acquisition and servicing of residential and commercial mortgage
loans and the subsequent warehousing, sale or securitization of such loans
through various public and private secondary markets. The Portfolio Asset
acquisition and resolution business involves acquiring Portfolio Assets at a
discount to Face Value and servicing and resolving such Portfolios in an effort
to maximize the present value of the ultimate cash recoveries. The Company also
seeks opportunities to originate and retain high yield commercial loans to
businesses and to finance real estate projects that are unable to access
traditional lending sources. The consumer lending business involves the
acquisition, origination, warehousing, securitization and servicing of consumer
receivables. The Company's current consumer lending operations are focused on
the acquisition of sub-prime automobile receivables.
The Company's financial results are affected by many factors including
levels of and fluctuations in interest rates, fluctuations in the underlying
values of real estate and other assets, and the availability and prices for
loans and assets acquired in all of the Company's businesses. The Company's
business and results of operations are also affected by the availability of
financing with terms acceptable to the Company and the Company's access to
capital markets, including the securitization markets.
The Company consummated the Merger of J-Hawk and FCBOT in July 1995. The
Company's financial statements reflect the Merger as an acquisition of FCBOT by
J-Hawk. For periods prior to July 1995 (with the exception of the restatement
for the Harbor Merger), the Company's financial statements reflect the
activities of J-Hawk. During such periods, J-Hawk was principally engaged in the
Portfolio Asset acquisition and resolution business. The Harbor Merger, which
occurred in July 1997, was accounted for as a pooling of interests. The
Company's historical financial statements have therefore been retroactively
restated to include the financial position and results of operations of Mortgage
Corp. for all periods presented. As a result of the
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Merger, the Harbor Merger and the significant period to period fluctuations in
the revenues and earnings of the Company's Portfolio Asset acquisition and
resolution business, period to period comparisons of the Company's results of
operations may not be meaningful.
ANALYSIS OF REVENUES AND EXPENSES
The following table summarizes the revenues and expenses of each of the
Company's businesses and presents the contribution that each business makes to
the Company's operating margin.
ANALYSIS OF REVENUES AND EXPENSES
YEAR ENDED DECEMBER 31,
-----------------------------
1997 1996 1995
------- ------- -------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
MORTGAGE BANKING:
Revenues:
Net mortgage warehouse income.......................... $ 3,499 $ 3,224 $ 2,355
Gain on sale of mortgage loans......................... 36,496 19,298 7,864
Servicing fees......................................... 14,732 10,079 6,508
Other.................................................. 10,999 5,019 3,715
------- ------- -------
Total............................................. 65,726 37,620 20,442
Expenses:
Salaries and benefits.................................. 30,398 16,105 8,673
Amortization of mortgage servicing rights.............. 7,550 4,091 3,823
Interest on other notes payables....................... 1,187 423 437
Occupancy, data processing, communication and other.... 20,705 11,013 6,734
------- ------- -------
Total............................................. 59,840 31,632 19,667
------- ------- -------
Operating contribution before direct taxes................ $ 5,886 $ 5,988 $ 775
======= ======= =======
Operating contribution, net of direct taxes............... $ 7,975 $ 3,724 $ 511
======= ======= =======
PORTFOLIO ASSET ACQUISITION AND RESOLUTION:
Revenues:
Gain on resolution of Portfolio Assets................. $24,183 $19,510 $11,984
Equity in earnings of Acquisition Partnerships......... 7,605 6,125 3,834
Servicing fees......................................... 11,513 12,440 10,903
Other.................................................. 4,402 6,592 4,205
------- ------- -------
Total............................................. 47,703 44,667 30,926
Expenses:
Salaries and benefits.................................. 5,353 6,002 4,500
Interest on other notes payable........................ 7,084 6,447 3,931
Asset level expenses, occupancy, data processing and
other................................................ 11,774 10,862 5,814
------- ------- -------
Total............................................. 24,211 23,311 14,245
------- ------- -------
Operating contribution before direct taxes................ $23,492 $21,356 $16,681
======= ======= =======
Operating contribution, net of direct taxes............... $23,299 $21,210 $15,745
======= ======= =======
CONSUMER LENDING:
Revenues:
Interest income........................................ $ 9,649 $ 3,604 $ --
Servicing fees and other............................... 632 46 --
------- ------- -------
Total............................................. 10,281 3,650 --
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YEAR ENDED DECEMBER 31,
-----------------------------
1997 1996 1995
------- ------- -------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
Expenses:
Salaries and benefits.................................. 2,959 698 --
Provision for loan losses.............................. 6,613 2,029 --
Interest on other notes payable........................ 3,033 1,284 --
Occupancy, data processing and other................... 3,414 1,469 --
------- ------- -------
Total............................................. 16,019 5,480
------- ------- -------
Operating contribution before direct taxes................ $(5,738) $(1,830) $ --
======= ======= =======
Operating contribution, net of direct taxes............... $(5,741) $(1,830) $ --
======= ======= =======
CORPORATE OVERHEAD:
Interest income on Class A Certificate(1)................. $ 3,553 $11,601 $ 8,597
Interest expense on senior subordinated notes............. -- (3,892) (4,721)
Salaries and benefits, occupancy, professional and other
income and expenses, net............................... (5,275) (7,843) (4,888)
------- ------- -------
Total............................................. (1,722) (134) (1,012)
------- ------- -------
Deferred tax benefit...................................... 13,592 16,159 --
Harbor Merger related expenses............................ (1,618) -- --
------- ------- -------
Net earnings before minority interest and preferred
dividends.............................................. 35,785 39,129 15,244
Minority interest......................................... (157) -- --
Preferred dividends....................................... (6,203) (7,709) (3,876)
------- ------- -------
Net earnings to common shareholders............... $29,425 $31,420 $11,368
======= ======= =======
SHARE DATA:
Net earnings per common share -- basic.................... $ 4.51 $ 4.83 $ 2.18
Net earnings per common share -- diluted.................. $ 4.46 $ 4.79 $ 2.18
Weighted average common shares outstanding -- basic....... 6,518 6,504 5,223
Weighted average common shares outstanding -- diluted..... 6,591 6,556 5,223
- ---------------
(1) Represents dividends on preferred stock accrued or paid prior to June 30,
1997 and interest paid on outstanding senior subordinated notes.
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MORTGAGE BANKING
The primary components of revenues derived by Mortgage Corp. and Capital
Corp. are net mortgage warehouse income, gain on sale of mortgage loans,
servicing fees earned for loan servicing activities, and other miscellaneous
sources of revenues associated with the origination and servicing of residential
and commercial mortgages. The principal components of expenses of Mortgage Corp.
and Capital Corp. are salaries and employee benefits, amortization of originated
and acquired mortgage servicing rights, interest expense and other general and
administrative expenses. The following paragraphs describe the principal factors
affecting each of the significant components of revenues of Mortgage Corp. and
Capital Corp. The following table presents selected information regarding the
revenues and expenses of the Company's mortgage banking business.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
MORTGAGE BANKING
YEAR ENDED DECEMBER 31,
--------------------------------------
1997 1996 1995
---------- ---------- ----------
(DOLLARS IN THOUSANDS)
WAREHOUSE INVENTORY:
Average inventory balance............................ $ 329,112 $ 138,035 $ 59,823
Net mortgage warehouse income:
Dollar amount..................................... 3,499 3,224 2,355
Percentage of average inventory balance........... 1.06% 2.34% 3.94%
GAIN ON SALE OF MORTGAGE LOANS:
Gain on sale of mortgage loans as a percentage of
loans sold:
Residential....................................... 0.98% 1.16% 1.27%
Home Equity....................................... 3.55% -- --
OMSR income as a percentage of residential mortgage
loans sold........................................ 1.75% 1.79% 1.82%
SERVICING REVENUES:
Average servicing portfolios:
Residential....................................... $3,661,031 $2,144,298 $1,262,497
Commercial........................................ 1,134,348 109,581 124,710
Sub-serviced...................................... 741,174 305,149 --
Servicing fees:
Residential....................................... $ 13,091 $ 9,625 $ 6,394
Commercial........................................ 809 126 114
Sub-serviced...................................... 832 328 --
---------- ---------- ----------
Total........................................ 14,732 10,079 6,508
Annualized servicing fee percentage:
Residential....................................... 0.36% 0.45% 0.51%
Commercial........................................ 0.07% 0.11% 0.09%
Sub-serviced...................................... 0.11% 0.11% --
Gain on sale of servicing rights..................... $ 4,246 $ 2,641 $ 2,011
Amortization of servicing rights:
Servicing rights amortization..................... $ 7,481 $ 4,091 $ 3,823
Servicing rights amortization as a percentage of
average servicing portfolio..................... 0.20% 0.19% 0.30%
PERSONNEL:
Personnel expenses................................... $ 30,398 $ 16,105 $ 8,673
Number of personnel (at period end):
Production........................................ 586 319 225
Servicing......................................... 118 93 49
Other............................................. 255 155 98
---------- ---------- ----------
Total........................................ 959 567 372
Salaried.......................................... 87% 84% 82%
Commission........................................ 13% 16% 18%
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Net Mortgage Warehouse Income
Mortgage Corp. originates or acquires residential mortgage loans, which are
recorded as mortgage loans held for sale and financed under warehouse credit
facilities pending sale. The difference between interest income on the
originated or acquired loans and the cost of warehouse borrowings is recorded as
net mortgage warehouse income. The amount of recorded net mortgage warehouse
income varies with the average volume of loans in the warehouse and the spread
between the coupon rate of interest on the loans and the interest cost of the
warehouse credit facility.
Gain on Sale of Mortgage Loans
Residential mortgage loans originated or acquired by Mortgage Corp.
currently are accumulated in inventory and held for sale. The disposition of the
loans generally produces a gain. Such gains result from the cash sale of the
mortgage loans and the additional recognition of the value of mortgage servicing
rights as proceeds, less the basis of the mortgage loans sold.
As of December 31, 1997, Capital Corp. had not completed a securitization
of Home Equity Loans. The portion of the Company's mortgage banking business
conducted through Capital Corp. is devoted to the acquisition of Home Equity
Loans with the expectation that they will be pooled and sold in public or
private securitization transactions. Gains on the securitization and sale of
Home Equity Loans represent the amount by which the proceeds received (including
the estimated value of retained subordinated interests) exceed the basis of the
Home Equity Loans and the costs associated with the securitization process. The
retained interests will be valued at the discounted present value of the cash
flows expected to be realized over the anticipated average life of the assets
sold after deducting future estimated credit losses, estimated prepayments,
servicing fees and other securitization fees related to the Home Equity Loans
sold. The recorded value of retained interests will be computed using Capital
Corp.'s assumptions of market discount rates, prepayment speeds, default rates,
credit losses and other costs based upon the unique underlying characteristics
of the Home Equity Loans comprising each securitization.
Capital Corp. expects that the assumptions it will use in its
securitization transactions will include discount rates of 15% and prepayment
speeds at annualized rates starting at approximately 4% per year and, depending
upon the mix of fixed and variable rate and prepayment penalty provisions of the
underlying loans, increasing to 25% to 40% per year. Loss assumptions are
expected to vary depending upon the mix of the credit quality and loan to value
characteristics of the underlying loans that are securitized. The actual
assumptions used by Capital Corp. in its securitization transactions will vary
based on numerous factors, including those listed above, and there can be no
assurance that actual assumptions will correspond to Capital Corp.'s current
expectations.
Servicing Fees and Amortization of Mortgage Servicing Rights
A significant component of Mortgage Corp.'s residential mortgage banking
business is attributable to the future right to service the residential mortgage
loans it originates or acquires. Mortgage Corp. generally retains the servicing
right upon the sale of the originated loan (and expects to retain such rights
upon securitization) and records the value of such right as mortgage servicing
rights on its balance sheet. Subsequently, Mortgage Corp. earns revenues as
compensation for the servicing activities it performs. Mortgage Corp. amortizes
the mortgage servicing right asset as a periodic expense to allocate the cost of
the servicing right to the income generated on a periodic basis.
The recorded values of mortgage servicing rights are reviewed on a
quarterly basis by comparing the fair market value of these rights as determined
by a third party to their recorded values. Based on this review, Mortgage Corp.
either adjusts amortization rates of such mortgage servicing rights or, if there
is any impairment in value, records a charge to earnings in the period during
which such impairment is deemed to have occurred. The fair market value of
mortgage servicing rights is heavily impacted by the relative levels of
residential mortgage interest rates. When interest rates decline, underlying
loan prepayment speeds generally increase. Prepayments in excess of anticipated
levels will cause actual fair market values of mortgage servicing
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rights to be less than recorded values thereby resulting in increases in the
rates of amortization, or a revaluation of recorded mortgage servicing rights as
described above.
A decline in interest rates generally contributes to higher levels of
mortgage loan origination (particularly refinancings) and the related
recognition of increased levels of gain on sale of mortgage loans. The ability
of Mortgage Corp. to originate loans and its ability to regenerate the recorded
value of its servicing portfolio on an annualized basis also provides Mortgage
Corp. with the ability to approximately replace the recorded value of its
residential servicing portfolio in a one-year time frame, based upon current
origination levels. Loans originated during periods of relatively low interest
rates generate servicing rights with a higher overall value due to the decreased
probability of future prepayment by the borrower. Accordingly, Mortgage Corp.
believes that it has an inherent hedge against a significant and swift decline
in the value of its recorded mortgage servicing rights. There can be no
assurance that, in the long term, Mortgage Corp. will be able to continue to
maintain an even balance between the production capacity of its origination
network and the principal value of its servicing portfolio.
In an environment of increasing interest rates, the rate of current and
projected future prepayments decreases, resulting in increases in fair market
values of mortgage servicing rights. Although the Company does not recognize
gain as a result of such increases in fair market values, it may decrease the
rate of amortization of the mortgage servicing rights. In addition, in periods
of rising interest rates, mortgage loan origination rates generally decline.
Other
In its commercial mortgage business, Mortgage Corp. generates loan
origination fees paid by commercial borrowers for underwriting and application
activities performed by Mortgage Corp. as a correspondent of various insurance
company and conduit lenders. In addition, Mortgage Corp. generates other fees
and revenues from various activities associated with originating and servicing
residential and commercial mortgage loans and in its construction lending
activities. Mortgage Corp. has in the past sold, and may in the future sell, a
portion of its rights to service residential mortgage loans. The results of such
sales are recorded as gains on sales of mortgage servicing rights and reflected
as a component of other revenue.
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
Revenues at Commercial Corp. consist primarily of cash proceeds on
disposition of assets acquired in Portfolio Asset acquisitions for Commercial
Corp.'s own account and its equity in the earnings of affiliated Acquisition
Partnerships. In addition, Commercial Corp. derives servicing fees from
Acquisition Partnerships for the servicing activities performed related to the
assets held in the Acquisition Partnerships. Following the Merger, Commercial
Corp. serviced assets held in an affiliated liquidating trust created for the
benefit of former FCBOT shareholders (the "Trust") and derived servicing fees
for its activities under a servicing agreement between the Trust and Commercial
Corp. During the first quarter of 1997, the Trust terminated the servicing
agreement and paid Commercial Corp. a termination payment of $6.8 million
representing the present value of servicing fees projected to have been earned
by Commercial Corp. upon the liquidation of the assets of the Trust, which was
expected to occur principally in 1997.
In its Portfolio Asset acquisition and resolution business, Commercial
Corp. acquires Portfolio Assets that are designated as nonperforming, performing
or real estate. Each Portfolio is accounted for as a whole and not on an
individual asset basis. To date, a substantial majority of the Portfolio Assets
acquired by Commercial Corp. have been designated as nonperforming. Once a
Portfolio has been designated as either nonperforming or performing, such
designation is not changed regardless of the performance of the assets
comprising the Portfolio. The Company recognizes revenue from Portfolio Assets
and Acquisition Partnerships based on proceeds realized from the resolution of
Portfolio Assets, which proceeds have historically varied significantly and
likely will continue to vary significantly from period to period. The following
table presents selected information regarding the revenues and expenses of the
Company's Portfolio Asset acquisition and resolution business.
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ANALYSIS OF SELECTED REVENUES AND EXPENSES
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
YEAR ENDED DECEMBER 31,
-----------------------------
1997 1996 1995
------- ------- -------
(DOLLARS IN THOUSANDS)
GAIN ON RESOLUTION OF PORTFOLIO ASSETS:
Average investment:
Nonperforming Portfolios............................... $61,764 $42,123 $27,298
Performing Portfolios.................................. 9,759 10,280 3,776
Real estate Portfolios................................. 21,602 30,224 39,795
Gain on resolution of Portfolio Assets:
Nonperforming Portfolios............................... $20,288 $11,635 $10,189
Real estate Portfolios................................. 3,895 7,875 1,795
------- ------- -------
Total................................................ 24,183 19,510 11,984
Interest income on performing Portfolios.................. $ 2,052 $ 2,603 $ 1,112
Gross profit percentage on resolution of Portfolio Assets:
Nonperforming Portfolios............................... 27.8% 38.5% 28.0%
Real estate Portfolios................................. 27.9% 19.3% 21.6%
Weighted average gross profit percentage............... 27.8% 27.5% 26.8%
Interest yield on performing Portfolios................... 21.0% 25.3% 29.5%
SERVICING FEE REVENUES:
Acquisition Partnerships.................................. $ 4,363 $ 6,468 $ 6,834
Trust..................................................... 6,800 4,241 3,110
Affiliates................................................ 350 1,731 959
------- ------- -------
Total................................................ 11,513 12,440 10,903
PERSONNEL:
Personnel expenses........................................ $ 5,353 $ 6,002 $ 4,500
Number of personnel (at period end):
Production............................................. 9 12 9
Servicing.............................................. 68 107 116
INTEREST EXPENSE:
Average debt.............................................. $85,262 $64,343 $36,348
Interest expense.......................................... 7,084 6,447 3,931
Average yield............................................. 8.3% 10.0% 10.8%
Nonperforming Portfolio Assets
Nonperforming Portfolio Assets consist primarily of distressed loans and
loan related assets, such as foreclosed-upon collateral. Portfolio Assets are
designated as nonperforming unless substantially all of the assets comprising
the Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. Commercial Corp. acquires such assets on the basis
of an evaluation of the timing and amount of cash flow expected to be derived
from borrower payments or disposition of the underlying asset securing the loan.
On a monthly basis, the amortized cost of each nonperforming Portfolio is
evaluated for impairment. A valuation allowance is established for any
impairment identified with provisions to establish such allowance charged to
earnings in the period identified.
All nonperforming Portfolio Assets are purchased at substantial discounts
from their Face Value. Net gain on the resolution of nonperforming Portfolio
Assets is recognized to the extent that proceeds collected on the Portfolio
exceed a pro rata portion of allocated costs of the resolved Portfolio Assets.
Proceeds from the resolution of Portfolio Assets that are nonperforming are
recognized as cash is realized from the collection, disposition and other
resolution activities associated with the Portfolio Assets. No interest income
or any other yield component of revenue is recognized separately on
nonperforming Portfolio Assets.
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Performing Portfolio Assets
Performing Portfolio Assets consist of consumer and commercial loans
acquired at a discount from the aggregate amount of Face Value. Portfolio Assets
are classified as performing if substantially all of the loans comprising the
Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. On a monthly basis, the amortized cost of each
performing Portfolio is evaluated for impairment. A valuation allowance is
established for any identified impairment with provisions to establish such
allowance charged to earnings in the period identified.
Interest income is recognized when accrued in accordance with the
contractual terms of the loans. The accrual of interest is discontinued once a
loan becomes past due 90 days or more. Acquisition discounts for the Portfolio
Assets as a whole are accreted as an adjustment to yield over the estimated life
of the Portfolio.
Real Estate Portfolios
Commercial Corp. also acquires Portfolios comprised solely of real estate.
Real estate Portfolios are recorded at the lower of cost or fair value less
estimated costs to sell. Costs relating to the development or improvement are
capitalized and costs relating to holding assets are charged to expense as
incurred. Rental income, net of expenses, is recognized as revenue when
received. Gains and losses are recognized based on the allocated cost of each
specific real estate asset.
Equity in Earnings of Acquisition Partnerships
Commercial Corp. accounts for its investments in Acquisition Partnerships
using the equity method of accounting. This accounting method generally results
in the pass-through of its pro rata share of earnings from the Acquisition
Partnerships' activities as if it had a direct investment in the underlying
Portfolio Assets held by the Acquisition Partnership. The revenues and earnings
of the Acquisition Partnerships are determined on a basis consistent with the
accounting methodology applied to nonperforming, performing and real estate
Portfolios described in the preceding paragraphs.
Distributions of cash flow from the Acquisition Partnerships are a function
of the terms and covenants of the loan agreements related to the secured
borrowings of the Acquisition Partnerships. Generally, the terms of the
underlying loan agreements permit some distribution of cash flow to the equity
partners so long as loan to cost and loan to value relationships are in
compliance with the terms and covenants of the applicable loan agreement. Once
the secured borrowings of the Acquisition Partnerships are fully paid, all cash
flow in excess
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of operating expenses is available for distribution to the equity partners. The
following chart presents selected information regarding the revenues and
expenses of the Acquisition Partnerships.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
ACQUISITION PARTNERSHIPS
YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
(DOLLARS IN THOUSANDS)
GAIN ON RESOLUTION OF PORTFOLIO ASSETS:
Gain on resolution of Portfolio Assets................... $ 26,533 $ 39,505 $ 51,370
Gross profit percentage on resolution of Portfolio
Assets................................................ 16.7% 22.7% 27.2%
Interest income on performing Portfolios................. $ 8,432 $ 7,870 $ --
Other interest income.................................... 1,053 862 --
INTEREST EXPENSE:
Interest expense......................................... 10,294 22,065 26,482
Average debt............................................. 111,422 188,231 223,028
Average interest cost.................................... 9.24% 11.72% 11.87%
OTHER EXPENSES:
Servicing fees........................................... $ 4,353 $ 6,809 $ 6,834
Legal.................................................... 1,957 2,266 2,109
Property protection...................................... 3,956 5,712 3,797
Other.................................................... 531 693 2,606
-------- -------- --------
Total other expenses............................. 10,797 15,480 15,346
-------- -------- --------
NET EARNINGS............................................... $ 14,927 $ 10,692 $ 9,542
======== ======== ========
The above table does not include equity earnings from the Acquisition
Partnerships operating in France, which equaled $519,000 in 1997.
Servicing Fee Revenues
Commercial Corp. derives fee income for its servicing activities performed
on behalf of the Acquisition Partnerships. Prior to the second quarter of 1997,
Commercial Corp. also derived servicing fees from the servicing of assets held
in the Trust. In connection with the Acquisition Partnerships, Commercial Corp.
earns a servicing fee of between 3% and 8% of gross cash collections generated
by the Acquisition Partnerships, rather than a periodic management fee based on
the Face Value of the assets being serviced. The rate of servicing fee charged
is a function of the average Face Value of the assets within each Portfolio
being serviced (the larger the average Face Value of the assets in a Portfolio,
the lower the fee percentage within the prescribed range).
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CONSUMER LENDING
The primary components of revenue derived by Consumer Corp. are interest
income and gain on sale of loans. The primary expenses of Consumer Corp. are
salaries and benefits, provision for loan losses and interest expense. The
following chart presents selected information regarding the revenues and
expenses of Consumer Corp.'s consumer lending business during 1997 and 1996.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
CONSUMER LENDING
YEAR ENDED DECEMBER 31,
------------------------
1997 1996
--------- ---------
(DOLLARS IN THOUSANDS)
INTEREST INCOME:
Average loans
Auto................................................... $50,154 $19,740
Other.................................................. 3,558 144
Interest income
Auto................................................... 9,067 3,546
Other.................................................. 570 30
Average yield
Auto................................................... 18.1% 18.0%
Other.................................................. 16.0% 20.8%
SERVICING REVENUES:
Affiliates................................................ $ 553 $ 16
PERSONNEL:
Personnel expenses........................................ $ 2,959 $ 698
Number of personnel (at period end):
Production............................................. 53 15
Servicing.............................................. 53 26
INTEREST EXPENSE:
Average debt.............................................. $34,129 $14,885
Interest expense.......................................... 3,016 1,258
Average yield............................................. 8.8% 8.5%
Interest Income
Interest income is accrued on originated and acquired loans at the
contractual rate of interest of the underlying loan. The accrual of interest
income is discontinued once a loan becomes 90 days past due.
Gain on Sale of Loans
Funding Corp. intends to accumulate and pool automobile loans acquired from
franchised dealerships for sales in public and private securitization
transactions. Such transactions are expected to result in the recognition of
gains to the extent that the proceeds received (including the estimated value of
the retained subordinated interests) exceed the basis of the automobile loans
and the costs associated with the securitization process. When the automobile
loans are securitized and sold, the retained interests will be valued at the
discounted present value of the cash flows expected to be realized over the
anticipated average life of the assets sold after future estimated credit
losses, estimated prepayments, servicing fees and other securitization fees
related to the loans sold. The discounted present value of such interests will
be computed using Consumer Corp.'s assumptions of market discount rates,
prepayment speeds, default rates, credit losses and other costs based upon the
unique underlying characteristics of the automobile loans comprising each
securitization.
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In its securitization transaction completed in 1997, Consumer Corp. assumed
that losses would approximate an aggregate of 14% of the outstanding principal
balance of the underlying loans. Consumer Corp. calculated the present value of
future cash flows from the securitization using discount rates of 12% to 15% per
year.
Provision for Loan Losses
The carrying value of consumer loans is evaluated on a monthly basis for
impairment. A valuation allowance is established for any impairment identified
with provisions to augment the allowance charged to earnings in the period
identified. The evaluation of the need for an allowance is determined on a pool
basis, with each pool being the loans originated or acquired during a quarterly
period of production or acquisition. Loans generally are acquired at a discount
from the Face Value of the loan with the acquisition discount established as an
allowance for losses at the acquisition date of the loan. If the initially
established allowance is deemed to be insufficient, additional allowances are
established through provisions charged to earnings.
The operating margin of Consumer Corp. was significantly impacted by 1997
provisions for loan losses in the amount of approximately $6.6 million related
to the loans originated in Consumer Corp.'s sub-prime auto receivable business.
The Company's initial venture into the sub-prime automobile market involved the
acquisition of a distressed sub-prime portfolio from a secured lender. Following
the acquisition of the portfolio, the Company began the acquisition of
additional loans on an indirect basis from financial institutions who originated
loans pursuant to contractual agreements with a subsidiary of Consumer Corp. The
Company concluded that the contractual underwriting standards and the purchase
discounts on which the initial program was based were insufficient to generate
automobile loans of acceptable quality to the Company. As a result, the Company
terminated its obligations with the financial institutions participating in the
original origination program effective January 31, 1998. The continued flow of
production into 1998 will require that the Company continue to provide for the
losses anticipated on such loans in 1998.
Based upon the experience gained with its initial consumer origination
program, the Company undertook to develop an origination and underwriting
approach that would give Consumer Corp. significantly greater control over the
origination and pricing standards governing its consumer lending activities. The
formation of Funding Corp. resulted from these development activities. The
underwriting process and purchase discount methodology employed by Funding Corp.
has significantly changed the underwriting criteria and purchase standards of
Consumer Corp. from the methodology employed during the majority of 1996 and
1997. In Funding Corp.'s case, the objectives established for purchasing loans
from originating dealers are designed to result in the purchase discount
equaling or exceeding the expected loss for all loans acquired.
BENEFIT (PROVISION) FOR INCOME TAXES
As a result of the Merger, the Company has substantial federal NOLs, which
can be used to offset the tax liability associated with the Company's pre-tax
earnings until the earlier of the expiration or utilization of such NOLs. The
Company accounts for the benefit of the NOLs by recording the benefit as an
asset and then establishing an allowance to value the net deferred tax asset at
a value commensurate with the Company's expectation of being able to utilize the
recognized benefit in the next three to four year period. Such estimates are
reevaluated on a quarterly basis with the adjustment to the allowance recorded
as an adjustment to the income tax expense generated by the quarterly earnings.
Significant events that change the Company's view of its currently estimated
ability to utilize the tax benefits, such as the Harbor Merger in the third
quarter of 1997, result in substantial changes to the estimated allowance
required to value the deferred tax benefits recognized in the Company's periodic
financial statements. Similar events could occur in the future, and would impact
the quarterly recognition of the Company's estimate of the required valuation
allowance associated with its NOLs.
Earnings for 1997 and 1996 were significantly increased by the recognition
of tax benefits resulting from the Company's reassessment of the valuation
allowance related to its NOL asset. Realization of the asset is dependent upon
generating sufficient taxable earnings to utilize the NOL. Prior to 1996, the
deferred tax asset resulting from the Company's NOL was entirely offset by its
valuation reserve. In 1997 and 1996, the
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valuation reserve was adjusted based on the Company's estimate of its future
pre-tax income. The amount of tax benefits recognized will be adjusted in future
periods should the estimates of future taxable income change. If there are
changes in the estimated level of the required reserve, net earnings will be
affected accordingly.
FIRSTCITY LIQUIDATING TRUST AND EXCHANGE OF PREFERRED STOCK
In connection with the Merger, the Company received the Class A Certificate
of the Trust (the "Class A Certificate"). Distributions from the Trust in
respect of the Class A Certificate were used to retire the senior subordinated
notes of the Company and to pay dividends on, and repurchase some of, the
special preferred stock of the Company (the "Special Preferred"). Pursuant to a
June 1997 settlement agreement with the Company, the Trust's obligation to the
Company under the Class A Certificate was terminated (other than the Trust's
obligation to reimburse the Company for certain expenses) in exchange for the
Trust's agreement to pay the Company an amount equal to $22.75 per share for the
1,923,481 shares of Special Preferred outstanding at June 30, 1997, the 1997
second quarter dividend of $0.7875 per share, and 15% interest from June 30,
1997 on any unpaid portion of the settlement agreement. Under such agreement,
the Company assumes the obligation for the payment of the liquidation preference
amount and the future dividends on the Special Preferred. As of December 31,
1997, the Trust had distributed $44.1 million to the Company under the
settlement agreement.
In June 1997, the Company began an offer to exchange one share of newly
issued adjusting rate preferred stock ("Adjusting Rate Preferred") for each
outstanding share of Special Preferred. The Company completed such exchange
offer in the third quarter of 1997 pursuant to which 1,073,704 shares of Special
Preferred were tendered for a like number of shares of Adjusting Rate Preferred.
The Special Preferred has a redemption value of $21.00 per share, a 15% annual
dividend rate and a redemption date of September 30, 1998. The Adjusting Rate
Preferred has a redemption value of $21.00 per share and a 15% annual dividend
rate through September 30, 1998, at which time the dividend rate is reduced to
10% per annum. The Adjusting Rate Preferred is redeemable by the Company on or
after September 30, 2003, with a mandatory maturity date of September 30, 2005.
The redemption by the Trust of its obligation on the Class A Certificate
represented a premium over the redemption value of the Special Preferred, which
is reflected as a deferred credit in the Company's financial statements. The
deferred credit is being accreted to income over the weighted average life of
the Special Preferred and the Adjusting Rate Preferred.
RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with
the Consolidated Financial Statements of the Company (including the Notes
thereto) included elsewhere in this Annual Report on Form 10-K.
1997 COMPARED TO 1996
The Company reported net earnings before minority interest and preferred
dividends of $35.8 million in 1997 (including a $15.5 million deferred tax
benefit) compared to $39.1 million in 1996 (including a $13.7 million deferred
tax benefit). Net earnings to common shareholders were $29.4 million in 1997
compared to $31.4 million in 1996. On a per share basis, basic net earnings
attributable to common shareholders were $4.51 in 1997 compared to $4.83 in
1996. Diluted net earnings per common share were $4.46 in 1997 compared to $4.79
in 1996.
Mortgage Banking
Mortgage Corp. experienced significant revenue growth in 1997 relative to
1996. The Direct Retail and Broker Retail origination networks experienced
substantial growth in levels of origination volume reflecting, in part, the
level of capital that has been contributed to Mortgage Corp. by the Company
following the Harbor
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Merger and relatively lower interest rates in 1997 compared to 1996. Such
revenue growth was partially offset by increases in operating expenses
associated with the increased levels of origination volume.
The Company entered the mortgage conduit business in August 1997 with the
formation of Capital Corp. Capital Corp. has generated nominal interest revenue
from its acquired Home Equity Loans, has incurred interest expense to finance
the acquisition of such loans and has incurred general and administrative
expenses in its start-up phase.
Gain on sale of mortgage loans. Gain on sale of mortgage loans increased by
89% to $36.5 million in 1997 from $19.3 million in 1996. This increase was the
result of substantial increases in the levels of residential mortgage loan
origination generated principally by the Broker Retail network of Mortgage Corp.
and, to a lesser extent, the Direct Retail network of Mortgage Corp., and the
resulting sales of such loans to government agencies and other investors. The
change in the gain on sale percentage recognized in 1997 compared to 1996 is the
result of the sale, on a servicing released basis, of approximately $120 million
of Home Equity Loans in 1997.
Net mortgage warehouse income. Net mortgage warehouse income increased by
8.5% to $3.5 million in 1997 from $3.2 million in 1996. This increase is the
result of a significant increase in the average balance of loans held in
inventory during the year offset by a decrease in the spread earned between the
interest rate on the underlying mortgages and the interest cost of the warehouse
credit facility as the overall levels of interest rates on residential mortgage
loans reached their lowest levels in several years.
Servicing fee revenues. Servicing fee revenues increased by 46.2% to $14.7
million in 1997 from $10.1 million in 1996 as a result of an increase in the
size of the servicing portfolio. Mortgage Corp. increased its servicing
portfolio with the purchase, in the second quarter of 1996, of Hamilton
Financial Services Corporation ("Hamilton") and its right to service
approximately $1.7 billion in mortgage loans, and by retaining the servicing
rights to a substantial portion of the residential mortgage loans originated
since the Harbor Merger. In addition, Mortgage Corp. substantially increased its
commercial mortgage servicing portfolio and its ability to originate commercial
mortgage loans for correspondents and conduit lenders with the purchase, in the
second quarter of 1997, of MIG Financial Corporation ("MIG"), a commercial loan
origination and servicing company based in California with a $1.6 billion
commercial mortgage servicing portfolio.
Other revenues. Other revenues increased by 119% to $11.0 million in 1997
from $5.0 million in 1996. This increase resulted from an increase in the gain
on sale of mortgage servicing rights of $1.6 million to $4.2 million in 1997
from $2.6 million in 1996 and an increase of $2.2 million in fee income
associated with residential and commercial mortgage origination activity.
Operating expenses. Operating expenses of Mortgage Corp. increased by 89.2%
to $59.8 million in 1997 from $31.6 million in 1996. The acquisition of Hamilton
in 1996 and MIG in 1997, both of which were accounted for as purchases by
Mortgage Corp., produced higher relative totals for all components of Mortgage
Corp.'s operating expenses in 1997 compared to 1996. The commencement of Capital
Corp.'s operations in late 1997 also contributed to the year over year
increases.
Salaries and benefits increased by $14.3 million in 1997 compared to 1996
reflecting the over 400 additional staff required to support the increase in
origination volumes derived principally from the Broker Retail network and, to a
lesser extent, the Direct Retail network, and the increase in the size and
number of loans in the residential and commercial servicing portfolios in 1997
compared to 1996.
Amortization of mortgage servicing rights increased in 1997 compared to
1996 as a result of the substantially larger investment in mortgage servicing
rights in 1997 compared to 1996. Interest on other notes payable (the portion
not associated with Mortgage Corp.'s warehouse credit facility) increased due to
increased working capital borrowings during 1997 as compared to 1996.
Occupancy expense increased by $3.6 million in 1997 compared to 1996 as the
result of the opening or acquisition of several new offices in 1997 in the
Broker Retail and Direct Retail networks. Increases in data
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processing, communication and other expenses in 1997 compared to 1996 resulted
from the substantial increases in the production and servicing volumes
experienced during 1997.
Portfolio Asset Acquisition and Resolution
Commercial Corp. purchased $183.2 million of Portfolio Assets during 1997
for its own account and through the Acquisition Partnerships compared to $205.5
million in acquisitions in 1996. Commercial Corp.'s year end investment in
Portfolio Assets increased to $90.0 million in 1997 from $76.2 million in 1996.
Commercial Corp. invested $37.1 million in equity in Portfolio Assets in 1997
compared to $36.0 million in 1996.
Net gain on resolution of Portfolio Assets. Proceeds from the resolution of
Portfolio Assets increased by 22.8% to $87.1 million in 1997 from $70.9 million
in 1996. The net gain on resolution of Portfolio Assets increased by 24.0% to
$24.2 million in 1997 from $19.5 million in 1996 as the result of increased cash
proceeds and a higher gross profit percentage in 1997 compared to 1996. The
gross profit percentage on the proceeds from the resolution of Portfolio Assets
in 1997 was 27.8% as compared to 27.5% in 1996.
Equity in earnings of Acquisition Partnerships. Proceeds from the
resolution of Portfolio Assets for the Acquisition Partnerships declined by
38.0% to $107.8 million in 1997 from $174.0 million in 1996 while the gross
profit percentage on proceeds increased to 25.2% in 1997 from 22.7% in 1996.
Offsetting the decline in cash proceeds was the reduction in interest and other
expenses incurred by the Acquisition Partnerships in 1997 compared to 1996.
Interest income in the Acquisition Partnerships increased nominally while
interest expense decreased by $11.8 million in 1997 compared to 1996. The year
to year comparisons result from the relative levels of interest earning assets
and interest bearing liabilities carried by the Acquisition Partnerships in each
of the two periods. In addition, the effect of refinancing Acquisition
Partnership Portfolio Assets reduced average interest rates incurred on
borrowings in 1997 to 9.2% from 11.7% in 1996. Other expenses of the Acquisition
Partnerships decreased by $4.7 million in 1997 generally reflecting the
relatively lower costs associated with the resolution of Portfolio Assets in
somewhat mature partnerships as compared to the property protection and
improvement expenses normally associated with new Portfolio Asset acquisitions.
The net result was an overall increase in the net income of the Acquisition
Partnerships of 39.6% to $14.9 million in 1997 from $10.7 million in 1996. As a
result, Commercial Corp.'s equity earnings from Acquisition Partnerships
increased by 24.2% to $7.6 million in 1997 from $6.1 million in 1996.
Servicing fee revenues. Servicing fee revenues decreased by 7.5% to $11.5
million in 1997 from $12.4 million in 1996. Servicing fees reported during 1997
included the receipt of a $6.8 million cash payment related to the early
termination of a servicing agreement between the Company and the Trust, under
which the Company serviced the assets of the Trust. The $6.8 million payment
represents the present value of servicing fees projected to have been earned by
Commercial Corp. upon liquidation of the Trust assets, which was expected to
occur principally in 1997. Servicing fees earned from the Trust in 1996 were
$4.2 million. Excluding fees related to Trust assets, servicing fees decreased
by 42.7% to $4.7 million in 1997 from $8.2 million in 1996 as a result of
decreased collection levels in the Acquisition Partnerships and affiliated
entities.
Other revenues. Other revenues declined to $4.4 million in 1997 compared to
$6.6 million in 1996 as a result of reduced levels of rental income derived from
lower average investments in real estate Portfolios in 1997 as compared to 1996.
Operating expenses. Operating expenses increased to $24.2 million in 1997
from $23.3 million in 1996. The relatively stable levels of operating expenses
incurred by Commercial Corp. in 1997 compared to 1996 reflect the relatively
consistent levels of investment and servicing activities associated with
Commercial Corp.'s operations during such periods.
Salaries and benefits declined in 1997 as a result of the consolidation of
some of the servicing offices as the Portfolios being serviced in the closed
offices reached final resolution.
Interest on other notes payable increased as a result of increased average
borrowing levels in 1997 as compared to 1996 offset by lower average costs of
borrowings.
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Asset level expenses incurred in connection with the servicing of Portfolio
Assets increased in 1997 compared to 1996 as a result of the increase in
investments in Portfolio Assets in 1997 compared to 1996. Occupancy and other
expenses decreased as a result of the consolidation of servicing offices in
1997.
Consumer Lending
Consumer Corp.'s revenues and expenses in 1997 were derived principally
from its original sub-prime automobile financing program, which was established
during the first quarter of 1996. Consumer Corp. terminated its obligations to
the financial institutions participating in such program effective as of January
31, 1998. In late 1997 Consumer Corp., through its 80% owned subsidiary, Funding
Corp., established a new sub-prime automobile financing program through which it
originates automobile loans through direct relationships with franchised
automobile dealerships. Substantially all of Consumer Corp.'s activities are
expected to be conducted through Funding Corp. during 1998.
Interest income. Interest income on consumer loans increased by 168% to
$9.6 million in 1997 from $3.6 million in 1996 reflecting increased levels of
loan origination activity in 1997 as compared to 1996 and an increase in the
average balance of aggregate loans held by Consumer Corp. during 1997.
Interest expense. Interest expense increased by 136% to $3.0 million in
1997 from $1.3 million in 1996 as a result of an increase in the average
outstanding level of borrowings secured by automobile receivables to $34.1
million in 1997 from $14.9 million in 1996. The average rate at which such
borrowings incurred interest increased to 8.8% from 8.5% for the same period.
Operating expenses. Salaries and benefits increased by 324% to $3.0 million
in 1997 from $0.7 million in 1996 as a result of the increased levels of
operating activity in 1997 as compared to 1996. In addition, during the later
portion of 1997, Consumer Corp.'s operating expenses reflected the duplicative
effects of the start up of Funding Corp. while still operating the indirect
origination program.
Provision for loan losses. The provision for loan losses on automobile
receivables increased by 226% to $6.6 million in 1997 from $2.0 million in 1996.
The increase is attributable to loan originations of $89.8 million in 1997
compared to loan originations of $17.6 million in 1996. Consumer Corp. increased
its rate of provision for loan losses based on its determination that the
discount rate at which it acquired loans under its original origination program
did not properly provide for the losses expected to be realized on the acquired
loans. The origination program currently operated by Funding Corp. generally
allows for the acquisition of loans from automobile dealerships at a larger
discount from par than Consumer Corp.'s original financing program. The Company
believes that such acquisition prices more closely approximate the expected loss
per occurrence on the loans originated. To the extent that Funding Corp. cannot
match such discount to expected losses, additional provisions might, in the
future, be required to properly provide for the risk of loss on the loans
originated. The Company expects to incur provisions for loan losses in 1998 on
automobile loans acquired by it during early 1998 through its original
origination program.
Securitization of automobile loans. During the second quarter of 1997,
Consumer Corp. completed its first sale and securitization of automobile loans.
Consumer Corp. has retained subordinated interests in the form of nonrated
tranches and excess spreads resulting from the securitization transaction and
reflected an aggregate of $6.7 million in such interests at December 31, 1997.
Other Items Affecting Net Income
The following items affect the Company's overall results of operations and
are not directly related to any one of the Company's businesses discussed above.
Corporate overhead. Interest income on the Class A Certificate during 1997
represents reimbursement to the Company from the Trust of accrual of dividends
of $3.6 million on special preferred stock through June 30, 1997 and interest
paid under a June 1997 agreement to retire the Class A Certificate. Company
level interest expense declined by 49.8% to $1.1 million in 1997 from $2.2
million in 1996 as a result of lower volumes of debt associated with the equity
required to purchase Portfolio Assets, equity interests in Acquisition
Partnerships and capital support to operating subsidiaries. The Company incurred
less indebted-
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ness in 1997 because a substantial portion of the Company's funding needs in
1997 were met by the Trust's redemption of its obligation under the Class A
Certificate. Other corporate income increased due to interest earned on the
excess liquidity derived from the Trust's redemption of the Class A Certificate.
Salary and benefits, occupancy and professional fees account for the majority of
other overhead expenses, which decreased in 1997 compared to 1996 as a result of
the decrease in the amount of executive and other officer bonuses granted in
1997 compared to 1996.
Income taxes. Federal income taxes are provided at a 35% rate applied to
taxable income and are offset by NOLs that the Company believes are available to
it as a result of the Merger. The tax benefit of the NOLs is recorded in the
period during which the benefit is realized. The Company reported a deferred tax
benefit of $13.6 million in 1997 as compared to a benefit of $16.2 million in
1996.
Harbor Merger related expenses. In 1997 the Company incurred Harbor Merger
related expenses of $1.6 million for legal, other professional and financial
advisory costs associated with the Harbor Merger.
1996 COMPARED TO 1995
The Company reported net earnings before minority interest and preferred
dividends of $39.1 million in 1996 (including a $13.7 million deferred tax
benefit) compared to $15.2 million in 1995. Net earnings to common shareholders
were $31.4 million in 1996 compared to $11.4 million in 1995. On a per share
basis, basic net earnings attributable to common shareholders were $4.83 in 1996
compared to $2.18 in 1995. Diluted net earnings per common share were $4.79 in
1996 compared to $2.18 in 1995.
Mortgage Banking
Mortgage Corp. experienced significant revenue growth in 1996 relative to
1995. The Broker Retail origination network in particular experienced
substantial growth in levels of production and origination volume. Such revenue
growth was partially offset by increases in operating expenses associated with
the increased levels of production and origination volume.
Gain on sale of mortgage loans. Gain on sale of mortgage loans increased by
145% to $19.3 million in 1996 from $7.9 million in 1995 due to substantial
increases in the levels of residential mortgage loan origination generated
principally by the Broker Retail origination network of Mortgage Corp. and, to a
lesser extent, the Direct Retail network of Mortgage Corp. Total production in
1996 increased to over $1.7 billion from $0.7 billion in 1995, which resulted in
increased sales volume of originated loans to government agencies and other
investors.
Net mortgage warehouse income. Net mortgage warehouse income increased by
36.9% to $3.2 million in 1996 from $2.4 million in 1995. This increase is the
result of an increase in the average balance of loans held in inventory during
the year coupled with a favorable spread between the interest rate on the
underlying mortgages and the interest cost of the warehouse credit facility
during the year.
Servicing fee revenues. Servicing fee revenues increased by 54.9% to $10.1
million in 1996 from $6.5 million in 1995 as a result of an increase in the size
of the servicing portfolio. Mortgage Corp. increased its servicing portfolio
with the purchase in the second quarter of 1996 of Hamilton and its right to
service approximately $1.7 billion in residential mortgage loans.
Other revenues. Other revenues increased by 35.1% to $5.0 million in 1996
from $3.7 million in 1995. This increase resulted from an increase in the gain
on sale of mortgage servicing rights of $0.6 million to $2.6 million in 1996
from $2.0 million in 1995. Other miscellaneous sources of fee income associated
with increased levels of mortgage loan production account for the balance of the
1996 over 1995 increase in other revenues.
Operating expenses. Operating expenses of Mortgage Corp. increased by 60.8%
to $31.6 million in 1996 from $19.7 million in 1995. The acquisition of Hamilton
in 1996, which was accounted for as a purchase, produced higher relative totals
for all components of Mortgage Corp.'s operating expenses in 1996 as compared to
1995.
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Salaries and benefits increased year over year reflecting the additional
staff required to support the increase in production volumes derived from the
Direct Retail and Broker Retail networks in 1996 as compared to 1995 and the
increase in the size and number of loans in the residential and commercial
servicing portfolios as compared to prior year totals.
Amortization of mortgage servicing rights increased in 1996 compared to
1995 as a result of the substantially larger investment in mortgage servicing
rights in 1996 compared to 1995.
Interest expense on other notes payable (the portion not associated with
Mortgage Corp.'s warehouse credit facility) remained constant from 1996 to 1995.
Increases in occupancy, data processing and other expenses in 1996 as
compared to 1995 resulted from the substantial increases in production and
servicing volume experienced during 1996.
Portfolio Asset Acquisition and Resolution
The Portfolio Asset acquisition and resolution business of the Company
generated substantial revenues in 1996. Commercial Corp. purchased $205.5
million of Portfolio Assets during 1996 for its own account and through
Acquisition Partnerships compared to $213.2 million in acquisitions in 1995.
Commercial Corp.'s investment in Portfolio Assets increased to $76.2 million at
year end 1996 from $47.0 million at year end 1995. Commercial Corp. invested
$36.0 million in equity in Portfolio Assets in 1996 compared to $24.6 million in
1995.
Net gain on resolution of Portfolio Assets. Proceeds from the resolution of
Portfolio Assets increased by 58.6% to $70.9 million in 1996 from $44.8 million
in 1995. The net gain on resolution of Portfolio Assets increased by 62.8% to
$19.5 million in 1996 from $12.0 million in 1995 as the result of increased cash
proceeds and a higher gross profit percentage in 1996 compared to 1995. The
gross profit percentage on the proceeds from the resolution of Portfolio Assets
in 1996 was 27.5% compared to 26.8% in 1995.
Equity in earnings of Acquisition Partnerships. Proceeds from the
resolution of Portfolio Assets for the Acquisition Partnerships declined by 7.9%
to $174.0 million in 1996 from $188.9 million in 1995 while the gross profit
percentage declined to 22.7% in 1996 from 27.2% in 1995. Offsetting the decline
in the gross profit percentage was an increase in the effective ownership
percentage of Commercial Corp. in the equity of the Acquisition Partnerships.
Interest income in the Acquisition Partnerships was $8.7 million in 1996
compared to no interest income in 1995. No performing Asset Portfolios were
acquired by the Acquisition Partnerships prior to 1996. Interest expense
decreased by $4.4 million in 1996 compared to 1995 reflecting a reduced level of
borrowing by the Acquisition Partnerships in 1996 compared to 1995. Interest
costs were relatively constant at 11.7% in 1996 as compared to 11.9% in 1995.
Other expenses of the Acquisition Partnerships were relatively unchanged at
$15.5 million in 1996 compared to $15.3 million in 1995. The net result was a
59.8% increase in the equity in earnings of Acquisition Partnerships to $6.1
million in 1996 from $3.8 million in 1995.
Servicing fee revenues. Servicing fee revenues increased by 14.1% to $12.4
million in 1996 from $10.9 million in 1995. Servicing fees from Acquisition
Partnerships totaled $6.5 million in 1996 compared to $6.8 million in 1995 while
fees from the Trust in 1996 were $4.2 million compared to $3.1 million in 1995.
Operating expenses. Salaries and benefits, amortization and other general
and administrative expenses increased by 63.6% to $23.3 million in 1996 from
$14.2 million in 1995, principally as a result of the increase in such costs
attributable to the acquisition of a portfolio and small commercial servicing
business in 1995, increased property expenses and amortization of goodwill and
servicing rights in 1996 (such expenses were incurred only in a portion of
1995). In addition, other expenses in 1995 included a recovery of $0.7 million
of prior year expenses related to the Merger.
Consumer Lending
The Company began its consumer lending business during the first quarter of
1996 with the acquisition of a sub-prime automobile loan portfolio and the
acquisition of the company through which the loans had been
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originated. During 1996, Consumer Corp. acquired $24.1 million in consumer loans
and originated $17.6 million in consumer loans.
Interest income. Interest income on consumer loans totaled $3.6 million in
1996 and reflected the recognition of interest income on the automobile finance
receivable contracts purchased or originated during the year.
Interest expense. Interest expense incurred during 1996 totaled $1.3
million on average borrowings of $14.8 million. Such borrowings incurred
interest at an average interest rate of 8.5% during 1996.
Operating expenses. Operating expenses reflect salaries, occupancy and
other expenses incurred in the first year's operation of the Company's
automobile finance business.
Provision for loan losses. The provision for loan losses on automobile
loans was $2.0 million in 1996, which reflects Consumer Corp.'s estimate of the
amount by which expected losses would exceed the discount at which the loans
were purchased.
Other Items Affecting Net Income
The following items affect the Company's overall results of operations and
are not directly related to any one of the Company's businesses discussed above.
Corporate overhead. Interest income on the Class A Certificate during 1996
represents reimbursement to the Company by the Trust of $3.9 million of interest
expense on the senior subordinated notes and accrual of dividends of $7.7
million on special preferred stock in 1996 compared to $4.7 million of interest
expense on the senior subordinated notes and $3.9 million of dividends on the
special preferred stock in 1995. Interest expense increased to $2.2 million in
1996 from $0.4 million in 1995 as a result of higher combined volumes of debt
associated with the equity required for the purchase of Portfolio Assets and
equity interests in Acquisition Partnerships, especially following the Merger. A
substantial portion of the Company's funding needs in 1995 were met by the cash
received by the Company in connection with the Merger. Increases in salaries and
benefits, occupancy and other expenses reflect the increases associated with
Company staff functions such as accounting, finance and treasury activities
required to support the growth and diversification efforts of the Company
following the Merger. A portion of the increase in overhead expenses is the
result of an increase in executive and officer bonuses in 1996 compared to 1995.
Income taxes. Federal income taxes are provided at a 35% rate applied to
taxable income and are offset by NOLs that the Company believes are available to
it as a result of the Merger. The tax benefit of the NOLs is recorded in the
period during which the benefit is realized. The Company reported a deferred tax
benefit of $16.2 million in 1996 as compared to an expense of $1.2 million in
1995 (reflecting income taxes accrued on income reported prior to the Merger).
LIQUIDITY AND CAPITAL RESOURCES
Generally, the Company requires liquidity to fund its operations, working
capital, payment of debt, equity for acquisition of Portfolio Assets,
investments in and advances to the Acquisition Partnerships, investments in
expanding businesses to support their growth, 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 debt
and dividends from the Company's subsidiaries, short-term borrowings from
revolving lines of credit, proceeds from equity market transactions,
securitization and other structured finance transactions and other special
purpose short-term borrowings.
In the future, the Company anticipates being able to raise capital through
a variety of sources including, but not limited to, public debt or equity
offerings (subject to limitations related to the preservation of the Company's
NOLs), thus enhancing the investment and growth opportunities of the Company.
The Company believes that these and other sources of liquidity, including
refinancing and expanding the Company's revolving credit facility to the extent
necessary, securitizations, and funding from senior lenders providing
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funding for Acquisition Partnership investments and direct portfolio and
business acquisitions, should prove adequate to continue to fund the Company's
contemplated activities and meet its liquidity needs.
The Company and each of its major operating subsidiaries have entered into
one or more credit facilities to finance its respective operations. Each of the
credit facilities to which the operating subsidiaries are parties are
nonrecourse to the Company and the other operating subsidiaries, except as
discussed below.
Excluding the term acquisition facilities of the unconsolidated Acquisition
Partnerships, as of December 31, 1997 the Company and its subsidiaries had
credit facilities providing for borrowings in an aggregate principal amount of
$1,041 million and outstanding borrowings of $751 million. The following table
summarizes the material terms of the credit facilities to which the Company, its
major operating subsidiaries and the Acquisition Partnerships were parties as of
March 24, 1998 and the outstanding borrowings under such facilities as of
December 31, 1997.
CREDIT FACILITIES
OUTSTANDING
PRINCIPAL BORROWINGS AS OF
AMOUNT DECEMBER 31, 1997 INTEREST RATE OTHER TERMS AND CONDITIONS
--------- ----------------- ------------- --------------------------
(DOLLARS IN MILLIONS)
FIRSTCITY
Company Credit
Facility.............. $ 35 $ 7 LIBOR + 5.0% Secured by the assets of
the Company, expires March
28, 1998(1)
Term fixed asset
facility.............. 1 1 Fixed 9.25% Secured by certain fixed
assets, expires January 1,
2001
MORTGAGE CORP.
Warehouse facility...... 450 309 LIBOR + 0.5% to 2.5% Revolving line to
warehouse residential
mortgage loans, expires
March 31, 1999
Supplemental warehouse
facility.............. 36 29 LIBOR + 0.5% to 2.25% Revolving line to
warehouse residential
mortgage loans and related
receivables, expires March
31, 1999
FNMA warehouse
facility.............. 187 187 Fed Funds + 0.8% to Open facility to fund
1.0% committed loans to FNMA
Operating line.......... 45 38 LIBOR + 2.25% Revolving operating line
secured by the
unencumbered assets of
Harbor, expires December
15, 2002
CAPITAL CORP.
Warehouse facility...... 36 36 Fixed 6.85% Repurchase agreement to
facilitate the acquisition
of Home Equity Loans,
expires April 13, 1998
COMMERCIAL CORP.
Portfolio acquisition
facility.............. 100 -- LIBOR + 2.5% Acquisition facility to
acquire Portfolio Assets,
expires February 28, 1999
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OUTSTANDING
PRINCIPAL BORROWINGS AS OF
AMOUNT DECEMBER 31, 1997 INTEREST RATE OTHER TERMS AND CONDITIONS
--------- ----------------- ------------- --------------------------
(DOLLARS IN MILLIONS)
French acquisition
facility.............. 15 8 French franc Acquisition facility to
LIBOR + 3.5% fund equity investments in
French Portfolio Assets,
expires March 31, 1999.
Guaranteed by Commercial
Corp. and the Company.
Term acquisition
facilities............ 86 86 Fixed at 7% to 7.66% Acquisition facilities for
and LIBOR + 5% existing Portfolio Assets.
Secured by assets of
Acquisition Partnerships,
various maturities
CONSUMER CORP.
Warehouse facility...... 50 50 LIBOR + 3% Revolving line secured by
automobile receivables,
expires May 17, 1998
UNCONSOLIDATED ACQUISITION
PARTNERSHIPS
Term acquisition
facilities.............. 69 69 Fixed at 7.51% to Senior and subordinated
10.17%, LIBOR + 3% to loans secured by Portfolio
6.5% and Prime + 2% Assets, various maturities
to 7%
- ---------------
(1) The Company Credit Facility maturing March 28, 1998 is expected to be
replaced by a similar facility totalling $40 million, maturing March 31,
1999.
FirstCity. The Company Credit Facility is a revolving credit facility with
Cargill Financial and is secured by the assets of the Company, including a
pledge of the stock of substantially all of its operating subsidiaries and its
equity interests in the Acquisition Partnerships. The amount of such facility
has ranged from $25 to $35 million since the Merger, with a maximum outstanding
amount of approximately $31 million. At December 31, 1997, the amount
outstanding under the facility totaled approximately $7 million. The Company
Credit Facility matures on March 28, 1998. The Company has received and executed
a preliminary term sheet commitment from a foreign bank outlining the terms of a
new credit facility to replace the Company Credit Facility. The term sheet
proposes a $40 million revolving credit facility, which will mature on March 31,
1999 and will be secured by substantially all of the Company's equity interests
in its subsidiaries and the Acquisition Partnerships.
Mortgage Corp. Currently, Mortgage Corp. has a primary warehouse facility
of $450 million with a group of banks led by Chase Bank, Houston. The facility,
which matures in March 1999, is used to finance mortgage warehouse operations as
well as other activities. The $450 million facility is priced at LIBOR plus a
different margin to LIBOR for each of the sub-limits within the facility. The
primary warehouse components of the facility are priced at LIBOR plus from
1.375% to 1.625%, depending upon the status of the warehouse collateral securing
the loan. In addition to its primary warehouse facility, Mortgage Corp.
maintains a $36 million supplemental facility priced at LIBOR plus 0.5% to 2.5%.
In addition, Mortgage Corp. has an additional revolving operating line with such
banks of $45 million, which bears interest at a rate of LIBOR plus 2.25%. The
banks are obligated to fund loans under such line through March 31, 1999,
although final maturity of any then outstanding loans may be extended, at
Mortgage Corp.'s election, to December 15, 2002.
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Mortgage Corp. considers these facilities adequate for its current and
anticipated levels of activity in its mortgage operations.
The Company has executed a performance guarantee in favor of the lending
bank group in the event of overdrafts arising in Mortgage Corp.'s funding
accounts. An overdraft could occur in the event of the presentment of a loan
closing draft to the drawee bank prior to receipt of full closed loan
documentation from the closing agent. The receipt of documents by the lending
bank would release funds under the warehouse facility to cover the closing draft
prior to the presentment of the draft, in normal circumstances. The possibility
exists, therefore, for an overdraft in Mortgage Corp.'s funding account. The
performance guarantee by the Company in favor of the lending bank group is to
cover such overdrafts that are not cleared in a specified period of time. In
addition, Mortgage Corp. has a $172 million warehouse facility for loans to be
resold to FNMA.
Capital Corp. Capital Corp. funds its activities with equity investments
and subordinated debt from the Company and is in the process of negotiating
nonrecourse warehouse credit and securitization facilities with three nationally
recognized investment banking firms in an aggregate amount of $500 million.
Funding for Home Equity Loans purchased by Capital Corp. is provided, in part,
under Mortgage Corp.'s warehouse credit facility and is subject to Mortgage
Corp.'s sub-limit for Home Equity Loans meeting the criteria established in
Mortgage Corp.'s warehouse credit agreement. The remainder of Capital Corp.'s
Home Equity Loan warehouse is funded under a loan repurchase agreement with
Nomura Securities, Inc. ("Nomura"). The repurchase agreement expires on April
13, 1998. Capital Corp. anticipates being able to successfully conclude
negotiations on some of its warehouse and securitization facilities prior to the
expiration of the Nomura repurchase facility. However, if it is unable to do so,
it would have to curtail activities to a significant degree.
Commercial Corp. Commercial Corp. funds its activities with equity
investments and subordinated debt from the Company and nonrecourse financing
provided by a variety of bank and institutional lenders. Such lenders provide
funds to the special purpose entities formed for the purpose of acquiring
Portfolio Assets or to Acquisition Partnerships formed for the purpose of
co-investing in asset pools with other investors, principally Cargill Financial.
Commercial Corp. recently entered into a credit facility with Nomura in the
amount of $100 million, priced at LIBOR plus 2.25% to 2.50%, the proceeds of
which fund up to 85% of the purchase price of Portfolio Assets acquired by
Commercial Corp. or the Acquisition Partnerships. This facility matures on
February 28, 1999. Commercial Corp. believes that such facility, when combined
with the cash flow from its existing Portfolio Assets and its investment in
equities of Acquisition Partnerships, is adequate to meet its current and
anticipated liquidity needs. A Commercial Corp. subsidiary recently entered into
a $15 million dollar equivalent French franc facility for use in Portfolio
purchases in France, which facility accrues interest at LIBOR plus 3.50%,
matures on March 31, 1999 and is guaranteed by Commercial Corp. and the Company.
Consumer Corp. Consumer Corp. funds its activities with equity investments
and subordinated debt from the Company and a limited recourse $50 million
warehouse credit facility with ContiTrade Services L.L.C. ("ContiTrade"). Funds
are advanced under the facility in accordance with an eligible loan borrowing
base with the facility priced at LIBOR plus 3.0%. Loans are eligible for
inclusion in the borrowing base if they meet documented underwriting standards
as approved by ContiTrade and are not delinquent beyond terms established in the
loan agreement. At various times, the size of the facility has been in excess of
the $50 million committed amount based upon approvals by the lender. Under the
terms of the credit facility, the Company guarantees 25% of the amount
outstanding under the facility from time to time in addition to an undertaking
by the Company to support the liquidity requirements required in securitization
transactions. The ContiTrade facility matures on May 17, 1998. Negotiations are
underway to extend the facility, but there can be no assurance that such
negotiations will be successful.
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FOURTH QUARTER
Net earnings before minority interest and preferred dividends for the
fourth quarter of 1997 were $5.7 million, including a $.3 million deferred tax
benefit. After deducting minority interest and preferred dividends, net earnings
attributable to common equity were $3.8 million, or $.58 per diluted share.
These results represent an annualized return on average equity of 13.7%. Net
earnings before minority interest and preferred dividends for the fourth quarter
of 1996 were $7.7 million, including a $1.9 million deferred tax benefit. After
deducting minority interest and preferred dividends, net earnings attributable
to common equity were $5.7 million in 1996, or $.86 per diluted share,
representing an annualized return on average equity of 28.2%. The following
table presents a summary of operations for the fourth quarters of 1997 and 1996.
CONDENSED CONSOLIDATED SUMMARY OF OPERATIONS
1997 1996
FOURTH FOURTH
QUARTER QUARTER
--------- ---------
(DOLLARS IN THOUSANDS,
EXCEPT PER SHARE DATA)
Revenues.................................................... $34,921 $24,238
Expenses.................................................... 29,219 18,296
------- -------
Net earnings before minority interest, preferred dividends
and income taxes.......................................... 5,702 5,942
Benefit (provision) for income taxes........................ (12) 1,742
------- -------
Net earnings before minority interest and preferred
dividends................................................. $ 5,690 $ 7,684
======= =======
Preferred dividends......................................... 1,515 1,937
Net earnings to common shareholders......................... $ 3,836 $ 5,747
======= =======
Net earnings per common share -- basic...................... $ 0.59 $ 0.88
Net earnings per common share -- diluted.................... $ 0.58 $ 0.86
EFFECT OF NEW ACCOUNTING STANDARDS
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishment of Liabilities," is effective for transfers of financial
assets and extinguishment of liabilities occurring after December 31, 1996 and
is to be applied prospectively. The Statement provides accounting and reporting
standards for transfers and servicing of financial assets that are sales from
transfers that are secured borrowings. This Statement has not had a material
impact on the Company's financial position or results of operations. SFAS No.
128, "Earnings Per Share," is effective for per share earnings calculations and
disclosures for periods ending after December 15, 1997, including interim
periods, and requires restatement of all prior period earnings per share data
that is presented. The accompanying earnings per share data included in this
document reflect the retroactive application of SFAS No. 128.
SFAS No. 129, "Disclosure of Information about Capital Structure,"
establishes standards for disclosing information about an entity's capital
structure and is effective for financial statements for periods ending after
December 15, 1997. SFAS No. 130, issued in June 1997, "Reporting Comprehensive
Income," establishes standards for reporting and display of comprehensive income
and its components in the financial statements. SFAS No. 130 is effective for
fiscal years beginning after December 15, 1997. SFAS No. 131, issued in June
1997, "Disclosure about Segments of an Enterprise and Related Information,"
establishes standards as to how public companies disclose information about
operating segments, products and services, geographic areas and major customers.
SFAS No. 131 is effective for financial statements for periods beginning after
December 15, 1997. These statements relate principally to disclosure issues and
are not expected to have a material impact on the Company's consolidated
financial position or results of operations.
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RISK FACTORS
RISKS ASSOCIATED WITH RAPID GROWTH AND ENTRY INTO NEW BUSINESSES
Following the Merger, the Company embarked upon a strategic diversification
of its business. Previously, the Company had been engaged primarily in the
Portfolio Asset acquisition and resolution business. The Company has recently
entered the residential and commercial mortgage banking business and the
consumer lending business through a combination of acquisitions and the start-up
of new business ventures. The entry of the Company into these new businesses has
resulted in increased demands on the Company's personnel and systems. The
development and integration of the new businesses requires the investment of
additional capital and the continuous involvement of senior management. The
Company also must manage a variety of businesses with differing markets,
customer bases, financial products, systems and managements. An inability to
develop, integrate and manage its businesses could have a material adverse
effect on the Company's financial condition, results of operations and business
prospects. The Company's ability to support and manage continued growth is
dependent upon, among other things, its ability to attract and retain senior
management for each of its businesses, to hire, train, and manage its workforce
and to continue to develop the skills necessary for the Company to compete
successfully in its existing and new business lines. There can be no assurance
that the Company will successfully meet all of these challenges.
CONTINUING NEED FOR FINANCING
General. The successful execution of the Company's business strategy
depends on its continued access to financing for each of its major operating
subsidiaries. In addition to the need for such financing, the Company must have
access to liquidity to invest as equity or subordinated debt to meet the capital
needs of its subsidiaries. Liquidity is generated by the cash flow to the
Company from subsidiaries, access to the public debt and equity markets and
borrowings incurred by the Company. The Company's access to the capital markets
is affected by such factors as changes in interest rates, general economic
conditions, and the perception in the capital markets of the Company's business,
results of operations, leverage, financial condition and business prospects. In
addition, the Company's ability to issue and sell common equity (including
securities convertible into, or exercisable or exchangeable for, common equity)
is limited as a result of the tax laws relating to the preservation of the NOLs
available to the Company as a result of the Merger. There can be no assurance
that the Company's funding relationships with commercial banks, investment banks
and financial services companies (including Cargill Financial) that have
previously provided financing for the Company and its subsidiaries will continue
past their respective current maturity dates. The majority of the credit
facilities to which the Company and its subsidiaries are parties have short-term
maturities. Negotiations are underway to extend certain of such credit
facilities that are approaching maturity and the Company expects that it will be
necessary to extend the maturities of other such credit facilities in the near
future. There can be no assurance that such negotiations will be successful. If
such negotiations do not result in the extension of the maturities of such
credit facilities and the Company or its subsidiaries cannot find alternative
funding sources on satisfactory terms, or at all, the Company's financial
condition, results of operations and business prospects would be materially
adversely affected. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."
Each of the Company and its major operating subsidiaries has its own source
of debt financing. In certain circumstances, a default by the Company or any of
its major operating subsidiaries in respect of indebtedness owed to a third
party constitutes a default under the Company Credit Facility. The credit
facilities to which the Company's major operating subsidiaries are party do not
contain similar cross-default or cross-acceleration provisions. Although the
Company intends to continue to segregate the debt obligations of each such
subsidiary, there can be no assurance that its existing financing sources will
continue to agree to such arrangements or that alternative financing sources
that would accept such arrangements would be available. In the event the
Company's major operating subsidiaries are compelled to accept cross-guarantees,
or cross-default or cross-acceleration provisions in connection with their
respective credit facilities, financial difficulties experienced by one of the
Company's subsidiaries could adversely impact the Company's other subsidiaries.
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Dependence on Warehouse Financing. As is customary in the mortgage banking
and consumer lending businesses, the Company's subsidiaries depend upon
warehouse credit facilities with financial institutions or institutional lenders
to finance the origination and purchase of loans on a short-term basis pending
sale or securitization. Implementation of the Company's business strategy
requires the continued availability of warehouse credit facilities, and may
require increases in the permitted borrowing levels under such facilities. There
can be no assurance that such financing will be available on terms satisfactory
to the Company. The inability of the Company to arrange additional warehouse
credit facilities, to extend or replace existing facilities when they expire or
to increase the capacity of such facilities may have a material adverse effect
on the Company's financial condition, results of operations and business
prospects.
RISKS OF SECURITIZATION
Significance of Securitization. The Company believes that it will become
increasingly dependent upon its ability to securitize Home Equity Loans,
sub-prime automobile loans and other loans to efficiently finance the volume of
assets expected to be generated. Accordingly, adverse changes in the secondary
market for such loans could impair the Company's ability to originate, purchase
and sell loans on a favorable or timely basis. Any such impairment could have a
material adverse effect upon the Company's financial condition, results of
operations and business prospects. Proceeds from the securitization of
originated and acquired loans are required to be used to repay borrowings under
warehouse credit facilities, thereby making such facilities available to finance
the origination and purchase of additional loan assets. There can be no
assurance that, as the Company's volume of loans originated or purchased
increases and other new products available for securitization increases, the
Company will be able to securitize its loan production efficiently. An inability
to efficiently securitize its loan production could have a material adverse
effect on the Company's financial condition, results of operations and business
prospects.
Securitization transactions may be affected by a number of factors, some of
which are beyond the Company's control, including, among other things, the
adverse financial condition of, or developments related to, some of the
Company's competitors, conditions in the securities markets in general, and
conditions in the asset-backed securitization market. The Company's
securitizations typically utilize credit enhancements in the form of financial
guaranty insurance policies in order to achieve enhanced credit ratings. Failure
to obtain insurance company credit enhancement could adversely affect the timing
of, or ability of the Company to effect, securitizations. In addition, the
failure to satisfy rating agency requirements with respect to loan pools would
adversely impact the Company's ability to effect securitizations.
Contingent Risks. Although the Company intends to sell substantially all of
the Home Equity Loans, sub-prime automobile loans and other consumer loans that
it originates or purchases, the Company retains some degree of credit risk on
substantially all loans sold. During the period in which loans are held pending
sale, the Company is subject to various business risks associated with the
lending business, including the risk of borrower default, the risk of
foreclosure and the risk that a rapid increase in interest rates would result in
a decline in the value of loans to potential purchasers. The Company expects
that the terms of its securitizations will require it to establish deposit
accounts or build over-collateralization levels through retention of
distributions otherwise payable to the holders of subordinated interests in the
securitization. The Company also expects to be required to commit to repurchase
or replace loans that do not conform to the representations and warranties made
by the Company at the time of sale.
Retained Risks of Securitized Loans. The Company makes various
representations with respect to the loans that it securitizes. With respect to
acquired loans, the Company's representations rely in part on similar
representations made by the originators of such loans when they were purchased
by the Company. In the event of a breach of its representations, the Company may
be required to repurchase or replace the related loan using its own funds. While
the Company may have a claim against the originator in the event of a breach of
any of these representations made by the originators, the Company's ability to
recover on any such claim will be dependent on the financial condition of the
originator. There can be no assurance that the Company will not experience a
material loss in respect of any of these contingencies.
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Performance Assumptions. Capital Corp. and Funding Corp.'s future net
income will be highly dependent on realizing securitization gains on the sale of
loans. Such gains will be dependent largely upon the estimated present values of
the subordinated interests expected to be derived from the transactions and
retained by the Company. Management makes a number of assumptions in determining
the estimated present values for the subordinated interests. These assumptions
include, but are not limited to, prepayment speeds, default rates and subsequent
losses on the underlying loans, and the discount rates used to present value the
future cash flows. All of the assumptions are subjective. Varying the
assumptions can have a material effect on the present value determination in one
securitization as compared to any other. Subsequent events will cause the actual
occurrences of prepayments, losses and interest rates to be different from the
assumptions used for such factors at the time of the recognition of the sale of
the loans. The effect of the subsequently occurring events could cause a
re-evaluation of the carrying values of the previously estimated values of the
subordinated interests and excess spreads and such adjustment could be material.
Because the subordinated interests to be retained by Capital Corp. and
Funding Corp. represent claims to future cash flow that are subordinated to
holders of senior interests, Capital Corp. and Funding Corp. retain a
significant portion of the risk of whether the full value of the underlying
loans may be realized. In addition, holders of the senior interests may have the
right to receive certain additional payments on account of principal in order to
reduce the balance of the senior interests in proportion to the credit
enhancement requirements of any particular transaction. Such payments for the
benefit of the senior interest holders will delay the payment, if any, of excess
cash flow to Capital Corp. and Funding Corp. as the holder of the subordinated
interests.
IMPACT OF CHANGING INTEREST RATES
Because most of the Company's borrowings are at variable rates of interest,
the Company will be impacted by fluctuations in interest rates. The Company
monitors the interest rate environment and employs hedging strategies designed
to mitigate certain effects of changes in interest rates when the Company deems
such strategies appropriate. However, certain effects of changes in interest
rates, such as increased prepayments of outstanding loans, cannot be mitigated.
Fluctuations in interest rates could have a material adverse effect on the
Company's financial condition, results of operations and business prospects.
Among other things, a decline in interest rates could result in increased
prepayments of outstanding loans, particularly on loans in the servicing
portfolio of Mortgage Corp. The value of servicing rights is a significant asset
of Mortgage Corp. As prepayments of serviced mortgages increase, the value of
such servicing rights (as reflected on the Company's balance sheet) declines,
with a corresponding reduction in income as a result of the impairment of the
value of mortgage servicing rights. Although to date the impact of such effect
has largely been mitigated by increased production of mortgages from
refinancings during periods of declining interest rates, there can be no
assurance that new mortgage production will be sufficient to mitigate such
effect in the future. Absent a level of new mortgage production sufficient to
mitigate the effect of mortgage loan prepayments, the future revenue and
earnings of the Company will be adversely affected. In addition to prepayment
risks, during periods of declining interest rates, Mortgage Corp. experiences
higher levels of borrowers who elect not to close on loans for which they have
applied because they tend to find loans at lower interest rates. If Mortgage
Corp. has entered into commitments to sell such a loan on a forward basis and
the prospective borrower fails to close, Mortgage Corp. must nevertheless meet
its commitment to deliver the contracted for loans at the promised yields.
Mortgage Corp. will incur a loss if it is required to deliver loans to an
investor at a committed yield higher than current market rates. A substantial
and sustained decline in interest rates also may adversely impact the amount of
distressed assets available for purchase by Commercial Corp. The value of the
Company's interest-earning assets and liabilities may be directly affected by
the level of and fluctuations in interest rates, including the valuation of any
residual interests in securitizations that would be severely impacted by
increased loan prepayments resulting from declining interest rates.
Conversely, a substantial and sustained increase in interest rates could
adversely affect the ability of the Company to originate loans and could reduce
the gains recognized by the Company upon their securitization and sale.
Fluctuating interest rates also may affect the net interest income earned by the
Company resulting from the difference between the yield to the Company on
mortgage and other loans held pending sale and the
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interest paid by the Company for funds borrowed under the Company's warehouse
credit facilities or otherwise.
CREDIT IMPAIRED BORROWERS
The Company's sub-prime borrowers generally are unable to obtain credit
from traditional financial institutions due to factors such as an impaired or
poor credit history, low income or another adverse credit event. The Company is
subject to various risks associated with these borrowers, including, but not
limited to, the risk that the borrowers will not satisfy their debt service
obligations and that the realizable value of the assets securing their loans
will not be sufficient to repay the borrowers' debt. While the Company believes
that the underwriting criteria and collection methods it employs enable it to
identify and control the higher risks inherent in loans made to such borrowers,
and that the interest rates charged compensate the Company for the risks
inherent in such loans, no assurance can be given that such criteria or methods,
or such interest rates, will afford adequate protection against, or compensation
for, higher than anticipated delinquencies, foreclosures or losses. The actual
rate of delinquencies, foreclosures or losses could be significantly accelerated
by an economic downturn or recession. Consequently, the Company's financial
condition, results of operations and business prospects could be materially
adversely affected. The Company has established an allowance for loan losses
through periodic earnings charges and purchase discounts on acquired receivables
to cover anticipated loan losses on the loans currently in its portfolio. No
assurance can be given, however, that loan losses in excess of the allowance
will not occur in the future or that additional provisions will not be required
to provide for adequate allowances in the future.
AVAILABILITY OF PORTFOLIO ASSETS
The Portfolio Asset acquisition and resolution business is affected by
long-term cycles in the general economy. In addition, the volume of domestic
Portfolio Assets available for purchase by investors such as the Company has
generally declined since 1993 as large pools of distressed assets acquired by
governmental agencies in the 1980s and early 1990s have been resolved or sold.
The Company cannot predict its future annual acquisition volume of Portfolio
Assets. Moreover, future Portfolio Asset purchases will depend on the
availability of Portfolios offered for sale, the availability of capital and the
Company's ability to submit successful bids to purchase Portfolio Assets. The
acquisition of Portfolio Assets has become highly competitive in the United
States. This may require the Company to acquire Portfolio Assets at higher
prices thereby lowering profit margins on the resolution of such Portfolios.
Under certain circumstances, the Company may choose not to bid for Portfolio
Assets that it believes cannot be acquired at attractive prices. As a result of
all the above factors, Portfolio Asset purchases, and the revenue derived from
the resolution of Portfolio Assets, may vary significantly from quarter to
quarter.
AVAILABILITY OF NET OPERATING LOSS CARRYFORWARDS
The Company believes that, as a result of the Merger, approximately $596
million of NOLs were available to the Company to offset future taxable income as
of December 31, 1995. Since December 31, 1995, the Company has generated an
additional $12 million in tax operating losses. Accordingly, as of December 31,
1997, the Company believes that it has approximately $608 million of NOLs
available to offset future taxable income. In accordance with the terms of
Financial Accounting Standards Board Statement Number 109 (relating to
accounting for income taxes), the Company has established a future utilization
equivalent to approximately $87.7 million of the total $608 million of NOLs,
which equates to a $30.7 million deferred tax asset on the Company's books and
records. However, because the Company's position in respect of its NOLs is based
upon factual determinations and upon legal issues with respect to which there is
uncertainty and because no ruling has been obtained from the Internal Revenue
Service (the "IRS") regarding the availability of the NOLs to the Company, there
can be no assurance that the IRS will not challenge the availability of the
Company's NOLs and, if challenged, that the IRS will not be successful in
disallowing the entire amount of the Company's NOLs, with the result that the
Company's $30.7 million deferred tax asset would be reduced or eliminated.
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Assuming that the $608 million in NOLs is available to the Company, the
entire amount of such NOLs may be carried forward to offset future taxable
income of the Company until the tax year 2005. Thereafter, the NOLs begin to
expire. The ability of the Company to utilize such NOLs will be severely limited
if there is a more than 50% ownership change of the Company during a three-year
testing period within the meaning of section 382 of the Internal Revenue Code of
1986, as amended (the "Tax Code").
If the Company were unable to utilize its NOLs to offset future taxable
income, it would lose significant competitive advantages that it now enjoys.
Such advantages include, but are not limited to, the Company's ability to offset
non-cash income recognized by the Company in connection with certain
securitizations, to generate capital to support its expansion plans on a
tax-advantaged basis, to offset its and its consolidated subsidiaries' pretax
income, and to have access to the cash flow that would otherwise be represented
by payments of federal tax liabilities.
ASSUMPTIONS UNDERLYING PORTFOLIO ASSET PERFORMANCE
The purchase price and carrying value of Portfolio Assets acquired by
Commercial Corp. are determined largely by estimating expected future cash flows
from such assets. Commercial Corp. develops and revises such estimates based on
its historical experience and current market conditions, and based on the
discount rates that the Company believes are appropriate for the assets
comprising the Portfolios. In addition, many obligors on Portfolio Assets have
impaired credit, with risks associated with such obligors similar to the risks
described in respect of borrowers under "-- Credit Impaired Borrowers." If the
amount and timing of actual cash flows is materially different from estimates,
the Company's financial condition, results of operations and business prospects
could be materially adversely affected.
GENERAL ECONOMIC CONDITIONS
Periods of economic slowdown or recession, or declining demand for
residential or commercial real estate, automobile loans or other commercial or
consumer loans may adversely affect the Company's business. Economic downturns
may reduce the number of loan originations by the Company's mortgage banking,
consumer and commercial finance businesses and negatively impact its
securitization activity and generally reduce the value of the Company's assets.
In addition, periods of economic slowdown or recession, whether general,
regional or industry-related, may increase the risk of default on mortgage loans
and other loans and could have a material adverse effect on the Company's
financial condition, results of operations and business prospects. Such periods
also may be accompanied by declining values of homes, automobiles and other
property securing outstanding loans, thereby weakening collateral coverage and
increasing the possibility of losses in the event of default. Significant
increases in homes or automobiles for sale during recessionary economic periods
may depress the prices at which such collateral may be sold or delay the timing
of such sales. There can be no assurance that there will be adequate markets for
the sale of foreclosed homes or repossessed automobiles. Any material
deterioration of such markets could reduce recoveries from the sale of
collateral.
Such economic conditions could also adversely affect the resolution of
Portfolio Assets, lead to a decline in prices or demand for collateral
underlying Portfolio Assets, or increase the cost of capital invested by the
Company and the length of time that capital is invested in a particular
Portfolio. All or any one of these events could decrease the rate of return and
profits to be realized from such Portfolio and materially adversely affect the
Company's financial condition, results of operations and business prospects.
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RISK OF DECLINING VALUE OF COLLATERAL
The value of the collateral securing mortgage loans, automobile and other
consumer loans and loans acquired for resolution, as well as real estate or
other acquired distressed assets, is subject to various risks, including
uninsured damage, change in location or decline in value caused by use, age or
market conditions. Any material decline in the value of such collateral could
adversely affect the financial condition, results of operations and business
prospects of the Company.
GOVERNMENT REGULATION
Many aspects of the Company's business are subject to regulation,
examination and licensing under various federal, state and local statutes and
regulations that impose requirements and restrictions affecting, among other
things, the Company's loan originations, credit activities, maximum interest
rates, finance and other charges, disclosures to customers, the terms of secured
transactions, collection, repossession and claims handling procedures, multiple
qualification and licensing requirements for doing business in various
jurisdictions, and other trade practices. The Company believes it is currently
in compliance in all material respects with applicable regulations, but there
can be no assurance that the Company will be able to maintain such compliance.
Failure to comply with, or changes in, these laws or regulations, or the
expansion of the Company's business into jurisdictions that have adopted more
stringent regulatory requirements than those in which the Company currently
conducts business, could have an adverse effect on the Company by, among other
things, limiting the interest and fee income the Company may generate on
existing and additional loans, limiting the states in which the Company may
operate or restricting the Company's ability to realize on the collateral
securing its loans. See "Business -- Government Regulation."
The mortgage banking industry in particular is highly regulated. Failure to
comply with any of the various state and federal laws affecting the industry,
all of which are subject to regular modification, may result in, among other
things, demands for indemnification or mortgage loan repurchases, certain rights
of rescission for mortgage loans, class action lawsuits, administrative
enforcement actions and civil and criminal liability. Furthermore, currently
there are proposed various laws, rules and regulations which, if adopted, could
materially affect the Company's business. There can be no assurance that these
proposed laws, rules and regulations, or other such laws, rules or regulations
will not be adopted in the future that will make compliance more difficult or
expensive, restrict the Company's ability to originate, purchase, service or
sell loans, further limit or restrict the amount of commissions, interest and
other charges earned on loans originated, purchased, serviced or sold by the
Company, or otherwise have a material adverse effect on the Company's financial
condition, results of operations and business prospects. See
"Business -- Government Regulation."
Members of Congress and government officials have from time to time
suggested the elimination of the mortgage interest deduction for federal income
tax purposes, either entirely or in part, based on borrower income, type of loan
or principal amount. The reduction or elimination of these tax benefits may
lessen the demand for residential mortgage loans and Home Equity Loans, and
could have a material adverse effect on the Company's financial condition,
results of operations and business prospects.
ENVIRONMENTAL LIABILITIES
The Company, through its subsidiaries and affiliates, acquires real
property in its Portfolio Asset acquisition and resolution business, and
periodically acquires real property through foreclosure of mortgage loans that
are in default. There is a risk that properties acquired by the Company could
contain hazardous substances or waste, contaminants or pollutants. The Company
may be required to remove such substances from the affected properties at its
expense, and the cost of such removal may substantially exceed the value of the
affected properties or the loans secured by such properties. Furthermore, the
Company may not have adequate remedies against the prior owners or other
responsible parties to recover its costs, either as a matter of law or
regulation, or as a result of such prior owners' financial inability to pay such
costs. The Company may find it difficult or impossible to sell the affected
properties either prior to or following any such removal.
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COMPETITION
All of the businesses in which the Company operates are highly competitive.
Some of the Company's principal competitors are substantially larger and better
capitalized than the Company. Because of their resources, these companies may be
better able than the Company to obtain new customers for mortgage or other loan
production, to acquire Portfolio Assets, to pursue new business opportunities or
to survive periods of industry consolidation. Access to and the cost of capital
are critical to the Company's ability to compete. Many of the Company's
competitors have superior access to capital sources and can arrange or obtain
lower cost of capital, resulting in a competitive disadvantage to the Company
with respect to such competitors.
In addition, certain of the Company's competitors may have higher risk
tolerances or different risk assessments, which could allow these competitors to
establish lower margin requirements and pricing levels than those established by
the Company. In the event a significant number of competitors establish pricing
levels below those established by the Company, the Company's ability to compete
would be adversely affected.
RISK ASSOCIATED WITH FOREIGN OPERATIONS
Commercial Corp. has acquired, and manages and resolves, Portfolio Assets
located in France, and is actively pursuing opportunities to purchase additional
pools of distressed assets in France, other areas of Western Europe and Mexico.
Foreign operations are subject to various special risks, including currency
translation risks, currency exchange rate fluctuations, exchange controls and
different political, social and legal environments within such foreign markets.
To the extent future financing in foreign currencies is unavailable at
reasonable rates, the Company would be further exposed to currency translation
risks, currency exchange rate fluctuations and exchange controls. In addition,
earnings of foreign operations may be subject to foreign income taxes that
reduce cash flow available to meet debt service requirements and other
obligations of the Company, which may be payable even if the Company has no
earnings on a consolidated basis. Any or all of the foregoing could have a
material adverse effect on the Company's financial condition, results of
operations and business prospects.
DEPENDENCE ON INDEPENDENT MORTGAGE BROKERS
The Company depends in large part on independent mortgage brokers for the
origination and purchase of mortgage loans. In 1997, a substantial portion of
the loans originated by Mortgage Corp., and all of the loans originated by
Capital Corp., were originated by independent mortgage brokers or otherwise
acquired from third parties. These independent mortgage brokers deal with
multiple lenders for each prospective borrower. The Company competes with these
lenders for the independent brokers' business based on a number of factors,
including price, service, loan fees and costs. The Company's financial
condition, results of operations and business prospects could be adversely
affected by changes in the volume and profitability of mortgage loans resulting
from, among other things, competition with other lenders and purchasers of such
loans.
Class action lawsuits have been filed against a number of mortgage lenders,
including Mortgage Corp., alleging that such lenders have violated the federal
Real Estate Settlement Procedures Act of 1974 by making certain payments to
independent mortgage brokers. If these cases are resolved against the lenders,
it may cause an industry-wide change in the way independent mortgage brokers are
compensated. Such changes may have a material adverse effect on the Company's
results of operations, financial condition and business prospects.
DEPENDENCE ON AUTOMOBILE DEALERSHIP RELATIONSHIPS
The ability of the Company to expand into new geographic markets and to
maintain or increase its volume of automobile loans is dependent upon
maintaining and expanding the network of franchised automobile dealerships from
which it purchases contracts. Increased competition, including competition from
captive finance affiliates of automobile manufacturers, could have a material
adverse effect on the Company's ability to maintain or expand its dealership
network.
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LITIGATION
Industry participants in the mortgage and consumer lending businesses from
time to time are named as defendants in litigation involving alleged violations
of federal and state consumer protection or other similar laws and regulations.
A judgment against the Company in connection with any such litigation could have
a material adverse effect on the Company's consolidated financial condition,
results of operations and business prospects.
RELATIONSHIP WITH AND DEPENDENCE UPON CARGILL
The Company's relationship with Cargill Financial is significant in a
number of respects. Cargill Financial, a subsidiary of Cargill, Incorporated, a
privately held, multi-national agricultural and financial services company,
provides equity and debt financings for many of the Acquisition Partnerships,
and provides a $35 million revolving line of credit to the Company, which
expires on March 28, 1998. Cargill Financial owns approximately 3.7% of the
Company's outstanding Common Stock, and a Cargill Financial designee, David W.
MacLennan, serves as a director of the Company. The Company believes its
relationship with Cargill Financial significantly enhances the Company's
credibility as a purchaser of Portfolio Assets and facilitates its ability to
expand into other businesses and foreign markets. Although management believes
that the Company's relationship with Cargill Financial is excellent, there can
be no assurance that such relationship will continue in the future. Absent such
relationship, the Company and the Acquisition Partnerships would be required to
find alternative sources for the financing that Cargill Financial has
historically provided. There can be no assurance that such alternative financing
would be available. Any termination of such relationship could have a material
adverse effect on the Company's financial condition, results of operations and
business prospects.
DEPENDENCE ON KEY PERSONNEL
The Company is dependent on the efforts of its senior executive officers,
particularly James R. Hawkins (Chairman and Chief Executive Officer), James T.
Sartain (President and Chief Operating Officer), Rick R. Hagelstein (Executive
Vice President and Director of Subsidiary Operations), Matt A. Landry, Jr.
(Executive Vice President and Chief Administrative Officer) and Richard J.
Gillen (Managing Director of Mortgage Finance). The Company is also dependent on
several of the key members of management of each of its operating subsidiaries,
many of whom were instrumental in developing and implementing the business
strategy for such subsidiaries. The inability or unwillingness of one or more of
these individuals to continue in his present role could have a material adverse
effect on the Company's financial condition, results of operations and business
prospects. Except for Mr. Gillen, none of the senior executive officers has
entered into an employment agreement with the Company. There can be no assurance
that any of the foregoing individuals will continue to serve in his current
capacity or for what time period such service might continue. The Company does
not maintain key person life insurance for any of its senior executive officers
other than Mr. Gillen.
INFLUENCE OF CERTAIN SHAREHOLDERS
The directors and executive officers of the Company collectively
beneficially own 42.3% of the Common Stock. Although there are no agreements or
arrangements with respect to voting such Common Stock among such persons except
as described below, such persons, if acting together, may effectively be able to
control any vote of shareholders of the Company and thereby exert considerable
influence over the affairs of the Company. James R. Hawkins, the Chairman of the
Board and Chief Executive Officer of the Company, is the beneficial owner of
15.8% of the Common Stock. James T. Sartain, President and Chief Operating
Officer of the Company, and ATARA I, Ltd. ("ATARA"), an entity associated with
Rick R. Hagelstein, Executive Vice President and Director of Subsidiary
Operations of the Company each beneficially own 5.8% of the outstanding Common
Stock. In addition, Cargill Financial owns approximately 3.7% of the Common
Stock. Mr. Hawkins, Mr. Sartain, Cargill Financial and ATARA are parties to a
shareholder voting agreement (the "Shareholder Voting Agreement"). Under the
Shareholder Voting Agreement, Mr. Hawkins, Mr. Sartain and ATARA are required to
vote their shares in favor of Cargill Financial's designee for director of the
Company,
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and Cargill Financial is required to vote its shares in favor of one or more of
the designees of Messrs. Hawkins and Sartain and ATARA. Richard J. Gillen,
Managing Director of Mortgage Finance, and Ed Smith are the beneficial owners of
10.6% and 9.7%, respectively, of the Common Stock. As a result, Messrs. Gillen
and Smith may be able to exert influence over the affairs of the Company and if
their shares are combined with the holdings of Messrs. Hawkins and Sartain and
the shares held by ATARA, will have effective control of the Company. There can
be no assurance that the interests of management or the other entities and
individuals named above will be aligned with the Company's other shareholders.
SHARES ELIGIBLE FOR FUTURE SALE
The utilization of the Company's NOLs may be limited or prohibited under
the Tax Code in the event of certain ownership changes. The Company's Amended
and Restated Certificate of Incorporation (the "Certificate of Incorporation")
contains provisions restricting the transfer of its securities that are designed
to avoid the possibility of such changes. Such restrictions may prevent certain
holders of common stock of the Company from transferring such stock even if such
holders are permitted to sell such stock without restriction under the
Securities Act, and may limit the Company's ability to sell common stock to
certain existing holders of common stock at an advantageous time or at a time
when capital may be required but unavailable from any other source.
RELIANCE ON SYSTEMS; YEAR 2000 ISSUES
The Company's computer systems are integral to the operation of its
businesses. There can be no assurance that these systems will continue to be
adequate to support the Company's growth. A failure of the Company's computer
systems, including a failure of data integrity or accuracy, could have a
material adverse effect on the Company's consolidated financial condition,
results of operations and business prospects.
Although the Company maintains its own computer systems for a significant
portion of its operations, the Company is substantially dependent on the
services of third-party servicers in its mortgage banking and Portfolio Asset
acquisition and resolution businesses. The Company has been informed by such
servicers that, although they intend to make the necessary modifications to
their computer systems, the computer systems operated by them are not yet year
2000 compliant. In addition, the Company interacts electronically with several
government agencies, including FHLMC, FNMA, FHA, FMHA and GNMA, whose computer
systems are not yet year 2000 compliant. There can be no assurance that such
third parties and government agencies will make the necessary modifications to
their respective computer systems to enable proper processing of transactions
relating to the year 2000 and beyond. Any failure by such entities to timely
correct year 2000 issues could have a material adverse effect on the Company's
consolidated financial condition, results of operations and business prospects.
ANTI-TAKEOVER CONSIDERATIONS
The Company's Certificate of Incorporation and by-laws contain a number of
provisions relating to corporate governance and the rights of shareholders.
Certain of these provisions may be deemed to have a potential "anti-takeover"
effect to the extent they are utilized to delay, defer or prevent a change of
control of the Company by deterring unsolicited tender offers or other
unilateral takeover proposals and compelling negotiations with the Company's
Board of Directors rather than non-negotiated takeover attempts even if such
events may be in the best interests of the Company's shareholders. The
Certificate of Incorporation also contains certain provisions restricting the
transfer of its securities that are designed to prevent ownership changes that
might limit or eliminate the ability of the Company to use its NOLs.
PERIOD TO PERIOD VARIANCES
The Company Portfolio Assets and Acquisition Partnerships based proceeds
realized from the resolution of the Portfolio Assets, which proceeds have
historically varied significantly and likely will continue to vary significantly
from period to period. Consequently, the Company's period to period revenue and
net income have historically varied, and are likely to continue to vary,
correspondingly. Such variances, alone or with other
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factors, such as conditions in the economy or the financial services industries
or other developments affecting the Company, may result in significant
fluctuations in the reported earnings of the Company and in the trading prices
of the Company's securities, particularly the Common Stock.
TAX, MONETARY AND FISCAL POLICY CHANGES
The Company originates and acquires financial assets, the value and income
potential of which are subject to influence by various state and federal tax,
monetary and fiscal policies in effect from time to time. The nature and
direction of such policies are entirely outside the control of the Company, and
the Company cannot predict the timing or effect of changes in such policies.
Changes in such policies could have a material adverse effect on the Company's
consolidated financial condition, results of operations and business prospects.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
DECEMBER 31,
----------------------
1997 1996
--------- ---------
(DOLLARS IN THOUSANDS,
EXCEPT PER SHARE DATA)
Cash and cash equivalents................................... $ 31,605 $ 16,445
Portfolio Assets, net....................................... 89,951 76,240
Loans receivable, net....................................... 90,115 41,310
Mortgage loans held for sale................................ 533,751 134,348
Equity investments in and advances to Acquisition
Partnerships.............................................. 35,529 21,761
Class A Certificate of FirstCity Liquidating Trust.......... -- 53,617
Mortgage servicing rights................................... 69,634 33,517
Receivable for servicing advances and accrued interest...... 21,410 16,045
Deferred tax benefit, net................................... 30,614 13,898
Other assets, net........................................... 37,510 18,008
-------- --------
Total Assets...................................... $940,119 $425,189
======== ========
LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY
Liabilities:
Notes payable............................................. $750,781 $266,166
Other liabilities......................................... 34,672 20,604
-------- --------
Total Liabilities................................. 785,453 286,770
Commitments and contingencies............................... -- --
Redeemable preferred stock:
Special preferred stock, including dividends of $669 and
$1,938, respectively (nominal stated value of $21 per
share; 2,500,000 shares authorized; 849,777 and
2,460,911 shares, respectively, issued and
outstanding)........................................... 18,515 53,617
Adjusting rate preferred stock, including dividends of
$846 in 1997 (redemption value of $21 per share;
2,000,000 shares authorized; 1,073,704 shares issued
and outstanding in 1997)............................... 23,393 --
Shareholders' equity:
Optional preferred stock (par value $.01 per share;
98,000,000 shares authorized; no shares issued or
outstanding)........................................... -- --
Common stock (par value $.01 per share; 100,000,000 shares
authorized; issued and outstanding: 6,526,510 and
6,513,346 shares, respectively)........................ 65 65
Paid in capital........................................... 29,509 29,783
Retained earnings......................................... 83,184 54,954
-------- --------
Total Shareholders' Equity........................ 112,758 84,802
-------- --------
Total Liabilities, Redeemable Preferred Stock and
Shareholders' Equity............................ $940,119 $425,189
======== ========
See accompanying notes to consolidated financial statements.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
-------------------------------------
1997 1996 1995
---------- ---------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenues:
Gain on sale of mortgage loans............................ $ 36,496 $ 19,298 $ 7,864
Net mortgage warehouse income............................. 3,499 3,224 2,355
Gain on sale of mortgage servicing rights................. 4,246 2,641 2,011
Servicing fees:
Mortgage............................................... 14,732 10,079 6,508
Other.................................................. 12,066 12,456 10,903
Gain on resolution of Portfolio Assets.................... 24,183 19,510 11,984
Equity in earnings of Acquisition Partnerships............ 7,605 6,125 3,834
Rental income on real estate Portfolios................... 332 3,033 1,277
Interest income........................................... 13,448 7,707 1,572
Other income.............................................. 9,462 3,415 3,060
Interest income on Class A Certificate.................... 3,553 11,601 8,597
-------- -------- -------
Total revenues.................................... 129,622 99,089 59,965
-------- -------- -------
Expenses:
Interest on other notes payable........................... 12,433 10,403 4,721
Salaries and benefits..................................... 42,191 26,927 16,767
Amortization:
Mortgage servicing rights.............................. 7,550 4,091 3,823
Other.................................................. 2,563 3,113 1,534
Provision for loan losses................................. 6,613 2,029 --
Harbor Merger related expenses............................ 1,618 -- --
Occupancy, data processing, communication and other....... 36,354 23,254 11,955
Interest on senior subordinated notes..................... -- 3,892 4,721
-------- -------- -------
Total expenses.................................... 109,322 73,709 43,521
-------- -------- -------
Net earnings before minority interest, preferred dividends
and income taxes.......................................... 20,300 25,380 16,444
Benefit (provision) for income taxes...................... 15,485 13,749 (1,200)
-------- -------- -------
Net earnings before minority interest and preferred
dividends................................................. 35,785 39,129 15,244
Minority interest......................................... (157) -- --
Preferred dividends....................................... (6,203) (7,709) (3,876)
-------- -------- -------
Net earnings to common shareholders......................... $ 29,425 $ 31,420 $11,368
======== ======== =======
Net earnings per common share -- basic...................... $ 4.51 $ 4.83 $ 2.18
Net earnings per common share -- diluted.................... $ 4.46 $ 4.79 $ 2.18
Weighted average common shares outstanding -- basic......... 6,518 6,504 5,223
Weighted average common shares outstanding -- diluted....... 6,591 6,556 5,223
See accompanying notes to consolidated financial statements.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
NUMBER OF TOTAL
COMMON COMMON PAID IN RETAINED SHAREHOLDERS'
SHARES STOCK CAPITAL EARNINGS EQUITY
--------- ------- ------- -------- -------------
(DOLLARS IN THOUSANDS)
BALANCES, DECEMBER 31, 1994.................. 255,257 $ 1,590 $ 8,014 $17,518 $ 27,122
Common stock issued........................ 5,935 59 720 -- 779
Common stock retired....................... (11,080) (111) (1,089) -- (1,200)
Net assets spun off to Combined Financial
Corporation............................. -- -- -- (5,352) (5,352)
Merger with First City Bancorporation of
Texas, Inc. (Note 2).................... 6,252,296 (1,473) 21,473 -- 20,000
Net earnings for 1995...................... -- -- -- 15,244 15,244
Preferred dividends........................ -- -- -- (3,876) (3,876)
Other...................................... -- -- 71 -- 71
--------- ------- ------- ------- --------
BALANCES, DECEMBER 31, 1995.................. 6,502,408 65 29,189 23,534 52,788
Exercise of warrants, options and employee
stock purchase plan..................... 10,938 -- 266 -- 266
Net earnings for 1996...................... -- -- -- 39,129 39,129
Preferred dividends........................ -- -- -- (7,709) (7,709)
Other...................................... -- -- 328 -- 328
--------- ------- ------- ------- --------
BALANCES, DECEMBER 31, 1996.................. 6,513,346.. 65 29,783 54,954 84,802
--------- ------- ------- ------- --------
Exercise of warrants, options and employee
stock purchase plan..................... 13,164 -- 318 -- 318
Change in subsidiary year end.............. -- -- -- (1,195) (1,195)
Net earnings for 1997, after minority
interest................................ -- -- -- 35,628 35,628
Preferred dividends........................ -- -- -- (6,203) (6,203)
Other...................................... -- -- (592) -- (592)
--------- ------- ------- ------- --------
BALANCES, DECEMBER 31, 1997.................. 6,526,510 $ 65 $29,509 $83,184 $112,758
========= ======= ======= ======= ========
See accompanying notes to consolidated financial statements.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
---------------------------------------
1997 1996 1995
----------- ----------- -----------
Cash flows from operating activities:
Net earnings.............................................. $ 35,785 $ 39,129 $ 15,244
Adjustments to reconcile net earnings to net cash used in
operating activities, net of effect of acquisitions:
Proceeds from resolution of Portfolio Assets............ 87,138 70,940 44,760
Gain on resolution of Portfolio Assets.................. (24,183) (19,510) (11,984)
Purchase of Portfolio Assets............................ (38,367) (60,329) (42,727)
Origination of automobile receivables................... (89,845) (17,635) --
Gain on sale of mortgage servicing rights............... (4,246) (2,641) (2,011)
Increase in mortgage loans held for sale................ (396,599) (30,418) (67,690)
Increase in construction loans receivable............... (10,414) (7,370) (1,446)
Originated mortgage servicing rights.................... (40,734) (18,128) (3,950)
Purchases of mortgage servicing rights.................. (5,798) (3,075) (2,429)
Proceeds from sale of mortgage servicing rights......... 14,598 9,048 2,130
Provision for loan losses............................... 6,613 2,029 --
Equity in earnings of Acquisition Partnerships.......... (7,605) (6,125) (3,834)
Proceeds from performing Portfolio Assets............... 78,821 11,646 1,293
(Increase) decrease in net deferred tax asset........... (14,200) (14,235) 186
Depreciation and amortization........................... 11,791 8,791 6,200
Increase in other assets................................ (25,370) (18,554) (11,770)
Increase (decrease) in other liabilities................ 17,220 (344) 2,797
Adjustment to equity from change in subsidiary year
end................................................... (1,195) -- --
----------- ----------- -----------
Net cash used in operating activities.............. (406,590) (56,781) (75,231)
----------- ----------- -----------
Cash flows from investing activities, net of effect of
acquisitions:
Advances to Acquisition Partnerships...................... (50) (1,256) (9,755)
Payments on advances to Acquisition Partnerships.......... 1,029 9,821 169
Acquisition of subsidiaries............................... 1,118 (3,936) (7,753)
Proceeds from sales of and payments on loans held for
investment.............................................. 492 122 465
Repurchases of loans from investors....................... (5,983) (1,196) --
Principal payments on Class A Certificate................. 46,477 115,337 --
Property and equipment, net............................... (2,919) (2,530) (1,821)
Contributions to Acquisition Partnerships................. (25,282) (30,704) (3,583)
Distributions from Acquisition Partnerships............... 11,833 31,279 5,206
----------- ----------- -----------
Net cash provided by (used in) investing
activities....................................... 26,715 116,937 (17,072)
----------- ----------- -----------
Cash flows from financing activities, net of effect of
acquisitions:
Borrowings under notes payable............................ 9,196,377 4,105,451 1,137,662
Payments of notes payable................................. (8,777,337) (4,048,369) (1,056,179)
Payment of senior subordinated notes...................... -- (105,690) --
Additions to notes payable to shareholders and officers... -- -- 1,930
Reduction of notes payable to shareholders and officers... -- -- (1,843)
Capital contribution of FCBOT ............................ -- -- 20,000
Purchase of special preferred stock....................... (12,567) -- --
Proceeds from issuance of common stock.................... 318 266 779
Distributions to minority interest........................ (5,129) -- --
Preferred dividends paid.................................. (6,627) (9,647) --
Retirement of common stock................................ -- -- (1,200)
Other increases in paid in capital........................ -- 64 64
----------- ----------- -----------
Net cash provided by (used in) financing
activities....................................... 395,035 (57,925) 101,213
----------- ----------- -----------
Net increase in cash........................................ $ 15,160 $ 2,231 $ 8,910
Cash, beginning of year..................................... 16,445 14,214 5,304
----------- ----------- -----------
Cash, end of year........................................... $ 31,605 $ 16,445 $ 14,214
=========== =========== ===========
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest................................................ $ 37,284 $ 21,420 $ 10,476
=========== =========== ===========
Income taxes............................................ $ 852 $ 116 $ 1,000
=========== =========== ===========
See accompanying notes to consolidated financial statements.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) BASIS OF PRESENTATION
As more fully discussed in Note 2, on July 3, 1995, FirstCity Financial
Corporation (the "Company" or "FirstCity") was formed by the merger of J-Hawk
Corporation and First City Bancorporation of Texas, Inc. Historical financial
statements prior to the merger date reflect the financial position and results
of operations of J-Hawk Corporation. Additionally, the Company's merger with
Harbor Financial Group, Inc. ("Mortgage Corp.") on July 1, 1997 is accounted for
as a pooling of interests. The accompanying consolidated financial statements
are retroactively restated to reflect the pooling of interests.
The preparation of financial statements in conformity with generally
accepted accounting principles 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, prepayment speeds of
loans in servicing portfolios, collectibility on loans held in inventory and for
investment. Actual results could differ materially from those estimates.
(B) DESCRIPTION OF BUSINESS
The Company is a diversified financial services company with offices
throughout the United States, and a presence in France and Mexico. The Company
is engaged in three principal businesses: (i) residential and commercial
mortgage banking; (ii) portfolio asset acquisition and resolution; and (iii)
consumer lending.
The Company engages in the mortgage banking business through direct retail
and broker retail mortgage banking activities through which it originates,
purchases, sells and services residential and commercial mortgage loans
throughout the United States. Additionally the Company acquires, originates,
warehouses and securitizes mortgage loans to borrowers who have significant
equity in their homes and who generally do not satisfy the more rigid
underwriting standards of the traditional residential mortgage lending market
(referred to herein as "Home Equity Loans"). In addition to mortgage banking
activities, the Company performs other ancillary services such as residential
property management, property appraisal and inspection, portfolio/corporate
evaluations, risk management and hedging advisory services, marketing of loan
servicing portfolios, and mergers and acquisitions advisory services.
In the portfolio asset acquisition and resolution business the Company
acquires and resolves portfolios of performing and nonperforming commercial and
consumer loans and other assets (collectively, "Portfolio Assets" or
"Portfolios"), which are generally acquired at a discount to their legal
principal balance. Purchases may be in the form of pools of assets or single
assets. The Portfolio Assets are generally nonhomogeneous assets, including
loans of varying qualities that are secured by diverse collateral types and
foreclosed properties. Some Portfolio Assets are loans for which resolution is
tied primarily to the real estate securing the loan, while others may be
collateralized business loans, the resolution of which may be based either on
business or real estate or other collateral cash flow. Portfolio Assets are
acquired on behalf of the Company or its wholly-owned subsidiaries, and on
behalf of legally independent domestic and foreign partnerships and other
entities ("Acquisition Partnerships") in which a partially owned affiliate of
the Company is the general partner and the Company and other investors are
limited partners.
The Company's consumer lending activities include the origination,
acquisition and servicing of sub-prime consumer loans principally secured by
automobiles with the intention of selling the acquired loans in securitization
transactions.
The Company services, manages and ultimately resolves or otherwise disposes
of substantially all of the assets it, its Acquisition Partnerships, or other
related entities acquire. The Company services all such assets until they are
collected or sold and normally does not manage assets for non-affiliated third
parties.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(C) PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of
all of the majority owned subsidiaries of the Company. Investments in 20 percent
to 50 percent owned affiliates are accounted for on the equity method. All
significant intercompany transactions and balances have been eliminated in
consolidation.
(D) CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company
considers all highly liquid debt instruments with original maturities of three
months or less to be cash equivalents. The Company has maintained balances in
various operating and money market accounts in excess of federally insured
limits.
(E) PORTFOLIO ASSETS
Portfolio Assets are reflected in the accompanying consolidated financial
statements as non-performing Portfolio Assets, performing Portfolio Assets or
real estate Portfolios. The following is a description of each classification
and the related accounting policy accorded to each Portfolio type:
Non-Performing Portfolio Assets
Non-performing Portfolio Assets consist primarily of distressed loans and
loan related assets, such as foreclosed upon collateral. Portfolio Assets are
designated as non-performing unless substantially all of the loans in the
Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. Such Portfolios are acquired on the basis of an
evaluation by the Company of the timing and amount of cash flow expected to be
derived from borrower payments or other resolution of the underlying collateral
securing the loan.
All non-performing Portfolio Assets are purchased at substantial discounts
from their outstanding legal principal amount, the total of the aggregate of
expected future sales prices and the total payments to be received from
obligors. Subsequent to acquisition, the amortized cost of non-performing
Portfolio Assets is evaluated for impairment on a quarterly basis. A valuation
allowance is established for any impairment identified through provisions
charged to earnings in the period the impairment is identified.
Net gain on resolution of non-performing Portfolio Assets is recognized as
income to the extent that proceeds collected exceed a pro rata portion of
allocated cost from the Portfolio. Cost allocation is based on a proration of
actual proceeds divided by total estimated proceeds of the pool. No interest
income is recognized separately on non-performing Portfolio Assets. All
proceeds, of whatever type, are included in proceeds from resolution of
Portfolio Assets in determining the gain on resolution of such assets.
Accounting for Portfolios is on a pool basis as opposed to an individual
asset-by-asset basis.
Performing Portfolio Assets
Performing Portfolio Assets consist primarily of Portfolios of consumer and
commercial loans acquired at a discount from the aggregate amount of the
borrowers' obligation. Portfolios are classified as performing if substantially
all of the loans in the Portfolio are being repaid in accordance with the
contractual terms of the underlying loan agreements.
Performing Portfolio Assets are carried at the unpaid principal balance of
the underlying loans, net of acquisition discounts. Interest is accrued when
earned in accordance with the contractual terms of the loans. The accrual of
interest is discontinued once a loan becomes past due 90 days or more.
Acquisition discounts for the Portfolio as a whole are accreted as an adjustment
to yield over the estimated life of the Portfolio. Accounting for these
Portfolios is on a pool basis as opposed to an individual asset-by-asset basis.
The Company accounts for its performing Portfolio Assets in accordance with
the provisions of Statement of Financial Accounting Standards ("SFAS") No. 114,
Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118,
which requires creditors to evaluate the collectibility of both contractual
interest and principal of loans when assessing the need for a loss accrual.
Impairment is measured
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
based on the present value of the expected future cash flows discounted at the
loans' effective interest rates, or the fair value of the collateral, less
estimated selling costs, if any loans are collateral dependent and foreclosure
is probable.
Real Estate Portfolios
Real estate Portfolios consist of real estate assets acquired from a
variety of sellers. Such Portfolios are carried at the lower of cost or fair
value less estimated costs to sell. Costs relating to the development and
improvement of real estate are capitalized, whereas those relating to holding
assets are charged to expense. Income or loss is recognized upon the disposal of
the real estate. Rental income, net of expenses, on real estate Portfolios is
recognized when received.
(F) LOANS RECEIVABLE
Construction loans receivable consist of single-family residential
construction loans originated by the Company and are carried at the lower of
cost or market.
Loans held for investment include originated residential mortgage loans and
other loans made to third parties. Mortgage loans held for investment are
transferred to the investment category at the lower of cost or market on the
date of transfer. The mortgage loans consist principally of loans originated by
the Company which do not meet investor purchase criteria and loans repurchased
from mortgage-backed securities pools.
Automobile and consumer finance receivables consist of sub-prime automobile
finance receivables and student loan receivables, which are originated and
acquired from third party dealers and other originators, purchased at a
non-refundable discount from the contractual principal amount. This discount is
allocated between discount available for loan losses and discount available for
accretion to interest income. Discounts allocated to discounts available for
accretion are deferred and accreted to income using the interest method. To date
all acquired discounts have been allocated as discounts available for loan
losses. To the extent the discount is considered insufficient to absorb
anticipated losses on the loans receivable, additions to the allowance are made
through a periodic provision for loan losses (see Note 4). The evaluation of the
allowance considers loan portfolio performance, historical losses, delinquency
statistics, collateral valuations and current economic conditions. Such
evaluation is made on an individual loan basis using static pool analyses.
Interest is accrued when earned in accordance with the contractual terms of
the loans. The accrual of interest is discontinued once a loan becomes past due
90 days or more.
(G) MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale include the market value of related hedge
contracts and are stated at the lower of cost or market value, as determined by
outstanding commitments from investors on an aggregate portfolio basis. Any
differences between the carrying amounts and the proceeds from sales are
credited or charged to operations at the time the sale proceeds are collected.
Loan origination fees and certain direct loan origination costs are
deferred until the related loan is sold. Discounts from origination of mortgage
loans held for sale are deferred and recognized as adjustments to gain or loss
upon sale. Loan servicing income represents fees earned for servicing loans
owned by investors. The fees generally are based on a contractual percentage of
the outstanding principal balance. Fees are recorded as income when cash
payments are received. Loan servicing costs are charged to expense as incurred.
(H) MORTGAGE SERVICING RIGHTS
The Company accounts for mortgage servicing rights in accordance with the
provisions of SFAS No. 122 ("Statement 122"), Accounting for Mortgage Servicing
Rights, an Amendment of FASB Statement No. 65.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Statement 122 requires a mortgage banking enterprise to recognize, as separate
assets, the rights to service mortgage loans for others, regardless of how those
servicing rights are acquired. This statement also requires that these
capitalized mortgage servicing rights be assessed for impairment based on the
fair value of those rights. In assessing impairment, the mortgage servicing
rights capitalized after adoption of Statement 122 are to be stratified based on
one or more of the predominant risk characteristics of the underlying loans.
Impairment is to be recognized through a valuation allowance for each impaired
stratum.
Mortgage servicing rights are recorded at the lower of cost or present
value of the estimated net future servicing income. The recorded cost is
amortized in proportion to, and over the period of, estimated future servicing
income adjusted to reflect the effect of prepayments received and anticipated.
The carrying value of mortgage servicing rights is stratified into pools based
on loan type and note rate. The fair value of each pool is evaluated in relation
to the estimated future discounted net servicing income over the estimated
remaining loan lives.
When mortgage loans are sold with servicing retained and the stated
servicing fee rate differs materially from the normal servicing fee rate, the
sales price is adjusted for this excess servicing for purposes of determining
gain or loss on the sale to provide for the recognition of a reduced servicing
fee in subsequent years. The adjustment approximates the present value of the
difference between the normal and stated servicing fees over the estimated life
of the mortgage loans. The capitalized excess fees are amortized in proportion
to, and over the period of, estimated net servicing income.
SFAS No. 125 ("Statement 125"), Accounting for Transfers and Servicing of
Financial Assets and Extinguishment of Liabilities, provides accounting and
reporting standards for transfers and servicing of financial assets and
extinguishments of liabilities based on consistent application of a
financial-components approach that focuses on control of assets and liabilities.
Under this approach, after a transfer, an entity recognizes all financial and
servicing assets it controls and liabilities it has incurred and derecognizes
financial assets it no longer controls and liabilities that have been
extinguished. Statement 125 is effective for transfers and servicing of
financial assets and extinguishments of liabilities occurring after December 31,
1996, and is to be applied prospectively. The Company adopted Statement 125
effective January 1, 1997. Adoption of Statement 125 did not have a material
impact on the consolidated financial position or results of operations of the
Company.
(I) PROPERTY AND EQUIPMENT
Property and equipment are carried at cost, less accumulated depreciation
and are included in other assets. Depreciation is provided using accelerated
methods over the estimated useful lives of the assets.
(J) RECEIVABLE FOR SERVICING ADVANCES
Funds advanced for escrow, foreclosure and other investor requirements are
recorded as receivables and a loss provision is recorded for estimated
uncollectible amounts. An allowance for losses is provided for potential losses
on loans serviced for others that are in the process of foreclosure or may be
reasonably expected to be foreclosed in the future.
(K) PREPAID COMMITMENT FEES
Prepaid commitment fees are included in other assets and represent fees
paid primarily to permanent investors for the right to deliver mortgage loans in
the future at a specified yield. These fees are recognized as expense when the
loans are sold to permanent investors, when the commitment expires, or when it
is determined that loans will not be delivered under the commitment. Deferred
gains or losses are included in the carrying amount of the loans being hedged,
which are valued at the lower of aggregate cost or market value.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(L) INTANGIBLES
Intangible assets represent the excess of cost over fair value of assets
acquired in connection with purchase transactions (goodwill) as well as the
purchase price of future service fee revenues and are included in other assets.
These intangible assets are amortized over periods estimated to coincide with
the expected life of the underlying asset pool owned or serviced by the acquired
subsidiary. The Company periodically evaluates the existence of intangible asset
impairment on the basis of whether such intangibles are fully recoverable from
the projected, undiscounted net cash flows of the related assets acquired.
(M) TAXES
The Company files a consolidated federal income tax return with its 80% or
greater owned subsidiaries. The Company records all of the allocated federal
income tax provision of the consolidated group in the parent corporation.
Deferred tax assets and liabilities are recognized for future tax
consequences attributable to differences between the financial statement
carrying amounts and the tax basis of existing assets and liabilities and
operating loss and tax credit carry forwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effects of future changes in tax laws or rates are not
anticipated. The measurement of deferred tax assets, if any, is reduced by the
amount of any tax benefits that, based on available evidence, are not expected
to be realized.
(N) NET EARNINGS PER COMMON SHARE
The Company adopted the provisions of SFAS No. 128, Earnings Per Share,
which revised the previous calculation methods and presentation of earnings per
share in the fourth quarter of 1997. Basic net earnings per common share
calculations are based upon the weighted average number of common shares
outstanding restated to reflect the equivalent number of shares of the Company's
common stock that were issued to the J-Hawk Corporation shareholders in
connection with the Merger and the Harbor Merger discussed in Note 2. Earnings
included in the earnings per common share calculation are reduced by minority
interest and preferred stock dividends. Potentially dilutive common share
equivalents include warrants and stock options in the diluted earnings per
common share calculations.
(O) IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
The Company adopted the provisions of SFAS No. 121, ("Statement 121"),
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of, on January 1, 1996. Statement 121 requires that long-lived
assets and certain identifiable intangibles be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of assets to be held and used is measured
by a comparison of the carrying amount of an asset to future net cash flows
expected to be generated by the asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceeds the fair value of the assets. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less
costs to sell. Adoption of Statement 121 did not have a material impact on the
consolidated financial position or results of operations of the Company.
(P) RECLASSIFICATIONS
Certain amounts in the financial statements for prior periods have been
reclassified to conform with current financial statement presentation.
74
76
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(2) MERGERS AND ACQUISITIONS
A Joint Plan of Reorganization by First City Bancorporation of Texas, Inc.
("FCBOT"), Official Committee of Equity Security Holders, and J-Hawk Corporation
("J-Hawk"), with the Participation of Cargill Financial Services Corporation
("Cargill Financial"), Under Chapter 11 of the United States Bankruptcy Code,
(the "Plan of Reorganization"), became effective on July 3, 1995. Pursuant to
the Plan of Reorganization and an Agreement and Plan of Merger (collectively
referred to as the "Plan") between FCBOT and J-Hawk, on July 3, 1995, J-Hawk was
merged (the "Merger") with and into FCBOT. Pursuant to the Merger, (i) the
former holders of common stock of J-Hawk received, in the aggregate,
approximately 49.9% of the outstanding common stock of the surviving entity, in
exchange for their shares of J-Hawk common stock, (ii) 2,460,911 shares or
approximately 50.1% of the outstanding common stock of the surviving entity was
distributed among former security holders of FCBOT pursuant to the Plan, and
(iii) the name of the corporation was changed to FirstCity Financial
Corporation. As a result of the implementation of the Plan and the consummation
of the Merger, FirstCity also issued (i) 9% senior subordinated notes (all of
which have been redeemed), (ii) warrants to purchase 500,000 shares of its
common stock at an exercise price of $25 per share, and (iii) special preferred
stock to certain former security holders of FCBOT.
J-Hawk contributed substantially all of its interests in its Acquisition
Partnerships, all of its servicing operations, substantially all of its
leasehold improvements and equipment and its entire management team to
FirstCity. All remaining assets and liabilities of J-Hawk were spun out to
Combined Financial Corporation (owned by the former J-Hawk shareholders) in June
1995. The common stock of J-Hawk was converted into 2,460,511 shares of
FirstCity common stock. FCBOT contributed $20 million in cash to FirstCity.
While the transaction was legally structured as a merger, substantively, the
transaction has been treated for accounting purposes as a purchase of FCBOT by
J-Hawk. The net assets of J-Hawk spun out to Combined Financial Corporation were
as follows:
Cash and equivalents........................................ $ 232
Purchased asset pools....................................... 12,375
Other assets................................................ 2,839
Notes payable............................................... (8,187)
Payable to stockholders and officers........................ (1,669)
Other liabilities........................................... (238)
-------
Net assets spun out............................... $ 5,352
=======
Pursuant to the Plan, substantially all of the legal and beneficial
interest in the assets of FCBOT, other than the $20 million in cash contributed
to FirstCity, were transferred to the newly-formed FirstCity Liquidating Trust
(the "Trust"), or to subsidiaries of the Trust. Such assets are being liquidated
over the life of the Trust pursuant to the terms thereof. FirstCity, as the sole
holder of the Class A Certificate of the Trust (the "Class A Certificate"),
received from the Trust amounts sufficient to pay certain expenses and its
obligations under the 9% senior subordinated notes and the special preferred
stock. The liquidation of the assets transferred to the Trust was managed by the
Company pursuant to an Investment Management Agreement between the Trust and the
Company. In the first quarter of 1997, the Investment Management Agreement was
terminated and the Company received $6.8 million.
75
77
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On September 21, 1995, the Company acquired the capital stock of
Diversified Financial Systems, Inc. and Diversified Performing Assets, Inc.
(collectively, "Diversified") for $12.9 million in cash, notes and additional
contingent consideration payable in the form of "cash flow" notes. The aggregate
purchase price was allocated to the net assets of Diversified based upon fair
value at acquisition date as follows (dollars in thousands):
Purchased asset pools....................................... $ 68,834
Intangibles................................................. 9,379
Other assets................................................ 414
Notes payable............................................... (63,515)
Other liabilities........................................... (2,196)
--------
Purchase price, net of cash received........................ $ 12,916
========
At December 31, 1996, the Company reflected a liability of $3.1 million to
a former shareholder related to such cash flow notes in a transaction accounted
for as a purchase and a note receivable from the same shareholder in the amount
of $1 million. In 1997, the Company entered into a modified note agreement with
the former shareholder providing for an amended note payable in the amount of
$5.4 million. The modified note agreement extinguishes the Company's liability
for any amounts due related to the cash flow notes and acts to off-set the note
receivable from the former shareholder. The additional net liability resulting
from this modification was reflected as an adjustment to goodwill in the
Company's 1997 consolidated balance sheet.
On July 1, 1997, the Company merged with Mortgage Corp. (the "Harbor
Merger"). The Company issued 1,580,986 shares of its common stock in exchange
for 100% of Mortgage Corp.'s outstanding capital stock in a transaction
accounted for as a pooling of interests. Mortgage Corp. originates and services
residential and commercial mortgage loans. Mortgage Corp. had approximately $12
million in equity, assets of over $300 million and 700 employees prior to the
Harbor Merger. The consolidated financial statements of the Company have been
restated to reflect the Harbor Merger as if it occurred on January 1, 1995.
Prior to the Harbor Merger, Mortgage Corp.'s fiscal year end was September 30.
During 1997, the year end of Mortgage Corp. and its subsidiaries was changed to
conform with the year end of the Company. Accordingly, the consolidated balance
sheet as of December 31, 1996 and the consolidated statements of income,
shareholders' equity and cash flows for the years ended December 31, 1996 and
1995 include information and contain the accounts of Mortgage Corp. and its
subsidiaries as of September 30, 1996 and for the years ended September 30, 1996
and 1995.
On May 15, 1996, Mortgage Corp. acquired for $3.6 million all of the
outstanding common stock of Hamilton Financial Services Corporation ("Hamilton")
and subsidiaries in a transaction accounted for as a purchase. The assets and
liabilities assumed have been recorded at their fair values effective May 1,
1996. No goodwill was recorded as a result of the acquisition. The Company's
consolidated financial statements include the results of operations and cash
flows of Hamilton since the acquisition date. Because the assets acquired by
Mortgage Corp. are immaterial to the consolidated financial position or results
of operations of the Company, the presentation of pro forma results of
operations of the Company and Hamilton for periods prior to the acquisition
would not be meaningful.
On May 15, 1997, Mortgage Corp. acquired substantially all of the assets of
MIG Financial Corporation ("MIG"), MIG's $1.7 billion commercial mortgage
servicing portfolio, and MIG's commercial mortgage operations headquartered in
Walnut Creek, California for an aggregate purchase price of $4 million plus the
assumption of certain liabilities in a transaction accounted for as a purchase.
The assets purchased consisted of servicing rights, fixed assets and the
business relationships of MIG. MIG's asset revenues and historical earnings are
insignificant to the total assets and results of operations of the Company. The
transaction was accounted for as a purchase. MIG originated about $400 million
in commercial mortgage loans in 1996. The
76
78
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
transaction was funded by $1.3 million of senior debt and $2.6 million of
subordinated debt. The Company provided the $2.6 million subordinated loan in
connection with such transaction. The terms of the loan reflected market terms
for comparable loans made on an arms'-length basis.
The Company's net revenues, net earnings to common shareholders and net
earnings per common share, for the six months ended June 30, 1997 and each of
the years in the two-year period ended December 31, 1996, before and after the
Harbor Merger are summarized as follows:
SIX MONTHS YEAR ENDED
ENDED DECEMBER 31,
JUNE 30, ------------------
1997 1996 1995
---------- ------- -------
Net revenues (including equity earnings):
Before 1997 pooling................................ $34,838 $61,469 $39,523
1997 pooling....................................... 29,830 37,620 20,442
After 1997 pooling................................. 64,668 99,089 59,965
Net earnings to common shareholders:
Before 1997 pooling................................ $ 8,966 $27,696 $10,857
1997 pooling....................................... 1,447 3,724 511
After 1997 pooling................................. 10,413 31,420 11,368
Net earnings per common share -- diluted:
Before 1997 pooling................................ $ 1.79 $ 5.57 $ 2.98
1997 pooling....................................... (0.21) (0.78) (0.80)
After 1997 pooling................................. 1.58 4.79 2.18
(3) PORTFOLIO ASSETS
Portfolio Assets are summarized as follows:
DECEMBER 31,
---------------------
1997 1996
-------- ---------
Non-performing Portfolio Assets............................. $130,657 $ 302,239
Performing Portfolio Assets................................. 16,131 13,986
Real estate Portfolios...................................... 22,777 25,303
-------- ---------
Total Portfolio Assets............................ 169,565 341,528
Discount required to reflect Portfolio Assets at carrying
value..................................................... (79,614) (265,288)
-------- ---------
Portfolio Assets, net............................. $ 89,951 $ 76,240
======== =========
Portfolio Assets are pledged to secure non-recourse notes payable.
(4) LOANS RECEIVABLE
Loans receivable are summarized as follows:
DECEMBER 31,
------------------
1997 1996
------- -------
Construction loans receivable............................... $19,594 $ 8,816
Residential mortgage loans held for investment.............. 6,386 1,097
Automobile and consumer finance receivables................. 73,417 34,090
Allowance for loan losses................................... (9,282) (2,693)
------- -------
Loans receivable, net..................................... $90,115 $41,310
======= =======
77
79
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The activity in the allowance for loan losses is summarized as follows for
the periods indicated:
DECEMBER 31,
-------------------
1997 1996
-------- -------
Balances, beginning of year................................. $ 2,693 $ --
Provision for loan losses................................. 6,613 2,029
Discounts acquired........................................ 13,152 5,989
Reduction in contingent liabilities....................... 458 1,415
Other (allocation of reserves to sold loans).............. (1,363) --
Charge off activity:
Principal balances charged off......................... (15,126) (7,390)
Recoveries............................................. 2,855 650
-------- -------
Net charge offs...................................... (12,271) (6,740)
-------- -------
Balances, end of year....................................... $ 9,282 $ 2,693
======== =======
During 1997 and 1996, a note recorded at the time of original purchase of
the initial automobile finance receivables pool and contingent on the ultimate
performance of the pool was adjusted to reflect a reduction in anticipated
payments due pursuant to the contingency. The reductions in the recorded
contingent liability were recorded as increases in the allowance for losses.
(5) MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale include loans collateralized by first lien
mortgages on one-to-four family residences as follows:
DECEMBER 31,
--------------------
1997 1996
-------- --------
Residential mortgage loans.................................. $522,970 $132,193
Unamortized premiums and discounts.......................... 10,781 2,155
-------- --------
$533,751 $134,348
======== ========
(6) INVESTMENTS IN ACQUISITION PARTNERSHIPS
The Company has investments in Acquisition Partnerships and their general
partners that are accounted for on the equity method. Acquisition Partnerships
invest in Portfolio Assets in a manner similar to the Company, as described in
Note 1. The condensed combined financial position and results of operations of
the Acquisition Partnerships, which include the domestic and foreign Acquisition
Partnerships and their general partners, are summarized below:
CONDENSED COMBINED BALANCE SHEETS
DECEMBER 31,
--------------------
1997 1996
-------- --------
Assets...................................................... $338,484 $240,733
======== ========
Liabilities................................................. $250,477 $144,094
Net equity.................................................. 88,007 96,639
-------- --------
$338,484 $240,733
======== ========
Company's equity in Acquisition Partnerships................ $ 35,529 $ 21,761
======== ========
78
80
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CONDENSED COMBINED SUMMARY OF EARNINGS
YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
Proceeds from resolution of Portfolio Assets....... $178,222 $174,012 $188,934
Gross margin....................................... 33,398 39,505 51,370
Interest income on performing Portfolio Assets..... 8,432 7,870 --
Net earnings....................................... $ 20,117 $ 10,692 $ 9,542
======== ======== ========
Company's equity in earnings of Acquisition
Partnerships..................................... $ 7,605 $ 6,125 $ 3,834
======== ======== ========
In the third quarter of 1996, the Company recognized $2.0 million in
servicing fees in connection with the sale and securitization of $75 million of
performing loans from the Acquisition Partnerships. During the third quarter of
1996, a majority of the debt of the Acquisition Partnerships was refinanced,
resulting in a $7 million equity distribution to the Company.
(7) CLASS A CERTIFICATE
The Company was the sole holder of the Class A Certificate. Distributions
from the Trust in respect of the Class A Certificate were used to retire the
senior subordinated notes payable. Pursuant to a June 1997 agreement with the
Trust, the Trust's obligation to the Company under the Class A Certificate was
terminated (other than the Trust's obligation to reimburse the Company for
certain expenses) in exchange for the Trust's agreement to pay the Company an
amount equal to $22.75 per share for the 1,923,481 outstanding shares of the
Company's special preferred stock at June 30, 1997, the 1997 second quarter
dividend of $.7875 per share, and 15% interest from June 30, 1997 on any unpaid
portion of the settlement amount. In 1997, the Company paid dividends of $5.1
million on special preferred stock and purchased 537,430 shares (representing
$11.3 million in liquidation preference) of special preferred stock with
distributions from the Trust. The Trust has distributed $44.1 million to the
Company as full satisfaction of the June 1997 agreement.
(8) MORTGAGE SERVICING RIGHTS AND DEFERRED EXCESS SERVICING FEES
Mortgage servicing rights and deferred excess servicing fees consist of the
following:
DECEMBER 31,
--------------------
1997 1996
-------- --------
Mortgage servicing rights................................... $ 87,742 $ 46,814
Deferred excess servicing fees.............................. 5,929 2,791
-------- --------
93,671 49,605
Accumulated amortization.................................... (23,489) (15,640)
-------- --------
70,182 33,965
Valuation allowance......................................... (548) (448)
-------- --------
$ 69,634 $ 33,517
======== ========
79
81
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(9) NOTES PAYABLE
Notes payable consisted of the following:
DECEMBER 31,
--------------------
1997 1996
-------- --------
Collateralized loans, secured by Portfolio Assets:
Fixed rate (7.66% at December 31, 1997), due 2002......... $ 79,206 $ --
Prime (8.25% at December 31, 1996) plus 3.00% to 5.00%.... -- 37,491
French franc LIBOR (3.5156% at December 31, 1997) plus
4.00%, due 1998........................................ 8,301
LIBOR (5.9637% at December 31, 1997) plus 4.00% to 5.00%,
due 1998............................................... 3,259 7,947
Collateralized loans, secured by automobile finance
receivables:
LIBOR (5.9637% at December 31, 1997) plus 3.00%, due
1998................................................... 50,006 25,329
Residential mortgage warehouse lines of credit, secured by
individual notes:
LIBOR (5.9637% at December 31, 1997) plus .50 to 2.50%,
due 1998............................................... 337,598 148,579
Fed Funds (6.75% at December 31, 1997) plus .80 to 1.0%,
due 1998............................................... 187,141 --
Repurchase agreements (5.9637% at December 31, 1997) plus
0.85%, due 1998........................................ 35,826 --
Other notes payable, secured by substantially all the assets
of Mortgage Corp.:
LIBOR (5.9637% at December 31, 1997) plus 2.25%, due
2002................................................... 38,000 20,000
Borrowings under revolving line of credit, secured and with
recourse to the Company................................... 6,994 19,384
Other secured borrowings, secured by fixed assets........... 849 2,689
-------- --------
Notes payable, secured.................................... 747,180 261,419
Notes payable to others (Diversified shareholder debt) 7%,
due 2003............................................... 3,601 4,747
-------- --------
$750,781 $266,166
======== ========
The Company has a $35 million revolving line of credit with Cargill
Financial. The line bears interest at LIBOR plus 5% and expires on March 28,
1998. The line is secured by substantially all of the Company's unencumbered
assets.
Under terms of certain borrowings, the Company and its subsidiaries are
required to maintain certain tangible net worth levels and debt to equity and
debt service coverage ratios. The terms also restrict future levels of debt. The
Company was in compliance with all covenants at December 31, 1997. At December
31, 1997, cash restricted pursuant to loan covenants totaled $2.1 million. The
aggregate maturities of notes payable for the five years ending December 31,
2002 are as follows: $627,693 in 1998, $11,409 in 1999, $10,671 in 2000, $11,240
in 2001 and $89,693 in 2002.
80
82
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(10) MORTGAGE SERVICING PORTFOLIO AND RELATED OFF-BALANCE SHEET CREDIT RISK, AND
INSURANCE COVERAGE
At December 31, 1997, a substantial portion of the Company's loan
production activity and collateral for loans serviced is concentrated within the
states of Texas and California. The Company's mortgage servicing portfolio is
comprised of the following:
DECEMBER 31,
------------------------
1997 1996
---------- ----------
Number of loans (in thousands).............................. 62 52
Aggregate principal balance................................. $6,688,452 $3,947,028
Related escrow funds........................................ $ 32,708 $ 49,462
The above table includes subserviced mortgage loans of approximately $707
million and $835 million at December 31, 1997 and 1996, respectively.
The Company is required to advance, from corporate funds, escrow and
foreclosure costs for loans which it services. A portion of these advances for
loans serviced for GNMA are not recoverable. As of December 31, 1997 and 1996,
reserves for unrecoverable advances of approximately $357 and $232,
respectively, were established for GNMA loans in default.
Upon foreclosure, an FHA/VA property is typically conveyed to HUD or the
VA. However, the VA has the authority to deny conveyance of the foreclosed
property to the VA (a "VA no-bid"). The VA, instead, reimburses the Company
based on a percentage of the loan's outstanding principal balance ("guarantee"
amount). For GNMA VA no-bids, the foreclosed property is conveyed to the Company
and the Company then assumes the market risk of disposing of the property. The
related allowance for GNMA VA loans in default for potential no-bid losses as of
December 31, 1997 and 1996, is included in the allowance for unrecoverable
advances described above.
The Company is servicing approximately $11.2 million in loans with recourse
to Mortgage Corp. on behalf of FNMA and other investors. The recourse obligation
is the result of servicing purchases by Mortgage Corp. pursuant to which
Mortgage Corp. assumed the recourse obligation. As a result, Mortgage Corp. is
obligated to repurchase those loans that ultimately foreclose.
In addition, Mortgage Corp. has issued various representations and
warranties associated with whole loan and bulk servicing sales. The
representations and warranties may require Mortgage Corp. to repurchase
defective loans as defined by the applicable servicing and sales agreements.
Mortgage Corp. and its subsidiaries originated and purchased mortgage loans
with principal balances totaling approximately $3.7 billion, $1.8 billion and
$.7 billion, respectively, in 1997, 1996 and 1995. Errors and omissions and
fidelity bond insurance coverage under a mortgage banker's bond was $4.5 million
at December 31, 1997 and 1996.
(11) PREFERRED STOCK AND SHAREHOLDERS' EQUITY
The authorized capital stock of the Company consists of the following: (1)
2.5 million shares of special preferred stock, par value $.01 per share, with a
nominal stated value of $21.00 per share; (2) 2 million shares of adjusting rate
preferred stock, par value $.01 per share, with a redemption value of $21.00 per
share; (3) 98 million shares of optional preferred stock, par value $.01 per
share; and (4) 100 million shares of common stock, par value $.01 per share.
Additionally, on July 3, 1995, under the Plan, the Company authorized the
issuance of up to 500,000 warrants to purchase common stock to certain of FCBOT
shareholders. In connection with the Merger, 4,921,422 shares of common stock,
2,460,911 shares of special preferred stock and 500,000 warrants to purchase
common stock were issued.
81
83
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The holders of shares of common stock are entitled to one vote for each
share on all matters submitted to a vote of common shareholders. In order to
preserve certain tax benefits available to the Company, transactions involving
shareholders holding or proposing to acquire more than 4.75% of outstanding
common shares are prohibited unless the prior approval of the Board of Directors
is obtained.
The holders of special preferred stock are entitled to receive the nominal
stated value on September 30, 1998, and cumulative quarterly cash dividends at
the annual rate of $3.15 per share. Accrued dividends through September 30, 1996
of $9.6 million, or $3.92 per share, were paid in 1996. Dividends of $5.8
million, or $3.15 per share, were paid in 1997. At December 31, 1997, accrued
dividends totaled $.7 million, or $.7875 per share, and were paid on January 15,
1998. In 1997, the Company purchased 537,430 shares (representing $11.3 million
in liquidation preference) of special preferred stock with a distribution from
the Trust. The special preferred stock carries no voting rights, except in the
event of non-payment of declared dividends.
In June 1997, the Company initiated an offer to exchange one share of
special preferred stock for one share of the newly designated adjusting rate
preferred stock. The adjusting rate preferred stock has a redemption value of
$21.00 per share and cumulative quarterly cash dividends at the annual rate of
$3.15 per share through September 30, 1998, adjusting to $2.10 per share through
the redemption date of September 30, 2005. The Company may redeem the adjusting
rate preferred stock after September 30, 2003 for $21 per share plus accrued
dividends. The adjusting rate preferred stock carries no voting rights except in
the event of non-payment of dividends. Pursuant to the exchange offer, 1,073,704
shares of special preferred stock were accepted for exchange for a like number
of shares of adjusting rate preferred stock. Dividends of $.8 million, or $.7875
per share, were paid in 1997 and additional dividends of $.8 million, or $.7875
per share were accrued at December 31, 1997 (paid on January 15, 1998).
The Board of Directors of the Company may designate the relative rights and
preferences of the optional preferred stock when and if issued. Such rights and
preferences can include liquidation preferences, redemption rights, voting
rights and dividends and shares can be issued in multiple series with different
rights and preferences. The Company has no current plans for the issuance of an
additional series of optional preferred stock.
Each warrant entitles the holder to purchase one share of common stock at
an exercise price of $25.00 per share, subject to adjustment in certain
circumstances, and expires on July 3, 1999. The Company may repurchase the
warrants for $1.00 per warrant should the quoted market price of the Company's
common stock exceed $31.25 for any 10 out of 15 consecutive trading days. During
1997 and 1996, 106 and 2,625 warrants, respectively, were exercised, with
497,269 warrants outstanding at December 31, 1997.
The Company has stock option and award plans for the benefit of key
individuals, including its directors, officers and key employees. The plans are
administered by a committee of the Board of Directors and provide for the grant
of up to a total of 730,000 shares of common stock.
The per share weighted-average fair value of stock options granted during
1997 and 1996 was $19.14 and $13.19, respectively, on the grant date using the
Black-Scholes option pricing model with the following assumptions: 1997 -- $0
expected dividend yield, risk-free interest rate of 6.46%, expected volatility
of 30%, and an expected life of 10 years; 1996 -- $0 expected dividend yield,
risk-free interest rate of 5.75%, expected volatility of 30%, and an expected
life of 9.7 years.
The Company applies Accounting Principles Board Opinion No. 25 in
accounting for its stock option and award plans and, accordingly, no
compensation cost has been recognized for its stock options in the financial
statements. Had the Company determined compensation cost based on the fair value
at the grant date for its stock options under SFAS No. 123, Accounting for
Stock-Based Compensation, the Company's net earnings
82
84
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
to common shareholders and net earnings per common share would have been reduced
to the pro forma amounts indicated below:
1997 1996
------- -------
Net earnings to common shareholders:
As reported............................................... $29,425 $31,420
Pro forma................................................. 28,263 30,707
Net earnings per common share -- diluted:
As reported............................................... $ 4.46 $ 4.79
Pro forma................................................. 4.29 4.68
Stock option activity during the periods indicated is as follows:
1997 1996
------------------ ------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
SHARES PRICE SHARES PRICE
------- -------- ------- --------
Outstanding at beginning of year.............. 223,100 $21.07 229,600 $20.20
Granted....................................... 125,200 26.47 18,000 30.75
Exercised..................................... (4,750) 20.00 (4,500) 20.00
Forfeited..................................... (29,250) 25.91 (20,000) 20.00
------- -------
Outstanding at end of year.................... 314,300 $22.64 223,100 $21.07
======= =======
At December 31, 1997, the range of exercise prices and weighted-average
remaining contractual life of outstanding options was $20.00 -- $30.75 and 7
years, respectively.
At December 31, 1997, there were 87,710 options exercisable with a
weighted-average exercise price of $20.25.
The Company has an employee stock purchase plan which allows employees to
acquire an aggregate of 100,000 shares of common stock of the Company at 85% of
the fair value at the end of each quarterly plan period. The value of the shares
purchased under the plan is limited to the lesser of 10% of compensation or
$25,000 per year. Under the plan, 8,308 shares were issued in 1997 and 3,813
shares were issued during 1996. At December 31, 1997, an additional 87,879
shares of common stock are available for issuance pursuant to the plan.
Earnings per share ("EPS") has been calculated in conformity with SFAS No.
128, Earnings Per Share, and all prior periods have been restated. A
reconciliation between the weighted average shares outstanding used in the basic
and diluted EPS computations is as follows:
YEAR ENDED DECEMBER 31,
------------------------------------
1997 1996 1995
---------- ---------- ----------
Net earnings to common shareholders.............. $ 29,425 $ 31,420 $ 11,368
========== ========== ==========
Weighted average common shares
outstanding -- basic........................... 6,517,716 6,504,065 5,223,021
Effect of dilutive securities:
Assumed exercise of stock options.............. 48,824 45,467 --
Assumed exercise of warrants................... 24,672 6,392 --
---------- ---------- ----------
Weighted average common shares
outstanding -- diluted......................... 6,591,212 6,555,924 5,223,021
========== ========== ==========
Net earnings per common share -- basic........... $ 4.51 $ 4.83 $ 2.18
Net earnings per common share -- diluted......... $ 4.46 $ 4.79 $ 2.18
83
85
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(12) INCOME TAXES
Income tax expense (benefit) consists of:
YEAR ENDED DECEMBER 31,
----------------------------
1997 1996 1995
-------- -------- ------
Federal and state current expense...................... $ 1,231 $ 2,751 $1,264
Federal deferred expense (benefit)..................... (16,716) (16,500) (64)
-------- -------- ------
Total........................................ $(15,485) $(13,749) $1,200
======== ======== ======
The actual income tax expense (benefit) attributable to earnings from
operations differs from the expected tax expense (computed by applying the
federal corporate tax rate of 35% to earnings from operations before income
taxes) as follows:
1997 1996 1995
-------- -------- -------
Computed expected tax expense......................... $ 7,105 $ 8,883 $ 5,755
Increase (reduction) in income taxes resulting from:
Tax effect of Class A Certificate................... (1,243) (4,060) (3,009)
Change in valuation allowance....................... (23,388) (18,616) (1,522)
Alternative minimum tax and state income tax........ 1,646 -- --
REMIC excess inclusion income....................... 268 -- --
Other............................................... 127 44 (24)
-------- -------- -------
$(15,485) $(13,749) $ 1,200
======== ======== =======
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets at December 31, 1997 and 1996, are as
follows:
1997 1996
--------- ---------
Deferred tax assets:
Investments in Acquisition Partnerships, principally due
to differences in basis for tax and financial reporting
purposes............................................... 1,453 $ 403
Intangibles, principally due to differences in
amortization........................................... 1,317 1,138
Book loss reserve greater than tax loss reserve........... (1,200) 849
Tax basis in fixed assets greater than book............... 255 255
Federal net operating loss carryforward................... 213,028 210,681
Valuation allowance....................................... (168,971) (192,360)
--------- ---------
Total deferred tax assets......................... 45,882 20,966
Deferred tax liabilities:
Book basis in servicing rights greater than tax basis..... (15,231) (7,031)
Other, net................................................ (37) (37)
--------- ---------
Total deferred tax liabilities.................... 15,268 (7,068)
--------- ---------
Net deferred tax asset...................................... $ 30,614 $ 13,898
========= =========
As a result of the Merger described in Note 2, the Company has net
operating loss carryforwards for federal income tax purposes of approximately
$608 million at December 31, 1997, available to offset future federal taxable
income, if any, through the year 2012. A valuation allowance is provided to
reduce the deferred tax assets to a level which, more likely than not, will be
realized. During 1997 and 1996, the Company adjusted the previously established
valuation allowance to recognize a deferred tax benefit of $23.4 million.
84
86
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The ultimate realization of the resulting net deferred tax asset is dependent
upon generating sufficient taxable income prior to expiration of the net
operating loss carryforwards. Although realization is not assured, management
believes it is more likely than not that all of the recorded deferred tax asset,
net of the allowance, will be realized. The amount of the deferred tax asset
considered realizable, however, could be adjusted in the future if estimates of
future taxable income during the carryforward period change. The change in
valuation allowance represents primarily an increase in the estimate of the
future taxable income during the carryforward period since the prior year end
and the utilization of net operating loss carryforwards since the Merger. The
ability of the Company to realize the deferred tax asset is periodically
reviewed and the valuation allowance is adjusted accordingly.
(13) EMPLOYEE BENEFIT PLAN
The Company has a defined contribution 401(k) employee profit sharing plan
pursuant to which the Company matches employee contributions at a stated
percentage of employee contributions to a defined maximum. The Company's
contributions to the 401(k) plan were $603 in 1997, $407 in 1996 and $226 in
1995.
(14) LEASES
The Company leases its current headquarters from a related party under a
noncancelable operating lease. The lease calls for monthly payments of $7.5
through its expiration in December 2001 and includes an option to renew for two
additional five-year periods. Rental expense for 1997, 1996 and 1995 under this
lease was $90 each year.
The Company also leases office space and equipment from unrelated parties
under operating leases expiring in various years through 2004. Rental expense
under these leases for 1997, 1996 and 1995 was $4.1 million, $2.3 million and
$1.5 million, respectively. As of December 31, 1997, the future minimum lease
payments under all noncancelable operating leases are: $4,992 in 1998, $4,326 in
1999, $2,234 in 2000, $1,486 in 2001 and $1,360 in 2002 and beyond.
The Company has subleased various office space. These sublease agreements
primarily relate to leases assumed in the acquisition of Hamilton. Future
minimum rentals to be received under noncancelable operating leases are $1,109,
$1,036 and $227 for the years 1998, 1999 and 2000, respectively.
(15) MORTGAGE LOAN PIPELINE, HEDGES, AND RELATED OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk
in the normal course of business through the origination and selling of mortgage
loans. The risks are associated with fluctuations in interest rates. The
financial instruments include commitments to extend credit, mandatory forward
contracts, and various hedging instruments. The instruments involve, to varying
degrees, interest rate risk in excess of the amount recognized in the
consolidated financial statements.
The Company's mortgage loan pipeline as of December 31, 1997, totaled
approximately $1.6 billion. The Company's exposure to loss in the event of
nonperformance by the party committed to purchase the mortgage loan is
represented by the amount of loss in value due to increases in interest rates on
its fixed rate commitments. The pipeline consists of approximately $300 million
of fixed rate commitments and $1.3 billion of floating rate obligations. The
floating rate commitments are not subject to significant interest rate risk.
Management believes that the Company had adequate lines of credit at December
31, 1997 to fund its projected loan closings from its mortgage loan pipeline.
The Company uses a variety of methods to hedge the interest rate risk of
the mortgage loans in the pipeline that are expected to close and the mortgage
loans held for sale. Mandatory forward commitments to sell whole loans and
mortgage-backed securities are the Company's primary hedge instruments. At
Decem-
85
87
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
ber 31, 1997, the Company had approximately $423 million of mandatory forward
commitments to sell. To the extent mortgage loans at the appropriate rates are
not available to fill these commitments, the Company has interest rate risk due
primarily to the impact of interest rate fluctuations on its obligations to fill
forward commitments.
The Company's mortgage loan pipeline and mandatory forward commitments are
included in the lower of cost or market value calculation of mortgage loans held
for sale.
(16) OTHER RELATED PARTY TRANSACTIONS
During 1996, the Company acquired a portfolio of sub-prime automobile
finance receivables from an Acquisition Partnership for approximately $23.6
million. This acquisition was at the carrying value of the Portfolio in the
Acquisition Partnership, thus resulting in no gain or loss on the transaction to
the Acquisition Partnership.
In January 1995, the Company entered into an agreement with a shareholder
to repurchase 11,080 shares of J-Hawk common stock for $1.2 million. The Company
paid the former shareholder $.4 million in cash and issued a $.8 million note,
which was assumed by Combined Financial Corporation, an affiliated entity, prior
to the Merger.
In 1995, the Company sold approximately $12 million (allocated cost) of
loans to a partnership owned by certain executive officers of J-Hawk. The
Company recognized approximately $3 million in gain from the transaction.
Additionally, the Company entered into a servicing arrangement with the
partnership to service the sold assets for a fee based on collections.
The Company has contracted with the Trust, the Acquisition Partnerships and
related parties as a third party loan servicer. Servicing fees totaling $12.1
million, $12.5 million and $10.9 million for 1997, 1996 and 1995, respectively,
and due diligence fees (included in other income) were derived from such
affiliates.
During 1997, the Company, along with selected Acquisition Partnerships,
sold certain assets to an entity 80% owned by the Company. The gain on the sale
of the assets was deferred and is being recognized as the assets are ultimately
resolved.
(17) COMMITMENTS AND CONTINGENCIES
The Company is involved in various legal proceedings in the ordinary course
of business. In the opinion of management, the resolution of such matters will
not have a material adverse impact on the consolidated financial condition,
results of operations or liquidity of the Company.
The Company is a 50% owner in an entity that is obligated to advance up to
$2.5 million toward the acquisition of Portfolio Assets from financial
institutions in California. At December 31, 1997, advances of $.2 million had
been made under the obligation.
(18) FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures about Fair Value of Financial Instruments,
requires that the Company disclose estimated fair values of its financial
instruments. Fair value estimates, methods and assumptions are set forth below.
(A) CASH AND CASH EQUIVALENTS AND CLASS A CERTIFICATE
The carrying amount of cash and cash equivalents and the Class A
Certificate approximated fair value at December 31, 1997 and 1996.
86
88
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(B) PORTFOLIO ASSETS AND LOANS RECEIVABLE
The Portfolio Assets and loans receivable are carried at the lower of cost
or estimated fair value. The estimated fair value is calculated by discounting
projected cash flows on an asset-by-asset basis using estimated market discount
rates that reflect the credit and interest rate risks inherent in the assets.
The carrying value of the Portfolio Assets and loans receivable was $180 million
and $118 million, respectively, at December 31, 1997 and 1996. The estimated
fair value of the Portfolio Assets and loans receivable was approximately $199
million and $134 million, respectively, at December 31, 1997 and 1996.
(C) MORTGAGE LOANS HELD FOR SALE
Market values of loans held for sale are generally based on quoted market
prices or dealer quotes. The carrying value of mortgage loans held for sale was
$534 million and $134 million, respectively, at December 31, 1997 and 1996. The
estimated fair value of mortgage loans held for sale approximated their carrying
value at December 31, 1997 and 1996.
(D) NOTES PAYABLE
Management believes that the repayment terms for similar rate financial
instruments with similar credit risks and the stated interest rates at December
31, 1997 and 1996 approximate the market terms for similar credit instruments.
Accordingly, the carrying amount of notes payable is believed to approximate
fair value.
(E) REDEEMABLE PREFERRED STOCK
Redeemable preferred stock is carried at redemption value plus accrued but
unpaid dividends. Carrying values were $41,908 and $53,617 at December 31, 1997
and 1996, respectively. Fair market values based on quoted market rates were
$42,048 and $59,062 at December 31, 1997 and 1996, respectively.
87
89
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
FirstCity Financial Corporation:
We have audited the accompanying consolidated balance sheets of FirstCity
Financial Corporation and subsidiaries as of December 31, 1997 and 1996, and the
related consolidated statements of income, shareholders' equity, and cash flows
for each of the years in the three-year period ended December 31, 1997. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of FirstCity
Financial Corporation and subsidiaries as of December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1997, in conformity with generally accepted
accounting principles.
KPMG Peat Marwick LLP
Fort Worth, Texas
March 24, 1998
88
90
FIRSTCITY FINANCIAL CORPORATION
The Harbor Merger, which occurred in July 1997, was accounted for as a
pooling of interests. The Company's historical financial statements have
therefore been retroactively restated to include the financial position and
results of operations of Mortgage Corp. for all periods presented. Earnings per
share has been calculated in conformity with SFAS No. 128, Earnings Per Share,
and all prior periods have been restated.
SELECTED QUARTERLY FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
1997 1996
------------------------------------- -------------------------------------
FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
------- ------- ------- ------- ------- ------- ------- -------
Income.................. $32,060 $28,295 $28,235 $33,427 $21,184 $24,238 $25,176 $22,366
Expenses................ 24,032 26,399 29,672 29,219 16,640 18,449 20,324 18,296
Equity in earnings of
Acquisition
Partnerships.......... 1,541 2,772 1,798 1,494 714 916 2,623 1,872
Net earnings before
minority interest and
preferred
dividends(2).......... 9,217 4,439 16,439 5,690 4,530 20,173 6,742 7,684
Preferred dividends..... 1,659 1,515 1,514 1,515 1,938 1,938 1,896 1,937
Net earnings to common
shareholders(2)....... 7,558 2,855 15,176 3,836 2,592 18,235 4,846 5,747
Net earnings per common
share -- Basic(2)..... 1.16 0.44 2.33 0.59 0.40 2.80 0.75 0.88
Net earnings per common
share -- Diluted(2)... 1.14 0.44 2.30 0.58 0.40 2.80 0.73 0.86
- ---------------
(2) Includes $13.3 million and $14.6 million, respectively, of deferred tax
benefits in third quarter of 1997 and second quarter of 1996
89
91
WAMCO PARTNERSHIPS
COMBINED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
(DOLLARS IN THOUSANDS)
ASSETS
1997 1996
-------- --------
Cash........................................................ $ 11,467 $ 8,812
Portfolio Assets, net....................................... 104,189 177,480
Investments in partnerships................................. 185 --
Investments in trust certificates........................... 5,816 5,195
Receivable from affiliates.................................. 892 234
Restricted cash............................................. 235 795
Other assets, net........................................... 2,958 3,150
-------- --------
$125,742 $195,666
======== ========
LIABILITIES AND PARTNERS' CAPITAL
Accounts payable (including $330 and $574 to affiliates in
1997 and 1996, respectively).............................. $ 441 $ 1,756
Accrued liabilities......................................... 1,081 1,738
Long-term debt (including $58,923 and $74,341 to affiliates
in 1997 and 1996, respectively)........................... 68,950 141,054
-------- --------
Total liabilities................................. 70,472 144,548
Commitments and contingencies............................... -- --
Partners' capital........................................... 55,270 51,118
-------- --------
$125,742 $195,666
======== ========
See accompanying notes to combined financial statements.
90
92
WAMCO PARTNERSHIPS
COMBINED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS)
1997 1996 1995
--------- --------- ---------
Proceeds from resolution of Portfolio Assets.............. $ 159,159 $ 174,012 $ 188,934
Cost of Portfolio Assets resolved......................... (132,626) (134,507) (137,564)
--------- --------- ---------
Gain on resolution of Portfolio Assets.................. 26,533 39,505 51,370
Interest income on performing Portfolio Assets............ 8,432 7,870 --
Interest expense (including $8,187, $14,571 and $13,333 to
affiliates in 1997, 1996 and 1995, respectively)........ (10,659) (22,065) (27,034)
General, administrative and operating expenses............ (10,338) (14,777) (14,870)
Other income (expense), net............................... 1,008 210 121
--------- --------- ---------
Net earnings............................................ $ 14,976 $ 10,743 $ 9,587
========= ========= =========
See accompanying notes to combined financial statements.
91
93
WAMCO PARTNERSHIPS
COMBINED STATEMENTS OF CHANGES IN PARTNERS' CAPITAL
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS)
CLASS B
CLASS A EQUITY EQUITY
------------------- --------
GENERAL LIMITED LIMITED GENERAL LIMITED
PARTNERS PARTNERS PARTNERS PARTNERS PARTNERS TOTAL
-------- -------- -------- -------- -------- --------
Balance at December 31, 1994..... $ 534 $ 26,193 $ 21,169 $ 56 $ 2,750 $ 50,702
Contributions.................. 82 4,027 -- 60 2,946 7,115
Distributions.................. (197) (9,645) (1,585) (31) (1,527) (12,985)
Net earnings................... 154 7,511 1,648 6 268 9,587
----- -------- -------- ----- -------- --------
Balance at December 31, 1995..... 573 28,086 21,232 91 4,437 54,419
Contributions.................. 54 2,621 -- 986 48,303 51,964
Distributions.................. (400) (19,598) (3,082) (860) (42,068) (66,008)
Net earnings................... 47 2,301 556 156 7,683 10,743
----- -------- -------- ----- -------- --------
Balance at December 31, 1996..... 274 13,410 18,706 373 18,355 51,118
Contributions.................. -- -- -- 522 29,592 30,114
Distributions.................. (113) (5,522) (16,533) (375) (18,395) (40,938)
Net earnings................... 111 5,432 1,173 162 8,098 14,976
----- -------- -------- ----- -------- --------
Balance at December 31, 1997..... $ 272 $ 13,320 $ 3,346 $ 682 $ 37,650 $ 55,270
===== ======== ======== ===== ======== ========
See accompanying notes to combined financial statements.
92
94
WAMCO PARTNERSHIPS
COMBINED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS)
1997 1996 1995
--------- --------- ---------
Cash flows from operating activities:
Net earnings.......................................... $ 14,976 $ 10,743 $ 9,587
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Amortization of loan origination and commitment
fees............................................. 1,707 1,483 2,415
Provision (credit) for losses...................... (587) 585 --
Net gain on Portfolio Assets....................... (26,533) (39,505) (51,370)
Purchase of Portfolio Assets....................... (73,734) (102,695) (101,626)
Capitalized costs on Portfolio Assets.............. (1,143) (3,330) (1,643)
Proceeds from resolution of Portfolio Assets....... 159,159 188,002 188,934
(Increase) decrease in receivable from
affiliates....................................... (660) (126) 49
Decrease in restricted cash........................ 560 1,956 765
Increase in other assets........................... (1,556) (2,191) (1,186)
Increase (decrease) in accounts payable ........... (1,304) 1,032 (135)
Increase (decrease) in accrued liabilities......... (601) (6,812) 1,730
--------- --------- ---------
Net cash provided by operating activities..... 70,284 49,142 47,520
Cash flows from investing activities:
Contribution to subsidiaries.......................... (185)
Purchase of trust certificates........................ (225) (4,224) --
Payments received from trust certificates............. 191 -- --
--------- --------- ---------
Net cash used in operating activities......... (219) (4,224) --
Cash flows from financing activities:
Borrowing on acquisition debt......................... -- -- 12,840
Repayment of acquisition debt......................... -- (28,967) (12,840)
Borrowing on long-term debt........................... 34,489 263,614 112,050
Repayment of long-term debt........................... (106,593) (265,041) (154,312)
Capital contributions................................. 30,114 38,180 7,115
Capital distributions................................. (25,420) (52,224) (12,985)
--------- --------- ---------
Net cash used in financing activities......... (67,410) (44,438) (48,132)
--------- --------- ---------
Net increase (decrease) in cash......................... 2,655 480 (612)
Cash at beginning of year............................... 8,812 8,332 8,944
--------- --------- ---------
Cash at end of year..................................... $ 11,467 $ 8,812 $ 8,332
========= ========= =========
Supplemental disclosure of cash flow information (note 5):
Cash paid for interest was approximately $11,091, $27,652 and $23,074 and for
1997, 1996 and 1995, respectively.
WAMCO V and WAMCO XVII contributed $1,243 and $324 of portfolio assets,
respectively, in exchange for an investment in trust certificates in 1996.
WAMCO IX, WAMCO XXI and WAMCO XXII contributed $1,542 of portfolio assets in
exchange for an equity interest in a related party. This equity interest was
subsequently distributed to the partners of the partnerships.
In January, 1997 a partner purchased the other 50% interest in the Whitewater
partnership, thus removing $14,043 in Portfolio and other assets and $14,043
of other liabilities and partners' capital from the accounts of the combined
WAMCO partnerships.
See accompanying notes to combined financial statements.
93
95
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS
DECEMBER 31, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS)
(1) ORGANIZATION AND PARTNERSHIP AGREEMENTS
The combined financial statements include the accounts of WAMCO III, Ltd.;
WAMCO V, Ltd.; WAMCO IX, Ltd.; WAMCO XVII, Ltd.; WAMCO XXI, Ltd.; WAMCO XXII,
Ltd.; WAMCO XXIII, Ltd.; WAMCO XXIV, Ltd.; WAMCO XXV, Ltd.; Calibat Fund, LLC;
DAP City Partners, L.P.; First B Realty, L.P.; First Paradee, L.P.; GLS
Properties, Ltd.; Imperial Fund I, L.P.; VOJ Partners, L.P. and Whitewater
Acquisition Co. One L.P., all of which are Texas limited partnerships
(Acquisition Partnerships or Partnerships). FirstCity Financial Corporation or
its wholly owned subsidiary, FirstCity Commercial Corporation, owns limited
partnership interests in all of the Partnerships. All significant intercompany
balances have been eliminated.
The Partnerships were formed to acquire, hold and dispose of Portfolio
Assets acquired from the Federal Deposit Insurance Corporation, Resolution Trust
Corporation and other nongovernmental agency sellers, pursuant to certain
purchase agreements or assignments of such purchase agreements. In accordance
with the purchase agreements, the Partnerships retain certain rights of return
regarding the assets related to defective title, past due real estate taxes,
environmental contamination, structural damage and other limited legal
representations and warranties.
Generally, the partnership agreements of the Partnerships provide for
certain preferences as to the distribution of cash flows. Proceeds from
disposition of and payments received on the Portfolio Assets are allocated based
on the partnership and other agreements which ordinarily provide for the payment
of interest and mandatory principal installments on outstanding debt before
payment of intercompany servicing fees and return of capital and restricted
distributions to partners.
Additionally, WAMCO III, Ltd., WAMCO V, Ltd., WAMCO XVII, Ltd., WAMCO XXI,
Ltd. and Whitewater Acquisition Co. One L.P. provide for Class A and Class B
Equity partners in their individual partnership agreements. The Class B Equity
limited partners are allocated 20 percent of cumulative net income recognized by
the respective partnerships prior to allocation to the Class A Equity limited
partners and the general partners.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) PORTFOLIO ASSETS
The Partnerships acquire and resolve portfolios of performing and
nonperforming commercial and consumer loans and other assets (collectively,
"Portfolio Assets" or "Portfolios"), which are generally acquired at a discount
to their legal principal balance. Purchases may be in the form of pools of
assets or single assets. The Portfolio Assets are generally nonhomogeneous
assets, including loans of varying qualities that are secured by diverse
collateral types and foreclosed properties. Some Portfolio Assets are loans for
which resolution is tied primarily to the real estate securing the loan, while
others may be collateralized business loans, the resolution of which may be
based either on business or real estate or other collateral cash flow. Portfolio
Assets are acquired on behalf of legally independent partnerships ("Acquisition
Partnerships") in which a corporate general partner, FirstCity Financial
Corporation ("FirstCity") and other investors are limited partners.
94
96
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Portfolio Assets are reflected in the accompanying consolidated financial
statements as non-performing Portfolio Assets, performing Portfolio Assets or
real estate Portfolios. The following is a description of each classification
and the related accounting policy accorded to each Portfolio type:
Non-Performing Portfolio Assets
Non-performing Portfolio Assets consist primarily of distressed loans and
loan related assets, such as foreclosed upon collateral. Portfolio Assets are
designated as non-performing unless substantially all of the loans in the
Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. Such Portfolios are acquired on the basis of an
evaluation by the Partnerships of the timing and amount of cash flow expected to
be derived from borrower payments or other resolution of the underlying
collateral securing the loan.
All non-performing Portfolio Assets are purchased at substantial discounts
from their outstanding legal principal amount, the total of the aggregate of
expected future sales prices and the total payments to be received from
obligors. Subsequent to acquisition, the amortized cost of non-performing
Portfolio Assets is evaluated for impairment on a quarterly basis. A valuation
allowance is established for any impairment identified through provisions
charged to earnings in the period the impairment is identified.
Net gain on resolution of non-performing Portfolio Assets is recognized as
income to the extent that proceeds collected exceed a pro rata portion of
allocated cost from the Portfolio. Cost allocation is based on a proration of
actual proceeds divided by total estimated proceeds of the Portfolio. No
interest income is recognized separately on non-performing Portfolio Assets. All
proceeds, of whatever type, are included in proceeds from resolution of
Portfolio Assets in determining the gain on resolution of such assets.
Accounting for Portfolios is on a pool basis as opposed to an individual
asset-by-asset basis.
Performing Portfolio Assets
Performing Portfolio Assets consist primarily of Portfolios of consumer and
commercial loans acquired at a discount from the aggregate amount of the
borrowers' obligation. Portfolios are classified as performing if substantially
all of the loans in the Portfolio are being repaid in accordance with the
contractual terms of the underlying loan agreements.
Performing Portfolio Assets are carried at the unpaid principal balance of
the underlying loans, net of acquisition discounts. Interest is accrued when
earned in accordance with the contractual terms of the loans. The accrual of
interest is discontinued once a loan becomes past due 90 days or more.
Acquisition discounts for the Portfolio as a whole are accreted as an adjustment
to yield over the estimated life of the Portfolio. Accounting for these
Portfolios is on a pool basis as opposed to an individual asset-by-asset basis.
The Partnerships account for performing Portfolio Assets in accordance with
the provisions of Statement of Financial Accounting Standards ("SFAS") No. 114,
Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118,
which requires creditors to evaluate the collectibility of both contractual
interest and principal of loans when assessing the need for a loss accrual.
Impairment is measured based on the present value of the expected future cash
flows discounted at the loans' effective interest rates, or the fair value of
the collateral, less estimated selling costs, if any loans are collateral
dependent and foreclosure is probable.
Real Estate Portfolios
Real estate Portfolios consist of real estate assets acquired from a
variety of sellers. Such Portfolios are carried at the lower of cost or fair
value less estimated costs to sell. Costs relating to the development and
improvement of real estate are capitalized, whereas those relating to holding
assets are charged to expense. Income or loss is recognized upon the disposal of
the real estate. Rental income, net of expenses, on real estate Portfolios is
recognized when received.
95
97
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Assets are foreclosed when necessary through an arrangement with an
affiliated entity whereby title to the foreclosed asset is held by the
affiliated entity and a note receivable from the affiliate is held by the
Partnership. Costs relating to the development and improvement of foreclosed
assets are capitalized by the Partnership. Costs relating to holding foreclosed
assets are charged to operating expense by the Partnership. For financial
statement presentation, the affiliated entity note receivable created by the
arrangement is included in Portfolio Assets and is recorded at the lower of
allocated cost or fair value less estimated cost to sell the underlying asset.
(B) INVESTMENT IN TRUST CERTIFICATES
The Partnerships hold an investment in trust certificates, representing an
interest in a REMIC created by the sale of certain Partnership assets. This
interest is subordinate to the senior tranches of the certificate. The
investment is carried at the unpaid balance of the certificate, net of
acquisition discounts. Interest is accrued in accordance with the contractual
terms of the agreement. Acquisition discounts are accreted as an adjustment to
yield over the estimated life of the investment.
(C) INCOME TAXES
Under current Federal laws, partnerships are not subject to income taxes;
therefore, no provision has been made for such taxes in the accompanying
combined financial statements. For tax purposes, income or loss is included in
the individual tax returns of the partners.
(D) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles 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. Actual results could differ from those estimates.
(3) PORTFOLIO ASSETS
Portfolio Assets are summarized as follows:
DECEMBER 31,
-----------------------
1997 1996
-------- ---------
Non-performing Portfolio Assets............................. $106,377 $ 308,554
Performing Portfolio Assets................................. 77,794 15,786
Real estate Portfolios...................................... 6,696 --
-------- ---------
Total Portfolio Assets............................ 190,867 324,340
Discount required to reflect Portfolio Assets at carrying
value..................................................... (86,678) (146,860)
-------- ---------
Portfolio Assets, net............................. $104,189 $ 177,480
======== =========
Portfolio Assets are pledged to secure non-recourse notes payable.
96
98
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
(4) NOTES PAYABLE
Notes payable at December 31, 1997 and 1996 consist of the following:
1997 1996
------- --------
Senior collateralized loans, secured by Portfolio Assets:
Prime (8.5% at December 31, 1997) plus 1.5% to 2.5%....... $ -- $ 39,283
LIBOR (5.7% at December 31, 1997) plus 3.00% to 6.5%...... 43,198 92,455
New York inter-bank offering rate (6.5% at December 31,
1996) plus 3%.......................................... -- 4,457
Fixed rate -- 7.51% to 10.17%............................. 24,681 --
Subordinated collateralized loans, secured by Portfolio
Assets:
Prime (8.5% at December 31, 1997) plus 2% to 7%........... 1,071 4,859
------- --------
$68,950 $141,054
======= ========
Collateralized loans are typically payable based on proceeds from
disposition of and payments received on the Portfolio Assets.
Contractual maturities (excluding principal and interest payments payable
from proceeds from dispositions of and payments received on the Portfolio
Assets) of long term debt are as follows:
Year ending December 31:
1998................................................... $ 6,068
1999................................................... 31,538
2000................................................... --
2001................................................... 27,344
2002................................................... --
Thereafter............................................. 4,000
-------
$68,950
=======
The loan agreements and master note purchase agreements, under which notes
payable were incurred, contain various covenants including limitations on other
indebtedness, maintenance of service agreements and restrictions on use of
proceeds from disposition of and payments received on the Portfolio Assets. As
of December 31, 1997, the Partnerships were in compliance with the
aforementioned covenants.
In connection with the long term debt, the Partnerships incurred
origination and commitment fees. These fees are amortized proportionate to the
principal reductions on the related notes and are included in general,
administrative and operating expenses. At December 31, 1997 and 1996,
approximately $1,298 and $2,712, respectively, of origination and commitment
fees are included in other assets, net.
Additionally, certain loan agreements contain provisions requiring the
Partnerships to maintain minimum balances in a restricted cash account as
additional security for certain notes payable. Approximately $235 and $552 of
restricted cash was held in such accounts as of December 31, 1997 and 1996,
respectively.
(5) TRANSACTIONS WITH AFFILIATES
Under the terms of the various servicing agreements between the
Partnerships and FirstCity, FirstCity receives a servicing fee based on proceeds
from resolution of the Portfolio Assets for processing transactions on the
Portfolio Assets and for conducting settlement, collection and other resolution
activities. Included in general, administrative and operating expenses in the
accompanying combined statements of operations is approximately $4,353, $6,468
and $6,834 in servicing fees incurred by the Partnerships in 1997, 1996 and
1995, respectively.
97
99
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Under the terms of the Partnership Agreement of Whitewater Acquisition Co.
One L.P. ("Whitewater"), the Class B Equity limited partners are to receive
interest on their Class B equity interest at prime plus 7% calculated on a
monthly basis. Whitewater has expensed $0, $3,435 and $3,486 in 1997, 1996 and
1995, respectively, included in interest expense in the accompanying combined
financial statements, under this partnership agreement. The interest will be
paid to the Class B Equity limited partners upon final disposition of the
Portfolio Assets or in accordance with the Master Note Purchase Agreement.
Under the terms of a Master Note Purchase Agreement, Varde, Varde II-A and
OPCO, limited partners of VOJ Partners L.P. ("VOJ"), are to receive 5 percent, 5
percent and 10 percent, respectively, of cumulative income before profit
participation expense recognized by VOJ. Due to continued net losses, VOJ wrote
off $103 of receivables from affiliates related to this profit participation
agreement. No amounts were accrued under this agreement during 1997. VOJ accrued
$103 in 1996 included in the receivables from affiliates and recognized $18 and
$68 in 1997 and 1996, respectively, included in other income (expenses), net, in
the accompanying combined financial statements.
Under the terms of a Master Note Purchase Agreement, each of two limited
partners of Imperial Fund I, L.P. ("Imperial") are to receive 10 percent of
cumulative income before profit participation expense recognized by Imperial.
Imperial has recorded accounts payable of $23 and $236 at December 31, 1997 and
1996, respectively, and expensed $92, $40 and $114 in the years ended December
31, 1997, 1996 and 1995, respectively, in the accompanying combined financial
statements under this profit participation agreement. The profit participation
will be paid to the limited partners upon final disposition of the Portfolio
Assets in accordance with the Master Note Purchase Agreement.
During 1996 in conjunction with a refinancing transaction, WAMCO XXII
transferred $42,047 in assets and $28,967 in liabilities to First Paradee in
return for a partnership interest in First Paradee. Subsequent to the transfer,
WAMCO XXII distributed its interest in First Paradee to its partners.
During 1996, WAMCO III distributed $704 in assets to its partners which was
subsequently contributed to WAMCO IX.
On January 1, 1997, FirstCity purchased the other limited partner's
interest in Whitewater for $4,165.
During 1997, Wamco XXI, Ltd. and Whitewater merged into WAMCO XXII, Ltd.
After the merger, Wamco XXII, Ltd. transferred $47,517 in assets and $516 in
liabilities to Bosque Asset Corporation (Bosque) in exchange for cash and an
investment in Bosque. Subsequent to the transaction, Wamco XXII, Ltd.
distributed its investment in Bosque to its partners and dissolved. During 1997,
Wamco IX, Ltd. contributed $3,316 in notes to Bosque in exchange for cash and an
investment in Bosque. Subsequent to the transfer, WAMCO IX, Ltd. distributed its
investment in Bosque to its partners.
(6) FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures about
Fair Value of Financial Instruments," requires that the Partnerships disclose
estimated fair values of their financial instruments. Fair value estimates,
methods and assumptions are set forth below.
(a) CASH, RESTRICTED CASH, RECEIVABLE FROM AFFILIATES, ACCOUNTS PAYABLE AND
ACCRUED LIABILITIES
The carrying amount of cash, restricted cash, receivable from affiliates,
accounts payable and accrued liabilities approximates fair value at December 31,
1997 and 1996 due to the short-term nature of such accounts.
98
100
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
(b) PORTFOLIO ASSETS
Portfolio Assets are carried at the lower of cost or estimated fair value.
The estimated fair value is calculated by discounting projected cash flows on an
asset-by-asset basis using estimated market discount rates that reflect the
credit and interest rate risk inherent in the assets. The carrying value of
Portfolio Assets is $104,189 and $177,480 at December 31, 1997 and 1996,
respectively. The estimated fair value of the Portfolio Assets is approximately
$122,515 and $221,352 at December 31, 1997 and 1996, respectively.
(c) INVESTMENTS IN TRUST CERTIFICATES
Investments in trust certificates are carried at the lower of cost or
estimated fair value. Management estimates that the cost of the investments
approximates fair value at December 31, 1997 and 1996.
(d) LONG-TERM DEBT
Management believes that for similar financial instruments with comparable
credit risks, the stated interest rates at December 31, 1997 and 1996
approximate market rates. Accordingly, the carrying amount of long-term debt is
believed to approximate fair value.
(7) COMMITMENTS AND CONTINGENCIES
Calibat Fund, LLC has committed to make additional investments in
partnerships up to $2,315 at December 31, 1997.
The Partnerships are involved in various legal proceedings in the ordinary
course of business. In the opinion of management, the resolution of such matters
will not have a material adverse impact on the combined financial condition,
results of operations or liquidity of the Partnerships.
99
101
INDEPENDENT AUDITORS' REPORT
The Partners
WAMCO Partnerships:
We have audited the accompanying combined balance sheets of the WAMCO
Partnerships as of December 31, 1997 and 1996, and the related combined
statements of operations, changes in partners' capital, and cash flows for each
of the years in the three-year period ended December 31, 1997. These combined
financial statements are the responsibility of the Partnerships' management. Our
responsibility is to express an opinion on these combined financial statements
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the combined financial statements referred to above present
fairly, in all material respects, the financial position of the WAMCO
Partnerships as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1997, in conformity with generally accepted accounting
principles.
KPMG Peat Marwick LLP
Fort Worth, Texas
March 24, 1998
100
102
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
Not applicable.
PART III
ITEM 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information called for by this item with respect to the Company's
directors and executive officers is incorporated by reference from the Company's
definitive proxy statement pertaining to the 1998 Annual Meeting of Stockholders
to be filed pursuant to Regulation 14A.
ITEM 11. EXECUTIVE COMPENSATION.
The information called for by this item is incorporated by reference from
the Company's definitive proxy statement pertaining to the 1998 Annual Meeting
of Stockholders to be filed pursuant to Regulation 14A.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information called for by this item is incorporated by reference from
the Company's definitive proxy statement pertaining to the 1998 Annual Meeting
of Stockholders to be filed pursuant to Regulation 14A.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information called for by this item is incorporated by reference from
the Company's definitive proxy statement pertaining to the 1998 Annual Meeting
of Stockholders to be filed pursuant to Regulation 14A.
101
103
PART IV
ITEM 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements
The consolidated financial statements of FirstCity and combined
financial statements of Acquisition Partnerships are incorporated
herein by reference to Item 8, "Financial Statements and
Supplementary Data," of this Report.
2. Financial Statement Schedules
Financial statement schedules have been omitted because the
information is either not required, not applicable, or is included
in Item 8, "Financial Statements and Supplementary Data."
3. Exhibits
EXHIBIT
NUMBER DESCRIPTION
------- -----------
2.1 -- Joint Plan of Reorganization by First City Bancorporation
of Texas, Inc., Official Committee of Equity Security
Holders and J-Hawk Corporation, with the Participation of
Cargill Financial Services Corporation, Under Chapter 11
of the United States Bankruptcy Code, Case No.
392-39474-HCA-11 (incorporated herein by reference to
Exhibit 2.1 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
2.2 -- Agreement and Plan of Merger, dated as of July 3, 1995,
by and between First City Bancorporation of Texas, Inc.
and J-Hawk Corporation (incorporated herein by reference
to Exhibit 2.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
3.1 -- Amended and Restated Certificate of Incorporation of the
Company (incorporated herein by reference to Exhibit 3.1
of the Company's Current Report on Form 8-K dated July 3,
1995 filed with the Commission on July 18, 1995).
3.2 -- Bylaws of the Company (incorporated herein by reference
to Exhibit 3.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
4.1 -- Certificate of Designations of the New Preferred Stock
($0.01 par value) of the Company.
4.2 -- Warrant Agreement, dated July 3, 1995, by and between the
Company and American Stock Transfer & Trust Company, as
Warrant Agent (incorporated herein by reference to
Exhibit 4.2 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
4.3 -- Registration Rights Agreement, dated July 1, 1997, among
the Company, Richard J. Gillen, Bernice J. Gillen, Harbor
Financial Mortgage Company Employees Pension Plan,
Lindsey Capital Corporation, Ed Smith and Thomas E.
Smith.
4.4 -- Stock Purchase Agreement, dated March 24, 1998, between
the Company and Texas Commerce Shareholders Company.
4.5 -- Registration Rights Agreement, dated March 24, 1998,
between the Company and Texas Commerce Shareholders
Company.
9.1 -- Shareholder Voting Agreement, dated as of June 29, 1995,
among ATARA I Ltd., James R. Hawkins, James T. Sartain
and Cargill Financial Services Corporation.
10.1 -- Trust Agreement of FirstCity Liquidating Trust, dated
July 3, 1995 (incorporated herein by reference to Exhibit
10.1 of the Company's Current Report on Form 8-K dated
July 3, 1995 filed with the Commission on July 18, 1995).
102
104
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.2 -- Investment Management Agreement, dated July 3, 1995,
between the Company and FirstCity Liquidating Trust
(incorporated herein by reference to Exhibit 10.2 of the
Company's Current Report on Form 8-K dated July 3, 1995
filed with the Commission on July 18, 1995).
10.3 -- Lock-Box Agreement, dated July 11, 1995, among the
Company, NationsBank of Texas, N.A., as lock-box agent,
FirstCity Liquidating Trust, FCLT Loans, L.P., and the
other Trust-Owned Affiliates signatory thereto, and each
of NationsBank of Texas, N.A. and Fleet National Bank, as
co-lenders (incorporated herein by reference to Exhibit
10.3 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
10.4 -- Custodial Agreement, dated July 11, 1995, among Fleet
National Bank, as custodian, Fleet National Bank, as
agent, FCLT Loans, L.P., FirstCity Liquidating Trust, and
the Company (incorporated herein by reference to Exhibit
10.4 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
10.5 -- Tier 3 Custodial Agreement, dated July 11, 1995, among
the Company, as custodian, Fleet National Bank, as agent,
FCLT Loans, L.P., FirstCity Liquidating Trust, and the
Company, as servicer (incorporated herein by reference to
Exhibit 10.5 of the Company's Form 8-A/A dated August 25,
1995 filed with the Commission on August 25, 1995).
10.6 -- 12/97 Amended and Restated Facilities Agreement, dated
effective as of December 3, 1997, among Harbor Financial
Mortgage Corporation, New America Financial, Inc., Texas
Commerce Bank National Association and the other
warehouse lenders party thereto.
10.7 -- Modification Agreement, dated January 26, 1998, to the
Amended and Restated Facilities Agreement, dated as of
December 3, 1997, among Harbor Financial Mortgage
Corporation, New America Financial, Inc. and Chase Bank
of Texas, National Association (formerly known as Texas
Commerce Bank National Association).
10.8 -- $50,000,000 3/98 Chase Texas Temporary Additional
Warehouse Note, dated March 17, 1998, by Harbor Financial
Mortgage Corporation and New America Financial, Inc., in
favor of Chase Bank of Texas, National Association.
10.9 -- Employment Agreement, dated as of July 1, 1997, by and
between Harbor Financial Mortgage Corporation and Richard
J. Gillen.
10.10 -- Employment Agreement, dated as of September 8, 1997, by
and between FirstCity Funding Corporation and Thomas R.
Brower, with similar agreements between FirstCity Funding
Corporation and each of James H. Aronoff and Christopher
J. Morrissey.
10.11 -- Shareholder Agreement, dated as of September 8, 1997,
among FirstCity Funding Corporation, FirstCity Consumer
Lending Corporation, Thomas R. Brower, Scot A. Foith,
Thomas G. Dundon, R. Tyler Whann, Bradley C. Reeves,
Stephen H. Trent and Blake P. Bozman.
10.12 -- Revolving Credit Loan Agreement, dated as of March 20,
1998, by and between FC Properties, Ltd. and Nomura Asset
Capital Corporation.
103
105
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.13 -- Revolving Credit Loan Agreement, dated as of February 27,
1998, by and between FH Partners, L.P. and Nomura Asset
Capital Corporation.
104
106
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.14 -- Note Agreement, dated as of June 6, 1997, among Bosque
Asset Corp., SVD Realty, L.P., SOWAMCO XXII, LTD., Bosque
Investment Realty Partners, L.P. and Bankers Trust
Company of California, N.A.
10.15 -- 60,000,000 French Franc Revolving Promissory Note, dated
September 25, 1997, by J-Hawk International Corporation
in favor of the Bank of Scotland.
10.16 -- Loan Agreement, dated as of September 25, 1997, by and
between Bank of Scotland and J-Hawk International
Corporation.
10.17 -- Guaranty Agreement, dated as of September 25, 1997, by
J-Hawk Corporation (now known as FirstCity Commercial
Corporation) in favor of Bank of Scotland.
10.18 -- Guaranty Agreement, dated as of September 25, 1997, by
FirstCity Financial Corporation in favor of Bank of
Scotland.
10.19 -- Warehouse Credit Agreement, dated as of May 17, 1996,
among ContiTrade Services L.L.C., N.A.F. Auto Loan Trust
and National Auto Funding Corporation.
10.20 -- Funding Commitment, dated as of May 17, 1996, by and
between ContiTrade Services L.L.C. and the Company.
10.21 -- Revolving Credit Agreement, dated as of December 29,
1995, by and between the Company and Cargill Financial
Services Corporation, as amended by the Eighth Amendment
to Revolving Credit Agreement dated February 1998.
23.1 -- Consent of KPMG Peat Marwick LLP.
23.2 -- Consent of KPMG Peat Marwick LLP.
27.1 -- Financial Data Schedule. (Exhibit 27.1 is being submitted
as an exhibit only in the electronic format of this
Annual Report on Form 10-K being submitted to the
Securities and Exchange Commission. Exhibit 27.1 shall
not be deemed filed for purposes of Section 11 of the
Securities Act of 1933, Section 18 of the Securities Act
of 1934, as amended, or Section 323 of the Trust
Indenture Act of 1939, as amended, or otherwise be
subject to the liabilities of such sections, nor shall it
be deemed a part of any registration statement to which
it relates.)
(b) The Company did not file a Report on Form 8-K during, or dated during,
the fourth quarter of 1997.
104
107
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
FIRSTCITY FINANCIAL CORPORATION
By /s/ JAMES R. HAWKINS
-----------------------------------
James R. Hawkins
Chairman of the Board
March 24, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ JAMES R. HAWKINS Chairman of the Board, Chief March 24, 1998
- ----------------------------------------------------- Executive Officer and Director
James R. Hawkins (Principal Executive Officer)
/s/ C. IVAN WILSON Vice Chairman and Director March 24, 1998
- -----------------------------------------------------
C. Ivan Wilson
/s/ JAMES T. SARTAIN President, Chief Operating Officer March 24, 1998
- ----------------------------------------------------- and Director
James T. Sartain
/s/ MATT A. LANDRY, JR. Executive Vice President, Senior March 24, 1998
- ----------------------------------------------------- Financial Officer, Managing
Matt A. Landry, Jr. Director -- Mergers and
Acquisitions and Director
(Principal Financial Officer and
Principal Accounting Officer)
/s/ RICK R. HAGELSTEIN Executive Vice President, Managing March 24, 1998
- ----------------------------------------------------- Director and Director
Rick R. Hagelstein
/s/ RICHARD J. GILLEN Chairman of the Board, President March 24, 1998
- ----------------------------------------------------- and Chief Executive Officer of
Richard J. Gillen FirstCity Financial Mortgage,
Managing Director and Director
105
108
SIGNATURE TITLE DATE
--------- ----- ----
/s/ RICHARD E. BEAN Director March 24, 1998
- -----------------------------------------------------
Richard E. Bean
/s/ BART A. BROWN, JR. Director March 24, 1998
- -----------------------------------------------------
Bart A. Brown, Jr.
/s/ DONALD J. DOUGLASS Director March 24, 1998
- -----------------------------------------------------
Donald J. Douglass
106
109
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
------- -----------
2.1 -- Joint Plan of Reorganization by First City Bancorporation
of Texas, Inc., Official Committee of Equity Security
Holders and J-Hawk Corporation, with the Participation of
Cargill Financial Services Corporation, Under Chapter 11
of the United States Bankruptcy Code, Case No.
392-39474-HCA-11 (incorporated herein by reference to
Exhibit 2.1 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
2.2 -- Agreement and Plan of Merger, dated as of July 3, 1995,
by and between First City Bancorporation of Texas, Inc.
and J-Hawk Corporation (incorporated herein by reference
to Exhibit 2.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
3.1 -- Amended and Restated Certificate of Incorporation of the
Company (incorporated herein by reference to Exhibit 3.1
of the Company's Current Report on Form 8-K dated July 3,
1995 filed with the Commission on July 18, 1995).
3.2 -- Bylaws of the Company (incorporated herein by reference
to Exhibit 3.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
4.1 -- Certificate of Designations of the New Preferred Stock
($0.01 par value) of the Company.
4.2 -- Warrant Agreement, dated July 3, 1995, by and between the
Company and American Stock Transfer & Trust Company, as
Warrant Agent (incorporated herein by reference to
Exhibit 4.2 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
4.3 -- Registration Rights Agreement, dated July 1, 1997, among
the Company, Richard J. Gillen, Bernice J. Gillen, Harbor
Financial Mortgage Company Employees Pension Plan,
Lindsey Capital Corporation, Ed Smith and Thomas E.
Smith.
4.4 -- Stock Purchase Agreement, dated March 24, 1998, between
the Company and Texas Commerce Shareholders Company.
4.5 -- Registration Rights Agreement, dated March 24, 1998,
between the Company and Texas Commerce Shareholders
Company.
9.1 -- Shareholder Voting Agreement, dated as of June 29, 1995,
among ATARA I Ltd., James R. Hawkins, James T. Sartain
and Cargill Financial Services Corporation.
10.1 -- Trust Agreement of FirstCity Liquidating Trust, dated
July 3, 1995 (incorporated herein by reference to Exhibit
10.1 of the Company's Current Report on Form 8-K dated
July 3, 1995 filed with the Commission on July 18, 1995).
10.2 -- Investment Management Agreement, dated July 3, 1995,
between the Company and FirstCity Liquidating Trust
(incorporated herein by reference to Exhibit 10.2 of the
Company's Current Report on Form 8-K dated July 3, 1995
filed with the Commission on July 18, 1995).
10.3 -- Lock-Box Agreement, dated July 11, 1995, among the
Company, NationsBank of Texas, N.A., as lock-box agent,
FirstCity Liquidating Trust, FCLT Loans, L.P., and the
other Trust-Owned Affiliates signatory thereto, and each
of NationsBank of Texas, N.A. and Fleet National Bank, as
co-lenders (incorporated herein by reference to Exhibit
10.3 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
110
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.4 -- Custodial Agreement, dated July 11, 1995, among Fleet
National Bank, as custodian, Fleet National Bank, as
agent, FCLT Loans, L.P., FirstCity Liquidating Trust, and
the Company (incorporated herein by reference to Exhibit
10.4 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
10.5 -- Tier 3 Custodial Agreement, dated July 11, 1995, among
the Company, as custodian, Fleet National Bank, as agent,
FCLT Loans, L.P., FirstCity Liquidating Trust, and the
Company, as servicer (incorporated herein by reference to
Exhibit 10.5 of the Company's Form 8-A/A dated August 25,
1995 filed with the Commission on August 25, 1995).
10.6 -- 12/97 Amended and Restated Facilities Agreement, dated
effective as of December 3, 1997, among Harbor Financial
Mortgage Corporation, New America Financial, Inc., Texas
Commerce Bank National Association and the other
warehouse lenders party thereto.
10.7 -- Modification Agreement, dated January 26, 1998, to the
Amended and Restated Facilities Agreement, dated as of
December 3, 1997, among Harbor Financial Mortgage
Corporation, New America Financial, Inc. and Chase Bank
of Texas, National Association (formerly known as Texas
Commerce Bank National Association).
10.8 -- $50,000,000 3/98 Chase Texas Temporary Additional
Warehouse Note, dated March 17, 1998, by Harbor Financial
Mortgage Corporation and New America Financial, Inc., in
favor of Chase Bank of Texas, National Association.
10.9 -- Employment Agreement, dated as of July 1, 1997, by and
between Harbor Financial Mortgage Corporation and Richard
J. Gillen.
10.10 -- Employment Agreement, dated as of September 8, 1997, by
and between FirstCity Funding Corporation and Thomas R.
Brower, with similar agreements between FirstCity Funding
Corporation and each of James H. Aronoff and Christopher
J. Morrissey.
10.11 -- Shareholder Agreement, dated as of September 8, 1997,
among FirstCity Funding Corporation, FirstCity Consumer
Lending Corporation, Thomas R. Brower, Scot A. Foith,
Thomas G. Dundon, R. Tyler Whann, Bradley C. Reeves,
Stephen H. Trent and Blake P. Bozman.
10.12 -- Revolving Credit Loan Agreement, dated as of March 20,
1998, by and between FC Properties, Ltd. and Nomura Asset
Capital Corporation.
10.13 -- Revolving Credit Loan Agreement, dated as of February 27,
1998, by and between FH Partners, L.P. and Nomura Asset
Capital Corporation.
10.14 -- Note Agreement, dated as of June 6, 1997, among Bosque
Asset Corp., SVD Realty, L.P., SOWAMCO XXII, LTD., Bosque
Investment Realty Partners, L.P. and Bankers Trust
Company of California, N.A.
10.15 -- 60,000,000 French Franc Revolving Promissory Note, dated
September 25, 1997, by J-Hawk International Corporation
in favor of the Bank of Scotland.
10.16 -- Loan Agreement, dated as of September 25, 1997, by and
between Bank of Scotland and J-Hawk International
Corporation.
10.17 -- Guaranty Agreement, dated as of September 25, 1997, by
J-Hawk Corporation (now known as FirstCity Commercial
Corporation) in favor of Bank of Scotland.
10.18 -- Guaranty Agreement, dated as of September 25, 1997, by
FirstCity Financial Corporation in favor of Bank of
Scotland.
10.19 -- Warehouse Credit Agreement, dated as of May 17, 1996,
among ContiTrade Services L.L.C., N.A.F. Auto Loan Trust
and National Auto Funding Corporation.
111
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.20 -- Funding Commitment, dated as of May 17, 1996, by and
between ContiTrade Services L.L.C. and the Company.
10.21 -- Revolving Credit Agreement, dated as of December 29,
1995, by and between the Company and Cargill Financial
Services Corporation, as amended by the Eighth Amendment
to Revolving Credit Agreement dated February 1998.
23.1 -- Consent of KPMG Peat Marwick LLP.
23.2 -- Consent of KPMG Peat Marwick LLP.
27.1 -- Financial Data Schedule. (Exhibit 27.1 is being submitted
as an exhibit only in the electronic format of this
Annual Report on Form 10-K being submitted to the
Securities and Exchange Commission. Exhibit 27.1 shall
not be deemed filed for purposes of Section 11 of the
Securities Act of 1933, Section 18 of the Securities Act
of 1934, as amended, or Section 323 of the Trust
Indenture Act of 1939, as amended, or otherwise be
subject to the liabilities of such sections, nor shall it
be deemed a part of any registration statement to which
it relates.)