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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
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FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
COMMISSION FILE NO. 1-12109
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DELTA FINANCIAL CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 11-3336165
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1000 WOODBURY ROAD, SUITE 200,
WOODBURY, NEW YORK 11797
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (516) 364-8500
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
NONE
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. |X|
As of June 30, 2003, the aggregate market value of the voting stock held
by non-affiliates of the Registrant, based on the closing price of $7.27, was
approximately $44.1 million.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2. Yes |_| No |X|
As of March 29, 2004, the Registrant had 16,935,502 shares of Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III, Items 10, 11, 12, 13 and 14 are incorporated by reference from
Delta Financial Corporation's definitive proxy statement to stockholders, which
will be filed with the Securities and Exchange Commission no later than 120 days
after December 31, 2003.
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PART I
ITEM 1. BUSINESS
An investment in our common stock involves substantial risks and
uncertainties. We encourage you to carefully review the information set forth in
Part II, Item 7 under the caption "Information Regarding Forward-Looking
Statements" for a description of these uncertainties.
BUSINESS OVERVIEW
GENERAL
Delta Financial Corporation (together with its subsidiaries, "Delta" or
"we") is a specialty consumer finance company that originates, securitizes and
sells (and, prior to May 2001, serviced) non-conforming mortgage loans. Our
loans are primarily secured by first mortgages on one- to four-family
residential properties. Throughout our 22-year operating history, we have
focused on lending to individuals who generally do not satisfy the credit,
documentation or other underwriting standards set by more traditional sources of
mortgage credit, including those entities that make loans in compliance with
conventional mortgage lending guidelines established by Fannie Mae and Freddie
Mac. We make loans to these borrowers for purposes such as debt consolidation,
refinancing, education and home improvement.
Our mortgage business has two principal components. First, we make
mortgage loans to individual borrowers. Each loan is a cash and expense outlay
for us, because our total cost incurred originating a loan exceeds the fees we
collect at the time we originate the loan. At the time we originate a loan, we
either finance the loan by borrowing under a warehouse line of credit, or
self-fund it. Second, we securitize the loans or sell the loans on a whole loan
basis and use the net proceeds from these transactions to repay our warehouse
lines of credit and for working capital.
We traditionally have structured our securitizations as off-balance sheet
sales, which requires us to record cash and non-cash revenues as gain on sale at
the time the transaction is completed. In 2004, we began structuring our
securitizations as on-balance sheet financings, which requires us to record
interest income on the outstanding portfolio of loans and interest expense on
the outstanding bonds financing the portfolio of loans over time. When we sell
whole loans, we record the premiums received upon sale as gain on sale revenue.
We were incorporated in 1996 as a Delaware corporation. Our corporate
offices are located at 1000 Woodbury Road, Woodbury, NY 11797 and we can be
contacted at (516) 364-8500 or through our Internet web site at
http://www.deltafinancial.com. Our filings with the Securities and Exchange
Commission ("SEC") can be accessed on the Investor Relations page of our web
site, through a link to EDGAR.
ORIGINATION OF MORTGAGE LOANS
We make mortgage loans through two distribution channels - wholesale and
retail. We receive loan applications both directly from borrowers and from
independent third-party mortgage brokers who submit applications on a borrower's
behalf. We process and underwrite the submission and, if the loan complies with
our underwriting criteria, approve the loan and lend the money to the borrower.
While we generally collect points and fees from the borrower when a loan closes,
our cost to originate a loan typically exceeds any fees we may collect from the
borrower.
In 2003, we originated approximately $1.7 billion of loans, of which
approximately $1.0 billion, or 59%, were brokered loans and $707 million, or
41%, were retail loans. In 2002, we originated approximately $872 million of
loans, of which $535 million, or 61%, were brokered loans and $337 million, or
39%, were retail loans.
Independent Mortgage Broker (Wholesale) Channel. Through our wholesale
distribution channel, we originate mortgage loans indirectly through independent
mortgage brokers and other real estate professionals who submit loan
applications on behalf of borrowers. We currently originate the majority of our
wholesale loans in 26 states, through a network of approximately 1,700 brokers.
The broker's role is to source the business, identify the applicant, assist in
completing the loan application, and process the loans, including, among other
things, gathering the necessary information and documents, and serving as the
liaison between the borrower and us through the entire origination process. We
review, process and underwrite the applications submitted by the broker, approve
or deny the application, set the interest rate and other terms of the loan and,
upon acceptance by the borrower and satisfaction of all conditions that we
impose as the lender, lend the money to the borrower. Due to the fact that
brokers conduct their own marketing and employ their own personnel to complete
loan applications and maintain contact with
borrowers - for which they charge a broker fee - originating loans through our
broker network is designed to allow us to increase our loan volume without
incurring the higher marketing and employee costs associated with increased
retail originations.
Retail Loan Channel. Through our retail distribution channel, we develop
retail loan leads ("retail loans") primarily through our telemarketing system,
and also through Internet leads, direct mail, radio advertising and our network
of four origination centers and seven retail offices located in nine states. Our
origination centers are typically staffed with considerably more loan officers
and cover a broader area than our retail offices. We continually monitor the
performance of our retail operations and evaluate current and potential retail
office locations on the basis of selected demographic statistics, marketing
analyses and other criteria that we have developed. In July 2003, we opened a
retail office in Kansas City, Kansas and in March 2004, we closed an
under-performing retail office in Columbus, Ohio, and effectively re-distributed
its operations to other larger, better performing retail offices located in
Ohio.
Typically, contact with the customer is initially handled through our
telemarketing center. On the basis of an initial screening conducted at the time
of the call, our telemarketer makes a preliminary determination of whether the
customer is interested in taking a loan out with us. If so, the telemarketer
will forward the customer to one of our origination centers or retail branches.
The mortgage analyst at the origination center or retail branch may complete the
application over the telephone, or schedule an appointment in the retail loan
office most conveniently located to the customer or in the customer's home,
depending on the customer's needs. The mortgage analyst assists the applicant in
completing the loan application, ensures that an appraisal has been ordered from
an independent third party appraisal company, orders a credit report from an
independent, nationally recognized credit reporting agency and performs various
other tasks in connection with the completion of the loan package. Our mortgage
analysts are trained to structure loans that meet the applicant's needs while
satisfying our lending guidelines. The loan package is underwritten for loan
approval through our Cincinnati, Ohio underwriting hub, our Woodbury, New York
offices, or in our Phoenix, Arizona origination center for our west coast
operations. If the loan package is approved, we will fund the loan.
Pooling of Loans Prior to Sale. After we close or fund a loan, we
typically pledge the loan as collateral under a warehouse line of credit to
obtain financing against that loan. By doing so, we replenish our capital so
that we can make new loans. Typically, loans are financed though a warehouse
line of credit for only a limited time - generally, not more than three months -
so that we can pool enough loans to sell or finance them through securitization
or through whole-loan sales. During this time, we earn interest paid by the
borrower as income, but this income is offset in part by the interest we pay to
the warehouse creditor for providing us with financing.
SECURITIZATIONS AND SALES OF LOANS
We typically securitize or sell our mortgage loans. Securitization
involves the public offering by a securitization trust of asset-backed
pass-through securities and related interests, including securitization
servicing rights on newly-originated pools of mortgage loans. Whole loan sales
are the sale of pools of individual loans to institutional investors, banks and
consumer finance-related companies on a servicing released basis.
Through 2003, we have derived the substantial majority of our revenue and
cash flow from selling mortgage loans through securitizations and whole loan
sales. We select the outlet depending on market conditions, relative
profitability and cash flows. We generally have realized higher gain on sale
when we securitize loans than when we sell whole loans. We apply the net
proceeds from securitizations and whole loan sales to pay down our warehouse
lines of credit - in order to make available capacity under these facilities for
future funding of mortgage loans - and utilize any additional funds for working
capital. In 2003, we sold approximately 97% of the loans we sold through
securitizations and approximately 3% as whole loan sales.
The following table sets forth certain information regarding the loans we
sold through our securitizations and on a whole loan basis during the periods
presented:
YEAR ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
2003 2002 2001
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Loans sold through securitizations $1,495,183 $ 819,039 $ 345,000
Whole loan sales 42,417 103,018 261,110
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Total loans sold $1,537,600 $ 922,057 $ 606,110
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2
In 2003, we sold the majority of our loans through the issuance of four
securitizations totaling $1.6 billion, of which we delivered a total of $1.5
billion of mortgage loans during 2003. We delivered the remaining $114 million
of mortgage loans in January 2004, using a pre-funding feature.
In the foreseeable future, we expect to continue to use a combination of
securitizations and whole loan sales, with the amounts of each dependent upon
the marketplace and our new goal of maximizing the size of our on-balance sheet
portfolio, which we believe will ultimately increase our earnings and remove
much of the volatility associated with recording gains each quarter from
securitizations. In this regard, beginning in 2004, we are structuring our
securitizations as on-balance sheet financings (portfolio-based accounting) and
not as off-balance sheet sale under SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities." See "-Recent
Developments" below.
Securitizations. Securitization, whether structured as off-balance sheet
sale or on-balance sheet financing, effectively provide us with a source of
long-term financing.
In a securitization, we pool together loans, typically each quarter, and
sell these loans to a securitization trust, which is a qualified special purpose
entity, or QSPE. The securitization trust raises cash to purchase the mortgage
loans from us by selling securities to the public. These securities, known as
"asset-backed pass-through securities," are secured, or backed, by the pool of
mortgage loans that the securitization trust purchases from us. These
asset-backed securities, or senior certificates, are usually purchased by
insurance companies, mutual funds and/or other institutional investors. These
securities represent senior interests in the cash flows from the mortgage loans
in the trust. We carry no contractual obligation related to these trusts or the
loans sold to them, nor do we have any direct or contingent liability related to
the trusts, except for the standard representations and warranties typically
made as part of a sale of loans on a non-recourse basis. Furthermore, we provide
no guarantees to investors with respect to the cash flow or performance for
these trusts.
In our securitizations, the securitization trust issues senior
certificates, which entitle the holders to receive the principal collected,
including prepayments of principal, on the mortgage loans in the trust. In
addition, holders receive a portion of the interest paid on the loans in the
trust equal to the pass-through interest rate on the remaining principal balance
of the pass-through certificates. Depending upon the structure, the
securitization trust may also issue interest-only certificates, which entitle
the holders to receive payments of interest at a pre-determined rate over a
fixed period of time. The securitization trust also issues a subordinate
certificate or BIO certificate, referred to as an excess cashflow certificate,
and a P certificate. Each month, the P certificate holder is entitled to receive
prepayment penalties received from borrowers who payoff their loans early.
For any monthly distribution, the holder of an excess cashflow certificate
receives payments only after all required payments have been made on all of the
other securities issued by the securitization trust. In addition, before the
holder of the excess cash flow certificate receives payments, cash flows from
such excess cashflow certificates are applied in a "waterfall" manner. See "Part
II, Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations - Loan Securitizations" for further information on the
"waterfall" and securitizations in general.
We began utilizing a new securitization structure in 2002, in which we
completed a concurrent net interest margin, or NIM, transaction. In a NIM
transaction, we sell the excess cashflow certificate and P certificate to a NIM
trust, which is also a QSPE. The NIM trust, in turn, issues interest-bearing NIM
note(s) and a NIM owner trust certificate. We sell the excess cashflow
certificate and P certificate without recourse, except that we provide standard
representations and warranties to the NIM trust. One or more investors purchase
the NIM note(s) for a cash price and we receive the net proceeds of the sale of
the note(s), together with the NIM owner trust certificate in consideration of
our selling the excess cashflow certificate and P certificates to the NIM Trust.
The NIM note(s) entitles the holder(s) to receive all cash flows generated by
the excess cashflow certificate and P certificate owned by the NIM trust until
the holder(s) are paid in full, including all principal and interest. The NIM
owner trust certificates entitle the holder to all cash flows generated by the
excess cashflow certificate and P certificate after the NIM note(s) have been
paid in full.
NIM transactions have enabled us to generate positive upfront cash flow
when we securitize our mortgage loans. The cash proceeds that we receive when
the securitization and related NIM transaction close, net of funding the upfront
overcollateralization, securitization and NIM-related costs, exceed our cost to
originate the loans included in the transaction. These transactions have yielded
cash proceeds in amounts comparable to, and in most cases higher than, whole
loan sales.
In the securitizations and related NIM transactions we completed in 2002
and 2003, in which the underlying
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securitization was structured as an off-balance sheet sale under SFAS No. 140,
we recorded the net cash proceeds generated from the sale of the NIM notes as a
component of our net gain on sale of mortgage loans. Under this structure, we
also retained, and recorded as a component of our net gain on sale of mortgage
loans, a relatively small excess cashflow certificate. We have recorded this
certificate at its estimated fair value, which has ranged from 0.0% to 1.0% of
the securitized collateral. Conversely, beginning with our 2004 securitizations,
in which the securitization will be structured as an on-balance sheet financing,
no gain on sale will be recorded, but rather the amount of the NIM notes will be
recorded as a liability on our balance sheet. In short, structuring the
underlying securitization as either an off-balance sheet sale or an on-balance
sheet financing does not change the overall economics of the transaction;
rather, it changes the timing of income recognition and how the securitization
is recorded on our financial statements in accordance with SFAS No. 140.
At the time we completed the 2003 securitizations, we recognized as
revenue the following economic interests, net of related transaction costs:
o the cash purchase price from the sale of the NIM note(s) issued by a
NIM trust;
o the cash purchase price from the sale of interest-only certificates;
o the value of the excess cashflow certificates (initially, the NIM
owner trust certificate) that we retained; and
o the cash premium we received from selling the right to service the
loans being securitized.
These economic interests were recorded as net gain on sale of mortgage
loans on our consolidated statement of operations.
Whole Loan Sales. We also sell loans, without retaining the right to
service the loans, in exchange for a cash premium. The premiums we receive from
the loan sales are recorded as revenue under net gain on sale of mortgage loans.
The cash premiums ranged between 2.6% to 5.8% (prior to reserve) of the
principal amount of the mortgage loans sold in this manner in 2003.
OTHER INCOME
In addition to the income and cash flows we earn from securitizations and
whole loan sales, we also earn income and generate cash flows from:
o the net interest spread earned on mortgage loans while we hold the
mortgage loans for sale (the difference between the interest rate on
the mortgage loan paid by the borrower less the financing costs we
pay to our warehouse lenders to fund our loans);
o net loan origination fees on wholesale loans and retail loans (these
fees are recorded as a component of net gain on sale of mortgage
loans); retained excess cashflow certificates;
o retained excess cashflow certificates;
o distributions from Delta Funding Residual Exchange Company LLC (the
"LLC"), a limited liability company that is not our affiliate. We
have a non-voting membership interest in the LLC, which entitles us
to receive 15% of the net cash flows from the LLC through June 2004
and, thereafter, 10% of the net cash flows from the LLC. We have not
received our distributions since the second quarter of 2003 due to a
dispute with the LLC's President, which has led us to commence a
lawsuit to recover all of the amounts due to us. (See "Item 3-Legal
Proceedings"); and
o miscellaneous interest income, including prepayment penalties
received on certain of the loans we sold in securitizations prior to
2002.
RECENT DEVELOPMENTS
In March 2004, we completed a $550 million securitization of mortgage
loans that we structured as an on-balance sheet financing. This structure
recognizes the related revenue as net interest income (interest income on the
mortgage loans, less interest expense on the bond financing) which is received
over the life of the loans, instead of recording virtually all of the income
upfront as a gain on sale of mortgage loans as our prior structures required
under SFAS No. 140. We plan to continue to utilize this securitization
structure, which eliminates gain-on-sale accounting treatment, and account for
all our future securitization transactions as on-balance sheet financings.
Consequently, income that would have otherwise been recognized upfront in 2004
as net gain on sale of mortgage loans will now be recognized as net interest
income over the life of the loans. As we transition to portfolio-based
accounting from gain-on-sale accounting, we expect to record negative earnings
throughout 2004 while we build the size of our portfolio generating net interest
income. Generally, the larger the portfolio of loans generating net
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interest income, the higher our earnings will be. We anticipate recording
positive earnings in 2005, with the expectation of further increasing earnings
in 2006, as the size of our on-balance sheet loan portfolio, and the net
interest income generated from the loan portfolio, increases. We believe
structuring, and therefore accounting for, securitizations as financings will
help provide a relatively more consistent source of income from these
transactions in future years.
BUSINESS STRATEGY
Over the past few years, our core business strategy has been to increase
profitability and generate cash revenues in excess of our cash expenses through
an increase in our overall loan production and average loan size so that we
could operate on a neutral to positive cash flow basis. As noted above in
"-Recent Developments," in 2004, we intend to transition to portfolio lending
accounting treatment from gain-on-sale accounting treatment by changing our
securitization structure. With this change, we have altered our business
strategy slightly to focus on maximizing the size of our on-balance sheet
securitized loan portfolio, which we ultimately believe will maximize earnings
and help provide a more consistent source of income from these transactions in
future years. As part of this strategy, we will seek to continue to increase our
overall loan production. We believe we have the necessary infrastructure in
place to continue to expand loan production in both our wholesale and retail
channels, without having to invest significantly in our infrastructure. We plan
to increase loan production by:
o increasing the number of commissioned-based account executives
responsible for generating new wholesale business;
o continuing to provide top quality service to our network of brokers
and retail clients;
o maintaining our loan underwriting standards;
o penetrating further our established and recently-entered markets and
expanding into new geographic markets;
o expanding our retail loan origination capabilities through larger
call centers; and
o maximizing the benefits from our proprietary web-based and workflow
technology platform.
CORPORATE RESTRUCTURING, DEBT MODIFICATION AND DEBT RESTRUCTURING
As discussed in more detail in "Note 3 to our Consolidated Financial
Statements - Corporate Restructuring, Debt Modification and Debt Restructuring,"
we engaged in a series of transactions beginning in 2000, and concluding in the
third quarter of 2001, aimed at improving our operating efficiencies and
reducing our then negative cash flow. We spent much of 2001 working on two
transactions in particular, which we believe were of primary importance in this
regard - selling our servicing portfolio and extinguishing most of our long term
debt.
o In May 2001, we completed the transfer of our servicing portfolio to
Ocwen FSB, which eliminated the significant cash drain associated
with making securitization advances and of servicing a highly
seasoned portfolio following three successive quarters of selling
the securitization servicing rights associated with newly originated
mortgage loans.
o In August 2001, we completed our Second Exchange Offer, which
extinguished substantially all of our long-term debt, leaving
approximately $11 million out of $150 million of our notes still
outstanding. In the Second Exchange Offer, we recorded a $19.3
million charge in our statement of operations. This debt
extinguishment helped us in three ways. First, it eliminated nearly
$139 million aggregate principal amount of debt, which we otherwise
would have had to repay in 2004. Second, it eliminated more than $14
million of annual interest expense that we would have had to pay to
the former noteholders. Third, the ratings agencies that previously
rated our notes and us withdrew their corporate ratings. On October
30, 2003, we redeemed at par all of our remaining outstanding 9.5%
Senior Notes due August 2004. The aggregate redemption price,
including principal and accrued interest, was approximately $11.0
million.
We believe that our transfer of servicing to Ocwen and the Second Exchange
Offer were essential steps in restructuring our operations and reducing our
negative cash flow previously associated with our servicing operations and the
notes.
5
HOME EQUITY LENDING OPERATIONS
OVERVIEW
Our consumer finance activities consist of originating, securitizing,
selling (and, prior to May 2001, servicing) non-conforming mortgage loans. These
loans are primarily secured by first mortgages on one- to four-family
residences. Once loan applications have been received, the underwriting process
completed and the loans funded, we typically package the loans in a portfolio
and sell the loan portfolio through a securitization or on a whole loan,
servicing released basis. In 2004, we have begun structuring our securitizations
as financings and not as sales. See " -Recent Developments" above.
We provide our customers with an array of loan products designed to meet
their varying needs, using a risk-based pricing strategy to develop products for
various risk categories. Historically, we have offered fixed-rate loan products
and, to date, the majority of our loan production has been fixed-rate. As we
have expanded geographically, we have also expanded our product offerings to
include hybrid mortgages, in which the interest rate remains fixed for the first
two or three years of the loan's term and then adjusts thereafter.
We primarily conduct our broker lending operations out of our Woodbury,
New York headquarters. Final underwriting approval for brokered loans is
centralized in our Woodbury, New York headquarters and Cincinnati, Ohio
underwriting hub. We conduct our retail operations out of four call centers,
seven retail offices and a telemarketing hub, located in nine states. Final
underwriting approval for retail loans is required from either of our retail
underwriting offices in Cincinnati, Ohio or Phoenix, Arizona, which have full
underwriting authority, or from our Woodbury, New York headquarters.
We adhere to our Best Practice Lending Program aimed at ensuring the
origination of quality loans and helping to better protect consumers. This Best
Practice Lending Program includes:
o fair lending initiatives aimed at ensuring that all borrowers are
treated fairly and similarly regardless of race, color, creed,
religion, national origin, sex, sexual orientation, marital status,
age, disability and the applicant's exercise, in good faith, of any
right under the Consumer Credit Protection Act;
o increased oversight of mortgage brokers and closing agents;
o enhanced fraud detection and protection;
o enhanced plain English disclosures; and
o other originations and underwriting initiatives which we believe
help protect consumers.
6
LOAN ORIGINATIONS
Our loan originations increased by 96% to $1,713 million in 2003 from $872
million in 2002. The following table shows certain data regarding our loans,
presented by channel of loan originations, for the years shown:
YEAR ENDED DECEMBER 31,
2003 2002 2001
---- ---- ----
(DOLLARS IN THOUSANDS)
Broker:
Number of brokered loans ............... 6,087 4,611 4,365
Principal balance ...................... $1,005,484 $ 534,999 $ 345,916
Average principal balance per loan .... $ 165 $ 116 $ 79
Combined weighted average initial loan-
to-value ratio(1) ................... 74.2% 74.6% 71.7%
Weighted average interest rate ........ 8.0% 9.5% 11.1%
Weighted average credit score .......... 622 601 584
Retail:
Number of brokered loans .............. 6,309 3,466 3,350
Principal balance ..................... $ 707,253 $ 337,191 $ 275,799
Average principal balance per loan .... $ 112 $ 97 $ 82
Combined weighted average initial loan-
to-value ratio(1) ................... 79.6% 79.5% 77.4%
Weighted average interest rate ........ 8.3% 9.1% 9.8%
Weighted average credit score .......... 633 631 633
Total loan purchases and originations:
Number of brokered loans .............. 12,396 8,077 7,715
Principal balance ..................... $1,712,737 $ 872,190 $ 621,715
Average principal balance per loan .... $ 138 $ 108 $ 81
Combined weighted average initial loan-
to-value ratio(1) ................... 76.4% 76.5% 74.2%
Weighted average interest rate ........ 8.1% 9.4% 10.5%
Weighted average credit score .......... 627 613 606
Percentage of loans secured by:
First mortgage ........................ 97.7% 96.3% 94.1%
- ----------
(1) We determine the weighted average initial loan-to-value ratio of a loan
secured by a first mortgage by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. We determine the weighted average initial
loan-to-value ratio of a loan secured by a second mortgage by taking the
sum of the loan secured by the first and second mortgages and dividing by
the lesser of the purchase price or the appraised value of the mortgage
property at origination.
The following table shows lien position, weighted average interest
rates and loan-to-value ratios for the years shown:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
FIRST MORTGAGE:
Percentage of total purchases and originations .. 97.7% 96.3% 94.1%
Weighted average interest rate .................. 8.1% 9.3% 10.5%
Weighted average initial loan-to-value ratio(1) . 76.4% 76.4% 74.2%
SECOND MORTGAGE:
Percentage of total purchases and originations .. 2.3% 3.7% 5.9%
Weighted average interest rate .................. 9.3% 10.5% 11.1%
Weighted average initial loan-to-value ratio(1) . 78.5% 79.3% 75.4%
- ---------------
(1) We determine the weighted average initial loan-to-value ratio of a loan
secured by a first mortgage by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. We determine the weighted average initial
loan-to-value ratio of a loan secured by a second mortgage by taking the
sum of the loan secured by the first and second mortgages and dividing by
the lesser of the purchase price or the appraised value of the mortgage
property at origination.
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The following table shows the geographic distribution of loan purchases
and originations for the periods indicated:
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------------------------------
2003 2002 2001
REGION PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE
- ------ ---------- ------------ ---------- ------------ ---------- ------------
(DOLLARS IN MILLIONS)
NY, NJ and PA ....... 45.8% $784.7 43.1% $376.1 40.0% $248.4
Midwest ............. 16.8 287.6 25.5 222.1 34.1 212.2
Mid-Atlantic* ....... 17.8 305.2 13.5 118.2 11.8 73.1
Southeast ........... 7.4 126.2 9.5 82.5 7.5 46.8
New England ......... 8.0 136.5 7.3 64.0 5.6 34.9
West ................ 4.2 72.5 1.1 9.3 1.0 6.3
- ------------
* Excluding New York (NY), New Jersey (NJ) and Pennsylvania (PA).
Wholesale Marketing. Historically, we have established and maintained
relationships with brokers offering non-conforming mortgage products.
Typically, we initiate contact with a broker through our Business
Development Department, supervised by a senior officer with over 21 years of
sales and marketing experience in the industry. We usually hire business
development representatives, or account executives, who have contacts with
brokers that originate non-conforming mortgage loans within their geographic
territory. The account executives are responsible for developing and maintaining
our broker network within their geographic territory by frequently visiting the
broker, communicating our underwriting guidelines, disseminating new product
information and pricing changes, and by demonstrating a continuing commitment to
understanding the needs of the customer. The account executives attend industry
trade shows and inform us about the products and pricing being offered by
competitors and new market entrants. This information assists us in refining our
programs and product offerings in order to remain competitive. Account
executives are compensated with a base salary and commissions based on the
volume of loans originated as a result of their efforts. At December 31, 2003,
we had 66 account executives.
Approval Process. Before a broker becomes part of our network, the broker
must go through an approval process. Once approved, brokers may begin submitting
applications and/or loans to us.
To be approved, a broker must:
o demonstrate that it the broker properly licensed and registered in
the state in which the broker seeks to transact business;
o submit to and pass a credit check; and
o sign a standard broker agreement with us that requires brokers to,
among other things:
>> abide by our fair lending policy;
>> follow the National Association of Mortgage Brokers Best
Practices Policies;
>> comply with all state and Federal laws; and
>> submit only true and accurate documents and disclosures.
We also perform searches on all new brokers using a third-party database
that contains public and nonpublic information on individuals and companies that
have incidents of potential fraud and misrepresentation. In addition, we
regularly review the performance of loans originated through our brokers.
Brokered Loans. For the year ended December 31, 2003, our broker network
accounted for $1.0 billion, or 59%, of our loan originations, compared to $535.0
million, or 61%, of our loan originations for the year ended December 31, 2002
and $345.9 million, or 56%, of our loan purchases and originations for the year
ended December 31, 2001. No single broker contributed more than 5.0%, 2.2% or
1.3% of our total loan production in the years ended December 31, 2003, 2002 and
2001, respectively.
8
Once approved, a broker may submit loan applications for prospective
borrowers. To process broker submissions, our broker originations channel is
organized by geographic regions and into teams, each consisting of account
executives, account managers and processors, which are generally assigned to
specific brokers. Since we operate in a highly competitive environment where
brokers often submit the same loan application to several prospective lenders
simultaneously, we strive to provide brokers with a rapid and informed response.
Account executives analyze the application and provide the broker with a
preliminary approval, subject to final underwriting approval, or a denial. In
addition, brokers can obtain preliminary approvals, typically within seconds,
directly from our proprietary originations software program - Click & Close(R) -
by logging in and entering the basic loan information. Once a package is
received from the broker, the application is logged into Click & Close, which
automatically queues the loan to an underwriter from the team covering that
geographic area and/or broker. If the application is approved by our
underwriter, a "conditional approval" will be issued to the broker with a list
of specific conditions to be met and additional documents to be supplied prior
to funding the loan. The file is then queued back to the account manager and
processor, who work directly with the submitting broker to collect the requested
information, meet all underwriting conditions and send out all appropriate
documentation and disclosures.
In most cases, we fund loans within 14 to 21 days after preliminary
approval of the loan application. In the case of a denial, we will make all
reasonable attempts to ensure that there is no missing information concerning
the borrower or the application that might change the denial decision on the
loan.
We compensate our account executives, who are the primary relationship
contacts with the brokers, mainly on a commission basis. We strive to have our
account executives maintain the level of knowledge and experience integral to
our commitment to providing the highest quality service for brokers. We believe
that by maintaining an efficient, trained and experienced staff, we have
addressed four central factors that determine where a broker sends its business:
o the service and support a lender provides;
o product offerings and pricing;
o the turn-around time, or speed with which a lender closes loans; and
o the lender's knowledge concerning the broker and his business.
Retail Loans. We develop retail loan leads primarily through our automated
telemarketing system and our network of four call centers and seven retail
offices located in nine states. For the year ended December 31, 2003, the retail
channel accounted for $707.2 million, or 41%, of our loan originations, compared
to $337.2 million, or 39%, of our loan originations for the year ended December
31, 2002 and $275.8 million, or 44%, of our loan originations for the year ended
December 31, 2001. Through our marketing efforts, the retail loan channel is
able to identify, locate and focus on individuals who, based on historic
customer profiles, are likely customers for our products. Our telemarketing
representatives identify interested customers and forward these potential
borrowers to a branch manager through our Click & Close system. The branch
managers, in turn, distribute these leads to mortgage analysts via Click & Close
by queuing the loan to a mortgage analyst's "to do" list in Click & Close. The
assigned mortgage analyst discusses the applicant's qualifications and available
loan products, negotiates loan terms with the borrower and processes the loan
through completion. Click & Close is utilized to queue the loan to underwriters
at the appropriate times for approvals and help to facilitate the loan
application process through closing.
We compensate our mortgage analysts, who are the primary relationship
contacts with our borrowers, predominantly on a commission basis. At December
31, 2003, we had 279 mortgage analysts.
LOAN UNDERWRITING
Underwriting Guidelines. We maintain written underwriting guidelines that
are utilized by all employees associated with the underwriting process.
Throughout our 22 year history, these guidelines have been reviewed and updated
from time to time by senior underwriters and the head of risk management. We
provide our underwriting guidelines to all of the brokers from whom we accept
loan applications. Loan applications received from brokers are classified
according to particular characteristics, including, but not limited to, the
applicant's:
o ability to pay;
o credit history (with emphasis on the applicant's existing mortgage
payment history);
o credit score;
9
o income documentation type;
o lien position;
o loan-to-value ratio;
o property type; and
o general stability, in terms of employment history, time in
residence, occupancy and condition and location of the collateral.
We have established classifications with respect to the credit profile of
the applicant, and each loan is placed into one of four letter ratings "A"
through "D," with sub-ratings within those categories. Terms of loans that we
make, as well as maximum loan-to-value ratios and debt-to-income ratios, vary
depending on the classification of the applicant and the borrower's credit
score. Loan applicants with less favorable credit ratings and/or lower credit
scores are generally offered loans with higher interest rates and lower
loan-to-value ratios than applicants with more favorable credit ratings and/or
higher credit scores. The general criteria our underwriting staff uses in
classifying loan applicants are set forth in the following table.
REST OF PAGE INTENTIONALLY LEFT BLANK
10
DELTA FUNDING CORPORATION
UNDERWRITING GUIDELINE MATRIX
- ------------------------------------------------------------------------------------------------------------------------------
FIRST MORTGAGE
- ------------------------------------------------------------------------------------------------------------------------------
OWNER OCCUPIED NON OWNER OCCUPIED
------------------------------------------------------------------------------------------------------
CREDIT LIMITED LIMITED
PROGRAM MIN FULL INCOME & FULL INCOME &
MAX LOAN CREDIT INCOME NO INCOME INCOME NO INCOME AS
AMOUNT SCORE CHECK CHECK AS STATED CHECK CHECK STATED DTI
- ------------------------------------------------------------------------------------------------------------------------------
LTV >80%:
PROPERTY LTV >90%: LTV >85%: LTV >80%: 1-4 FAMILY
RESTRICTIONS 1-2 FAMILY 1-2 FAMILY 1-2 FAMILY LTV >85%:
DETACHED DETACHED DETACHED 1-2 FAMILY
& CONDO'S & CONDO'S & CONDO'S DETACHED
- ------------------------------------------------------------------------------------------------------------------------------
675 100% 1st Mtg 100% 1st Mtg 90% 1st Mtg 90% 1st Mtg 80% 1st Mtg 70% 1st Mtg **55%
650 100% 1st Mtg 95% 1st Mtg 85% 1st Mtg 85% 1st Mtg 80% 1st Mtg 70% 1st Mtg
A+ 625 100% 1st Mtg 95% 1st Mtg 85% 1st Mtg 85% 1st Mtg 75% 1st Mtg 70% 1st Mtg
UP TO $750,000 550 95% 1st Mtg 90% 1st Mtg 80% 1st Mtg 80% 1st Mtg 75% 1st Mtg 70% 1st Mtg
525 90% 1st Mtg 85% 1st Mtg 80% 1st Mtg 80% 1st Mtg 75% 1st Mtg NA
500 85% 1st Mtg 80% 1st Mtg NA 80% 1st Mtg NA NA
80% 1st Mtg 75% 1st Mtg NA 75% 1st Mtg NA NA
- ------------------------------------------------------------------------------------------------------------------------------
675 100% 1st Mtg 100% 1st Mtg 90% 1st Mtg 90% 1st Mtg 80% 1st Mtg 70% 1st Mtg
650 100% 1st Mtg 95% 1st Mtg 85% 1st Mtg 85% 1st Mtg 80% 1st Mtg 70% 1st Mtg
A1 625 100% 1st Mtg 95% 1st Mtg 85% 1st Mtg 85% 1st Mtg 75% 1st Mtg 70% 1st Mtg
UP TO $750,000 600 95% 1st Mtg 90% 1st Mtg 80% 1st Mtg 80% 1st Mtg 75% 1st Mtg 70% 1st Mtg **55%
550 90% 1st Mtg 85% 1st Mtg 80% 1st Mtg 80% 1st Mtg 75% 1st Mtg NA
525 85% 1st Mtg 75% 1st Mtg NA 75% 1st Mtg NA NA
500 80% 1st Mtg 70% 1st Mtg NA 70% 1st Mtg NA NA
- ------------------------------------------------------------------------------------------------------------------------------
600 90% 1st Mtg 85% 1st Mtg 80% 1st Mtg 80% 1st Mtg 75% 1st Mtg 70% 1st Mtg
A2 575 90% 1st Mtg 85% 1st Mtg 80% 1st Mtg 80% 1st Mtg 75% 1st Mtg NA
UP TO $500,000 550 85% 1st Mtg 80% 1st Mtg 75% 1st Mtg 80% 1st Mtg 70% 1st Mtg NA **55%
525 80% 1st Mtg 75% 1st Mtg NA 75% 1st Mtg NA NA
500 75% 1st Mtg 70% 1st Mtg NA 70% 1st Mtg NA NA
- ------------------------------------------------------------------------------------------------------------------------------
600 90% 1st Mtg 80% 1st Mtg 75% 1st Mtg 80% 1st Mtg 70% 1st Mtg
B1 575 85% 1st Mtg 80% 1st Mtg 75% 1st Mtg 80% 1st Mtg 70% 1st Mtg
UP TO $500,000 550 85% 1st Mtg 75% 1st Mtg 70% 1st Mtg 75% 1st Mtg 65% 1st Mtg **55%
525 80% 1st Mtg NA NA NA NA
500 75% 1st Mtg NA NA NA NA
- ------------------------------------------------------------------------------------------------------------------------------
575 85% 1st Mtg 75% 1st Mtg 70% 1st Mtg 75% 1st Mtg
B2 550 80% 1st Mtg 70% 1st Mtg 70% 1st Mtg 70% 1st Mtg **55%
UP TO $500,000 525 75% 1st Mtg NA NA NA
500 70% 1st Mtg NA NA NA
- ------------------------------------------------------------------------------------------------------------------------------
C1 575 80% 1st Mtg 75% 1st Mtg 75% 1st Mtg
UP TO $400,000 550 80% 1st Mtg 70% 1st Mtg 70% 1st Mtg **55%
525 75% 1st Mtg NA NA
500 70% 1st Mtg NA NA
- ------------------------------------------------------------------------------------------------------------------------------
C2 550 75% 1st Mtg
UP TO $400,000 525 70% 1st Mtg PROPERTY RESTRICTIONS **55%
500 65% 1st Mtg
- --------------------------------------
D1 550 70% 1st Mtg OO FIC, LIC & NIC over 90% LTV, only:
UP TO $350,000 500 65% 1st Mtg 1-2 family, Min MV of $150,000 **55%
- --------------------------------------
* D2 525 65% 1st Mtg 3-4 family, Min MV of $150,000 Y 25 pt. higher score **55%
UP TO $350,000 500 60% 1st Mtg OO As Stated Over 85%: 1-2 family detached & condos
- --------------------------------------
* D3
UP TO $350,000 550 60% 1st Mtg **55%
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
CREDIT
PROGRAM
MAX LOAN
AMOUNT MORTGAGE PAYMENT HISTORY BANKRUPTCY INFORMATION
- ------------------------------------------------------------------------------------------------------------------------------
PROPERTY
RESTRICTIONS
- ------------------------------------------------------------------------------------------------------------------------------
EXCELLENT MORTGAGE HISTORY *** MINIMUM 3 YEARS OLD
0x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
A+ * For extended LTV's with credit score < 575, Chapter 13 discharge must be
UP TO $750,000 0x60 months 13 to 24. 1 year old at closing
No foreclosures last 3 years.
- ------------------------------------------------------------------------------------------------------------------------------
EXCELLENT MORTGAGE HISTORY *** MINIMUM 3 YEARS OLD
1x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
A1 * For extended LTV's with credit score < 575, Chapter 13 discharge must be 1 year old at
UP TO $750,000 0x60 months 13 to 24. closing
No foreclosures last 3 years.
- ------------------------------------------------------------------------------------------------------------------------------
EXCELLENT MORTGAGE HISTORY *** MINIMUM 2 YEARS OLD
A2 2x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
UP TO $500,000 * For extended LTV's with credit score < 575, Chapter 13 must be discharged before
0x90 months 13 to 24. closing.
No foreclosures last 3 years.
- ------------------------------------------------------------------------------------------------------------------------------
GOOD MORTGAGE HISTORY *** MINIMUM 2 YEARS OLD
B1 3x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
UP TO $500,000 No foreclosures last 2 years. Chapter 13 must be discharged before
If mortgage history(s) for the past closing.
12 months is 0x30, the foreclosure/NOD
restriction will be lowered to 18 months.
- ------------------------------------------------------------------------------------------------------------------------------
GOOD MORTGAGE HISTORY *** MINIMUM 18 MONTHS OLD
B2 2x30 & 1x60 or Unlimited 30's, 0x60 Chapter 7 discharge or Chapter 13 filing.
UP TO $500,000 on mortgages within last 12 months. Open Chapter 13 considered.
No foreclosures last 18 months. Mortgage must be paid as agreed since
If mortgage history(s) for the past filing.
12 months is 0x30, the foreclosure/NOD
restriction will be lowered to 12 months.
- ------------------------------------------------------------------------------------------------------------------------------
C1 FAIR MORTGAGE HISTORY *** MINIMUM 1 YEAR OLD
UP TO $400,000 0x90 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
No worse than D-30 at closing. No late payments on mortgages
No foreclosures last 12 months. since Chapter 7 or 13 filing.
- ------------------------------------------------------------------------------------------------------------------------------
C2 FAIR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $400,000 1x90 on mortgages within last 12 months. Open Chapter 13 considered.
No worse than D-60 at closing.
- ------------------------------------------------------------------------------------------------------------------------------
D1 POOR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $350,000 1x120 on mortgages within last 12 months. Open Chapter 13 considered.
No worse than D-90 at closing.
- ------------------------------------------------------------------------------------------------------------------------------
* D2 POOR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $350,000 No worse than D-119 at closing. Open Chapter 13 considered.
Mortgage NOT in foreclosure.
- ------------------------------------------------------------------------------------------------------------------------------
* D3 POOR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $350,000 Open foreclosures considered case-by-case Open Chapter 13 considered.
- ------------------------------------------------------------------------------------------------------------------------------
Minimum Market Value: $70,000 - OO FIC, LIC & NIC>90% OO As Stated > 85%
- --------------------------------------------------------------------------------
Minimum Market Value for NOO (All LTV's): $70,000 || NOO FIC > 85%, Minimum
Market Value $150,000
- --------------------------------------------------------------------------------
** For LTV's above 80% and/or income less than $25K/yr, maximum DTI = 50% for
programs A+ through D3.
- --------------------------------------------------------------------------------
*** Lower LTV by 5% for programs D2 & D3 in: Connecticut, Idaho, Illinois,
Indiana, Iowa, Maine, Massachusetts, New Jersey, New York, Oklahoma,
Vermont & Wisconsin.
- --------------------------------------------------------------------------------
**** Chapter 13 involuntary dismissal date follows the same guidelines as
Chapter 7 discharge.
- --------------------------------------------------------------------------------
DELTA FUNDING CORPORATION
UNDERWRITING GUIDELINE MATRIX
- ----------------------------------------------------------------------------------------------------------------------------
SECOND MORTGAGE
- ----------------------------------------------------------------------------------------------------------------------------
OWNER OCCUPIED NON OWNER OCCUPIED
- ----------------------------------------------------------------------------------------------------------------------------
CREDIT PROGRAM MIN CREDIT FULL LIMITED INCOME & NO
MAX LOAN AMOUNT SCORE INCOME CHECK INCOME CHECK FULL INCOME CHECK DTI
- ----------------------------------------------------------------------------------------------------------------------------
PROPERTY RESTRICTIONS 2ND MORTGAGES NOT AVAILABLE FOR: SCORES < 550, AS STATED LOANS,
NPO LOANS, MIXED USE/MULTI-FAMILY & DOUBLE WIDE MANUFACTURED
HOMES OR "UNIQUE PROPERTIES".
- ----------------------------------------------------------------------------------------------------------------------------
675 #100% 2ND MTG 80% 2nd Mtg 75% 2nd Mtg
650 #100% 2ND MTG 80% 2nd Mtg 75% 2nd Mtg
625 90% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg **55%
A+ 600 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg
UP TO $750,000 550 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg
525 NA NA NA
500 NA NA NA
- ----------------------------------------------------------------------------------------------------------------------------
675 #100% 2ND MTG 80% 2nd Mtg 75% 2nd Mtg
650 #100% 2ND MTG 80% 2nd Mtg 75% 2nd Mtg
625 90% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg
A1 600 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg **55%
UP TO $750,000 550 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg
525 NA NA NA
500 NA NA NA
- ----------------------------------------------------------------------------------------------------------------------------
600 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg
A2 575 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg
UP TO $500,000 550 85% 2nd Mtg 80% 2nd Mtg 75% 2nd Mtg **55%
525 NA NA NA
500 NA NA NA
- ----------------------------------------------------------------------------------------------------------------------------
600 80% 2nd Mtg 80% 2nd Mtg 70% 2nd Mtg
B1 575 80% 2nd Mtg 80% 2nd Mtg 70% 2nd Mtg
UP TO $500,000 550 80% 2nd Mtg 75% 2nd Mtg 70% 2nd Mtg **55%
525 NA NA NA
500 NA NA NA
- ----------------------------------------------------------- ------------------
B2 575 80% 2nd Mtg 100% CLTV (over 90% CLTV)
UP TO $500,000 550 80% 2nd Mtg requirements: Minimum 650 middle
525 NA credit score FIC only (24 mos. **55%
500 NA bank statements not permitted)
- ----------------------------------------------------------- Minimum 4 years bankruptcy ------------------
575 75% 2nd Mtg discharge or Consumer Credit
C1 550 75% 2nd Mtg Counseling not permitted Single
UP TO $400,000 525 NA family residence only. No condos **55%
500 NA Refinance only. No purchase money
- ----------------------------------------------------------- Minimum loan amount: $40K (stand ------------------
C2 550 2ND MTGES NOT alone) Min loan amt for DFC 1st
UP TO $400,000 525 AVAILABLE FOR: and 2nd: $20K Maximum loan amount: **55%
500 Score < 550 As $250,000 Minimum FMV: $70,000 12
- ----------------------------------- stated loans NPO month mortgage history required If ------------------
D1 550 loans Mixed use reporting to credit 0x60 month
UP TO $350,000 500 property 13-24 **55%
- ----------------------------------- Multi-family -----------------------------------------------------------
*D2 525 property
UP TO $350,000 500 Double/multi-wide, **55%
- ----------------------------------- manufactured -----------------------------------------------------------
*D3 550 homes "Unique" **55%
UP TO $350,000 property
- --------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
CREDIT
PROGRAM
MAX LOAN
AMOUNT MORTGAGE PAYMENT HISTORY BANKRUPTCY INFORMATION
- ------------------------------------------------------------------------------------------------------------------------------
PROPERTY
RESTRICTIONS
- ------------------------------------------------------------------------------------------------------------------------------
EXCELLENT MORTGAGE HISTORY *** MINIMUM 3 YEARS OLD
0x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
A+ * For extended LTV's with credit score < 575, Chapter 13 discharge must be
UP TO $750,000 0x60 months 13 to 24. 1 year old at closing
No foreclosures last 3 years.
- ------------------------------------------------------------------------------------------------------------------------------
EXCELLENT MORTGAGE HISTORY *** MINIMUM 3 YEARS OLD
1x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
A1 * For extended LTV's with credit score < 575, Chapter 13 discharge must be 1 year old at
UP TO $750,000 0x60 months 13 to 24. closing
No foreclosures last 3 years.
- ------------------------------------------------------------------------------------------------------------------------------
EXCELLENT MORTGAGE HISTORY *** MINIMUM 2 YEARS OLD
A2 2x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
UP TO $500,000 * For extended LTV's with credit score < 575, Chapter 13 must be discharged before
0x90 months 13 to 24. closing.
No foreclosures last 3 years.
- ------------------------------------------------------------------------------------------------------------------------------
GOOD MORTGAGE HISTORY *** MINIMUM 2 YEARS OLD
B1 3x30 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
UP TO $500,000 No foreclosures last 2 years. Chapter 13 must be discharged before
If mortgage history(s) for the past closing.
12 months is 0x30, the foreclosure/NOD
restriction will be lowered to 18 months.
- ------------------------------------------------------------------------------------------------------------------------------
GOOD MORTGAGE HISTORY *** MINIMUM 18 MONTHS OLD
B2 2x30 & 1x60 or Unlimited 30's, 0x60 Chapter 7 discharge or Chapter 13 filing.
UP TO $500,000 on mortgages within last 12 months. Open Chapter 13 considered.
No foreclosures last 18 months. Mortgage must be paid as agreed since
If mortgage history(s) for the past filing.
12 months is 0x30, the foreclosure/NOD
restriction will be lowered to 12 months.
- ------------------------------------------------------------------------------------------------------------------------------
C1 FAIR MORTGAGE HISTORY *** MINIMUM 1 YEAR OLD
UP TO $400,000 0x90 on mortgages within last 12 months. Chapter 7 discharge or Chapter 13 filing.
No worse than D-30 at closing. No late payments on mortgages
No foreclosures last 12 months. since Chapter 7 or 13 filing.
- ------------------------------------------------------------------------------------------------------------------------------
C2 FAIR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $400,000 1x90 on mortgages within last 12 months. Open Chapter 13 considered.
No worse than D-60 at closing.
- ------------------------------------------------------------------------------------------------------------------------------
D1 POOR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $350,000 1x120 on mortgages within last 12 months. Open Chapter 13 considered.
No worse than D-90 at closing.
- ------------------------------------------------------------------------------------------------------------------------------
* D2 POOR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $350,000 No worse than D-119 at closing. Open Chapter 13 considered.
Mortgage NOT in foreclosure.
- ------------------------------------------------------------------------------------------------------------------------------
* D3 POOR MORTGAGE HISTORY Chapter 7 must be discharged by closing.
UP TO $350,000 Open foreclosures considered case-by-case Open Chapter 13 considered.
- ------------------------------------------------------------------------------------------------------------------------------
Minimum Market Value: $70,000 - OO FIC, LIC & NIC>90% OO As Stated > 85%
- --------------------------------------------------------------------------------
Minimum Market Value for NOO (All LTV's): $70,000 || NOO FIC > 85%, Minimum
Market Value $150,000
- --------------------------------------------------------------------------------
** For LTV's above 80% and/or income less than $25K/yr, maximum DTI = 50% for
programs A+ through D3.
- --------------------------------------------------------------------------------
*** Lower LTV by 5% for programs D2 & D3 in: Connecticut, Idaho, Illinois,
Indiana, Iowa, Maine, Massachusetts, New Jersey, New York, Oklahoma,
Vermont & Wisconsin.
- --------------------------------------------------------------------------------
**** Chapter 13 involuntary dismissal date follows the same guidelines as
Chapter 7 discharge.
- --------------------------------------------------------------------------------
We use these categories and characteristics as guidelines only. On a
case-by-case basis, we may determine that the prospective borrower warrants an
exception from the guidelines if sufficient compensating factors exist. Examples
of compensating factors we consider include the following:
o low debt ratio;
o long-term stability of employment and/or residence;
o excellent payment history on past mortgages;
o a significant reduction in monthly expenses; or
o low loan-to-value ratio.
The following table sets forth certain information with respect to our
originations of first and second mortgage loans by borrower classification,
along with weighted average coupons, for the periods shown and highlights the
improved credit quality of our originations.
(dollars in thousands)
PERCENT
YEAR CREDIT TOTAL OF TOTAL WAC(1) WLTV(2)
- ---- ------ ----- -------- ------ -------
2003 A $1,539,028 89.9% 8.0% 77.5%
B 92,886 5.4 9.3 69.9
C 55,431 3.2 9.7 66.2
D 25,392 1.5 10.8 56.2
---------- ------ ------ ------
Totals $1,712,737 100.0% 8.1% 76.4%
========== ====== ====== ======
2002 A $ 752,920 86.3% 9.1% 78.1%
B 57,186 6.6 10.3 70.3
C 42,903 4.9 11.1 66.0
D 19,181 2.2 12.1 55.5
---------- ------ ------ ------
Totals $ 872,190 100.0% 9.4% 76.5%
========== ====== ====== ======
2001 A $ 478,485 77.0% 10.0% 76.7%
B 59,729 9.6 11.5 68.6
C 61,498 9.9 12.2 66.7
D 22,003 3.5 13.2 57.4
---------- ------ ------ ------
Totals $ 621,715 100.0% 10.5% 74.2%
========== ====== ====== ======
- ------------------
(1) Weighted Average Coupon ("WAC").
(2) Weighted Average Initial Loan-to-Value Ratio ("WLTV").
The mortgage loans we originate have amortization schedules ranging from
five years to 30 years, generally bear interest at fixed rates and require equal
monthly payments, which are due as of a scheduled day of each month.
Substantially all of our mortgage loans are fully amortizing loans. The
principal amounts of the loans we originate generally range from a minimum of
$25,000 to a maximum of $750,000, and we will lend up to 100% of the combined
loan-to-value ratio. Our loans are generally secured by one- to four-family
residences, including condominiums and town-houses, and these properties are
usually occupied by the owner. It is our policy not to accept commercial
properties or unimproved land as collateral. However, we will accept mixed-use
properties, such as a property where a portion of the property is used for
residential purposes and the balance is used for commercial purposes, and we
will accept small multifamily properties of five to eight units, both at reduced
loan-to-value ratios. We do not originate loans where any senior mortgage
contains open-end advance, negative amortization or shared appreciation
provisions - all of which could have the effect of increasing the amount of the
senior mortgage, thereby increasing the combined loan-to-value, or LTV, and
increasing the risk of the loan to us.
13
Documentation and review. Our mortgage loan program includes:
o a full documentation program;
o a limited documentation program;
o a no income verification program for self-employed borrowers; and
o a stated income program.
Our borrowers' total monthly debt obligations - which include principal
and interest on the new loan and all other mortgages, loans, charge accounts and
scheduled indebtedness - generally are 50% or less of the borrower's monthly
gross income. Some of our borrowers will qualify using our maximum
debt-to-income ratio of 55%. For loans to borrowers who are salaried employees,
we require current employment information in addition to employment history. We
verify this information based on one or more of the following items: written
confirmation from employers, recent pay-stubs, recent W-2 tax forms, recent tax
returns, bank statements and telephone confirmation from the employer. For our
limited documentation program, we require either six months of bank statements
or a job letter to be submitted which contains substantially the same
information one would find on a standard verification of employment form,
including:
o job position;
o length of time on job;
o current salary; and
o the job letter should appear on the employer's letterhead and
include the telephone number and signature of the individual
completing the letter on behalf of the employer.
For our no income verification program, we require proof of
self-employment in the same business for two years. We only offer our stated
income program, which represents a very small percentage of our loans, for
better credit quality borrowers where a telephone verification is performed by
an underwriter to verify that the borrower is employed. We usually require lower
combined loan-to-value ratios with respect to loans made under programs other
than the full documentation program.
We assess a borrower's credit-worthiness primarily based on the borrower's
mortgage history and credit score, and we generally adjust our pricing and
loan-to-value ratios based on many other risk parameters. Our borrowers often
have either (a) mortgage or other credit delinquencies, (b) problems providing
documentation required by traditional lenders, and/or (c) collateral types that
traditional lenders will not lend against. Qualification for a loan is based
primarily upon our risk-based pricing model and guidelines, which we have
developed over our 22 year history and our extensive database of prior loan
performance. Because there are compelling circumstances with some borrowers, we
employ experienced non-conforming mortgage loan credit underwriters to review
the applicant's credit profile and to evaluate whether an impaired credit
history is a result of adverse circumstances or a continuing inability or
unwillingness to meet credit obligations in a timely manner. An applicant's
credit record will often be impaired by personal circumstances, including
divorce, family illnesses or deaths and temporary job loss due to layoffs and
corporate downsizing.
As part of our settlement agreements with New York State regulators -
i.e., the Remediation Agreement and Stipulated Order on Consent - we agreed to
modify certain aspects of our underwriting guidelines. These agreements expired
in September 2002; however, we are voluntarily abiding by these underwriting
guidelines and intend to continue to originate loans in accordance with these
agreements in the foreseeable future.
We have a staff of 49 underwriters with an average of 10 years of
non-conforming lending experience and five years working for us. All
underwriting functions for broker originations are conducted in our Woodbury,
New York headquarters and our Cincinnati, Ohio underwriting office. All
underwriting functions for retail originations are conducted in our retail
underwriting "hub," located in Cincinnati, Ohio, our Phoenix, Arizona
origination center and our Woodbury, New York headquarters. We do not delegate
underwriting authority to any third party. Our underwriting department functions
independently of our business development and sales departments and does not
report to any individual directly involved in the sales origination process.
None of our underwriters are compensated on an incentive or commission basis.
Our underwriters are trained to review all components of the loan to determine
its compliance with our underwriting guidelines.
We have instituted underwriting internal controls that are designed to
ensure that loans are generally reviewed and approved by a minimum of two
underwriters. The underwriting department employs underwriters with different
levels of experience and authority. Loans generally must receive a secondary
review by an underwriter of equal or higher rank. Although the most senior
underwriters do not require a secondary review in some circumstances, the
14
vast majority of our loans are reviewed by at least two underwriters. Similarly,
maximum loan amount and loan-to-value approval authorities are assigned to each
level, ensuring that loans at the highest dollar or LTV-limits we offer are
reviewed and approved only by the underwriting department's most senior members.
Appraisals and Quality Control. We underwrite every loan submitted by
thoroughly reviewing credit and by performing the following:
o a separate appraisal review conducted by our underwriter and/or
appraisal review department on appraisals that were not centrally
ordered by us; and
o a full compliance review, to ensure that all documents have been
properly prepared, all applicable disclosures given in a timely
fashion, and proper compliance with all federal and state
regulations.
We require appraisals to be performed by third-party, fee-based appraisers
or by our approved appraisers and to conform generally to current Fannie Mae and
Freddie Mac secondary market requirements for residential property appraisals.
Each appraisal includes, among other things, an inspection of both the exterior
and interior of the subject property and data from sales within the preceding 12
months of similar properties within the same general location as the subject
property. We perform an appraisal review on each loan prior to closing on
appraisals that were not centrally ordered by us. We do not believe that the
general quality control practices of many conventional mortgage lenders, which
is to perform only drive-by appraisals after closings, provides sufficient
protection for non-centrally ordered appraisals. As such, in addition to
reviewing each of these appraisals for accuracy, we access alternate sources to
validate sales used in the appraisals to determine market value. These sources
include:
o Multiple Listing Services;
o assessment and sales services, such as Comps, Inc., Pace, 1st
American and Transamerica;
o on-line Internet services such as Realtor.com; and
o other sources for verification, including broker price opinions and
market analyses by local real estate agents.
For quality control purposes, using the criteria that we have developed
over time, we actively track and grade all appraisers from whom we accept
appraisals. We do not accept work from appraisers who have not conformed to our
review standards.
After completing the underwriting and processing of a brokered loan, we
schedule the closing of the loan with an approved closing attorney or settlement
agent. We hold the closing attorney or settlement agent responsible for
completing the loan closing transaction in accordance with applicable law and
our operating procedures. We also require title insurance that insures our
interest as a lender, and evidence of adequate homeowner's insurance naming us
or our servicing agent as an additional insured party on all loans.
We perform a post-funding quality control review to monitor and evaluate
our loan origination policies and procedures. The quality control department is
separate from the underwriting department and reports directly to a member of
senior management.
Our quality control department samples at least 10% of all loan
originations and performs a full quality control re-underwriting and review, the
results of which are reported to senior management on a quarterly basis. On a
daily basis, should the need arise, the manager of quality control underwriting
will notify senior management of any critical loan findings. The sample of loans
reviewed are selected in the following manner:
o all early default payments and customer complaints;
o at least 5% of the loans reviewed are selected on a random basis;
and
o targets, which may be based on sources of business (both internal
branches/teams and external brokers, areas or other third parties)
or products (perceived riskier products and newly offered products).
If any discrepancies are discovered during the review process, a senior
quality control underwriter re-reviews the loan and proceeds with any necessary
follow-up actions. Discrepancies noted by the review are analyzed and corrective
actions are instituted. A typical quality control underwriting review currently
includes:
o obtaining a new verification of value and/or photo for each
property;
o re-verifying the credit report;
o reviewing loan applications for completeness, signature, and
consistency with other processing documents;
o obtaining new written and/or verbal verification of income and
employment from employer;
15
o obtaining new written and/or verbal verification of mortgage to
re-verify any outstanding mortgages, if necessary; and
o analyzing the underwriting and program selection decisions.
We update the quality control process from time to time as our policies
and procedures change.
Click & Close(R). Click & Close ("C&C") is a proprietary web-based system
that we developed internally to streamline and integrate our origination
process. Click & Close, or C&C, opens an online channel of communications
between us, brokers, borrowers and a wide range of other mortgage information
sources. We currently use C&C to automate and facilitate many of our origination
processes, including but not limited to:
o logging in and tracking applications in our retail and wholesale
channels;
o increasing the amount of internal loan origination processes that
can be handled electronically, which reduces paper flow between
account managers, loan processors and underwriters and allows us to
become more paperless;
o generating pre-approvals utilizing our risk-based pricing model;
o generating stipulation sheets, preliminary disclosures and other
documents; and
o easy, real time supervisory oversight to ensure all applications are
being worked on in a timely manner.
We are continuing to improve C&C to further streamline our processes and
to reduce the paper flow required throughout the mortgage origination process.
Our goal is to become paperless and, ultimately, lower our cost to originate.
LOAN SECURITIZATIONS AND SALES
We securitize or sell virtually all of the mortgage loans we originate. As
a fundamental part of our present business and financing strategy, we securitize
almost all of our mortgage loans. We may also choose to sell a small number of
our loans as whole loans when we believe that market conditions present an
opportunity to achieve a better return through such sales. In 2003,
securitizations and whole loan sales comprised approximately 97% and 3%,
respectively, of our loan sales.
Securitizations. During 2003, we issued four securitizations totaling $1.6
billion in collateral, of which we delivered a total of $1.5 billion of mortgage
loans during 2003. We delivered the remaining $114 million of mortgage loans in
January 2004 using a pre-funding feature. All of our 2003 securitizations
received ratings on various classes of securities ranging from AAA/Aaa to
BBB-/Baa3 by S&P, Fitch and Moody's, respectively. The following table sets
forth information with respect to our 2003 securitizations by offering size,
which includes pre-funded amounts, duration weighted average pass-through rate
and type of credit enhancement.
INITIAL DURATION
OFFERING SIZE COLLATERAL WEIGHTED AVERAGE CREDIT
SECURITIZATION ISSUED (MILLIONS) (MILLIONS) PASS-THROUGH RATE ENHANCEMENT
-------------- ------ ---------- ---------- ----------------- -----------
2003-1......... 03/27/03 $258.6 $263.1 2.40% Senior/Sub
2003-2......... 06/26/03 $393.0 $400.0 2.19% Senior/Sub
2003-3......... 09/30/03 $434.7 $440.0 1.83% Senior/Sub
2003-4......... 12/29/03 $470.0 $475.0 2.13% Senior/Sub
Whole Loan Sales Without Recourse. We have found that, from time to time,
we can receive better economic results by selling some of our mortgage loans on
a whole loan basis, without retaining servicing rights, generally in private
transactions to financial institutions or consumer finance companies. We
recognize a gain or loss when we sell loans on a whole loan basis equal to the
difference between the cash proceeds received for the loans and our investment
in the loans, including any unamortized loan origination fees and costs. We
generally sell these loans without recourse, except that we provide standard
representations and warranties to the purchasers of such loans. In 2003 and
2002, we sold whole loans without recourse on a servicing-released basis of
$42.4 million and $103.0 million, respectively.
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LOAN SERVICING
Prior to May 2001, we serviced substantially all of the loans that we
originated and purchased since our inception in 1982.
In January 2001, we entered into an agreement with Ocwen to transfer our
servicing portfolio to it. In May 2001, we physically transferred our entire
servicing portfolio to Ocwen, and laid-off our servicing staff. We no longer
service loans nor do we have a servicing operation. We do, however, maintain
several employees to assist third parties with delinquent and defaulted loans,
as well as portfolio retention. Currently, Ocwen services our loans while in
inventory pending securitization or whole loan sale. We make the determination
to have either Ocwen or other similar servicers service the loans at the time we
securitize our mortgage loans. If we choose a servicer other than Ocwen, then
Ocwen will, on our behalf, transfer the mortgage loans electronically to the
other servicer. We anticipate that a servicing transfer can be completed within
45 days following the close of the securitization. We will continue to make
on-going determinations as to who the servicer will be on each of our
securitizations.
COMPETITION
As an originator of mortgage loans, we face intense competition, primarily
from diversified consumer financial companies and other diversified financial
institutions, mortgage banking companies, commercial banks, credit unions,
savings and loans, mortgage REITs and finance companies. Many of these
competitors in the financial services business are substantially larger, have
more capital and substantially greater resources than we do, a lower cost of
funds and a more established market presence that we have. In addition, we have
experienced increased competition over the Internet, where barriers to entry are
relatively low. Competition can take many forms, including interest rates and
costs of the loan, less stringent underwriting standards, convenience in
obtaining a loan, customer service, amount and term of a loan and marketing and
distribution channels. Furthermore, the level of gains realized by us and our
competitors on the sale of the type of loans originated has attracted additional
competitors into this market, which has lowered the gains that may be realized
by us on future loan sales. In addition, efficiencies in the asset-backed market
have generally created a desire for even larger transactions, giving companies
with greater volumes of originations a competitive advantage, including a
pricing advantage.
If our competitors increase their marketing efforts to include our target
market of borrowers, we may be forced to reduce the rates and fees we currently
charge in order to maintain and expand our market share. Any reduction in our
rates or fees could reduce our profitability and harm our business.
Over the past several years, many larger finance companies, financial
institutions and conforming mortgage originators have adapted their conforming
origination programs and allocated resources to the origination of
non-conforming loans. Some of these companies have begun to offer products
similar to those offered by us to customers in our target market. For example,
the government-sponsored entities, Fannie Mae and Freddie Mac, have begun to
adapt some of their programs to include some products similar to those offered
by us, and have begun to expand their presence into the non-conforming market.
These government-sponsored entities have a size and cost-of-funds advantage that
allows them to purchase loans with lower rates or fees than we are willing to
offer. A material expansion of their involvement in the market to purchase
subprime loans could change the dynamics of the industry in which we operate in
ways adverse to us by virtue of their size, pricing power and the inherent
advantages of a government charter. In addition, if as a result of their
purchasing practices, these government-sponsored entities experience
higher-than-expected losses, overall investor perception of the subprime
mortgage industry may suffer. The entrance of these government-sponsored
entities and other larger and better-capitalized competitors into our market may
reduce our market share and/or our overall level of loan originations.
We depend primarily on independent mortgage brokers for the origination of
our wholesale mortgage loans, which constitute the majority of our loan
production. These independent mortgage brokers have relationships with multiple
lenders and are not obligated by contract or otherwise to do business with us.
We compete with these lenders for the independent brokers' business on the basis
of pricing, service, loan fees, costs and other factors. Competition from other
lenders could negatively affect the volume and pricing of our wholesale loans,
which could reduce our loan production.
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REGULATION
We must comply with the laws and regulations, as well as judicial and
administrative decisions, in all of the jurisdictions in which we are licensed
to originate mortgage loans, as well as an extensive body of federal law and
regulations. Our business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities. Our consumer
lending activities are subject to, among other laws and regulations, the
following:
o the Federal Truth-in-Lending Act and Regulation Z (including the
Home Ownership and Equity Protection Act of 1994);
o the Equal Credit Opportunity Act of 1974, as amended (ECOA);
o the Fair Credit Reporting Act of 1970, as amended;
o the Real Estate Settlement Procedures Act (RESPA), and Regulation X;
o the Home Mortgage Disclosure Act;
o the Federal Debt Collection Practices Act; and
o other federal, state and local statutes and regulations affecting
our activities.
We also are subject to the rules and regulations of, and examinations by,
the Department of Housing and Urban Development ("HUD") and state regulatory
authorities with respect to originating, processing and underwriting loans (and
servicing loans prior to May 2001). These rules and regulations, among other
things:
o impose licensing obligations on us;
o establish eligibility criteria for mortgage loans;
o prohibit discrimination;
o provide for inspections and appraisals of properties;
o require credit reports on loan applicants;
o regulate assessment, collection, foreclosure and claims handling,
investment and interest payments on escrow balances and payment
features;
o mandate specified disclosures and notices to borrowers; and
o in some cases, fix maximum interest rates, fees and mortgage loan
amounts.
Failure to comply with these requirements can lead to, among other things,
loss of approved status, demands for indemnification or mortgage loan
repurchases, rights of rescission for mortgage loans, class action and other
lawsuits, and administrative enforcement actions.
Several states and local municipalities have recently enacted so-called
"high cost" mortgage laws and/or regulations. While many of these laws and
regulations contain some provisions that are similar to one another, there are a
variety of provisions that vary from state to state and municipality to
municipality, which has significantly increased the costs of compliance. In
addition, dozens of other state and local laws and regulations are currently
under consideration, with more likely to be proposed in the foreseeable future,
that are intended to further regulate our industry. Many of these laws and
regulations seek to impose broad restrictions on a number of commonly accepted
lending practices, including some of our practices. There can be no assurance
that these proposed laws, rules and regulations, or other similar laws, rules or
regulations, will not be adopted in the future. Adoption of these laws, rules
and regulations could harm our business by:
o substantially increasing the costs of compliance with a variety of
potentially inconsistent federal, state and local laws;
o substantially increasing the risk of litigation or administrative
action associated with complying with these proposed federal, state
and local laws, particularly those aspects of such proposed laws
that contain subjective, as opposed to objective, requirements;
18
o restricting our ability to charge rates and fees adequate to
compensate us for the risk associated with a portion of our loans;
or
o if the law, rule or regulation is too onerous, potentially limiting
our ability or willingness to operate in a particular geographic
area.
There are also several potential federal bills being proposed, at least
one of which may provide for federal preemption over these existing and proposed
state and local laws and regulations. There can be no assurance that any federal
law will be passed addressing this matter, or that, if passed, it will contain a
provision that preempts these state and local laws and regulations.
o In July 2003, regulations adopted by the Office of Thrift
Supervision became effective. These regulations eliminated the
ability of state-chartered financial institutions and bankers to
charge prepayment penalties on alternative mortgages under the
Federal Alternative Mortgage Transactions Parity Act, while
federally-regulated entities still enjoy that right. As a result,
these regulations provide a competitive disadvantage for
state-chartered entities, such as our company, in certain states
with respect to alternative mortgages.
In September 1999, we settled allegations by the New York State Banking
Department, or the NYSBD, and a lawsuit by the New York State Office of the
Attorney General, or the NYOAG, alleging that we had violated various state and
federal lending laws. The global settlement was evidenced by (a) a Remediation
Agreement by and between our subsidiary, Delta Funding, and the NYSBD, dated as
of September 17, 1999 and (b) a Stipulated Order on Consent by and among Delta
Funding, us and the NYOAG, dated as of September 17, 1999. As part of the
settlement, among other things, we agreed to the following:
o we have implemented agreed upon changes to our lending practices;
o we are providing reduced loan payments aggregating $7.25 million to
a group of borrowers identified by the NYSBD; and
o we created a fund managed by the NYSBD and financed by the grant of
525,000 shares of our common stock.
Each month, on behalf of borrowers designated by the NYSBD, we make
subsidy payments to the related securitization trusts. These subsidy payments
fund the difference between the original loan payments and the reduced loan
payments. As part of the Second Exchange Offer we completed in August 2001 (see
Note 2 "Summary of Regulatory Settlement" and Note 3 "Corporate Restructuring,
Debt Modification and Debt Restructuring" to Notes to the Consolidated Financial
Statements), the LLC is obligated to satisfy these payment subsidies out of the
cash flows generated by the mortgage related securities it owns. If the LLC's
cash flows are insufficient to pay this obligation, we remain responsible to
satisfy our obligations under the Remediation Agreement.
The proceeds of the stock fund will be used to pay borrowers and to
finance a variety of consumer educational and counseling programs. We do not
manage the fund created for this purpose. The number of shares of common stock
deposited in the fund does not adjust to account for fluctuations in the market
price of our common stock. Changes to the market price of these shares of common
stock deposited in the fund do not have any impact on our financial statements.
We did not make any additional financial commitments between the settlement date
and March 2000, or at any time thereafter. The Stipulated Order on Consent and
the Remediation Agreement both expired by their terms in September 2002. We
remain obligated as discussed above to continue to make subsidy payments on
behalf of borrowers identified by the NYSBD for so long as these borrowers
continue to make payments under the applicable mortgage loans.
We believe that we are in compliance in all material respects with
applicable federal and state laws and regulations.
ENVIRONMENTAL MATTERS
To date, we have not been required to perform any environmental
investigation or clean-up activities, nor have we been subject to any
environmental claims. There can be no assurance, however, that this will remain
the case in the future. Although we primarily lend to owners of residential
properties, in the course of our business, we may acquire properties securing
loans that are in default. There is a risk that we could be required to
investigate and clean-up hazardous or toxic substances or chemical releases at
these properties, and may be held liable to a
19
governmental entity or to third parties for property damage, personal injury and
investigation and clean-up costs incurred in connection with the contamination.
In addition, the owner or former owners of a contaminated site may be subject to
common law claims by third-parties based on damages and costs resulting from
environmental contamination emanating from the property.
EMPLOYEES
As of December 31, 2003, we had a total of 912 employees (including both
full-time and part-time employees). None of our employees are covered by a
collective bargaining agreement. We consider our relations with our employees to
be good.
ITEM 2. PROPERTIES
Our executive and administrative offices are located at 1000 Woodbury
Road, Woodbury, New York 11797, where we lease approximately 107,000 square feet
of office space at an aggregate annual rent of approximately $2.3 million. The
lease provides for certain scheduled rent increases and expires in 2009.
We also maintain business development offices in New Jersey, Ohio,
Pennsylvania and Virginia. Our retail operation currently maintains four retail
call centers in Woodbury, New York, Pittsburgh, Pennsylvania, Charlotte, North
Carolina and Phoenix, Arizona, and seven retail mortgage origination offices in
Illinois, Missouri, Ohio (2), Pennsylvania, Tennessee and Kansas. We also
maintain one telemarketing hub and one underwriting hub in Ohio. The terms of
these leases vary as to duration and rent escalation provisions, with the latest
expiring in 2009.
ITEM 3. LEGAL PROCEEDINGS
Because the nature of our business involves the collection of numerous
accounts, the validity of liens and compliance with various state and federal
lending laws, we are subject, in the normal course of business, to numerous
claims and legal proceedings, including class actions. The current status of
these class actions and other litigation is summarized below.
o In or about November 1998, we received notice that we had been named
in a lawsuit filed in the United States District Court for the
Eastern District of New York. In December 1998, the plaintiffs filed
an amended complaint alleging that we had violated the Home
Ownership and Equity Protection Act, or HOEPA, the Truth in Lending
Act, or TILA, and Section 349 of the New York State General Business
Law, which relates to consumer protection for deceptive practices.
The complaint sought (a) certification of a class of plaintiffs, (b)
declaratory judgment permitting rescission, (c) unspecified actual,
statutory, treble and punitive damages, including attorneys' fees,
(d) injunctive relief and (e) declaratory judgment declaring the
loan transactions as void and unconscionable. On December 7, 1998,
plaintiff filed a motion seeking a temporary restraining order and
preliminary injunction, enjoining us from conducting foreclosure
sales on 11 properties. The District Court Judge ruled that in order
to consider the motion, plaintiff must move to intervene on behalf
of these 11 borrowers. Thereafter, plaintiff moved to intervene on
behalf of three of these 11 borrowers and sought injunctive relief
on their behalf. We opposed the motions. On December 14, 1998, the
District Court Judge granted the motion to intervene and on December
23, 1998, the District Court Judge issued a preliminary injunction
that enjoined us from proceeding with the foreclosure sales of the
three interveners' properties. We filed a motion for reconsideration
of the December 23, 1998 order. In January 1999, we filed an answer
to plaintiffs' first amended complaint. In July 1999, the plaintiffs
were granted leave, on consent, to file a second amended complaint.
In August 1999, the plaintiffs filed a second amended complaint
that, among other things, added additional parties but contained the
same causes of action alleged in the first amended complaint. In
September 1999, we filed a motion to dismiss the complaint, which
was opposed by plaintiffs and, in June 2000, was denied in part and
granted in part by the Court. In or about October 1999, plaintiffs
filed a motion seeking an order preventing us, our attorneys and/or
the NYSBD from issuing notices to a number of our borrowers, in
accordance with the settlement agreement entered into by and between
the NYSBD and us. In or about October 1999 and November 1999,
respectively, the NYSBD and our company submitted opposition to
plaintiffs' motion. In March 2000, the Court issued an order that
permitted us to issue an approved form of the notice. In September
1999, the plaintiffs filed a motion for class certification, which
we opposed in February 2000, and which was ultimately withdrawn
without prejudice by the plaintiffs in January 2001. In February
2002, we executed a settlement agreement with the plaintiffs, under
which we denied all wrongdoing, but agreed to resolve the litigation
on a class-wide basis. The Court preliminarily approved the
settlement and a
20
fairness hearing was held in May 2002. We are awaiting a decision
from the Court on the fairness hearing. We believe that the Court
will approve the settlement, but if it does not, we believe that we
have meritorious defenses and intend to defend this suit, but cannot
estimate with any certainty our ultimate legal or financial
liability, if any, with respect to the alleged claims.
o In or about March 1999, we received notice that we had been named in
a lawsuit filed in the Supreme Court of the State of New York, New
York County, alleging that we had improperly charged certain
borrowers processing fees. The complaint sought: (a) certification
of a class of plaintiffs, (b) an accounting and (c) unspecified
compensatory and punitive damages, including attorneys' fees, based
upon alleged (i) unjust enrichment, (ii) fraud and (iii) deceptive
trade practices. In April 1999, we filed an answer to the complaint.
In September 1999, we filed a motion to dismiss the complaint, which
was opposed by the plaintiffs, and in February 2000, the Court
denied the motion to dismiss. In April 1999, we filed a motion to
change venue and the plaintiffs opposed the motion. In July 1999,
the Court denied the motion. We appealed, and in March 2000, the
Appellate Court granted our appeal to change venue from New York
County to Nassau County. In August 1999, the plaintiffs filed a
motion for class certification, which we opposed in July 2000. In or
about September 2000, the Appellate Court granted the plaintiffs'
motion for class certification, from which we appealed. The
Appellate Court denied our appeal in December 2001. In or about June
2001, we filed a motion for summary judgment to dismiss the
complaint, which was denied by the Court in October 2001. We
appealed that decision, but the Appellate Court denied our appeal in
November 2002. We filed a motion to reargue in December 2002, which
was denied by the Appellate Court in January 2003. Discovery will
now continue in the lower Court. We believe that we have meritorious
defenses and intend to defend this suit, but cannot estimate with
any certainty our ultimate legal or financial liability, if any,
with respect to the alleged claims.
o In July 2003, we commenced a lawsuit in the Supreme Court of the
State of New York, Nassau County, against the LLC, Delta Funding
Residual Management, Inc., or DFRM, and James E. Morrison, President
of the LLC and DFRM, alleging that (1) the LLC breached its
contractual duties by failing to pay approximately $142,000 due to
us in June 2003, and (2) that Mr. Morrison and DFRM knowingly and
intentionally caused the default, thereby breaching their respective
fiduciary duties to the LLC. The complaint seeks: (a) payment of
amounts past due under our agreement with the LLC, plus interest;
(b) specific performance of the LLC's obligations to us in the
future; and (c) monetary damages for breach of fiduciary duty, in an
amount to be determined by the Court. In September 2003, Morrison,
the LLC and DFRM filed a motion to dismiss our complaint and the LLC
and DFRM filed a countersuit in the Supreme Court of the State of
New York, New York County, against several of our directors and
officers and us seeking, among other things, damages of not less
than $110 million. The counterclaim alleges misrepresentation,
negligence and/or fraud by defendants in that case relating to our
Second Exchange Offer in 2001. In October 2003, we filed our
opposition to the motion to dismiss and cross-moved to consolidate
the two actions in Nassau County. In November 2003, we answered in
the New York County action. In February 2004, the Nassau County
Court denied Morrison's motion to dismiss our causes of action
seeking (a) payment of amounts due under our agreements with the LLC
and (b) monetary damages for breach of fiduciary duty, and granted
Morrison's motion to dismiss our cause of action seeking specific
performance to preclude future defaults by Morrison and the LLC. The
Court also granted our motion to consolidate the cases in Nassau
County. We believe we have meritorious claims in our lawsuit and
meritorious defenses in the countersuit. We intend to vigorously
prosecute our claims and vigorously defend ourselves against the
countersuit. We cannot estimate with any certainty our ultimate
legal or financial recovery and/or liability, if any, with respect
to the alleged claims in the countersuit.
o In or about December 2003, we received notice that we had been named
in a two lawsuits filed by the same plaintiff in the Circuit Court,
Third Judicial Circuit in Madison County, Illinois. One alleged that
we had improperly charged certain borrowers fax fees, and one
alleged that we improperly retained extra per diem interest when
loans were satisfied. The complaints seek: (a) certification of a
class of plaintiffs; (b) direction to return fax fees charged to
borrowers; (c) unspecified compensatory and statutory damages,
including pre-judgment and post judgment interest and attorneys'
fees, based upon alleged: (1) breach of contract, (2) statutory
fraud, and (3) unjust enrichment. In February 2004, we filed a
motion to dismiss the case pertaining to fax fees claims, and in
March 2004 we filed a motion to dismiss the case pertaining to per
diem interest claims. The plaintiffs have not yet responded to the
motions. We believe that we have meritorious defenses and intend to
vigorously defend these suits, but cannot estimate with any
certainty our ultimate legal or financial liability, if any, with
respect to the alleged claims.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PRICE RANGE OF COMMON STOCK
Our common stock trades on the American Stock Exchange (the "AMEX") under
the symbol "DFC". The following table sets forth for the periods indicated the
range of the high and low closing sales prices for our common stock.
2003 HIGH LOW
---- ----- -----
First Quarter ............................ $2.18 $1.15
Second Quarter ........................... 8.15 2.10
Third Quarter ............................ 9.39 5.18
Fourth Quarter ........................... 7.82 6.29
2002 HIGH LOW
---- ----- -----
First Quarter ............................ $1.54 $0.85
Second Quarter ........................... 2.76 0.91
Third Quarter ............................ 2.74 1.65
Fourth Quarter ........................... 1.50 0.95
In 2002 and through May 2003, our common stock araded on the OTC Bulletin
Board under the ticker symbol "DLTO." In May 2003, our common stock was listed
on the AMEX.
On March 29, 2004, we had approximately 176 stockholders of record. This
number does not include beneficial owners holding shares through nominee or
"street" names. We believe the number of beneficial stockholders is
approximately 2,400.
DIVIDEND POLICY
We paid $1.4 million in dividends on our Series A Preferred Stock in 2003
and did not pay any common stock dividends in 2003. Under the terms of our
Certificate of Designations for our Series A preferred stock, we began paying
dividends to holders of our Series A preferred stock in June 2003, and we are
limited in our ability to pay dividends to holders of our common stock. In
connection with our financing plans for 2004, we intend to use $13.9 million of
any such future offering proceeds to redeem all of our Series A Preferred Stock.
Following such a redemption, we will consider whether it is advisable to begin
paying dividends to the holders of our common stock.
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SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table sets forth information about the shares of common
stock issuable under our equity compensation plans at December 31, 2003:
EQUITY COMPENSATION PLAN INFORMATION
- ----------------------------------------------------------------------------------------------------------------------------------
PLAN CATEGORY NUMBER OF SECURITIES TO BE WEIGHTED-AVERAGE NUMBER OF SECURITIES REMAINING
ISSUED UPON EXERCISE OF EXERCISE PRICE OF AVAILABLE FOR FUTURE ISSUANCE
OUTSTANDING OPTIONS OUTSTANDING OPTIONS UNDER EQUITY COMPENSATION
PLANS (1)
- ----------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans
approved by security holders 2,236,950 $ 2.00 1,463,050
Equity compensation plans not
approved by security holders n/a n/a n/a
Total 2,236,950 $ 2.00 1,463,050
- --------------------
(1) Excluding securities reflected in the first column.
RECENT SALES OF UNREGISTERED SECURITIES
In the year ended December 31, 2003, we issued 862,403 shares of our
common stock upon the exercise of certain warrants originally issued in 2001.
The shares were issued pursuant to the exemption provided by Regulation D under
the Securities Act of 1933, as amended. The exercise price of each warrant was
$.01 per share.
23
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
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2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Statement of Operations Data: (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenues:
Net gain on sale of mortgage loans ......... $ 94,782 $ 57,974 $ 38,326 $ 52,574 $ 86,466
Interest income ............................ 12,418 11,803 11,158 15,594 19,127
Excess cashflow certificate income ......... 2,323 1,973 11,774 32,554 18,214
Impairment of excess cashflow certificates . -- (2,085) (19,676) (15,861) (6,300)
Gain (loss) on sale of excess cashflow certs 220 -- (25,402) -- --
Servicing fees ............................. -- -- 2,983 14,191 16,341
Other income ............................... 425 1,281 188 3,069 768
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Total revenues ........................ 110,168 70,946 19,351 102,121 134,616
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Expenses
Payroll and related costs .................. 39,147 27,120 29,867 40,363 45,881
Interest expense ........................... 5,509 5,273 16,132 30,386 26,656
General and administrative ................. 23,460 22,685 48,333 44,378 54,350
Capitalized mortgage servicing impairment .. -- -- -- 38,237 --
Restructuring and other special charges .... -- -- 2,678 11,382 --
Extinguishment of debt ..................... -- -- 19,255 -- --
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Total expenses ....................... 68,116 55,078 116,265 164,746 126,887
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Income (loss) before income tax expense (benefit) 42,052 15,868 (96,914) (62,625) 7,729
Provision for income tax expense (benefit) ..... (25,354) (1,769) 2,876 (13,208) 3,053
----------------------------------------------------------------------------
Net income (loss) ............................ $ 67,406 $ 17,637 $ (99,790) $ (49,417) $ 4,676
----------------------------------------------------------------------------
BASIC EARNINGS PER SHARE:
Net income (loss) per share ...................... $ 4.05 $ 1.11 $ (6.28) $ (3.11) $ 0.30
DILUTED EARNINGS PER SHARE(1):
Net income (loss) per share ...................... $ 3.59 $ 1.04 $ (6.28) $ (3.11) $ 0.30
Basic weighted average number of
shares outstanding ................... 16,308,561 15,894,913 15,883,749 15,883,749 15,511,214
Diluted weighted average number of
shares outstanding ................... 18,407,249 16,971,028 15,883,749 15,883,749 15,512,457
Selected Balance Sheet Data:
Loans held for sale, net ....................... $ 190,801 $ 33,984 $ 94,407 $ 82,698 $ 89,036
Capitalized mortgage servicing rights .......... -- -- -- -- 45,927
Excess cashflow certificates, net .............. 19,853 24,565 16,765 216,907 224,659
Total assets ................................... 256,991 73,544 133,806 452,697 556,835
Warehouse financing ............................ 144,826 13,757 80,877 74,935 94,688
Senior notes ................................... -- 10,844 10,844 149,571 149,474
Investor payable ............................... -- -- -- 69,489 82,204
Total liabilities .............................. 161,038 44,047 121,956 354,973 409,694
Stockholders' equity ........................... $ 95,953 $ 29,497 $ 11,850 $ 97,724 $ 147,141
(1) For 2001 and 2000, stock options of approximately 23,000 and 37,000,
respectively, are excluded from the calculation of diluted earnings per
share because their effect is antidilutive in periods where losses are
reported.
24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with our Consolidated
Financial Statements and accompanying Notes to Consolidated Financial Statements
set forth therein. Please see "Information Regarding Forward-Looking
Statements."
GENERAL
We are a specialty consumer finance company that originates, securitizes
and sells (and, prior to May 2001, serviced) non-conforming mortgage loans. Our
loans are primarily secured by first mortgages on one- to four-family
residential properties. Throughout our 22-year operating history, we have
focused on lending to individuals who generally do not satisfy the credit,
documentation or other underwriting standards set by more traditional sources of
mortgage credit, including those entities that make loans in compliance with
conventional mortgage lending guidelines established by Fannie Mae and Freddie
Mac. We make loans to these borrowers for purposes such as debt consolidation,
refinancing, education and home improvements.
Our mortgage business has two principal components. First, we make
mortgage loans to individual borrowers, which is a cash and expense outlay for
us, because our cost to originate a loan exceeds the fees we collect at the time
we originate the loan. At the time we originate a loan, and prior to the time we
securitize or sell the loan, we either finance the loan by borrowing under a
warehouse line of credit or self-fund it. Second, we securitize loans and sell
loans on a whole loan basis, and use the net proceeds from these transactions to
repay our warehouse lines of credit and for working capital. We traditionally
have structured our securitizations as sales, which requires us to record cash
and non-cash revenues as gain on sale at the time the transactions are
completed. We began structuring our securitizations as financings in 2004, which
requires us to record revenues from these transactions over time. When we sell
whole loans, we record the premiums received upon sale as revenue.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
Excess cashflow certificates. Our excess cashflow certificates primarily
consist of the right to receive the future excess cash flows from pools of
securitized mortgage loans, in securitizations structured as off-balance sheet
sales. These future excess cash flows generally consist of:
o the positive difference between the interest paid on the underlying
mortgage loans and the interest paid on the pass-through
certificates sold to investors in the securitization which, when we
sell net interest margin ("NIM") notes - in a simultaneous
transaction to the underlying securitization - is only received
after the NIM notes are paid in full;
o in most of our securitizations, prepayment penalties received from
borrowers who pay off their loans generally within the first few
years of their lives (which, when we sell NIM notes, is only
received after the NIM notes are paid in full); and
o additional mortgage loans pledged as collateral in excess of the
principal amount of certificates issued and outstanding; the
"overcollateralization", or "O/C", is designed to provide additional
assurance that the securities sold in the securitization will be
paid according to their terms (and which we describe in greater
detail under "-Securitizations").
The excess cash flows we receive are highly dependent upon the interest
rate environment, because "basis risk" exists between the securitization trust's
assets and liabilities. For example, in each of the securitizations that we
issued since 2002, the interest cost of the pass-through certificates sold to
investors is indexed against one-month LIBOR. As a result, each month, the
interest rate received by the pass-through certificate holders from the
securitization trust may adjust upwards or downwards as one-month LIBOR changes
(liability) - while the majority of the underlying mortgage loans in the
securitization trust have a fixed note rate for at least two to three years
(asset). As a result, as rates rise and fall, the amount of our excess cash
flows will fall and rise, respectively, which in turn will increase or decrease
the value of our excess cashflow certificates. Although we are not currently
acquiring new excess cashflow certificates, we retain those that we acquired
before we began to structure our securitizations as financings in 2004.
In each of our securitizations in which we sold NIM note(s), we purchased
an interest rate cap, which helps mitigate the basis risk for the approximate
time that the NIM notes are anticipated to be outstanding.
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The accounting estimates we use to value excess cashflow certificates are
a "critical accounting estimate" because they can materially affect our net
income. The valuation of our excess cashflow certificates requires us to
forecast interest rates, mortgage principal payments, prepayments and loan loss
assumptions, each of which is highly uncertain and requires a large degree of
judgment. The rate used to discount the projected cash flows is also critical in
the valuation of our excess cashflow certificates. Management uses internal,
historical mortgage loan performance data and published forward LIBOR curves to
value future expected excess cash flows. We believe that the value of our excess
cashflow certificates is fair, but can provide no assurance that future
prepayment and loss experience, changes in LIBOR or changes in their required
market discount rate will not require write-downs of our excess cashflow
certificate asset. We have written down the value of our excess cashflow
certificates in the past. Write-downs would reduce our income in future periods.
A more detailed discussion of our excess cashflow certificates can be found
under "-Excess Cashflow Certificates, Net" below.
Accounting for Hedging Activities. We do not use derivatives to speculate
on interest rates. Rather, we use derivatives in conjunction with planned or
existing balance sheet instruments in such a way as to alter the performance
characteristics of virtually any such instrument. Authorized applications may
(a) offset some or all of the price or income effects of the associated
instrument due to interest rate changes, or (b) be applied with the expectation
that they will serve either to enhance the yield or lower the cost relative to
those that would otherwise be generated. Authorized derivatives are limited to
those that trade with active secondary markets, such as interest rate swaps,
interest rate caps and exchange-traded interest rate futures contracts.
The relevant accounting guidance is the Financial Accounting Standard No.
133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging
Activities." Although this statement became effective in January 2001, its
implementation had no impact for us, because we did not hedge during the years
2002 and 2001. For the year ended December 31, 2003, we recorded a small hedge
gain.
SFAS NO. 133 calls for all derivatives to be recorded on the balance sheet
at market value. When used as hedges, special treatment may be permitted, but
only if a hedging relationship is properly documented and qualifying criteria
are satisfied. For derivative financial instruments not designated as hedging
instruments, all gains or losses, whether realized or unrealized, are recognized
in current period earnings.
Accounting for Income Taxes. Significant management judgment is required
in developing our provision for income taxes, including the determination of
deferred tax assets and liabilities and any valuation allowances that might be
required against the deferred tax asset. As of December 31, 2003, we have not
recorded a valuation allowance on our deferred tax assets based on management's
belief that operating income will more likely than not be sufficient to realize
the benefit of these assets over time. The evaluation of the need for a
valuation allowance takes into consideration our recent earnings history,
current tax position and estimates of taxable income in the near term.
Significant judgment is required in considering the relative impact of
negative and positive evidence related to the ability to realize deferred tax
assets. In the event that actual results differ from these estimates or if our
current trend of positive operating income changes, we may be required to record
a valuation allowance on our deferred tax assets, which could have a material
adverse effect on our consolidated financial condition and results of
operations. We recognize all of our deferred tax assets if we believe, on a more
likely than not basis, that all of the benefits of the carryforward losses and
other deferred tax assets will be realized. Management believes that, based on
the available evidence, it is more likely than not that we will realize the
benefit from our deferred tax assets.
SECURITIZATIONS
Securitizations, whether structured as off-balance sheet sales or
on-balance sheet financings, effectively provide us with a source of long-term
financing.
In a securitization, we pool together loans, typically each quarter, and
sell these loans to a newly-formed securitization trust, which is a qualified
special purpose entity, or QSPE. These trusts are established for the limited
purpose of buying our mortgage loans. We carry no contractual obligation related
to these trusts or the loans sold to them, nor do we have any direct or
contingent liability related to the trusts, except for the standard
representations and warranties typically made as part of a sale of loans on a
non-recourse basis. Furthermore, we provide no guarantees to investors with
respect to cash flow or performance for these trusts.
26
The securitization trust raises cash to purchase the mortgage loans from
us by selling securities to the public. These securities, known as "asset-backed
pass-through securities," are secured, or backed, by the pool of mortgage loans
purchased by the securitization trust from us. These asset-backed securities, or
senior certificates, which are usually purchased by insurance companies, mutual
funds and/or other institutional investors, represent senior interests in the
cash flows from the mortgage loans in the trust.
In our securitizations, the securitization trust issues senior
certificates, which entitle the holders of these senior certificates to receive
the principal collected, including prepayments of principal, on the mortgage
loans in the trust. In addition, holders receive a portion of the interest paid
on the loans in the trust equal to the pass-through interest rate on the
remaining principal balance of the pass-through certificates. Depending upon the
structure, the securitization trust may also issue interest-only certificates,
which entitle the holders to receive payments of interest at a pre-determined
rate over a fixed period of time. The securitization trust also issues a
subordinate certificate or BIO certificate (referred to as an excess cashflow
certificate), and a P certificate. Each month, the P certificate holder is
entitled to receive prepayment penalties received from borrowers who payoff
their loans early.
For any monthly distribution, the holder of an excess cashflow certificate
receives payments only after all required payments have been made on all the
other securities issued by the securitization trust. In addition, before the
holder of the excess cash flow certificate receives payments, cash flows from
the excess cashflow certificates are applied in a "waterfall" manner as follows:
o first, to cover any losses on the mortgage loans in the related
mortgage loan pool, because the excess cashflow certificates are
subordinate in right of payment to all other securities issued by
the securitization trust;
o second, to reimburse the bond insurer, if any, of the related series
of pass-through certificates for amounts paid by or otherwise owing
to that insurer;
o third, to build or maintain the overcollateralization provision
described below for that securitization trust at the required level
by being applied as an accelerated payment of principal to the
holders of the pass-through certificates of the related series;
o fourth, to reimburse holders of the subordinated certificates of the
related series of pass-through certificates for unpaid interest and
for any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates that
was not paid because of the imposition of a cap on their
pass-through rates - these payments are called "basis risk shortfall
amounts."
The overcollateralization provision is a credit enhancement that is
designed to protect the securities sold to the securitization pass-through
investors from credit losses, which arise principally from defaults on the
underlying mortgage loans. In short, overcollateralization occurs when the
amount of collateral (i.e., mortgage loans) owned by a securitization trust
exceeds the aggregate amount of senior pass-through certificates. The O/C is
created to absorb losses that the securitization trust may suffer, as loans are
liquidated at a loss. Historically, we built up the O/C typically over the first
18 to 24 months of a securitization (with the specific timing depending upon the
structure, amount of excess spread, and performance of the securitization), by
utilizing the cash flows from the excess cashflow certificates to make
additional payments of principal to the holders of the pass-through certificates
until the required O/C level was reached. Beginning in our 2002 securitizations,
and in each of our 2003 securitizations, we created the O/C by initially selling
pass-through securities totaling approximately 98.5% of the total amount of
mortgage loans sold to the trust. In doing so, we created the full amount of the
O/C required by the trust at the time we complete the securitization, instead of
over time. For example, if a securitization trust contains collateral of $100
million principal amount of mortgage loans, we sell approximately $98.5 million
in senior pass-through certificates. Prior to our 2002 securitization
transactions, we typically issued pass-through certificates for a par purchase
price, or a slight discount to par - with par representing the aggregate
principal balance of the mortgage loans backing the asset-backed securities. For
example, if a securitization trust contains collateral of $100 million of
mortgage loans, we typically received close to $100 million in proceeds from the
sales of these certificates, depending upon the structure we use for the
securitization.
The O/C is generally expressed as a percentage of the initial mortgage
loan or collateral principal balance sold to the securitization trust. The
required O/C is initially determined by either the rating agencies and/or the
bond insurer, if any, using various factors, including:
o characteristics of the mortgage loans sold to the trust, such as
credit scores and loan-to-value ratios;
27
o the amount of excess spread between the interest rate on the pool of
mortgage loans sold to the securitization trust and the interest
paid to the pass-through certificate holders, less the servicing
fee, and other related expenses such as trustee fees and bond
insurer fees, if any; and
o the structure of the underlying securitization (e.g., issuing BBB-
certificates creates greater credit enhancement in the
securitization transaction, which generally results in a lower O/C).
Our securitizations have typically required an O/C of between 1.05% and
3.0% of the initial mortgage loans sold to the securitization trust. The
required O/C can increase or decrease throughout the life of the transaction
depending upon subordination levels, delinquency and/or loss tests and is
subject to minimums and maximums, as defined by the rating agencies and/or the
bond insurer insuring the securitization. In our securitizations prior to 2002,
after the O/C requirement is reached, the cash flows from the excess cashflow
certificates are then distributed to us as the holder of the excess cashflow
certificates, in accordance with the "waterfall" described above. Over time, if
the cash collected during the periods exceeds the amount necessary to maintain
the required O/C, all other required distributions have been made, and there is
no shortfall in the related required O/C, the excess is paid to us as holder of
the excess cashflow certificate.
Each securitization trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which helps ensure the timely payment of interest and
the ultimate payment of principal of the credit-enhanced investor certificate,
or both. This form of securitization is referred to as a "hybrid". In
"senior-subordinated" structures, the senior certificate holders are protected
from losses by subordinated certificates, which absorb any such losses first. In
addition to this credit enhancement, the excess cash flows that would otherwise
be paid to the holder of the excess cashflow certificate is used when and if it
subsequently becomes necessary to obtain or maintain required
overcollateralization limits. Overcollateralization is used to absorb losses
prior to making a claim on the financial guaranty insurance policy or the
subordinated certificates.
We began utilizing a new securitization structure in 2002, in which we
completed a concurrent net interest margin, or NIM, transaction. In a NIM
transaction, we sell the excess cashflow certificate and P certificate to a NIM
trust, which is also a QSPE. The NIM trust. in turn, issues interest-bearing NIM
note(s) and a NIM owner trust certificate. We sell the excess cashflow
certificate and P certificate without recourse, except that we provide standard
representations and warranties to the NIM trust. One or more investors purchase
the NIM note(s) for a cash price and we receive the net proceeds of the sale of
the note(s), together with the NIM owner trust certificate in consideration of
our selling the excess cashflow certificate and P certificates to the NIM Trust.
The NIM note(s) entitles the holder to be paid a specified interest rate,
and further provides for all cash flows generated by the excess cashflow
certificate and P certificate to be used to pay all principal and interest on
the NIM note(s) until paid in full. This typically occurs approximately 22-25
months from the date the NIM note(s) were issued. The NIM owner trust
certificate entitles us to all cash flows generated by the excess cashflow
certificate and P certificate after the holder of the NIM note(s) has been paid
in full. As such, for securitizations structured as off-balance sheet sales, we
classify the NIM owner trust certificate on our balance sheet as an excess
cashflow certificate and value the NIM owner trust certificate using the same
assumptions that we utilize in valuing excess cashflow certificates.
As part of a NIM transaction, we were required by the rating agencies, and
the NIM structure itself, to "fully fund" the O/C at closing - as opposed to
having it build up over time as we had in past securitizations - which is why we
sold senior pass-through certificates totaling approximately 1.05% to 2.00% less
than the collateral sold to the securitization trust. We use a portion of the
net proceeds we receive from selling NIM note(s) to make up for the difference
between (1) the principal amount of the mortgage loans sold and (2) the proceeds
from selling the senior pass-through certificates.
NIM transactions have enabled us to generate positive upfront cash flow
when we securitized our mortgage loans - i.e., the cash proceeds that we receive
when the securitization and related NIM transaction close, net of funding the
upfront overcollateralization, securitization and NIM costs, exceed our cost to
originate the loans included in the transaction. These transactions have yielded
cash proceeds in amounts comparable to, and in most cases higher than, whole
loan sales.
In the securitizations and related NIM transactions we completed in 2002
and 2003, the underlying securitization was structured as an off-balance sheet
sale under SFAS No. 140. In these transactions, we recorded the net cash
proceeds generated from the sale of the NIM notes as a component of our net gain
on sale of mortgage
28
loans. Under this structure, we also retained, and recorded as a component of
our net gain on sale of mortgage loans, a relatively small excess cashflow
certificate. We recorded this certificate at its estimated fair value, ranging
from 0.0% to 1.0% of the securitized collateral. Conversely, beginning with our
2004 securitizations (in which the securitization will be structured as an
on-balance sheet financing), no gain on sale will be recorded, but rather the
amount of the NIM notes will be recorded as a liability on our balance sheet. In
short, structuring the underlying securitization as either an off-balance sheet
sale or an on-balance sheet financing does not change the overall economics of
the transaction; rather, it changes the timing of income recognition and how it
is recorded on our financial statements in accordance with SFAS No. 140.
However, the use of portfolio-based accounting structures will result in
differences in our future expected results of operations as compared to historic
results.
Off-Balance Sheet Securitizations. Through the end of 2003, we have
structured our securitizations as off-balance sheet transactions. Accordingly,
under SFAS No. 140, we have recorded a gain on sale of mortgage loans upon
completion of each such securitization. For example, in each of the four
securitizations that we issued in 2003, we derived, and recorded as revenue, the
following economic interests:
o we received a cash purchase price from the sale of the NIM note(s)
issued by a NIM trust, to which we sold the excess cashflow
certificates;
o we received a cash purchase price from the sale of interest-only
certificates, which entitle the holders to receive payments of
interest at a pre-determined rate and over a fixed period of time;
o we received a cash premium from selling the right to service the
loans that we securitized. This right entitles the contractual
servicer to service the loans on behalf of the securitization trust,
and earn a contractual servicing fee, and ancillary servicing fees,
including prepayment penalties relating to the servicing rights we
previously sold, in that capacity;
o we retained a NIM owner trust certificate, which entitles us to
receive cash flows generated by the excess cashflow certificates and
the P certificate issued in connection with the securitization after
the holder of the NIM note(s) has been paid in full. Although the
cash flows generated by excess cashflow certificates are received
over time, under GAAP, we must report as income at the time of the
securitization the present value of all projected cash flows we
expect to receive in the future from these excess cashflow
certificates based upon an assumed discount rate. Our valuation of
these excess cashflow certificates is primarily based on:
(1) our estimate of the amount of expected losses or defaults that
will take place on the underlying mortgage loans over the life
of the mortgage loans;
(2) the expected amount of prepayments on the mortgage loans due
to the underlying borrowers of the mortgage loans paying off
their mortgage loans prior to the stated maturity;
(3) the LIBOR forward curve, using current LIBOR as the floor
rate; and
(4) a discount rate.
While we retained an excess cashflow certificate on our $435 million
securitization completed in the quarter ended September 30, 2003 and our $470
million securitization completed in the fourth quarter ended December 31, 2003,
we did not record it as an asset and corresponding revenue item due to the
securitization structure we used to maximize cash revenues. Historically, in our
securitizations, we have sold pass-through certificates with credit ratings from
the rating agencies that were rating the securitization transactions ranging
from AAA to BBB. In our securitization completed in the third quarter of 2003,
we issued a limited principal amount of certificates rated BBB-. This structure
reduced the amount of overcollateralization required, compared to a structure
without a BBB- certificate, because the BBB- certificate replaces credit
enhancement that would have otherwise been achieved solely through
overcollateralization and the corresponding excess cashflow certificate. Had we
not sold a BBB- certificate, the same credit enhancement would have been
produced through a higher overcollateralization, which would have
correspondingly led to a higher valued excess cashflow certificate. The BBB-
certificate made possible a lower upfront overcollateralization than if we did
not sell a BBB- certificate, which, in turn, resulted in our receiving higher
cash proceeds from the securitization, as the senior certificates represent a
larger percentage of the aggregate value of the mortgage loans sold - e.g., a
1.2% O/C results in $98.8 million of certificates being sold against every $100
million of mortgage loans purchased by the securitization trust, whereas a 2.2%
O/C results in $97.8 million of certificates being sold against every $100
million of mortgage loans purchased by the securitization trust (rating agencies
and the securitization structure require us to sell more mortgage loans
(collateral) than the amount of certificates issued). Hence, the lower the
upfront overcollateralization, the greater the upfront cash proceeds received.
As a result of the cash flow needed to pay the interest on and principal amount
of BBB- rated
29
certificates, coupled with less overcollateralization and based upon our gain on
sale assumptions, we ascribed no value to the excess cashflow certificate that
we retained in the securitizations for those two quarters. However, if the loans
underlying these securitization transactions perform better than our
expectations, we will recognize excess cash flows from the excess cashflow
certificates and record the cash and interest income as received. As with all of
our most recent securitization structures, we will not receive excess cash
flows, if any, from the excess cashflow certificate until the NIM note is paid
off in full.
At the time we completed the 2003 securitizations, we recognized as
revenue each of the economic interests described above, which were recorded as
net gain on sale of mortgage loans in our consolidated statement of income.
Our net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate the loans,
adjusted for the following:
o any direct loan origination costs incurred (an increase in the
investment) and loan origination fees received (a decrease in the
investment) in connection with the loans, which are treated as a
component of the initial investment in loans;
o the principal payments received, and the amortization of the net
loan fees or costs, during the period we held the loans prior to
their securitization; and
o any gains (a decrease in the investment) or losses (an increase in
the investment) we incur on any hedging instruments that we may have
utilized to hedge against the effects of changes in interest rates
during the period we hold the loans prior to their securitization
(See "-Hedging").
We allocate our basis in the mortgage loans and excess cashflow
certificates between the portion of the mortgage loans and excess cashflow
certificates sold through securitization and the portion retained (the NIM owner
trust certificate since 2002) based on the relative fair values of those
portions on the date of sale. We may recognize gains or losses attributable to
the changes in fair value of the excess cashflow certificates, which are
recorded at estimated fair value and accounted for as "trading" securities.
Since there is no active market for the excess cashflow certificates, we
determine their estimated fair value by discounting the expected cash flows.
On-Balance Sheet Securitizations. Beginning in the first quarter of 2004,
we completed our first on-balance sheet securitization. We intend to utilize
this structure going forward. This securitization was structured for accounting
purposes as a financing under SFAS No. 140 ("portfolio-based" accounting). This
securitization does not meet the qualifying special purpose entity criteria
under SFAS No. 140 and related interpretations because, after the loans are
securitized, we have the right to repurchase from the trust up to one percent of
the aggregate outstanding principal balance of the mortgage loans as of the
securitization closing date at a fixed purchase price.
Accordingly, the securitization trust and the underlying mortgage loans it
owns (referred to as "securitized loans") are consolidated for financial
reporting purposes. The securitized loans, therefore, effectively remain on our
balance sheet, with the securitization financing replacing the warehouse
financing originally associated with the securitized loans. In this structure,
no excess cashflow certificates are recorded at the time the securitization is
completed. Rather, we record interest income on securitized loans and interest
expense on the bonds issued in the securitization over the life of the
securitization instead of recognizing a one-time gain. Deferred debt issuance
costs and discount related to the bonds are amortized on a level yield basis
over the estimated life of the bonds. We also add to our balance sheet the
incremental direct fees and costs to originate the loans, in addition to the
servicing rights sold on the mortgage loans, which are amortized on a level
yield basis over the estimated life of the related loans using the interest
method calculation. Because our securitizations beginning in 2004 will utilize
"portfolio-based" accounting, we expect there to be significant differences in
our future results of operations, compared to historical results. As such, we do
not expect historical results will provide a particularly meaningful comparison
to 2004 results. We believe that portfolio-based accounting treatment, however,
more closely matches the recognition of income with the receipt of cash payments
on the individual loans.
Despite carrying the securitized loans and the securitization financing on
our financial statements, we are generally not legally obligated to make
payments to the holders of the asset-backed pass-through securities issued as
part of our securitizations. Rather, the holders of the asset-backed securities
receive repayment only from the cash flows from the mortgage loans specifically
collateralizing the debt. In short, structuring securitizations as on-balance
sheet financings does not materially alter our contractual responsibilities in a
securitization.
30
EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the
present value of the related excess cashflow certificates (which, in the
securitizations we have issued since 2002, includes NIM owner trust
certificates, and the underlying BIO certificates and P certificates), using
assumptions we make regarding the underlying mortgage loans. The excess cashflow
certificate is then recorded on our consolidated financial statements at an
estimated fair value. Our estimates primarily include the following:
o future rate of prepayment of the mortgage loans - the expected
amount of prepayments on the mortgage loans due to the underlying
borrowers paying off their mortgage loan prior to the loan's
expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of
expected losses or defaults that will take place on the underlying
mortgage loans over the life of the mortgage loans because the
excess cashflow certificates are subordinated to all other
securities issued by the securitization trust. Consequently, any
losses sustained on mortgage loans comprising a particular
securitization trust are first absorbed by the excess cashflow
certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) -
our estimate of future interest rates, which affects both the rate
paid to the floating rate pass-through security investors (primarily
the one-month LIBOR index) and the adjustable rate mortgage loans
sold to the securitization trust (which provide for a fixed rate of
interest for the first 24 or 36 months and a six-month variable rate
of interest thereafter using the six-month LIBOR index); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the cash flow we
expect to receive in the future from the certificate based upon our best
estimate. We monitor the performance of the loans underlying each excess
cashflow certificate, and any changes in our estimates (and any resulting
changes in value of the excess cashflow certificates) are reflected in the line
item called "excess cashflow certificate income" in the quarter in which we make
the change in our estimate. Although we believe that the assumptions we use are
reasonable, there can be no assurance as to the accuracy of the assumptions or
estimates.
In determining the fair value of each of the excess cashflow certificates,
we make the following underlying assumptions regarding mortgage loan
prepayments, mortgage loan default rates, the LIBOR forward curve and discount
rates:
(a) Prepayments. We base our prepayment rate assumptions upon our
ongoing analysis of the performance of the mortgage pools we
previously securitized, and the performance of similar pools of
mortgage loans securitized by others in the industry. We apply
different prepayment speed assumptions to different loan product
types because it has been our experience that different loan product
types exhibit different prepayment patterns. Generally, our loans
can be grouped into two loan products - fixed-rate loans and
adjustable-rate loans. With fixed-rate loans, an underlying
borrower's interest rate remains fixed throughout the life of the
loan. Our adjustable-rate loans are a "hybrid" between fixed- and
adjustable-rate loans, in that the interest rate generally remains
fixed, typically for the first two or three years of the loan, and
then adjusts, typically every six months thereafter. Within each
product type, factors other than interest rates can affect our
prepayment rate assumptions. These factors include:
o whether or not a loan contains a prepayment penalty, which is
the amount a borrower must pay to a lender if the borrower
prepays the loan within a certain time after the loan was
originated. Loans containing a prepayment penalty typically
are not repaid as quickly as those without a penalty; and
o as is customary in our industry with adjustable-rate mortgage
loans, the introductory interest rate we charge to the
borrower is artificially lower, between one and two full
percentage points, than the rate for which the borrower would
have otherwise qualified. Generally, once the interest rate
begins to
31
adjust, the interest rate payable on that loan increases, at
times fairly substantially. This interest rate increase can be
exacerbated if there is an absolute increase in interest
rates. As a result of these increases and the potential for
future increases, adjustable rate mortgage loans typically are
more susceptible to early prepayments.
There are several reasons why a loan may prepay prior to its
maturity, including, but not limited to:
o a decrease in interest rates;
o improvement in the borrower's credit profile, which may allow
the borrower to qualify for a lower interest rate loan;
o competition in the mortgage market, which may result in lower
interest rates being offered to the borrower;
o the borrower's sale of his or her home;
o the borrower's need for additional funds; and
o a default by the borrower, resulting in foreclosure by the
lender.
It is unusual for a borrower to prepay a mortgage loan during the
first few months because:
o it typically takes at least several months after the mortgage
loans are originated for any of the above events to occur;
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our current prepayment assumptions for the
month one and peak speed. The assumptions have not changed since
September 2001.
LOAN TYPE MONTH ONE PEAK SPEED
---------------------------------------------------
Fixed Rate 4.00% 30.00%
Adjustable Rate 4.00% 75.00%
If mortgage loans prepay faster than anticipated, we will earn less
income in connection with the mortgage loans and receive less excess
cash flow in the future because the mortgage loans have paid off.
Conversely, if mortgage loans prepay at a slower rate than
anticipated, we earn more income and more excess cash flow in the
future, subject to the other factors that can affect the cash flows
from, and our valuation of, the excess cashflow certificates.
(b) Default Rate. At December 31, 2003 and 2002, on each newly issued
securitization, we apply a default reserve for both fixed- and
adjustable-rate loans sold to the securitization trusts totaling
5.00% of the amount initially securitized. We apply a default or
loss rate to the excess cashflow certificate because it is the
"first-loss" piece and is subordinated in right of payment to all
other securities issued by the securitization trust. If defaults are
higher than we anticipate, we will receive less income and less
excess cash flow than expected in the future. Conversely, if
defaults are lower than we expected, we will receive more income and
more excess cash flow than expected in the future, subject to the
other factors that can affect the cash flows from, and our valuation
of, the excess cashflow certificates.
(c) LIBOR Forward Curve. The LIBOR forward curve is used to project
future interest rates, which affects both the rate paid to the
floating rate pass-through security investors (primarily one-month
LIBOR) and the adjustable rate mortgage loans sold to the
securitization trust (a fixed rate of interest for either the first
24 or 36 months then a variable rate of interest thereafter using
six-month LIBOR). A significant portion of our loans are fixed-rate
mortgages, and a significant amount of the securities sold by the
securitization trust are floating-rate securities (the interest rate
adjusts based upon an index, such as one-month LIBOR). As such, our
excess cashflow certificates are subject to significant basis risk
and a change in LIBOR will, impact our excess spread. If LIBOR is
lower than anticipated, we will receive more income and more excess
cash flows than expected in the future, subject to the other factors
that can affect the cash flows from, and our valuation of, the
excess cashflow certificates. Conversely, if LIBOR is higher than
expected, we will receive less income and less excess cash flows
than expected in the future. In each of our securitizations in which
we sold NIM note(s), we purchased an interest rate cap, which helps
mitigate
32
the basis risk for the approximate time that the NIM notes are
outstanding.
(d) Discount Rate. We use a discount rate that we believe reflects the
risks associated with our excess cashflow certificates. Because
quoted market prices on comparable excess cashflow certificates are
not available, we compare our valuation assumptions and performance
experience to our competitors in the non-conforming mortgage
industry. Our discount rate takes into account the asset quality and
the performance of our securitized mortgage loans compared to that
of the industry and other characteristics of our securitized loans.
We quantify the risks associated with our excess cashflow
certificates by comparing the asset quality and payment and loss
performance experience of the underlying securitized mortgage pools
to comparable industry performance. The discount rate we use to
determine the present value of cash flows from excess cashflow
certificates reflects increased uncertainty surrounding current and
future market conditions, including without limitation, uncertainty
concerning inflation, recession, home prices, interest rates and
conditions in the equity markets.
We utilized a discount rate of 15% at December 30, 2003 and 2002 on
all excess cashflow certificates. Prior to the quarter ended
September 30, 2001, we used an 18% discount rate on a NIM
transaction we consummated in November 2000. We increased the
discount rate on these excess cashflow certificates during the
period that the senior NIM securities remained outstanding, to
account for the potentially higher risk associated with the residual
cash flows expected to be received by the holder of the certificated
interest in the NIM trust, which was subordinated to the multiple
senior securities sold in the NIM transaction. As part of the Second
Exchange Offer, all of the excess cashflow certificates that were
subject to the November 2000 NIM transaction were transferred to the
LLC. We did not increase the discount rate on the excess cashflow
certificates from our latest securitizations despite issuing NIM
securities because the NIM securities in the most recent
transactions were:
o issued from a single securitization as compared to the
November 2000 NIM transaction, which was backed by a
combination of six securitizations issued between September
1997 and March 1999 resulting in more volatility or
variability in determining the timing of cash flows to be
received by the NIM; and
o issued from a new securitization as compared to the November
2000 NIM transaction, which was backed by several seasoned
securitization trusts. The predictability in determining the
timing of cash flows for the first two years on a newly issued
securitization is typically higher than securitizations that
have been outstanding for a greater period of time because
defaults or losses to the trust within the first few years of
issuance are typically lower and more predictable compared to
a more seasoned securitization that has been outstanding for a
longer period of time. Additionally, prepayment speeds are
more predictable compared to more seasoned transactions, which
is aided by the presence of prepayment penalties, which
typically expire within the first few years after a mortgage
loan is originated. Therefore, there is a higher probability
in determining the timing of cash flows to the NIM investor on
a new issuance securitization as compared to a seasoned
transaction.
At March 2001, we sold five of our excess cashflow certificates with a
carrying value of $40.4 million at a discount for a cash purchase price of $15.0
million. As a result, we recorded a loss on the transaction of $25.4 million.
At September 30, 2001, we recorded a charge to impairment of excess
cashflow certificates to reflect a valuation adjustment to our excess cashflow
certificates totaling $19.7 million. Our change in assumptions at September 30,
2001, primarily reflect recent unforeseen market events relating to the
terrorist attacks on September 11, 2001, that further accelerated an economic
downturn in the U.S. economy, and which, together with the hostilities in
Afghanistan and related uncertainties, we believe may have a significant adverse
impact on the economy for the foreseeable future.
At March 31, 2002, we recorded a $2.1 million charge to impairment of
excess cashflow certificates to reflect a valuation adjustment to our excess
cashflow certificates. The charge relates to the timing of excess cashflow
that are to be received by our excess cashflow certificates after the release or
"stepdown" of the overcollateralization account.
33
In August 2003, we sold three of our excess cashflow certificates, which
had a $10.0 million carrying value in the aggregate, for $10.2 million in cash.
We recorded the gain earned from the sale in gain(loss) of excess cashflow
certificates, and reduced the value of our excess cashflow certificates on our
balance sheet accordingly.
The following table summarizes the excess cashflow activity for the years
ended December 31 as follows:
(Dollars in thousands) 2003 2002 2001
- ----------------------------------------------------------------------------
Balance, beginning of year $ 24,565 16,765 216,907
New excess cashflow certificates 6,941 10,499 11,081
Net accretion/(amortization) of excess
cashflow certificates (1,653) (614) 1,945
Fair value adjustments -- (2,085) (19,676)
Sales (10,000) -- (40,402)
Second Exchange Offer (1) -- -- (153,090)
- ----------------------------------------------------------------------------
Balance, end of year $ 19,853 24,565 16,765
============================================================================
(1) The Second Exchange Offer was consummated on August 29, 2001. In the
Second Exchange Offer, holders of approximately $138.1 million (of $148.2
million) in principal amount of our senior secured notes and $1.1 million
(of $1.8 million) in principal amount of our senior notes exchanged their
notes for commensurate interests in voting membership interests in the
LLC, a newly-formed limited liability company (unaffiliated with us), to
which we transferred all of the mortgage-related securities previously
securing the senior secured notes (primarily comprised of excess cashflow
certificates - $153.1 million).
Our valuation of retained excess cashflow certificates is highly dependent
upon the reasonableness of our assumptions and the predictiveness of the
relationships that drive the results of our valuation model. The assumptions we
utilize, described above, are complex, as we must make judgment calls about the
effect of matters that are inherently uncertain. As the number of variables and
assumptions affecting the possible future resolution of the uncertainties
increase, those judgments become even more complex.
In volatile markets, like those we have experienced over the past several
years, there is increased risk that our actual results may vary significantly
from our assumed results. The longer the time period over which the uncertainty
will exist, the greater the potential volatility for our valuation assumptions
and the fair value of our excess cashflow certificates.
For example, assumptions regarding prepayment speeds, defaults and LIBOR
rates are used in estimating fair values of our excess cashflow certificates. If
loans prepay faster than estimated, or loan loss levels are higher than
anticipated, or LIBOR is higher than anticipated, we may be required to write
down the value of such certificates. While we believe that our assumptions are
reasonable estimates using our historical loan performance and the performance
of similar mortgage pools from other lenders - in addition to accessing other
public information about market factors such as interest rates, inflation,
recession, unemployment and real estate market values, among other things -
these are just estimates and it is virtually impossible to predict the actual
level of prepayments and losses, which are also driven by consumer behavior.
DEFERRED TAX ASSET
As of December 31, 2003, we carried a net deferred tax asset of $31.2
million on our consolidated financial statements. This asset is based upon our
assumed 39% effective tax rate. Our deferred tax asset is comprised primarily of
Federal and state net operating losses, or "NOLs," net of the tax impact.
At September 30, 2003, we reversed a valuation allowance that we had
established in 2000 against our deferred tax asset. As of December 31, 2002, we
had a gross deferred tax asset of $48.0 million, a gross deferred tax liability
of $0.1 million and a valuation allowance of $42.3 million. Management and the
Audit Committee of the Board of Directors believed that the reversal was
appropriate principally because of our eight consecutive quarters of
profitability and positive cash flow, together with the planned retirement of
all our long-term unsecured debt. We have recorded minimal taxes in our results
of operations over the prior seven quarters - from the fourth quarter of 2001
through the second quarter of 2003 - as a result of the valuation allowance
against our deferred tax asset, which was primarily generated by NOLs in 2000
and 2001.
The reversal of the valuation allowance has two significant effects, as
follows:
34
o first, we have recorded additional income equal to the amount
of the valuation allowance reversal in the third quarter
(which was partially offset by a change in our effective tax
rate) reflected in our statement of income in the line item
income tax benefit; and
o second, going forward, our financial statements will reflect
an effective income tax rate of 39%, even though we expect to
continue to pay only minimal cash taxes (either alternative
minimum tax ("AMT") or excess inclusion income tax, as well as
minimal state taxes) until our net operating losses are fully
utilized.
Our deferred tax asset of $31.2 million consists primarily of (1) NOLs,
net of tax, totaling $27.0 million, which can be used to offset the tax
liability generated from approximately $69.2 million of pre-tax income (the NOLs
principally expire in 2021), and (2) the excess of the tax basis over book basis
on our excess cashflow certificates, net of tax, of $2.3 million.
NON-GAAP PRESENTATION
In 2001, 2002 and the first two quarters of 2003 (prior to our reversal of
the deferred tax asset valuation allowance), our financial statements included
only a minimal tax provision. Because the foregoing effects of the reversal of
the deferred tax asset valuation allowance may make it difficult for investors
to make a meaningful period-over-period comparison, we have provided a Non-GAAP
presentation in addition to our GAAP results to assist investors. This Non-GAAP
presentation excludes (a) income produced by the reversal of the valuation
allowance in the third quarter of 2003, (b) an income tax benefit in the third
quarter of 2002, and (c) expense related to a change in our effective tax rate
recorded in the third quarter of 2003. By doing so, we aim to provide investors
with the ability to make period-over-period comparisons based upon our
previously reported results of operations, which, in effect, approximates our
pre-tax earnings and is reflected as "Non-GAAP net income" and "Non-GAAP EPS."
- --------------------------------------------------------------------------------
NON-GAAP EARNINGS RECONCILIATION TABLE (UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER DILUTED EPS)
TWELVE MONTHS ENDED
DECEMBER 31,
---------------------------------
2003 2002 2001
---- ---- ----
Net income, as reported $ 67,406 17,637 (99,790)
======== ======== ========
(Less)add: income tax (benefit)/expense (25,354) (1,769) 2,876
Less: AMT/Excess Inclusion Income Tax (711) (431) (2,876)
-------- -------- --------
Non-GAAP net income $ 41,341 15,437 (99,790)
======== ======== ========
Diluted EPS:
Net income per diluted share, as reported $ 3.59 1.04 (6.28)
Non-GAAP EPS 2.17 0.91 (6.28)
- --------------------------------------------------------------------------------
35
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2003, COMPARED TO THE YEAR ENDED DECEMBER 31, 2002
GENERAL
We recorded net income for the year ended December 31, 2003 of $67.4
million, or $4.05 per share basic and $3.59 per share diluted, compared to $17.6
million, or $1.11 per share basic and $1.04 per share diluted, for the year
ended December 31, 2002. Net income for 2003 was favorably impacted by an income
tax benefit of $30.2 million, or $1.64 per diluted share. Net income for 2002
was also favorably impacted by an income tax benefit of $2.2 million, or $0.13
per diluted share.
REVENUES
Total revenues increased $39.3 million, or 55%, to $110.2 million for the
year ended December 31, 2003, from $70.9 million for the year ended December 31,
2002. The increase in revenues in 2003 was primarily attributable to higher net
gain on sale due to us completing securitizations, net of pre-funding, of $1.5
billion in 2003, compared to $819.0 million in 2002.
We originated $1.7 billion of mortgage loans for the year ended December
31, 2003, representing a 96% increase from $872.2 million of mortgage loans
originated for the year ended December 31, 2002. We securitized, and delivered
$1.5 billion of loans to the securitization trusts during the year ended
December 31, 2003, representing approximately an 80% increase from the $819.0
million of loans we securitized during 2002. Because it was more advantageous
for us to securitize our loans in 2003, as compared to whole loan sales, whole
loan sales decreased for the year ended December 31, 2003 to $42.4 million,
representing a 59% decrease from the $103.0 million of whole loans sold for the
year ended December 31, 2002.
Net Gain on Sale of Mortgage Loans. Net gain on sale of mortgage loans is
represented by the following:
(1) the sum of:
(a) the cash purchase price we receive in connection with selling
one or more of the following securities in connection with our
securitization(s) for a particular period: (i) a NIM note, net
of overcollateralization amount and interest rate cap and/or
(ii) an interest-only certificate;
(b) the fair value of the non-cash excess cashflow certificates we
retain in a securitization for each period;
(c) the cash premium received from selling mortgage servicing
rights in connection with each securitization; and
(d) the cash premium earned from selling whole loans on a
servicing-released basis.
(2) less the (i) costs associated with securitizations, (ii) any hedge
loss (gain) associated with a particular securitization, (iii) any
loss associated with loans sold at a discount, and (iv) deferred
origination costs and fees associated with mortgage loans sold.
36
YEAR ENDED DECEMBER 31,
2003 2002
---- ----
Net Gain on Sale of Mortgage Loans (Dollars in thousands)
Loans Sold ............................................... $ 1,537,600 $ 922,057
=========== ===========
NIM Proceeds, Net ........................................ $ 67,159 $ 42,050
Interest Only Certificate Proceeds ....................... 12,913 --
Excess Cashflow Certificate (owner trust certificates)(1) 6,941 10,499
Mortgage Servicing Rights ................................ 8,910 7,248
Hedging .................................................. 438 --
Gain on whole loan sales ................................. 2,137 4,547
Loan origination fees .................................... 25,079 14,366
Loan origination costs ................................... (21,654) (15,197)
Less: Securitization transaction costs .................. (7,141) (5,539)
----------- -----------
Net gain on sale recorded ............................. $ 94,782 $ 57,974
=========== ===========
Net gain on sale recorded (as a percent of loans sold) 6.2% 6.3%
(1) The reduction in value of the excess cashflow certificates in 2003
compared to 2002 is primarily due to us not recording any excess cash flow
certificates in the third and fourth quarter of 2003. (see "- Excess
Cashflow Certificate, Net").
Net gain on sale of mortgage loans increased $36.8 million, or 63%, to
$94.8 million for the year ended December 31, 2003, from $58.0 million for the
year ended December 31, 2002. This increase was primarily due to higher loan
production resulting in a greater amount of loans securitized and sold on a
whole loan basis in 2003, compared to 2002, partially offset by a decrease in
our weighted-average net gain on sale margin for the year ended December 31,
2003 to 6.2% from 6.3% in 2002.
Interest Income. Interest income primarily represents the sum of:
(1) the gross interest we earn on loans held for sale;
(2) securitization accrued bond interest (income received from the
securitization trust for fixed-rate pass-through certificates
at the securitization settlement date);
(3) cash interest earned on bank accounts; and
(4) miscellaneous interest income, including prepayment penalties
received on several of our securitizations prior to 2002.
YEAR ENDED DECEMBER 31,
------------------------
2003 2002
---- ----
Interest Income (Dollars in thousands)
Interest earned on loans held for sale $10,497 $ 8,134
Securitization accrued bond interest 1,330 1,901
Miscellaneous interest income 591 1,768
------- -------
Total interest income $12,418 $11,803
======= =======
Interest income increased $0.6 million, or 5%, to $12.4 million for the
year ended December 31, 2003, from $11.8 million for the year ended December 31,
2002. The increase in interest income is due to the higher average loan balance
on the loans we originated and held for sale, partially offset by a lower
weighted-average interest rate (8.13%) for our loans held for sale during the
year ended December 31, 2003 and, consequently, less interest earned on these
loans, compared to 2002 (9.35%). In addition, we received less prepayment
penalties (miscellaneous interest income) and securitization bond interest in
the year ended December 30, 2003 compared to 2002.
Excess Cashflow Certificate Income. Excess cashflow certificate income
primarily represents the sum of:
(1) the cash we receive from our excess cashflow certificates; and
37
(2) the non-cash mark-to-market of our excess cashflow
certificates.
Excess cashflow certificate income increased $0.3 million, to $2.3 million
for the year ended December 31, 2003, from $2.0 million for the year ended
December 31, 2002.
Impairment of excess cashflow certificates. Impairment of certificates
represents the write-down of the fair value of excess cashflow certificates.
In 2002, we recorded a charge to impairment on certificates totaling $2.1
million, relating to the timing of excess cash flows that are to be received by
the excess cashflow certificate after the release or "step-down" of the
overcollateralization account. There were no impairments recorded during the
twelve months ended December 31, 2003.
Gain (loss) on excess cashflow certificates. Gain(loss) of excess cashflow
certificates represents the difference between the sale price and the carrying
value of excess cashflow certificates sold. In 2003, we sold three excess
cashflow certificates for a gain of $0.2 million. We did not sell any of our
excess cashflow certificates in 2002.
Other Income. Other income represents the sum of (1) distributions from
Delta Funding Residual Exchange Company, LLC (the "LLC"), and (2) any other
miscellaneous income.
Other income decreased $0.9 million, or 69%, to $0.4 million for the year
ended December 31, 2003, from $1.3 million for the year ended December 31, 2002.
The decrease was primarily the result of lower income collected from the LLC. We
have a non-voting membership interest in the LLC, which entitles us to receive
15% of the net cash flows from the LLC through June 2004 and, thereafter, 10% of
the net cash flows from the LLC. We have not received our distributions since
the second quarter of 2003 due to a dispute with the LLC's President, which has
led us to commence a lawsuit to recover all of the amounts due to us. See "Part
I, Item 3, "Legal Proceedings".
EXPENSES
Total expenses increased by $13.0 million, or 24%, to $68.1 million for
the year ended December 31, 2003, from $55.1 million for the year ended December
31, 2002. The increase was primarily related to higher payroll and related cost
required to support the significant increase in our mortgage loan production.
Payroll and Related Costs. Payroll and related costs include salaries,
benefits and payroll taxes for all non-production related employees and
non-deferrable production related employees cost.
Payroll and related costs increased by $12.0 million, or 44%, to $39.1
million for the year ended December 31, 2003, from $27.1 million for the year
ended December 31, 2002. The increase was primarily due to higher compensation
and related payroll costs related to the increase in our staff, including
payroll taxes, 401k match, medical benefits and related costs. As of December
31, 2003, we employed 912 full and part-time employees, compared to 695 full and
part-time employees as of December 31, 2002.
Interest Expense. Interest expense includes the borrowing cost under our
warehouse credit facility to finance loan originations, equipment financing and
the senior notes.
YEAR ENDED DECEMBER 31,
--------------------------
2003 2002
------ ------
Interest Expense (Dollars in thousands)
Interest expense on loans financed in warehouse $4,390 $3,602
Capital lease 255 461
Senior notes (1) 854 1,030
Other 10 180
------ ------
Total interest expense $5,509 $5,273
====== ======
(1) On October 30, 2003, we redeemed, at par, all of our outstanding 9.5%
senior notes due August 2004. The aggregate redemption price, including
principal and accrued interest, was approximately $11.0 million.
Interest expense increased by $0.2 million, or 4%, to $5.5 million for the
year ended December 31, 2003, from $5.3 million for the year ended December 31,
2002. The increase in interest expense is due to the higher average financed
balance on the loans we originated and held for sale, partially offset by a
lower borrowing cost under
38
warehouse facilities. The average one-month LIBOR rate, which is the benchmark
used to determine our cost of borrowed funds, decreased on average to 1.2% for
the year ended December 31, 2003, compared to an average of 1.8% for the year
ended December 31, 2002. The increase was partially offset by the redemption of
all our outstanding 9.5% senior notes in October 2003 and the corresponding
interest we saved by redeeming these notes early.
General and Administrative Expenses. General and administrative expenses
consist primarily of office rent, insurance, telephone, depreciation, legal
reserves and fees, license fees, accounting fees, travel and entertainment
expenses, advertising and promotional expenses and the provision for loan losses
on the inventory of loans held for sale and recourse loans.
General and administrative expenses increased $0.8 million, or 4%, to
$23.5 million for the year ended December 31, 2003, from $22.7 million for the
year ended December 31, 2002. The increase was primarily due to an increase in
expenses associated with higher loan production and ongoing expansion of our
wholesale and retail divisions. This was partially offset by lower depreciation
expenses resulting from fully depreciated assets.
Income Taxes. Deferred tax assets and liabilities are recognized on the
income reported in the financial statements regardless of when such taxes are
paid. These deferred taxes are measured by applying current enacted tax rates.
We recorded an income tax benefit of $25.4 million for the year ended
December 31, 2003, which was primarily related to our reversing a deferred tax
asset valuation allowance and expenses for the change in our effective tax rate.
See "-Deferred Tax Asset" above.
For the same period in 2002, we recorded an income tax benefit of $2.2
million related to our obtaining a favorable resolution to tax issues for which
we had previously reserved and do not expect to recur. This was offset by a tax
provision of $0.4 million, which primarily related to excess inclusion income
generated by our excess cashflow certificates.
Excess inclusion income cannot be offset by our NOLs under the real estate
mortgage investment trust, or REMIC, tax laws. It is primarily caused by the
REMIC securitization trust utilizing cash that otherwise would have been paid to
us as holder of the excess cashflow certificate, in order to make payments to
other security holders, to create and/or maintain overcollateralization by
artificially paying down the principal balance of the asset-backed securities.
In the future, we expect to continue to incur a modest amount of excess
inclusion income, which we will be unable to offset with our NOLs.
YEAR ENDED DECEMBER 31, 2002, COMPARED TO THE YEAR ENDED DECEMBER 31, 2001
GENERAL
We recorded net income for the year ended December 31, 2002 of $17.6
million, or $1.11 per share basic and $1.04 per share diluted, compared to a net
loss of $99.8 million, or $6.28 per share basic and diluted, for the year ended
December 31, 2001. Our net income for 2002 included a special tax benefit of
$2.2 million, or $0.14 per share basic and $0.13 diluted, which primarily
relates to our obtaining favorable resolutions to tax issues for which we had
previously reserved.
The majority of the net loss in 2001 related to: (1) a $25.4 million loss
of excess cashflow certificates sold for a cash purchase price significantly
below our carrying value for such certificates; (2) an impairment charge of
$19.7 million to our excess cashflow certificates; (3) a charge of $19.3 million
related to the extinguishment of debt; (4) a charge of $10.7 million relating to
our disposition and transfer to Ocwen of our servicing platform in May 2001; (5)
a charge of $3.6 million relating to a change in accounting estimates regarding
the life expectancy of our computer-related equipment; (6) a charge of $1.4
million relating to professional fees incurred in connection with the Second
Exchange Offer; and (7) a charge of $1.5 million for establishing a reserve for
non-performing mortgage loans that were ultimately sold.
REVENUES
Total revenues increased $51.5 million, or 265%, to $70.9 million for the
year ended December 31, 2002, from $19.4 million for the year ended December 31,
2001. The increase in revenues was primarily the result of two charges we
incurred in 2001 that significantly reduced revenues in that year. First, we
recorded a $25.4 million loss of five excess cashflow certificates sold for a
cash purchase price significantly below their carrying value. Second,
39
we recorded an adjustment to our remaining excess cashflow certificates due to
changes in our valuation assumptions totaling $19.7 million. The increase in
revenues in 2002 was also attributable to higher net gain on sale due to us
completing securitizations, net of pre-funding, of $819.0 million in 2002,
compared to $345.0 million in 2001. The increase in revenue was partially offset
by (1) a decrease in interest income from our retained excess cashflow
certificates, as we transferred the majority of these certificates in connection
with our Second Exchange Offer in 2001, and (2) our not receiving any servicing
fees following the transfer of our servicing portfolio to Ocwen in May 2001. See
"-Corporate Restructuring, Debt Modification and Debt Restructuring."
We originated $872.2 million of mortgage loans for the year ended December
31, 2002, representing a 40% increase from $621.7 million of mortgage loans
originated for the year ended December 31, 2001. We securitized, net of
pre-funding, $819.0 million of loans during the year ended December 31, 2002,
representing a 137% increase from the $345.0 million of loans we securitized
during 2001. Our whole loan sales amounted to $103.0 million during the year
ended December 31, 2002, representing a 61% decrease from the $261.1 million of
whole loans sold for the year ended December 31, 2001.
Net gain on sale of mortgage loans increased $19.7 million, or 51%, to
$58.0 million for the year ended December 31, 2002, from $38.3 million for the
year ended December 31, 2001. This increase was primarily due to (a) higher loan
production resulting in a greater amount of loans securitized and sold on a
whole loan basis in 2002 as compared to 2001, (b) our securitizing a higher
percentage of mortgage loans in 2002, instead of selling whole loans
servicing-released, which typically results in a higher net gain on sale
percentage than whole loan sales and (c) our selling approximately $60 million
of mortgage loans we had held in inventory at December 31, 2001 in addition to
the mortgage loans we originated during 2002. We securitized, net of
pre-funding, $819.0 million in 2002 and sold $103.0 million of mortgage loans on
a servicing-released basis in 2002, compared to $345.0 million of loans
securitized and $261.1 million of mortgage loans sold in 2001.
YEAR ENDED DECEMBER 31,
2002 2001
---- ----
Net Gain on Sale of Mortgage Loans (Dollars in thousands)
Loans Sold ............................................... $ 922,057 $ 606,100
========= =========
NIM Proceeds, Net ........................................ $ 42,050 $ --
Interest Only Certificate Proceeds ....................... -- 13,332
Excess Cashflow Certificate (owner trust certificates) ... 10,499 11,081
Mortgage Servicing Rights ................................ 7,248 5,213
Hedging .................................................. -- --
Gain on whole loan sales ................................. 4,547 11,099
Loan origination fees .................................... 14,366 13,485
Loan origination costs ................................... (15,197) (13,797)
Less: Securitization transaction costs .................. (5,539) (2,087)
--------- ---------
Net gain on sale recorded .......................... $ 57,974 $ 38,326
========= =========
Net gain on sale recorded (as a percent of loans sold) 6.3% 6.3%
Interest income increased $0.6 million, or 5%, to $11.8 million for the
year ended December 31, 2002, from $11.2 million for the year ended December 31,
2001. The increase was primarily due to our higher average loan balance (and,
consequently, more interest earned on loans held for sale) in 2002 compared to
2001.
YEAR ENDED DECEMBER 31,
-----------------------
2002 2001
--------- ---------
(Dollars in thousands)
Interest Income
Interest earned on loans held for sale $ 8,134 $ 7,144
Securitization accrued bond interest 1,901 2,819
Miscellaneous interest income 1,768 1,195
--------- ---------
Total interest income $ 11,803 $ 11,158
========= =========
40
Excess cashflow certificate income decreased $9.8 million, or 83%, to $2.0
million for the year ended December 31, 2002, from $11.8 million for the year
ended December 31, 2001. The decrease in 2002 to our excess cashflow
certificates was primarily due to our transfer of the majority of our
certificates as part of the Second Exchange Offer in 2001. See "-Corporate
Restructuring, Debt Modification and Debt Restructuring."
Impairment of excess cashflow certificates. In 2002, we recorded a charge
to impairment on excess cashflow certificates totaling $2.1 million, relating to
the timing of excess cash flows that are to be received by the excess cashflow
certificate after the release or "step-down" of the overcollateralization
account. In 2001, we recorded a charge to our excess cashflow certificates due
to changes in our valuation assumptions totaling $19.7 million.
Gain (loss) on sale of excess cashflow certificates was $25.4 million.
During 2001, we sold five of our excess cashflow certificates, which had a
carrying value of $40.4 million, for a cash purchase price of $15.0 million.
Servicing Fees. We did not receive any servicing fees during 2002 since we
transferred our entire servicing portfolio to Ocwen in May of 2001. In 2001,
servicing fees totaled $3.0 million.
Other income increased $1.1 million, or 550%, to $1.3 million for the year
ended December 31, 2002, from $0.2 million for the year ended December 31, 2001.
The increase in other income during the twelve months ended December 31, 2002 is
primarily due to us starting to receive distributions from the LLC in the first
quarter of 2002.
EXPENSES
Total expenses decreased by $61.2 million, or 53%, to $55.1 million for
the year ended December 31, 2002, from $116.3 million for the year ended
December 31, 2001. The decrease in expenses primarily resulted from expenses we
incurred in 2001 that did not recur in 2002, including expenses associated
primarily with: (1) our disposition and transfer of our servicing portfolio to
Ocwen in May 2001; (2) capital charges associated with repurchasing our interest
and servicing advance securitizations prior to the sale of the servicing
portfolio; (3) a change in accounting estimates regarding the life expectancy of
our computer-related equipment in 2001; (4) a charge for reserves primarily
against a pool of non-performing loans, which we ultimately sold in July 2001;
and (5) a charge related to professional fees incurred with the second exchange
offer. The decrease also resulted from (a) a significantly lower interest
expense in 2002 resulting from (1) our extinguishing approximately $139.2
million of Notes in the Second Exchange Offer (see "-Corporate Restructuring,
Debt Modification and Debt Restructuring"), and (2) lower warehouse financing
costs due to lower borrowing costs during 2002, as well as (b) a special tax
benefit in 2002 related to a favorable resolution to tax issues for which we had
previously reserved and do not expect to recur.
Payroll and related costs decreased by $2.8 million, or 9%, to $27.1
million for the year ended December 31, 2002, from $29.9 million for the year
ended December 31, 2001. The decrease was primarily the result of a downsizing
effectuated as part of our overall corporate restructuring related to our
transfer of our servicing operations in May 2001.
Interest expense decreased by $10.8 million, or 67%, to $5.3 million for
the year ended December 31, 2002 from $16.1 million for the year ended December
31, 2001. The decrease was primarily attributable to (1) our extinguishing
$139.2 million of senior notes in August 2001 and the corresponding interest
related thereto, and (2) lower warehouse financing costs due to lower borrowing
costs. The average one-month LIBOR rate, which is the benchmark used to
determine our cost of borrowed funds, decreased on average to 1.8% for the year
ended December 31, 2002, compared to an average of 3.9% for the year ended
December 31, 2001.
YEAR ENDED DECEMBER 31,
-----------------------
2002 2001
---- ----
Interest Expense (Dollars in thousands)
Interest expense on loans financed in warehouse $ 3,602 $ 5,480
Capital lease 461 813
Senior notes (1) 1,030 9,201
Other 180 638
--------- ---------
Total interest expense $ 5,273 $ 16,132
========= =========
41
(1) In August 2001, we completed our Second Exchange Offer, which extinguished
substantially all of our long-term debt, leaving approximately $11 million
out of $150 million of our notes still outstanding.
General and administrative expenses decreased $25.6 million, or 53%, to
$22.7 million for the year ended December 31, 2002, from $48.3 million for the
year ended December 31, 2001. The year ended December 31, 2001 included expenses
primarily associated with (1) our disposition and transfer of our servicing
portfolio in May 2001 to Ocwen, (2) capital charges previously associated with
our interest and servicing advance securitizations prior to the sale of the
servicing portfolio, (3) a change in accounting estimates regarding the life
expectancy of our computer-related equipment, and (4) a charge for reserves
primarily against a pool of non-performing loans, which we ultimately sold in
July 2001.
Restructuring and Other Special Charges. In 2001, we recorded $2.7 million
of restructuring and other special charges relating to professional fees
incurred in connection with the Second Exchange Offer in 2001 (see "-Corporate
Restructuring, Debt Modification and Debt Restructuring") and charges relating
to the disposition of branches and severance costs associated with closing our
servicing operation.
Extinguishment of Debt. In 2001, we recorded a charge of $19.3 million,
related to the extinguishment of debt associated with our notes. See "-Corporate
Restructuring, Debt Modification and Debt Restructuring."
Income Taxes. We recorded a tax benefit of $1.8 million for the year ended
December 31, 2002, primarily due to a special tax benefit of $2.2 million
related to our obtaining a favorable resolution to tax issues for which we had
previously reserved and do not expect to recur. This was offset by a tax
provision of $0.4 million, which was primarily related to excess inclusion
income generated by our excess cashflow certificates. In 2001, we recorded a tax
provision of $2.9 million, which was primarily related to excess inclusion
income.
We had less taxable excess inclusion income in 2002, as compared to 2001,
due to our holding lower excess cashflow certificates during the period. Excess
inclusion income cannot be offset by our NOLs under the REMIC tax laws.
FINANCIAL CONDITION
DECEMBER 31, 2003 COMPARED TO DECEMBER 31, 2002
Cash and interest-bearing deposits increased $1.2 million, or 35%, to $4.6
million at December 31, 2003, from $3.4 million at December 31, 2002. This
increase was primarily related to timing of cash received and disbursed from
normal operations.
Accounts receivable increased $0.9 million, or 53%, to $2.6 million at
December 31, 2003, from $1.7 million at December 31, 2002. This increase is
primarily due to the timing of interest on mortgage loans collected by our loan
servicing provider, which is paid to us in the following period.
Loans held for sale, net, increased $156.8 million, or 461%, to $190.8
million at December 31, 2003, from $34.0 million at December 31, 2002. This
asset represents mortgage loans held in inventory awaiting either a whole loan
sale or securitization. This increase was primarily directly related to our
strategy of increasing the loans in inventory to earn the additional spread
income or "carry" for additional periods.
Excess cashflow certificates, net decreased $4.7 million, or 19%, to $19.9
million at December 31, 2003, from $24.6 million at December 31, 2002. This
decrease was primarily due to our sale of three excess cashflow certificates
with an aggregate carrying value of $10.0 million, and to a lesser extent the
change in fair value of our excess cashflow certificates, partially offset by
our recording two new excess cashflow certificates, totaling $6.9 million from
loans securitized during 2003. In 2003, we did not record an excess cashflow
certificate on our $435 million third quarter and $470 million fourth quarter
securitizations due to the securitization structure we utilized. Changes in fair
value incorporate any change in value (accretion or reduction) in the carrying
value of the excess cashflow certificates and the cash distributions we received
from them. See the Notes to Consolidated Financial Statements - Note No. 7,
"Excess Cashflow Certificates, net").
Equipment, net, increased $0.5 million, or 19%, to $3.1 million at
December 31, 2003, from $2.6 million at December 31, 2002. This increase is
primarily due to the net difference between equipment purchased and periodic
depreciation of fixed assets.
Prepaid and other assets increased $3.2 million, or 188%, to $4.9 million
at December 31, 2003, from $1.7 million at December 31, 2002. This increase was
primarily due to higher prepaid expenses related to the prefunding
42
feature of our fourth quarter 2003 securitization transaction, compared to the
expenses related to our fourth quarter 2002 securitization.
Deferred tax asset increased $25.6 million, or 457%, to $31.2 million at
December 31, 2003, from $5.6 million at December 31, 2002. This increase was
primarily due to our reversal of the valuation allowance we maintained against
our deferred tax asset, which was established in 2000, partially offset by a
change to our effective tax rate in the third quarter of 2003. See Notes to
Consolidated Financial Statements - "Income Taxes."
Warehouse financing increased $131.0 million, or 949%, to $144.8 million
at December 31, 2003, from $13.8 at December 31, 2002. This increase was
primarily attributable to a higher amount of mortgage loans held for sale and
financed under our warehouse credit facilities, pending their securitization or
sale.
In October 2003, we redeemed, at par, all of our outstanding 9.5% senior
notes due August 2004. At December 31, 2002 the senior notes had an outstanding
principal amount of $10.8 million.
Accounts payable and accrued expenses decreased $3.9 million, or 25%, to
$11.6 million at December 31, 2003, from $15.5 million at December 31, 2002.
This decrease was primarily the result of the timing of various operating
accruals and payables.
Stockholders' equity increased $66.5 million, or 225%, to $96.0 million at
December 31, 2003, from $29.5 million at December 31, 2002. This increase is
primarily due to our positive earnings for the year, which includes a reversal
of our deferred tax asset valuation allowance.
CONTRACTUAL OBLIGATIONS
The following table summarizes our material contractual obligations as of
December 31, 2003:
(Dollars in thousands)
PAYMENTS DUE BY PERIODS
-------------------------------------------------------------------
LESS THAN 1 1 TO 3 3 TO 5 MORE THAN 5
TOTAL YEAR YEARS YEARS YEARS
- --------------------------------------------------------------------------------------
Operating Leases $ 20,050 4,612 9,274 5,977 187
Capital Leases 2,362 1,204 1,158 -- --
- --------------------------------------------------------------------------------------
As of December 31, 2003, we did not have any long-term debt, purchase
obligations or other long-term liabilities, as defined under GAAP.
LIQUIDITY AND CAPITAL RESOURCES
We require substantial amounts of cash to fund our loan originations,
securitization activities and operations. We have increased our working capital
over the last nine quarters, mainly by generating substantial cash proceeds from
our quarterly securitization and related NIM transactions, as our loan
originations expanded. Prior to that, however, we operated generally on a
negative cash flow basis. Embedded in our current cost structure are many fixed
costs, which are not likely to be significantly affected by a relatively
substantial increase in loan originations. If we can continue to originate a
sufficient amount of mortgage loans and generate sufficient cash proceeds from
our securitizations and sales of whole loans to offset our current cost
structure and cash uses, we believe we can continue to generate positive cash
flow in the next several fiscal quarters. However, there can be no assurance
that we will be successful in this regard. To do so, we must generate sufficient
cash from:
o the premiums we receive from selling NIM and/or interest-only
certificates in connection with our securitizations;
o the premiums we receive from selling our mortgage servicing rights
in connection with our securitizations;
o the premiums we receive from selling whole loans, servicing
released;
o origination fees on newly closed loans;
o excess cashflow certificates we retained in connection with our
securitizations prior to 2004; and
o interest income we receive on our loans held for sale prior to
securitization and/or whole loans sales.
There can be no assurance, however, that we will continue generating positive
cash flow in 2004 or at all.
43
Currently, our primary uses of cash requirements include the funding of:
o mortgage loans held for sale which are not financed;
o interest expense on warehouse lines of credit and other financing;
o scheduled principal pay downs on other financing;
o transaction costs, credit enhancement (O/C) and bond discount
incurred in connection with our securitization program;
o general ongoing administrative and operating expenses, including the
cost to originate loans;
o tax payments on excess inclusion income generated from our excess
cashflow certificates; and
o preferred stock dividends.
Historically, we have financed our operations utilizing various secured
credit financing facilities, issuance of corporate debt, issuances of equity,
and the sale of interest-only certificates and/or NIM notes and mortgage
servicing rights sold in conjunction with each of our securitizations to offset
our negative operating cash flow and support our originations, securitizations,
and general operating expenses.
Currently, our primary sources of liquidity, subject to market conditions,
continue to be:
o on-balance sheet warehouse financing and other secured financing
facilities, such as capital leasing;
o securitizations of mortgage loans and our corresponding sale of NIM
certificates and/or interest-only certificates, depending upon the
securitization structure, and mortgage servicing rights;
o sales of whole loans;
o cash flows from retained excess cashflow certificates;
o origination fees, interest income and other cash revenues; and
o utilizing NIM securitizations and/or selling or financing our
retained excess cashflow certificates.
In addition to our common stock, as of December 31, 2003, we currently
have outstanding Series A preferred stock having an aggregate preference of
$13.9 million, for which we are required to pay a 10% annual dividend, payable
semi-annually, commencing in July 2003. We are required to comply with
restrictive covenants in connection with our Series A preferred stock. We
believe we are in compliance with these covenants as of December 31, 2003. In
connection with our financing plans for 2004, we intend to use a portion of any
such future offering proceeds to redeem all of the outstanding Series A
Preferred Stock.
We have repurchase agreements with several institutions that have
purchased mortgage loans from us. Currently, some of the agreements provide for
the repurchase by us of any of the mortgage loans that go to foreclosure sale.
At the foreclosure sale, we will repurchase the mortgage, if necessary, and make
the institution whole. The dollar amount of loans that were sold with recourse
and are still outstanding totaled $1.8 million at December 31, 2003 and $2.6
million at December 31, 2002. Included in accounts payable is an allowance for
losses on loans sold with recourse of $1.1 million at December 31, 2003 and $1.2
million at December 31, 2002, respectively.
In August 2003, we sold three of our excess cashflow certificates to a
third party purchaser for $10.2 million, a slight gain to our carrying value of
$10.0 million. The net proceeds of this sale will be used for working capital.
We may, from time to time, if opportunities arise that we deem to be
appropriate, repurchase in the open market some of our outstanding capital stock
and/or sell some or all of our remaining excess cashflow certificates.
On October 30, 2003, we redeemed, at par all of our outstanding 9.5%
senior notes due August 2004. The aggregate redemption price, including
principal and accrued interest was approximately $11.0 million. We used our
existing cash to fund the redemption transaction. Any unexercised warrants,
which were issued in connection with the issuance of our senior notes on
December 21, 2002, have expired pursuant to their terms. See Note No. 8,
"Warrants," to Notes to the Consolidated Financial Statements.
Subject to our ability to execute our business strategy and the various
uncertainties described above (and described in more detail in "-Forward Looking
Statements and Risk Factors" below), we anticipate that we will
44
have sufficient cash flows from operations, short-term funding and capital
resources to meet our liquidity obligations for at least the next 12 months.
FINANCING FACILITIES
We need to borrow substantial sums of money each quarter to originate
mortgage loans. We have relied upon a limited number of counterparties to
provide us with financing facilities to fund our loan originations. Our ability
to fund current operations and accumulate loans for securitization depends to a
large extent upon our ability to secure short-term financing on acceptable
terms. There can be no assurance that we will be able to either renew or replace
these warehouse facilities at their maturities at terms satisfactory to us or at
all. If we are not able to obtain financing, we will not be able to originate
new loans and our business and results of operations will be materially and
adversely affected.
To accumulate loans for securitization, we borrow money on a short-term
basis through committed secured warehouse lines of credit and committed
repurchase agreements. The material terms and features of our financing
facilities in place at December 31, 2003 are as follows:
Greenwich Capital Repurchase Facility. We have a $250 million facility
with Greenwich Capital Financial Products, Inc., which bears interest based on a
margin over one-month LIBOR. This facility provides the ability to borrow
against first and second lien loans and "wet" collateral, which are loans that
have closed and have been funded, but for which we have not yet received the
loan documents from the closing agent. The facility provides the ability to
borrow at the lesser of 97% of fair market value or 100% of the par amount of
the mortgage loans between 0-59 days delinquent. Mortgage loans between 60-180
days delinquent may be financed at lower borrowing percentages. In March 2004,
we increased the facility to $350 million. This facility expires in October 2004
and bears interest based on a margin over one-month LIBOR. As of December 31,
2003, the outstanding balance under the facility was $94.8 million.
Citigroup Warehouse Line of Credit. We have a $250 million facility with
Citigroup Global Markets, Inc., which bears interest based on a margin over
one-month LIBOR. This facility provides the ability to borrow against first and
second lien loans and wet collateral. The facility provides the ability to
borrow at the lesser of 97% of fair market value or 100% of the par amount of
the mortgage loans between 0-59 days delinquent. Mortgage loans between 60-180
days delinquent may be financed at lower borrowing percentages. In March 2004,
we increased the facility to $350 million and extended the expiration date to
March 2005. This facility bears interest based on a margin over one-month
LIBOR. As of December 31, 2003, the outstanding balance under the facility was
$50.0 million.
Our warehouse agreements require us to comply with various operating and
financial covenants. The continued availability of funds provided to us under
these agreements is subject to, among other conditions, our continued compliance
with these covenants. We believe we are in compliance with these covenants as of
December 31, 2003.
SECURITIZATION FINANCING
Beginning in March 2004, we have financed, and expect to continue to
finance, our mortgage loan portfolio on a long-term basis by issuing
asset-backed securities. We believe that issuing asset-backed securities
provides us a low-cost method of financing our mortgage loan portfolio. In
addition, it allows us to reduce our interest rate risk on our fixed-rate loans
by securitizing them. Our ability to issue asset-backed securities depends on
the overall performance of our mortgage loans, as well as the continued general
demand for securities backed by non-conforming mortgages and home equity loans.
We are generally not legally obligated to make payments to the holders of
the asset-backed securities issued as part of our securitizations. Instead, the
holders of the asset-backed securities can expect repayment only from the cash
flows from mortgage loans specifically collateralizing the debt.
INTEREST RATE RISK
Our primary market risk exposure is interest rate risk. Our results of
operations may be significantly affected by the level of and fluctuation in
interest rates, which affect our ability to earn a spread between interest
received on our loans and the cost of our borrowings, including the cost of
interest rate caps, if any, that are tied to various interest rate swap
maturities, LIBOR, and other interest rate spread products, such as mortgage,
auto and credit card backed receivable certificates. Our profitability is likely
to be adversely affected during any period of unexpected or rapid
45
changes in interest rates. A substantial and sustained increase in interest
rates could adversely affect our ability to originate loans. A significant
decline in interest rates could increase the level of loan prepayments, thereby
decreasing the size of the loan servicing portfolio underlying our
securitizations. To the extent excess cashflow certificates have been
capitalized on our financial statements, higher than anticipated rates of loan
prepayments or losses could require us to write down the value of such excess
cashflow certificates, adversely impacting our earnings. In an effort to
mitigate the effect of interest rate risk, we periodically review our various
mortgage products and identify and modify those that have proven historically
more susceptible to prepayments. However, there can be no assurance that these
modifications to our product line will mitigate effectively any interest rate
risk in the future.
Periods of unexpected or rapid changes in interest rates, and/or other
volatility or uncertainty regarding interest rates, also can adversely affect us
by increasing the likelihood that asset-backed investors will demand higher
spreads than normal to offset the volatility and/or uncertainty, which decreases
the value of the excess cashflow certificates we receive in connection with a
securitization.
Fluctuating interest rates also may affect the net interest income we
earn, resulting from the difference between the yield we receive on loans held
pending sale and the interest paid by us for funds borrowed under our warehouse
facility. In the past, from time to time, we have undertook to hedge our
exposure to this risk by using various hedging strategies, including Fannie Mae
mortgage securities, treasury rate lock contracts and/or interest rate swaps.
See "-Hedge Accounting" below. Fluctuating interest rates also may significantly
affect the excess cash flows from our excess cashflow certificates, as the
interest rate on some of our asset-backed securities change monthly based on
one-month LIBOR, but the collateral that backs such securities are comprised of
mortgage loans with either fixed interest rates or "hybrid" interest rates -
fixed for the initial two or three years of the mortgage loan, and adjusting
thereafter every six months - which creates basis risk. See "-Excess Cashflow
Certificate, Net". With our transition to on-balance sheet portfolio
securitizations in 2004, we may undertake to hedge our exposure to interest rate
risk as described below in "-Hedge Accounting."
HEDGE ACCOUNTING
We do not use derivatives to speculate on interest rates. Rather, we use
derivatives in conjunction with planned or existing balance sheet instruments in
such a way as to alter the performance characteristics of virtually any such
instrument. Authorized applications may (a) offset some or all of the price or
income effects of the associated instrument due to interest rate changes, or (b)
be applied with the expectation that they will serve either to enhance the yield
or lower the cost relative to those that would otherwise be generated.
Authorized derivatives are limited to those that trade with active secondary
markets, such as interest rate swaps, interest rate caps and exchange-traded
interest rate futures contracts.
The relevant accounting guidance is the Financial Accounting Standard No.
133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging
Activities." Although this statement became effective in January 2001, its
implementation had no impact for us, because we did not hedge during the years
2002 and 2001. For the year ended December 31, 2003, we recorded a hedge gain of
$0.4 million.
SFAS No. 133 calls for all derivatives to be recorded on the balance sheet
at market value. When used as hedges, special treatment may be permitted, but
only if a hedging relationship is properly documented and qualifying criteria
are satisfied. For derivative financial instruments not designated as hedging
instruments, all gains or losses, whether realized or unrealized, are recognized
in current period earnings.
Two distinct hedging types might apply to interest rate exposures - fair
value hedges and cash flow hedges. The former applies to recognized assets or
liabilities, where market values are subject to change as a consequence of an
interest rate changes. The latter are appropriate in connection with uncertain
interest revenues or expenses associated with forthcoming periods - whether as a
consequence of an existing variable rate asset or liability or an intended
purchase or sale.
For a fair value hedge, all gains or losses on the derivative are recorded
in earnings. In addition, the carrying value of the hedged item is adjusted due
to changes in the market value attributable to the risk being hedged, and this
change in value is also recorded in current income. We exercise our discretion
to choose to designate the risk being hedged as (a) the full price change of the
hedged item, (b) the price change due to changes in a benchmark rate (which is
either the risk free U.S. Treasury rate or the LIBOR-based swap rate), or (c)
the price change due to the
46
changes in the interest rate associated with the hedged item (i.e., the
benchmark rate plus a credit spread), depending on the specifics of the hedge
application in question.
To qualify for fair value accounting treatment:
o hedges must be documented at the inception of the hedge, with the
objective and strategy stated, along with an explicit description of
the methodology used to assess hedge effectiveness;
o the hedge must be expected to be "highly effective," both at the
inception of the hedge and on an ongoing basis - effectiveness
measures must relate the gains or losses of the derivative to those
changes in the fair value of the hedged item that are due to the
risk being hedged;
o if the hedged item is a portfolio of similar assets or liabilities,
each component must share the risk exposure, and each item is
expected to respond to the risk factor in comparable proportions;
o portions of a portfolio may be hedged if they are (a) a percentage
of the portfolio, (b) one or more selected cash flows, (c) an
embedded option (provided it is not accounted for as a stand-alone
option), (d) the residual value in a lessor's net investment in a
direct financing or sale-type lease; and
o a change in the fair value of the hedged item must present an
exposure to the earnings of the reporting entity.
For a cash flow hedge, derivative results are divided into the "effective"
portion and the "ineffective" portion. The ineffective component of the hedge
result is realized in current income, while the effective portion is initially
posted to Other Comprehensive Income, or OCI, and later re-classified as income
in the same time frame in which the forecasted cash flow affects earnings.
To qualify for cash flow accounting treatment:
o hedges must be documented at the inception of the hedge, with the
objective and strategy stated, along with an explicit description of
the methodology used to assess hedge effectiveness;
o dates (or periods) for the expected forecasted events and the nature
of the exposure involved (including quantitative measures of the
size of the exposure) must be explicitly documented;
o the hedge must be expected to be "highly effective," both at the
inception of the hedge and on an ongoing basis. Effectiveness
measures must relate the gains or losses of the derivative to
changes in the cash flows associated with the hedged item;
o the forecasted transaction must be probable; and
o the forecasted transaction must be made with a different
counterparty than the reporting entity.
If and when hedge accounting is discontinued - most likely because it is
determined that the hedge no longer qualifies as being sufficiently effective --
the derivative will continue to be recorded on the balance sheet at its fair
value, with gains or losses being recorded in earnings.
INFLATION
Inflation most significantly affects our loan originations and values of
our excess cashflow certificates, because of the substantial effect inflation
can have on interest rates. Interest rates normally increase during periods of
high inflation and decrease during periods of low inflation. (See "--Interest
Rate Risk").
IMPACT OF NEW ACCOUNTING STANDARDS
For discussion regarding the impact of new accounting standards, refer to
Note No. 1 of the Notes to the Consolidated Financial Statements.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
Except for historical information contained in the report, certain matters
discussed in this Form 10-K are "forward-looking statements" as defined in the
Private Securities Litigation Reform Act, or PSLRA, of 1995, which involve risk
and uncertainties that exist in our operations and business environment, and are
subject to change on a
47
variety of important factors. A forward-looking statement may contain words such
as "anticipate that," "believes," "continue to," "estimates," "expects to,"
"hopes," "intends," "plans," "to be," "will be," "will continue to be," or
similar words. Such statements are subject to the "safe harbor" provisions of
the PSLRA. We caution readers that numerous important factors discussed below,
among others, in some cases have caused, and in the future could cause, our
actual results to differ materially from those expressed in any forward-looking
statements made in the report. The following include some, but not all, of the
factors or uncertainties that could cause our actual results to differ from our
projections:
o Our ability or inability to earn a sufficient spread between our
cost of funds and our average mortgage rates to generate sufficient
revenues and cash flows to offset our current cost structure and
cash uses;
o Our ability or inability to return to profitability in 2005, after
recording losses in 2004;
o The effects of interest rate fluctuations and our ability or
inability to hedge effectively against these fluctuations in
interest rates, the effect of changes in monetary and fiscal
policies, social and economic conditions, unforeseen inflationary
pressures and monetary fluctuation;
o Our ability or inability to originate a sufficient amount of
mortgage loans, and subsequent sale or securitization of such loans,
to offset our current cost structure and cash uses;
o Our ability or inability to continue our practice of securitizing
mortgage loans held for sale, as well as our ability to utilize
optimal securitization structures (including the sale of NIM and/or
interest-only certificates, and the sale of servicing rights, at the
time of securitization) at terms favorable to us to generate
sufficient cash proceeds to offset our current cost structure;
o Our ability or inability to continue to access lines of credit at
favorable terms and conditions, including without limitation,
warehouse and other credit facilities used to finance
newly-originated mortgage loans held for sale and our ability or
inability to comply with covenants contained in these lines of
credit;
o The potential effect that possible conflicts with other sovereign
nations, including the conflict in Iraq, or terrorist acts and/or
threats, may have on the U.S. economy and capital markets, and in
particular the asset-backed market;
o The effect that the adoption of new, or amendments in, federal,
state or local lending laws and regulations and the application of
these laws and regulations may have on our ability to originate
loans within a particular area, or to ultimately sell those loans
through securitization or on a whole-loan basis. Many states and
local municipalities have adopted and/or are considering adopting
laws that are intended to further regulate our industry. Many of
these laws and regulations seek to impose broad restrictions on
certain commonly accepted lending practices, including some of our
practices. In addition, enacted federal, state and local laws could
impact overcollateralization requirements set by the ratings
agencies, which could decrease the cash proceeds we may receive from
our securitizations.
o The FTC's "do not call" registries may limit our ability to utilize
telemarketing to generate retail leads and originate retail loans,
and our ability or inability to find alternative methods of
generating retail leads and originating retail loans. Our marketing
operations are or may become subject to various federal and state
"do not call" list requirements. The FTC has recently amended its
rules to provide for a national "do not call" registry. Under these
new federal regulations, consumers may have their phone numbers
added to the national "do not call" registry. Generally, we are
prohibited from cold calling anyone on that registry. The FTC
implemented this registry in 2003. These regulations may restrict
our ability to market effectively our products and services to new
customers. Furthermore, compliance with these regulations may prove
costly and difficult, and we may incur penalties for improperly
conducting our marketing activities;
o Costs associated with litigation and rapid or unforeseen escalation
of the cost of regulatory compliance, generally including but not
limited to, the adoption of new, or changes in, federal, state or
local lending laws and regulations and the application of such laws
and regulations, licenses, environmental compliance, the adoption of
new, or changes in accounting policies and practices and the
application of such polices and practices. Failure to comply with
various federal, state and local regulations, accounting policies
and/or environmental compliance can lead to the loss of approved
status, rights of rescission for mortgage loans, class action
lawsuits, demands for indemnification or loan repurchases by
purchasers of our loans and administrative enforcement action
against us;
48
o Our ability or inability to detect misrepresentations, fraudulent
information or negligent acts on the part of loan applicants,
mortgage brokers, other vendors or our employees in our loan
originations prior to funding and the effect it may have on our
business, including potentially harming to our reputation, resulting
in poorer performing loans and/or demands for indemnification or
loan repurchases by purchasers of our loans, among other things;
o Our ability or inability to continue monetizing our existing excess
cashflow certificates, including without limitation, selling,
financing or securitizing (through NIM transactions) such assets;
o Our ability or inability to access the equity and debt markets upon
terms favorable to us, or at all, if necessary to raise additional
capital to fund our business;
o The impact of changes in our accounting policies, including our
change to on-balance sheet treatment of our securitizations;
o Shares of our common stock available for future sale could harm our
stock price. Sales of a substantial number of shares of our common
stock, including shares held by members of management or previously
issued in unregistered transactions, or the perception that these
sales could occur, could harm prevailing market prices for our
common stock. In addition, a substantial number of shares of our
common stock will, under our employee benefit plans, be issued or
reserved for issuance from time to time, and these shares of common
stock will be available for sale in the public markets. Moreover,
the issuance of additional shares of our common stock in the future
would be available for sale in the public markets;
o Periods of general economic slowdown or recession may be accompanied
by decreased demand for consumer credit and declining real estate
values. Because of our focus on credit-impaired borrowers, the
actual rate of delinquencies, foreclosures and losses on loans
affected by the borrowers' reduced ability to use home equity to
support borrowings could be higher than those generally experienced
in the mortgage lending industry. Any sustained period of increased
delinquencies, foreclosure, losses or increased costs could
adversely affect our ability to securitize or sell loans in the
secondary market;
o Increased competition within our markets;
o The effect that poor servicing or collections by third-party
servicers who service the loans we originate, and/or regulatory
actions and class action lawsuits against these servicers, could
have on the value of our excess cashflow certificates and/or our
ability to sell or securitize loans in the future;
o The effect that an interruption in, or breach of, our information
systems could have on our business;
o Our ability or inability to adapt to and implement technological
changes to become and/or remain competitive and/or efficient;
o Unpredictable delays or difficulties in the development of new
product programs;
o The unanticipated expenses of assimilating newly-acquired businesses
into our structure, as well as the impact of unusual expenses from
ongoing evaluations of business strategies, asset valuations,
acquisitions, divestitures and organizational structures;
o Regulatory actions, which may have an adverse impact on our lending;
and
o Changes in regulations issued by the Office of Thrift Supervision
may limit our ability to charge prepayment penalties on some of the
mortgage loans we originate, which could have an adverse impact on
our securitizations, NIM transactions and excess cashflow
certificates.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We originate mortgage loans and then sell the mortgage loans through whole
loan sales and securitizations. As a result, our primary market risk is interest
rate risk. In turn, interest rates are highly sensitive to many factors,
including:
o governmental monetary and tax policies;
o domestic and international economic and political considerations;
and
49
o other factors beyond our control.
Changes in the general interest rate levels between the time we originate
mortgage loans and the time when we sell the mortgage loans in securitization
transactions or whole loan sales can affect their value and, consequently, our
net gain on sale revenue by affecting the "excess spread" between the interest
rate on the mortgage loans and the interest rate paid on the pass-through
certificates issued by the securitization trusts. If interest rates rise between
the time we originate the loans and the time we sell the loans in a
securitization transaction, the excess spread generally narrows, resulting in a
loss in value of the loans and a lower net gain on sale for us. Since we close
and fund mortgage loans at a specified interest rate with an expected gain on
sale to be booked at the time of their sale, our exposure to decreases in the
fair value of the mortgage loans arises when moving from a lower to a higher
interest rate environment. A higher interest rate environment results in our
having higher cost of funds. This decreases both the fair value of the mortgage
loans, and the net spread we earn between the mortgage interest rate on each
mortgage loan and our cost of funds under available warehouse lines of credit
used to finance the loans prior to their sale in a securitization transaction.
As a result, we may experience a lower gain on sale.
The following table illustrates the impact on our earnings resulting from
a hypothetical 10 basis point change in interest rates. Historically, such a
basis point increase has resulted in an approximately 10 basis point change in
the excess spread or "yield." The product of 10 basis points in yield (0.10%)
and the duration of 2.5 years equals a 25.0 basis point or 0.25% change in the
net gain on sale as shown below.
10 BASIS POINT DECREASE IN 10 BASIS POINT INCREASE IN
DESCRIPTION INTEREST RATES BASE INTEREST RATES
- ----------------------------------------------------------------------------------------------
Securitization amount $100,000,000 $100,000,000 $100,000,000
Net gain on sale % 5.25% 5.00% 4.75%
Net gain $ 5,250,000 $ 5,000,000 $ 4,750,000
The table below demonstrates the sensitivity, at December 30, 2003, of the
estimated fair value of our excess cashflow certificates caused by an immediate
10% and 20%, respectively, adverse change in the key assumptions we use to
estimate fair value:
FAIR VALUE OF EXCESS IMPACT TO
CASHFLOW CERTIFICATES EARNINGS
--------------------- --------
(dollars in thousands)
Fair value as of 12/31/03: $19,853
10% increase in prepayment speed 17,318 2,534
20% increase in prepayment speed 15,866 3,987
10% increase in credit losses 15,820 4,033
20% increase in credit losses 12,492 7,361
10% increase in discount rates 19,067 786
20% increase in discount rates 18,358 1,495
10% increase in one- and six-month LIBOR 17,246 2,607
20% increase in one- and six-month LIBOR 15,066 4,787
These sensitivities are hypothetical and are presented for illustrative
purposes only. Changes in the fair value resulting from a change in assumptions
generally cannot be extrapolated because the relationship of the change in
assumption to the resulting change in fair value may not be linear. Each change
in assumptions presented above was calculated independently, without changing
any other assumption. However, in reality, changes in one assumption may result
in changes in another assumption, which may magnify or counteract the
sensitivities. For example, a change in market interest rates may simultaneously
impact prepayment speeds, credit losses and the discount rate. It is impossible
to predict how one change in a particular assumption may impact other
assumptions.
To reduce our financial exposure to changes in interest rates, we may
hedge our mortgage loans held for sale through hedging products that are
correlated to the pass-though certificates issued in connection with the
50
securitization of our mortgage loans (e.g., interest rate swaps) (See
"-Hedging"). Changes in interest rates also could adversely affect our ability
to originate loans and/or could affect the level of loan prepayments thereby
impacting the size of the loan portfolio underlying our excess cashflow
certificates and, consequently, the value of our excess cashflow certificates.
(See "-Interest Rate Risk" and "-Forward Looking Statements and Risk Factors").
51
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEPENDENT AUDITORS' REPORT
To The Board of Directors and Stockholders of
Delta Financial Corporation:
We have audited the accompanying consolidated balance sheets of Delta Financial
Corporation and subsidiaries as of December 31, 2003 and 2002 and the related
consolidated statements of operations, comprehensive income, changes in
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 2003. 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 auditing standards generally accepted
in the United States of America. 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 Delta Financial
Corporation and subsidiaries as of December 31, 2003 and 2002 and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2003 in conformity with accounting principles
generally accepted in the United States of America.
The Company adopted FASB Statement No. 145, "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" as
of December 31, 2002.
/s/ KPMG LLP
Melville, New York
March 22, 2004
52
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2003 and 2002
(Dollars in thousands) 2003 2002
- ----------------------------------------------------------------------------------------------------------
ASSETS
Cash and interest-bearing deposits .................................. $ 4,576 3,405
Accounts receivable ................................................. 2,569 1,700
Loans held for sale, net ............................................ 190,801 33,984
Excess cashflow certificates, net ................................... 19,853 24,565
Equipment, net ...................................................... 3,147 2,553
Prepaid and other assets ............................................ 4,861 1,737
Deferred tax asset, net ............................................. 31,184 5,600
- ----------------------------------------------------------------------------------------------------------
Total assets ................................................ $ 256,991 73,544
==========================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Bank payable ........................................................ $ 2,292 1,369
Warehouse financing ................................................. 144,826 13,757
Other borrowings .................................................... 2,362 2,595
Senior notes ........................................................ -- 10,844
Accounts payable and accrued expenses ............................... 11,558 15,482
- ----------------------------------------------------------------------------------------------------------
Total liabilities ........................................... 161,038 44,047
- ----------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY:
Preferred stock, Series A, $.01 par value. Authorized 150,000 shares,
139,156 shares authorized and outstanding ....................... 13,916 13,916
Common stock, $.01 par value. Authorized 49,000,000 shares;
17,032,052 shares issued and 16,915,252 shares outstanding at
December 31, 2003 and 16,022,349 shares issued and 15,905,549
shares outstanding at December 31, 2002 ......................... 170 160
Additional paid-in capital .......................................... 99,913 99,482
Accumulated deficit ................................................. (16,728) (82,743)
Treasury stock, at cost (116,800 shares) ............................ (1,318) (1,318)
- ----------------------------------------------------------------------------------------------------------
Total stockholders' equity .................................. 95,953 29,497
- ----------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity .................. $ 256,991 73,544
==========================================================================================================
See accompanying notes to consolidated financial statements.
53
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 2003, 2002 and 2001
(Dollars in thousands, except per share data) 2003 2002 2001
- -----------------------------------------------------------------------------------------------------------------------
REVENUES:
Net gain on sale of mortgage loans ............... $ 94,782 57,974 38,326
Interest income .................................. 12,418 11,803 11,158
Excess cashflow certificate income ............... 2,323 1,973 11,774
Impairment of excess cashflow certificates ....... -- (2,085) (19,676)
Gain(loss) on sale of excess cashflow certificates 220 -- (25,402)
Servicing fees ................................... -- -- 2,983
Other income ..................................... 425 1,281 188
- -----------------------------------------------------------------------------------------------------------------------
Total revenues ............................... 110,168 70,946 19,351
- -----------------------------------------------------------------------------------------------------------------------
EXPENSES:
Payroll and related costs ........................ 39,147 27,120 29,867
Interest expense ................................. 5,509 5,273 16,132
General and administrative ....................... 23,460 22,685 48,333
Restructuring and other special charges .......... -- -- 2,678
Extinguishment of debt ........................... -- -- 19,255
- -----------------------------------------------------------------------------------------------------------------------
Total expenses ............................... 68,116 55,078 116,265
- -----------------------------------------------------------------------------------------------------------------------
Income (loss) before income tax expense (benefit) .... 42,052 15,868 (96,914)
Provision for income tax expense (benefit) ........... (25,354) (1,769) 2,876
- -----------------------------------------------------------------------------------------------------------------------
Net income (loss) ............................ $ 67,406 17,637 (99,790)
=======================================================================================================================
BASIC EARNINGS PER SHARE:
Net income (loss) per share .......................... $ 4.05 1.11 (6.28)
DILUTED EARNINGS PER SHARE:
Net income (loss) per share .......................... $ 3.59 1.04 (6.28)
Basic- Weighted average number of shares outstanding 16,308,561 15,894,913 15,883,749
Diluted- Weighted average number of shares outstanding 18,407,249 16,971,028 15,883,749
See accompanying notes to consolidated financial statements.
54
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Years ended December 31, 2003, 2002 and 2001
ADDITIONAL
PREFERRED CAPITAL PAID-IN ACCUMULATED TREASURY
(Dollars in thousands) STOCK STOCK CAPITAL DEFICIT STOCK TOTAL
- ----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2000 ......... -- 160 99,472 (590) (1,318) 97,724
Issuance of preferred stock related to
debt exchange .................... 13,916 -- -- -- -- 13,916
Net loss ............................. -- -- -- (99,790) -- (99,790)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 ......... 13,916 160 99,472 (100,380) (1,318) 11,850
Stock options exercised .............. -- -- 10 -- -- 10
Net income ........................... -- -- -- 17,637 -- 17,637
- ----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 ......... 13,916 160 99,482 (82,743) (1,318) 29,497
Stock options exercised .............. -- 1 431 -- -- 432
Warrants exercised ................... -- 9 -- -- 9
Preferred stock dividends ............ -- -- -- (1,391) -- (1,391)
Net income ........................... -- -- -- 67,406 -- 67,406
- ----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003 ......... $ 13,916 170 99,913 (16,728) (1,318) 95,953
- ----------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
55
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2003, 2002 and 2001
(Dollars in thousands) 2003 2002 2001
- ------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income (loss) ........................................ $ 67,406 17,637 (99,790)
Adjustments to reconcile net income to net cash (used in)
provided by operating activities:
(Reversal)provision for loan and recourse losses ..... (12) 603 2,431
Depreciation and amortization ........................ 1,634 3,236 8,361
Extinguishment of debt ............................... -- -- 19,255
Deferred tax benefit ................................. (25,584) -- --
Deferred origination costs ........................... 751 545 578
(Gain) loss on sale of excess cashflow certificates .. (220) -- 25,402
Impairment of excess cashflow certificates ........... -- 2,085 19,676
Excess cashflow certificates received in
securitization transactions, net ................... (5,288) (9,885) (13,026)
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable ........... (869) 2,362 17,542
(Increase) decrease in loans held for sale, net ...... (157,468) 59,348 (14,263)
(Increase) decrease in prepaid and other assets ...... (3,124) (173) 42,127
(Decrease) increase in accounts payable and
accrued expenses ................................ (4,012) (4,808) 205
Decrease in investor payable ......................... -- -- (69,489)
Decrease in advance payment by borrowers
for taxes and insurance ........................... -- -- (12,940)
- -------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by operating activities ...... (126,786) 70,950 (73,931)
- -------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Proceed on sale of excess cashflow certificates .......... 10,220 -- 15,000
(Purchase) disposition of equipment ...................... (2,228) (791) 1,735
- ------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities ...... 7,992 (791) 16,735
- -------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Proceeds (repayments) of warehouse financing ............. 131,069 (67,120) 5,941
Repayments of other borrowings ........................... (233) (6,156) (4,945)
Increase in bank payable, net ............................ 923 102 340
Redemption of Senior Notes ............................... (10,844) -- --
- -------------------------------------------------------------------------------------------------------------
Cash dividends paid on preferred stock ................... (1,391) -- --
Proceeds from exercise of warrants ....................... 9 -- --
Proceeds from exercise of stock options .................. 432 10 --
- -------------------------------------------------------------------------------------------------------------
Net cash provided (used in) financing activities ......... 119,965 (73,164) 1,336
- -------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and interest-bearing deposits 1,171 (3,005) (55,860)
Cash and interest-bearing deposits at beginning of period ... 3,405 6,410 62,270
- -------------------------------------------------------------------------------------------------------------
Cash and interest-bearing deposits at end of period ......... $ 4,576 3,405 6,410
=============================================================================================================
Supplemental Information:
Cash paid during the year for:
Interest ................................................. $ 5,911 5,435 14,605
Income taxes ............................................. 1,018 278 888
=============================================================================================================
See accompanying notes to consolidated financial statements.
56
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003, 2002, AND 2001
(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) ORGANIZATION
Delta Financial Corporation ("Delta," "we," or the "Company") is a
Delaware corporation, which was organized in August 1996. On October 31, 1996,
we acquired all of the outstanding common stock of Delta Funding Corporation
("Delta Funding"), a New York corporation which had been organized on January 8,
1982 for the purpose of originating, selling, servicing and investing in
residential first and second mortgages. On November 1, 1996, we completed an
initial public offering of 4,600,000 shares of common stock, $.01 par value.
(b) PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements are prepared on the
accrual basis of accounting and include our accounts and those of our
wholly-owned subsidiaries. All significant inter-company accounts and
transactions have been eliminated in consolidation.
(c) USE OF ESTIMATES
The preparation of the consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America
requires our management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting periods.
Significant items subject to such estimates and assumptions include the carrying
amount of excess cashflow certificates and a valuation allowance on deferred tax
assets. Actual results could differ from those estimates and assumptions.
(d) RECLASSIFICATION
Certain prior period amounts in the consolidated financial statements and
notes have been reclassified to conform with the current year presentation.
(e) LOAN ORIGINATION FEES AND COSTS
Loan origination fees received, net of direct costs of originating or
acquiring mortgage loans, are recorded as adjustments to the initial investment
in the loan. Such fees are deferred and amortized until the loans are
securitized or sold.
(f) LOANS HELD FOR SALE, NET
Loans held for sale are accounted for at the lower of cost or estimated
fair value, determined on a net aggregate basis. Cost includes unamortized loan
origination fees and costs which are recognized as a component of net gain on
sale and are amortized over the estimated life of the loans or when sold. Net
unrealized losses are provided for in a valuation allowance created through a
charge to operations. Losses are recognized when the fair value is less than
cost.
(g) SECURITIZATION AND SALE OF MORTGAGE LOANS
Securitizations, whether structured as off-balance sheet sales or
on-balance sheet financings, effectively provide us with a source of long-term
financing.
In a securitization, we pool together loans, typically each quarter, and
sell these loans to a securitization trust, which is a qualified special purpose
entity, or QSPE. The securitization trust raises cash to purchase the mortgage
loans from us by selling securities to the public. These securities, known as
"asset-backed pass-through securities," are secured, or backed, by the pool of
mortgage loans that the securitization trust purchases from us. These
asset-backed securities, or senior certificates, are usually purchased by
insurance companies, mutual funds and/or other institutional investors. These
securities represent senior interests in the cash flows from the mortgage loans
in the trust. We carry no contractual obligation related to these trusts or the
loans sold to them, nor do we have any direct or contingent liability related to
the trusts, except for the standard representations and warranties typically
made as part of a sale of loans on a non-recourse basis. Furthermore, we provide
no guarantees to investors with respect to the cash flow or performance for
these trusts.
In our securitizations, the securitization trust issues senior
certificates, which entitle the holders of these senior certificates to receive
the principal collected, including prepayments of principal, on the mortgage
loans in the trust.
57
In addition, holders receive a portion of the interest paid on the loans in the
trust equal to the pass-through interest rate on the remaining principal balance
of the pass-through certificates. Depending upon the structure, the
securitization trust may also issue interest-only certificates, which entitle
the holders to receive payments of interest at a pre-determined rate over a
fixed period of time. The securitization trust also issues a subordinate
certificate or BIO certificate, referred to as an excess cashflow certificate,
and a P certificate. Each month, the P certificate holder is entitled to receive
prepayment penalties received from some borrowers who payoff their loans early.
For any monthly distribution, the holder of an excess cashflow certificate
receives payments only after all required payments have been made on all the
other securities issued by the securitization trust. In addition, before the
holder of the excess cash flow certificate receives payments, cash flows from
such excess cashflow certificates are applied in a "waterfall" manner described
in more detail in Note 6 "Securitization."
We began utilizing a new securitization structure in 2002, in which we
completed a concurrent net interest margin, or NIM, transaction. In a NIM
transaction, we sell the excess cashflow certificate and P certificate to a NIM
trust (which is also a QSPE), which in turn, issues interest-bearing NIM note(s)
and a NIM owner trust certificate. We sell the excess cashflow certificate and P
certificate for a cash purchase price without recourse except that we provide
standard representations and warranties to the NIM trust. One or more investors
purchase the NIM note(s) and we receive the proceeds of the sale of the note(s),
together with the NIM owner trust certificate in consideration of our selling
the excess cashflow certificate and P certificates to the NIM Trust.
The NIM note(s) entitles the holder to be paid a specified interest rate,
and further provides for all cash flows generated by the excess cashflow
certificate and P certificate to be used to pay all principal and interest on
the NIM note(s) until paid in full. This typically occurs approximately 22-25
months from the date the NIM note(s) were issued. The NIM owner trust
certificate entitles us to all cash flows generated by the excess cashflow
certificate and P certificate after the holder of the NIM note(s) has been paid
in full. As such, for securitizations structured as off-balance sheet sales, we
classify the NIM owner trust certificate on our balance sheet as an excess
cashflow certificate and value the NIM owner trust certificate using the same
assumptions that we utilize in valuing excess cashflow certificates.
As part of a NIM transaction, we are required to "fully fund" the O/C at
closing as required by the rating agencies and due to the securitization
structure itself - as opposed to having it build up over time as we had in past
securitizations - which is why we sold senior pass-through certificates totaling
approximately 1.05% to 2.00% less than the collateral sold to the securitization
trust. We use a portion of the proceeds we receive from selling NIM note(s) to
make up for the difference between (1) the principal amount of the mortgage
loans sold and (2) the proceeds from selling the senior pass-through
certificates.
NIM transactions have enabled us to generate positive upfront cash flow
when we securitized our mortgage loans - i.e., the cash proceeds that we receive
when the securitization and related NIM transaction close (net of funding the
upfront overcollateralization and securitization and NIM costs) have exceeded
our cost to originate the loans included in the transaction. The transactions
have have yielded cash proceeds in amounts comparable to, and in most cases
higher than, whole loan sales.
In the securitizations and related NIM transactions we completed in 2002
and 2003, in which the underlying securitization was structured as an
off-balance sheet sale under SFAS No. 140, we recorded the net cash proceeds
generated from the sale of the NIM notes as a component of our net gain on sale
of mortgage loans. Under this structure, we also retained (and recorded as a
component of our net gain on sale of mortgage loans) a relatively small excess
cashflow certificate that we recorded at its estimated fair value, ranging from
0.0% to 1.0% of the securitized collateral. See Note No. 6 of Notes to the
Consolidated Financial Statements --"Securitization".
We have found that, at times, we can receive better economic results by
selling some mortgage loans on a whole loan, non-recourse basis, without
retaining servicing rights, generally in private transactions to financial
institutions or consumer finance companies. We recognize a gain or loss when we
sell loans on a whole loan basis
58
equal to the difference between the cash proceeds received for the loans and our
investment in the loans, including any unamortized loan origination fees and
costs.
(h) EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The excess cashflow
certificates represent an ownership interest in a securitization trust. The
assets of each securitization trust consist primarily of two groups of mortgage
loans: a group of fixed rate mortgage loans and a group of hybrid/adjustable
rate mortgage loans. The mortgage loans in each mortgage pool underlying each
excess cashflow certificate consist of fully amortizing and balloon mortgage
loans secured by first or second liens primarily on one- to four-family
residential real properties having original terms to stated maturity of not
greater than 30 years.
The amount initially allocated to the excess cashflow certificates at the
date of a securitization reflects their fair value. At the time each
securitization transaction closes, we determine the present value of the related
excess cashflow certificates using certain assumptions we make regarding the
underlying mortgage loans. The excess cashflow certificate is then recorded on
our consolidated financial statements at an estimated fair value. Our estimates
primarily include the following:
o future rate of prepayment of the mortgage loans - the expected
amount of prepayments on the mortgage loans due to the underlying
borrowers of the mortgage loans paying off their mortgage loan prior
to the loan's expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of
expected losses or defaults that will take place on the underlying
mortgage loans over the life of the mortgage loans because the
excess cashflow certificates are subordinate in right of payment to
all other securities issued by the securitization trust.
Consequently, any losses sustained on mortgage loans comprising a
particular securitization trust are first absorbed by the excess
cashflow certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) -
our estimate of future interest rates which affects both the rate
paid to the floating rate pass-through security investors (primarily
the 1 month LIBOR index) and the adjustable rate mortgage loans sold
to the securitization trust (which provide for a fixed rate of
interest for the first 24 or 36 months and a 6 month variable rate
of interest thereafter using the 6 month LIBOR index); and
o a discount rate used to calculate present value.
The amount recorded for the excess cashflow certificates is reduced for
distributions that we receive as the holder of these excess cashflow
certificates, and is adjusted for subsequent changes in the fair value of the
excess cashflow certificates we hold. The value of each excess cashflow
certificate represents the cash flow we expect to receive in the future from the
certificate based upon our best estimate. We monitor the performance of the
loans underlying each excess cashflow certificate, and any changes in our
estimates (and consequent changes in value of the excess cashflow certificates)
is reflected in the line item called "impairment of excess cashflow
certificates" in the quarter in which we make any change in our estimate.
Although we believe that the assumptions we use are reasonable, there can be no
assurance as to the accuracy of the assumptions or estimates. See Note 7 "Excess
Cashflow Certificates, Net."
(i) FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards (SFAS) No. 107, "Disclosure
About Fair Value of Financial Instruments," requires us to disclose the fair
value of financial instruments for which it is practicable to estimate fair
value. Fair value is defined as the amount at which a financial instrument could
be exchanged in a current transaction between willing parties, other than in a
forced sale or liquidation, and is best evidenced by a quoted market price.
Other than excess cashflow certificates which are reported at fair value,
substantially all our assets and liabilities deemed to be financial instruments
are carried at cost, which approximates their fair value.
(j) CASH AND INTEREST-BEARING DEPOSITS
The fair value of cash and interest-bearing deposits consist of money
market accounts which approximates the carrying value reported in our
consolidated balance sheet.
(k) EQUIPMENT, NET
Equipment, including leasehold improvements, is stated at cost, less
accumulated depreciation and amortization. Depreciation of equipment is computed
using the straight-line method over the estimated useful lives of three to
59
seven years. Leasehold improvements are amortized over the lesser of the terms
of the lease or the estimated useful lives of the improvements. Expenditures for
betterments and major renewals are capitalized and ordinary maintenance and
repairs are charged to operations as incurred.
(l) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
effects of differences between the financial reporting and tax bases of assets
and liabilities. These deferred taxes are measured by applying current enacted
tax rates.
(m) EARNINGS PER SHARE
Basic Earnings Per Share ("EPS") excludes dilution and is computed by
dividing income available to common stockholders by the weighted-average number
of common shares outstanding for the period. Diluted EPS reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock or resulted in the issuance of
common stock that then shared in the earnings of the entity.
(n) STOCK-BASED COMPENSATION
We apply the intrinsic-value-based method of accounting prescribed by
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations including the Financial Accounting
Standards Board, or FASB, Interpretation No. 44, Accounting for Certain
Transactions involving Stock Compensation, an interpretation of APB Opinion No.
25, issued in March 2000, to account for its fixed-plan stock options. Under
this method, compensation expense is recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price. SFAS
No. 123, Accounting for Stock-Based Compensation, established accounting and
disclosure requirements using a fair-value-based method of accounting for
stock-based employee compensation plans. As allowed by SFAS No. 123. We have
elected to continue to apply the intrinsic-value-based method of accounting
described above, and has adopted only the disclosure requirements of SFAS No.
123. The following table illustrates the effect on net income if the
fair-value-based method had been applied to all outstanding and unvested awards
in each period.
YEAR ENDED DECEMBER 31,
-----------------------
(dollars in thousands, except share data) 2003 2002 2001
---------------------------------------------
Net income (loss), as reported $ 67,406 $ 17,637 $ (99,790)
Deduct total stock-based employee
compensation expense determined under
fair-value-based method for all rewards,
Net of tax (282) (469) (445)
----------- ----------- -----------
Pro forma net income (loss) $ 67,124 $ 17,168 $ (100,235)
=========== =========== ===========
Earnings (loss) per share:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---------------------------------------------
Basic - as reported $ 4.05 $ 1.11 $ (6.28)
=========== =========== ===========
Basic - pro forma $ 3.92 $ 1.07 $ (6.31)
=========== =========== ===========
Diluted - as reported $ 3.59 $ 1.04 $ (6.28)
=========== =========== ===========
Diluted - pro forma $ 3.48 $ 1.00 $ (6.31)
=========== =========== ===========
(o) SEGMENT REPORTING
We operate as one reporting segment, as such, the segment disclosure
requirements, are not applicable to us.
(p) IMPACT OF NEW ACCOUNTING STANDARDS
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." SFAS
No. 150 addresses the accounting for certain financial instruments that, under
previous guidance, issuers could account for as equity. The statement requires
that those instruments be classified as liabilities in statements of financial
position. SFAS No. 150 is effective for all financial
60
instruments entered into or modified after May 31, 2003. However, the effective
date of the statement's provisions related to the classification and measurement
of certain mandatory redeemable non-controlling interests has been deferred
indefinitely by the FASB, pending further Board action. The adoption of the
provisions of SFAS No. 150 did not impact our results of operations or financial
condition.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No.
133, "Accounting for Derivatives Instruments and Hedging Activities," for
certain decisions made by the Board as part of the Derivatives Implementation
Group process. This statement is effective for contracts entered into or
modified after June 30, 2003 and hedging relationships entered into after June
30, 2003. The provisions of SFAS No. 149 did not impact our results of
operations or financial condition.
In January 2003, the FASB issued Interpretation 46, "Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51" ("FIN 46") which
was subsequently amended in December 2003 by FIN 46R. FIN 46R requires a
variable interest entity to be consolidated by a company if that company is
subject to a majority of the risk of loss from the variable interest entity's
activities or is entitled to receive a majority of the entity's residual
returns, or both. Prior to FIN 46R, a company included another entity in its
consolidated financial statements only if it controlled the entity through
voting interests. The consolidation requirements of FIN 46R are applicable to
variable interest entities created after December 31, 2003. For interests held
in variable interest entities created before January 1, 2004, FIN 46R is
applicable beginning on January 1, 2005. The assets, liabilities and
non-controlling interests of variable interest entities created before January
1, 2004 would initially be measured at their carrying amounts, with any
difference between the net amount added to the balance sheet and any previously
recognized interest being recognized as the cumulative effect of an accounting
change. If determining the carrying amounts is not practicable, fair value at
the date FIN 46R first applies may be used. Some of our subsidiaries are QSPEs
formed in connection with off-balance sheet securitizations and are not subject
to the requirements of FIN 46R. Our subsidiaries that are considered variable
interest entities subject to the requirements of FIN 46R, namely the trusts
related to our on-balance sheet securitizations, are currently being
consolidated and are included in our consolidated financial statements.
Management does not expect that the application of FIN 46R will have a material
impact on our consolidated balance sheet.
(q) HEDGING ACTIVITIES
In connection with our strategy to mitigate interest rate risk on our
excess spread, we use derivative financial instruments such as Euro dollar
interest rate swaps and interest rate caps. We do not use derivatives to
speculate on interest rates. Rather, we use derivatives in conjunction with
planned or existing balance sheet instruments in such a way as to alter the
performance characteristics of virtually any such instrument. Authorized
applications may (a) offset some or all of the price or income effects of the
associated instrument due to interest rate changes, or (b) they could be applied
with the expectation that they will serve either to enhance the yield or lower
the cost relative to those which would otherwise be generated; and authorized
derivatives are limited to those that trade with active secondary markets.
SFAS No. 133 is the relevant accounting guidance and provides for all
derivatives to be recorded on the balance sheet at market value. When used as
hedges, special treatment may be permitted, but only if a hedging relationship
is properly documented and qualifying criteria are satisfied. For derivative
financial instruments not designated as hedging instruments, all gains or
losses, whether realized or unrealized, are recognized in current period
earnings.
Two distinct hedging types might apply to interest rate exposures - fair
value hedges and cash flow hedges. Fair value hedges apply to recognized assets
or liabilities, where value is subject to change as a consequence of an interest
rate change. Cash flow hedges, on the other hand are appropriate in connection
with uncertain interest revenues or expenses associated with forthcoming periods
- - whether as a consequence of an existing variable rate asset or liability or an
intended purchase or sale.
For fair value hedges, all gains or losses on the derivative are recorded
in earnings. In addition, the carrying value of the hedged item is adjusted due
to changes in the market value attributable to the risk being hedged, and this
change in value is also recorded in current income. We exercise our
discretion to choose to designate the risk being hedged as (a) the full price
change of the hedged item, (b) the price change due to changes in a benchmark
rate (either the risk free U.S. Treasury rate or the LIBOR-based swap rate), or
(c) the price change due to the changes in
61
the interest rate associated with the hedged item (i.e., the benchmark rate plus
a credit spread), depending on the specifics of the hedge application in
question.
For cash flow hedges, derivative results are divided into the "effective"
portion and the "ineffective" portion. The ineffective component of
the hedge results is realized in current income, while the effective portion is
initially posted to Other Comprehensive Income, or OCI, and later re-classified
as income in the same time frame in which the forecasted cash flow affects
earnings.
If and when hedge accounting is discontinued - most likely because it is
determined that the derivative no longer qualifies as an effective hedge -- the
derivative will continue to be recorded on the balance sheet at its fair value,
with gains or losses being recorded in earnings.
(2) SUMMARY OF REGULATORY SETTLEMENTS
In September 1999, we settled allegations by the New York State Banking
Department (the "NYSBD") and a lawsuit by the New York State Office of the
Attorney General (the "NYOAG") alleging that we had violated various state and
federal lending laws. The global settlement was evidenced by (a) a Remediation
Agreement by and between Delta Funding and the NYSBD, dated as of September 17,
1999 and (b) a Stipulated Order on Consent by and among Delta Funding, Delta
Financial and the NYOAG, dated as of September 17, 1999. As part of the
Settlement, we, among other things, implemented agreed upon changes to our
lending practices; are providing reduced loan payments aggregating $7.25 million
to certain borrowers identified by the NYSBD; and have created a fund managed by
the NYSBD and financed by the grant of 525,000 shares of Delta Financial's
common stock.
Each month, on behalf of borrowers previously designated by the NYSBD, we
make subsidy payments to the related securitization trusts. These subsidy
payments fund the differential between the original loan payments and the
reduced loan payments. As part of the Second Exchange Offer we completed in
August 2001 (see Note No. 3 "-Corporate Restructuring, Debt Modification, and
Debt Restructuring"), Delta Funding Residual Exchange Company, LLC (the "LLC")
(which is not our affiliate), the voting membership interests of which are owned
by former holders of our senior secured notes and senior notes due 2004 (the
"Notes") who tendered their Notes for such membership interests and other
securities - is obligated to satisfy these payment subsidies out of the cash
flows generated by the mortgage related securities it owns. If the LLC's cash
flows are insufficient to pay this obligation (which we believe is unlikely), we
remain responsible to satisfy our obligations under the Remediation Agreement.
The proceeds of the stock fund will be used to pay borrowers and to
finance a variety of consumer educational and counseling programs. We do not
manage the fund created for this purpose. The number of shares of common stock
deposited in the fund does not adjust to account for fluctuations in the market
price of our common stock. Changes to the market price of these shares of common
stock deposited in the fund do not have any impact on our financial statements.
We did not make any additional financial commitments between the settlement date
and March 2000 or thereafter. The Stipulated Order on Consent and the
Remediation Agreement both expired in September 2002. We remain obligated as
discussed above to continue to make subsidy payments on behalf of borrowers
previously identified by the NYSBD for so long as such borrowers continue to
make payments under the mortgage loans.
In March 2000, we finalized an agreement with the U.S. Department of
Justice, the Federal Trade Commission and the Department of Housing and Urban
Development, to complete the global settlement we had reached with the NYSBD and
NYOAG. The federal agreement mandated some additional compliance efforts for us,
but it did not require any additional financial commitment by us. The federal
agreement expired in March 2003.
We believe we are in compliance in all material respects with applicable
federal and state laws and regulations.
(3) CORPORATE RESTRUCTURING, DEBT MODIFICATION, AND DEBT RESTRUCTURING
In 2000, we began a corporate restructuring - by reducing our workforce
and modifying the terms of the indenture governing our senior notes due 2004
(the "senior notes") - as part of our continuing efforts to improve operating
efficiencies and to address our negative cash flow from operations. Entering
2001, management still had several concerns, which we believed needed to be
addressed for us to remain a viable company. Our principal concerns were:
62
o the cash drain created by our then ongoing monthly delinquency and
servicing advance requirements as servicer for securitization trust
(known as "securitization advances");
o the high cost of servicing a seasoned loan portfolio, including the
capital charges associated with making securitization advances;
o our ability to make timely interest payments on our senior notes and
senior secured notes due 2004 (the "senior secured notes"); and
o our ability to effectuate a successful business model given the
overhang of corporate ratings of "Caa2" by Moody's and "CC" by
Fitch.
Therefore in the first quarter of 2001, we embarked upon a business plan
aimed at alleviating some of these concerns and issues.
CORPORATE RESTRUCTURING
In January 2001, we entered into an agreement with Ocwen Financial
Corporation ("Ocwen") to transfer our servicing portfolio to Ocwen. In May 2001,
we physically transferred our entire servicing portfolio to Ocwen, and laid-off
the majority of our servicing staff - a total of 128 employees. We recorded a
$0.5 million pre-tax charge relating to this restructuring which is included in
the line item called "restructuring and other special charges" on our
consolidated statements of operations. This charge relates to employee severance
associated with closing our servicing operations. We no longer service loans nor
do we have a servicing operation.
DEBT MODIFICATION AND DEBT RESTRUCTURING
In August 2000, we announced an agreement to modify the terms of the
indenture governing our senior notes (the "Debt Modification"). With the consent
of the holders of greater than fifty percent of our senior notes, we modified a
negative pledge covenant in the senior notes indenture, which had previously
prevented us from selling or otherwise obtaining financing by using our excess
cashflow certificates as collateral. In consideration for the senior
noteholders' consent, we agreed, in an exchange offer (the "First Exchange
Offer"), to offer then current holders the opportunity to exchange their then
existing senior notes for (a) new senior secured notes due 2004 (the "senior
secured notes") and (b) ten-year warrants to buy approximately 1.6 million
shares of common stock, at an initial exercise price of $9.10 per share, subject
to upward or downward adjustment in certain circumstances. In December 2002, the
exercise price for the warrants issued by us was adjusted downward to $0.01 per
share in accordance with our agreement. The senior secured notes had the same
coupon, face amount and maturity date as the senior notes and, up until the
Second Debt Restructuring (see below) were secured by at least $165 million of
the our excess cashflow certificates. The First Exchange Offer was consummated
in December 2000, with holders of greater than $148 million (of $150 million) of
senior notes tendering in the exchange.
In February 2001, we entered into a letter of intent with the beneficial
holders of over fifty percent of our senior secured notes to restructure, and
ultimately extinguish, the senior secured notes (the "Second Debt
Restructuring"). In March 2001, we obtained the formal consent of these
beneficial holders of the senior secured notes through a consent solicitation
that modified certain provisions of the senior secured notes indenture to, among
other things, allow for the release of two excess cashflow certificates then
securing the senior secured notes. We were first able to finance and then
ultimately sell the excess cashflow certificates underlying five securitizations
with a carrying value of $40.4 million (including two excess cashflow
certificates that were released as part of the Second Debt Restructuring) for a
$15 million cash purchase price to provide working capital.
In consideration for their consent, we agreed to offer the holders of the
senior secured notes (and the senior notes, collectively, the "notes"), an
opportunity to exchange their notes for new securities described immediately
below (the "Second Exchange Offer"). The Second Exchange Offer was consummated
on August 29, 2001, pursuant to which holders of approximately $138.1 million
(of $148.2 million) in principal amount of our senior secured notes and $1.1
million (of $1.8 million) in principal amount of our senior notes, exchanged
their notes for commensurate interests in:
o voting membership interests in Delta Funding Residual Exchange
Company LLC (the "LLC"), a newly-formed limited liability company
(which is not our affiliate), to which we transferred all of the
mortgage-related securities previously securing the senior secured
notes (primarily comprised of excess cashflow certificates);
63
o shares of common stock of a newly-formed management corporation that
will manage the LLC's assets; and
o shares of our newly-issued Series A preferred stock having an
aggregate preference amount of $13.9 million.
The LLC is controlled by the former noteholders that now hold all the
voting membership interest in the LLC. As part of the transaction, we obtained a
non-voting membership interest in the LLC, which entitles us to receive 15% of
the net cash flows from the LLC for the first three years (through June 2004)
and, thereafter, 10% of the net cash flows from the LLC. The net cash flows from
the LLC are equal to the total cash flows generated by the assets held by the
LLC for a particular period, less (a) all expenses of the LLC, (b) certain
related income tax payments, and (c) the NYSBD subsidy payments (see "- Note No.
2 Summary of Regulatory Settlement"). We began receiving distributions from the
LLC in the first quarter of 2002 from a fourth quarter 2001 distribution. We
have not received our distributions since the second quarter of 2003 due to a
dispute with the LLC's President, which has led us to commence a lawsuit to
recover all of the amounts due to us. See "Part I, Item 3, "Legal Proceedings".
As part of the Second Exchange Offer, all tendering noteholders waived
their right to receive any future interest coupon payments on the tendered notes
beginning with the August 2001 interest coupon payment. With the closing of the
Second Exchange Offer, we recorded a charge of $19.3 million related to the
extinguishment of debt and paid the August 2001 interest coupon payment on the
approximately $10.8 million of notes that did not tender in the Second Exchange
Offer. The notes bear interest at a rate of 9.5% per annum, payable
semi-annually (on February 1st and August 1st) and a maturity date of August 1,
2004 when all outstanding principal is due. On October 30, 2003, we redeemed, at
par, all of our outstanding 9.5% Senior Notes due August 2004. The aggregate
redemption price, including principal and accrued interest, was approximately
$11.0 million.
(4) LOANS HELD FOR SALE, NET
Our inventory consists of first and second mortgages, which had a weighted
average interest rate of 8.23% per annum at December 31, 2003 and 8.45% per
annum at December 31, 2002. Certain of these mortgages totaling $144.8 million
are pledged as collateral for a portion of the warehouse financing and other
borrowings.
Loans held for sale, net, are summarized as follows:
(Dollars in thousands) December 31, 2003 December 31, 2002
- --------------------------------------------------------------------------------
Loans held for sale $ 191,402 $ 34,170
Net deferred origination (fees) cost (501) 249
Valuation allowance (100) (435)
- --------------------------------------------------------------------------------
Loans held for sale, net $ 190,801 $ 33,984
================================================================================
INTEREST INCOME
The following table is a summary of interest income:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
(DOLLARS IN THOUSANDS)
Interest earned on loans held for sale ..... $10,497 8,134 7,144
Securitization accrued bond interest ....... 1,330 1,901 2,819
Miscellaneous interest income ............. 591 1768 1,195
------- ------ ------
Total interest income ................... $12,418 11,803 11,158
======= ====== ======
(5) FINANCIAL STATEMENT RECLASSIFICATIONS
64
Certain amounts reflected in the Consolidated Financial Statements for the
year ended December 31,2002 and December 31,2001 have been reclassified to
conform to the presentation for the year ended December 31, 2003.
SFAS No. 91,"Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Indirect Costs of Leases" requires that
certain nonrefundable fees and costs associated with originating loans are
deferred at the point they are incurred and generally are recognized over the
life of the loan. If a mortgage loan is sold, the deferred fees and costs are
recognized at that time of sale. These loan origination fees and costs have been
classified as a component of the gain on the sale of the loans in this period
and previously reported amounts have been reclassified to conform to the current
presentation. This reclassification did not impact net income (loss) in the
current period or in any prior period. The deferral of origination fees and
expenses had the following effect for the periods presented:
YEAR ENDED DECEMBER 31,
-----------------------------------
2003 2002 2001
---- ---- ----
(DOLLARS IN THOUSANDS)
Revenue as previously reported .......... $ 131,822 86,143 33,148
Reclassification of direct origination
expenses ............................... (21,654) (15,197) (13,797)
--------- --------- ---------
Total revenue ........................ $ 110,168 70,946 19,351
========= ========= =========
YEAR ENDED DECEMBER 31,
-----------------------------------
2003 2002 2001
---- ---- ----
(DOLLARS IN THOUSANDS)
Expenses as previously reported ......... $ 89,770 70,275 130.062
Reclassification of direct origination
expenses ............................... (21,654) (15,197) (13,797)
--------- --------- ---------
Total expenses ....................... $ 68,116 55,078 116,265
========= ========= =========
6) SECURITIZATION
During 2003, we issued four securitizations totaling $1.6 billion in
collateral, of which we delivered a total of $1.5 billion of mortgage loans
during 2003. We delivered the remaining $114 million of mortgage loans in
January 2004 using a pre-funding feature. All of our 2003 securitizations
received ratings on various classes of securities ranging from AAA/Aaa to
BBB-/Baa3 by S&P, Fitch and Moody's, respectively. The following table sets
forth certain information with respect to our 2003 securitizations by offering
size, which includes pre-funded amounts, duration weighted average pass-through
rate and type of credit enhancement.
INITIAL DURATION
OFFERING SIZE COLLATERAL WEIGHTED AVERAGE CREDIT
SECURITIZATION ISSUED (MILLIONS) (MILLIONS) PASS-THROUGH RATE ENHANCEMENT
-------------- ------ ---------- ---------- ----------------- -----------
2003-1......... 03/27/03 $258.6 $263.1 2.40% Senior/Sub
2003-2......... 06/26/03 $393.0 $400.0 2.19% Senior/Sub
2003-3......... 09/30/03 $434.7 $440.0 1.83% Senior/Sub
2003-4......... 12/29/03 $470.0 $475.0 2.13% Senior/Sub
In a securitization, we pool together loans, typically each quarter, and
sell these loans to a newly-formed securitization trust, which is a QSPE. These
trusts are established for the limited purpose of buying our mortgage loans. We
carry no contractual obligation related to these trusts or the loans sold to
them, nor do we have any direct or contingent liability related to the trusts,
except for the standard representations and warranties typically made as part of
a sale of loans on a non-recourse basis. Furthermore, we provide no guarantees
to investors with respect to cash flow or performance for these trusts.
The securitization trust raises cash to purchase the mortgage loans from
us by selling securities to the public. These securities, known as "asset-backed
pass-through securities," are secured, or backed, by the pool of mortgage loans
purchased by the securitization trust from us. These asset-backed securities, or
senior certificates, which are usually purchased by insurance companies, mutual
funds and/or other institutional investors, represent senior interests in the
cash flows from the mortgage loans in the trust.
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In our securitizations, the securitization trust issues senior
certificates, which entitle the holders of these senior certificates to receive
the principal collected, including prepayments of principal, on the mortgage
loans in the trust. In addition, holders receive a portion of the interest paid
on the loans in the trust equal to the pass-through interest rate on the
remaining principal balance of the pass-through certificates. Depending upon the
structure, the securitization trust may also issue interest-only certificates,
which entitle the holders to receive payments of interest at a pre-determined
rate over a fixed period of time. The securitization trust also issues a
subordinate certificate or BIO certificate (referred to as an excess cashflow
certificate), and a P certificate. Each month, the P certificate holder is
entitled to receive prepayment penalties received from borrowers who payoff
their loans early.
For any monthly distribution, the holder of an excess cashflow certificate
receives payments only after all required payments have been made on all the
other securities issued by the securitization trust. In addition, before the
holder of the excess cash flow certificate receives payments, cash flows from
the excess cashflow certificates are applied in a "waterfall" manner as follows:
o first, to cover any losses on the mortgage loans in the related
mortgage loan pool, because the excess cashflow certificates are
subordinate in right of payment to all other securities issued by
the securitization trust;
o second, to reimburse the bond insurer, if any, of the related series
of pass-through certificates for amounts paid by or otherwise owing
to that insurer;
o third, to build or maintain the overcollateralization provision
described below for that securitization trust at the required level
by being applied as an accelerated payment of principal to the
holders of the pass-through certificates of the related series;
o fourth, to reimburse holders of the subordinated certificates of the
related series of pass-through certificates for unpaid interest and
for any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates that
was not paid because of the imposition of a cap on their
pass-through rates - these payments are called "basis risk shortfall
amounts."
The overcollateralization provision is a credit enhancement required by
the rating agencies and/or bond insurers rating the certificates - that is
designed to protect the securities sold to the securitization pass-through
investors from credit losses, which arise principally from defaults on the
underlying mortgage loans. In short, overcollateralization occurs when the
amount of collateral (i.e., mortgage loans) owned by a securitization trust
exceeds the aggregate amount of senior pass-through certificates. The O/C is
created to absorb losses that the securitization trust may suffer, as loans are
liquidated at a loss. Historically, we built up the O/C typically over the first
18 to 24 months of a securitization (with the specific timing depending upon the
structure, amount of excess spread, and performance of the securitization), by
utilizing the cash flows from the excess cashflow certificates to make
additional payments of principal to the holders of the pass-through certificates
until the required O/C level was reached. Beginning in our 2002 securitizations
and in each of our 2003 securitizations, we created the O/C by initially selling
pass-through securities totaling approximately 98.5% of the total amount of
mortgage loans sold to the trust. In doing so, we created the full amount of the
O/C required by the trust at the time we completed the securitization, instead
of over time. For example, if a securitization trust contains collateral of $100
million principal amount of mortgage loans, we sell approximately $98.5 million
in senior pass-through certificates. Prior to our 2002 securitization
transactions, we typically issued pass-through certificates for a par purchase
price, or a slight discount to par - with par representing the aggregate
principal balance of the mortgage loans backing the asset-backed securities. For
example, if a securitization trust contains collateral of $100 million of
mortgage loans, we typically received close to $100 million in proceeds from the
sales of these certificates, depending upon the structure we use for the
securitization.
The O/C is generally expressed as a percentage of the initial mortgage
loan or collateral principal balance sold to the securitization trust. The
initial O/C is initially determined by either the rating agencies and/or the
bond insurer, if any, using various factors, including:
o characteristics of the mortgage loans sold to the trust, such as
credit scores and loan-to-value ratios;
o the amount of excess spread between the interest rate on the pool of
mortgage loans sold to the securitization trust and the interest
paid to the pass-through certificate holders, less the servicing
fee, and other related expenses such as trustee fees and bond
insurer fees, if any; and
o the structure of the underlying securitization--for example, issuing
BBB-certificates creates greater credit enhancement in the
securitization transaction, which generally results in a lower o/c).
66
Our securitizations have typically required an O/C of between 1.05% and
3.0% of the initial mortgage loans sold to the securitization trust. The
required O/C can increase or decrease throughout the life of the transaction
depending upon subordination levels, delinquency and/or loss tests and is
subject to minimums and maximums, as defined by the rating agencies and/or the
bond insurer insuring the securitization. In our securitizations prior to 2002,
after the O/C requirement is reached, the cash flows from the excess cashflow
certificates are then distributed to us as the holder of the excess cashflow
certificates, in accordance with the "waterfall" described above. Over time, if
the cash collected during the periods exceeds the amount necessary to maintain
the required O/C, all other required distributions have been made, and there is
no shortfall in the related required O/C, the excess is paid to us as holder of
the excess cashflow certificate.
Each securitization trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which helps ensure the timely payment of interest and
the ultimate payment of principal of the credit-enhanced investor certificate,
or both (known as a "hybrid"). In "senior-subordinated" structures, the senior
certificate holders are protected from losses by subordinated pass-through
certificates, which absorb any such losses first. In addition to such credit
enhancement, the excess cash flows that would otherwise be paid to the holder of
the excess cashflow certificate is used when and if it subsequently becomes
necessary to obtain or maintain required overcollateralization limits.
Overcollateralization is used to absorb losses prior to making a claim on the
financial guaranty insurance policy or the subordinated certificates.
We began utilizing a new securitization structure in 2002, in which we
completed a concurrent net interest margin, or NIM, transaction. In a NIM
transaction, we sell the excess cashflow certificate and P certificate to a NIM
trust (which is also a QSPE), which in turn, issues interest-bearing NIM note(s)
and a NIM owner trust certificate. We sell the excess cashflow certificate and P
certificate for a cash purchase price without recourse except that we provide
standard representations and warranties to the NIM trust. One or more investors
purchase the NIM note(s) and we receive the net proceeds of the sale of the
note(s), together with the NIM owner trust certificate in consideration of our
selling the excess cashflow certificate and P certificates to the NIM Trust.
The NIM note(s) entitles the holder to be paid a specified interest rate,
and further provides for all cash flows generated by the excess cashflow
certificate and P certificate to be used to pay all principal and interest on
the NIM note(s) until paid in full. This typically occurs approximately 22-25
months from the date the NIM note(s) were issued. The NIM owner trust
certificate entitles us to all cash flows generated by the excess cashflow
certificate and P certificate after the holder of the NIM note(s) has been paid
in full. As such, for securitizations structured as off-balance sheet sales, we
classify the NIM owner trust certificate on our balance sheet as an excess
cashflow certificate and value the NIM owner trust certificate using the same
assumptions that we utilize in valuing excess cashflow certificates.
As part of a NIM transaction, we are required to "fully fund" the O/C at
closing - as opposed to having it build up over time as we had in past
securitizations - which is why we sold senior pass-through certificates totaling
approximately 1.05% to 2.00% less than the collateral in the securitization
trust. We use a portion of the proceeds we receive from selling NIM note(s) to
make up for the difference between (1) the principal amount of the mortgage
loans sold and (2) the proceeds from selling the senior pass-through
certificates.
NIM transactions have enabled us to generate positive upfront cash flow
when we securitized our mortgage loans - i.e., the cash proceeds that we receive
when the securitization and related NIM transaction close (net of funding the
upfront overcollateralization and securitization and NIM costs) exceed our cost
to originate the loans included in the transaction. The transactions have
yielded net cash proceeds in amounts comparable to, and in most cases higher
than, whole loan sales.
In the securitizations and related NIM transactions we completed from 2002
through 2003, in which the underlying securitization was structured as an
off-balance sheet sale under SFAS No. 140, we recorded the net cash proceeds
generated from the sale of the NIM notes as a component of our net gain on sale
of mortgage loans. Under this structure, we also retained (and recorded as a
component of our net gain on sale of mortgage loans) a relatively small excess
cashflow certificate that we recorded as at its estimated fair value, ranging
from 0.0% to 1.0% of the securitized collateral.
67
Off-Balance Sheet Securitizations. Through the end of 2003, we have
structured our securitizations as off-balance sheet transactions. Accordingly,
under SFAS No. 140, we have recorded a gain on sale of mortgage loans upon
completion of each such securitization. For instance, in each of the four
securitizations that we issued in 2003, we derived, and recorded as revenue, the
following economic interests:
o we received a cash purchase price from the sale of the NIM note(s)
issued by a NIM trust, to which we sold the excess cashflow
certificates;
o we received a cash purchase price from the sale of interest-only
certificates, which entitle the holders to receive payments of
interest at a pre-determined rate and over a fixed period of time;
o we received a cash premium from selling the right to service the
loans that we securitized. This right entitles the contractual
servicer to service the loans on behalf of the securitization trust,
and earn a contractual servicing fee, and ancillary servicing fees,
including prepayment penalties relating to the servicing rights we
previously sold, in that capacity;
o we retained a NIM owner trust certificate, which entitles us to
receive cash flows generated by the excess cashflow certificates and
the P certificate issued in connection with the securitization after
the holder of the NIM note(s) has been paid in full. Although the
cash flows generated by excess cashflow certificates are received
over time, under GAAP, we must report as income at the time of the
securitization the present value of all projected cash flows we
expect to receive in the future from these excess cashflow
certificates based upon an assumed discount rate. Our valuation of
these excess cashflow certificates is primarily based on:
(1) our estimate of the amount of expected losses or defaults that
will take place on the underlying mortgage loans over the life
of the mortgage loans;
(2) the expected amount of prepayments on the mortgage loans due
to the underlying borrowers of the mortgage loans paying off
their mortgage loans prior to the stated maturity;
(3) the LIBOR forward curve, using current LIBOR as the floor
rate; and
(4) a discount rate.
While we retained an excess cashflow certificate on our $435 million
securitization completed in the quarter ended September 30, 2003 and our $470
million securitization completed in the fourth quarter ended December 31, 2003,
we did not record either certificate as an asset and corresponding revenue item
due to the securitization structure we used to maximize cash revenues.
Historically, in our securitizations, we have sold pass-through certificates
with credit ratings from the rating agencies that were rating the securitization
transactions ranging from AAA to BBB. In our securitizations completed in the
third and fourth quarters of 2003, we issued a limited principal amount of
certificates rated BBB-. This structure reduced the amount of
overcollateralization required, compared to a structure without a BBB-
certificate, because the BBB- certificate replaces credit enhancement that would
have otherwise been achieved solely through overcollateralization and the
corresponding excess cashflow certificate. Had we not sold a BBB- certificate,
the same credit enhancement would have been produced through a higher
overcollateralization, which would have correspondingly led to a higher valued
excess cashflow certificate. The BBB- certificate made possible a lower upfront
overcollateralization than if we did not sell a BBB- certificate, which, in
turn, resulted in our receiving higher cash proceeds from the securitization, as
the senior certificates represent a larger percentage of the aggregate value of
the mortgage loans sold - e.g., a 1.2% O/C results in $98.8 million of
certificates being sold against every $100 million of mortgage loans purchased
by the securitization trust, whereas a 2.2% O/C results in $97.8 million of
certificates being sold against every $100 million of mortgage loans purchased
by the securitization trust (rating agencies and the securitization structure
requires us to sell more mortgage loans (collateral) than the amount of
certificates issued). Hence, the lower the upfront overcollateralization, the
greater the upfront cash proceeds received. As a result of the cash flow needed
to pay the interest on and principal amount of BBB- rated certificates, coupled
with less overcollateralization and based upon our gain on sale assumptions, we
ascribed no value to the excess cashflow certificate that we retained in the
securitizations for those two quarters. However, if the loans underlying these
securitization transactions perform better than our expectations, we will
recognize excess cash flows from the excess cashflow certificates and record the
cash and interest income as received. As with all of our most recent
securitization structures, we will not receive excess cash flows, if any, from
the excess cashflow certificate until the NIM note is paid off in full.
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At the time we completed the 2003 securitizations, we recognized as
revenue each of the economic interests described above, which were recorded as
net gain on sale of mortgage loans in our consolidated statement of income.
A summary of the gain on sale we received from our aggregate
securitizations and whole loan sales in 2003, 2002 and 2001 is presented below.
"Loans Sold" represents the amount of loans actually transferred to the
respective securitization trusts during each year and whole loans sold on a
servicing-released basis:
YEAR ENDED DECEMBER 31,
-------------------------------------------
2003 2002 2001
---- ---- ----
Net Gain on Sale of Mortgage loans (Dollars in thousands)
Loans Sold ............................................... $ 1,537,600 $ 922,057 $ 606,100
=========== =========== ===========
NIM Proceeds, Net ........................................ $ 67,159 $ 42,050 $ --
Interest Only Certificate Proceeds ....................... 12,913 -- 13,332
Excess Cashflow Certificate (owner trust certificates)(1) 6,941 10,499 11,081
Mortgage Servicing Rights ................................ 8,910 7,248 5,213
Hedging .................................................. 438 -- --
Gain on whole loan sales ................................. 2,137 4,547 11,099
Loan origination fees .................................... 25,079 14,366 13,485
Loan origination costs ................................... (21,654) (15,197) (13,797)
Less: Securitization transaction costs .................. (7,141) (5,539) (2,087)
----------- ----------- -----------
Net gain on sale recorded ............................. $ 94,782 $ 57,974 $ 38,326
=========== =========== ===========
Net gain on sale recorded (as a percent of loans sold) 6.2% 6.3% 6.3%
(1) The reduction in value of the excess cashflow certificates in 2003
compared to 2002 is primarily due to our not recording any excess cash
flow certificates in the third and fourth quarter of 2003. (See "- Excess
Cashflow Certificate, Net").
Our net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate the loans,
adjusted for the following:
o any direct loan origination costs incurred (an increase in the
investment) and loan origination fees received (a decrease in the
investment) in connection with the loans, which are treated as a
component of the initial investment in loans;
o the principal payments received, and the amortization of the net
loan fees or costs, during the period we held the loans prior to
their securitization; and
o any gains (a decrease in the investment) or losses (an increase in
the investment) we incur on any hedging instruments that we may have
utilized to hedge against the effects of changes in interest rates
during the period we hold the loans prior to their securitization.
We allocate our basis in the mortgage loans and excess cashflow
certificates between the portion of the mortgage loans and excess cashflow
certificates sold through securitization and the portion retained (the NIM owner
trust certificate since 2002) based on the relative fair values of those
portions on the date of sale. We may recognize gains or losses attributable to
the changes in fair value of the excess cashflow certificates, which are
recorded at estimated fair value and accounted for as "trading" securities.
Since there is no active market for the excess cashflow certificates, we
determine their estimated fair value by discounting the expected cash flows.
(7) EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the
present value of the related excess cashflow certificates (which, in the
securitizations we have issued since 2002, includes NIM owner trust
certificates, and the underlying BIO certificates and P certificates), using
assumptions we make regarding the underlying mortgage
69
loans. The excess cashflow certificate is then recorded on our consolidated
financial statements at an estimated fair value. Our estimates primarily include
the following:
o future rate of prepayment of the mortgage loans - the expected
amount of prepayments on the mortgage loans due to the underlying
borrowers paying off their mortgage loan prior to the loan's
expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of
expected losses or defaults that will take place on the underlying
mortgage loans over the life of the mortgage loans because the
excess cashflow certificates are subordinated to all other
securities issued by the securitization trust. Consequently, any
losses sustained on mortgage loans comprising a particular
securitization trust are first absorbed by the excess cashflow
certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) -
our estimate of future interest rates, which affects both the rate
paid to the floating rate pass-through security investors (primarily
the one-month LIBOR index) and the adjustable rate mortgage loans
sold to the securitization trust (which provide for a fixed rate of
interest for the first 24 or 36 months and a six-month variable rate
of interest thereafter using the six-month LIBOR index); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the cash flow we
expect to receive in the future from such certificate based upon our best
estimate. We monitor the performance of the loans underlying each excess
cashflow certificate, and any changes in our estimates (and consequent changes
in value of the excess cashflow certificates) are reflected in the line item
called "excess cashflow certificate income" in the quarter in which we make any
such change in our estimate. Although we believe that the assumptions we use are
reasonable, there can be no assurance as to the accuracy of the assumptions or
estimates.
In determining the fair value of each of the excess cashflow certificates,
we make the following underlying assumptions regarding mortgage loan
prepayments, mortgage loan default rates, the LIBOR forward curve and discount
rates:
a) Prepayments. We base our prepayment rate assumptions upon our
ongoing analysis of the performance of the mortgage pools we
previously securitized, and the performance of similar pools of
mortgage loans securitized by others in the industry. We apply
different prepayment speed assumptions to different loan product
types because it has been our experience that different loan product
types exhibit different prepayment patterns. Generally, our loans
can be grouped into two loan products - fixed-rate loans and
adjustable-rate loans. With fixed-rate loans, an underlying
borrower's interest rate remains fixed throughout the life of the
loan. Our adjustable-rate loans are a "hybrid" between fixed- and
adjustable-rate loans, in that the interest rate generally remains
fixed, typically for the first two or three years of the loan, and
then adjusts, typically every six months thereafter. Within each
product type, factors other than interest rate can affect our
prepayment rate assumptions. These factors include:
o whether or not a loan contains a prepayment penalty - an
amount that a borrower must pay to a lender if the borrower
prepays the loan within a certain time after the loan was
originated. Loans containing a prepayment penalty typically
are not repaid as quickly as those without a penalty;
o as is customary in our industry with adjustable-rate mortgage
loans, the introductory interest rate we charge to the
borrower is artificially lower, between one and two full
percentage points, than the rate for which the borrower would
have otherwise qualified. Generally, once the interest rate
begins to adjust, the interest rate payable on that loan
increases, at times fairly substantially. This interest rate
increase can be exacerbated if there is an absolute increase
in interest rates. As a result of these increases and the
potential for future increases, adjustable rate mortgage loans
typically are more susceptible to early prepayments.
There are several reasons why a loan may prepay prior to its
maturity, including but not limited to:
o a decrease in interest rates;
o improvement in the borrower's credit profile, which may allow
the borrower to qualify for a lower interest rate loan;
70
o competition in the mortgage market, which may result in lower
interest rates being offered to the borrower;
o the borrower's sale of his or her home;
o the borrower's need for additional funds; and
o a default by the borrower, resulting in foreclosure by the
lender.
It is unusual for a borrower to prepay a mortgage loan during the
first few months because:
o it typically takes at least several months after the mortgage
loans are originated for any of the above events to occur;
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our current prepayment assumptions for the
month one and peak speed. The assumptions have not changed since
September 2001.
Loan Type Month One Peak Speed
---------------------------------------------------
Fixed Rate 4.00% 30.00%
Adjustable Rate 4.00% 75.00%
If mortgage loans prepay faster than anticipated, we will earn less
income in connection with the mortgage loans and receive less excess
cash flow in the future because the mortgage loans have paid off.
Conversely, if mortgage loans prepay at a slower rate than
anticipated, we earn more income and more excess cash flow in the
future, subject to the other factors that can affect the cash flows
from, and our valuation of, the excess cashflow certificates.
(b) Default Rate. At December 31, 2003 and 2002, on each newly issued
securitization, we apply a default reserve for both fixed- and
adjustable-rate loans sold to the securitization trusts totaling
5.00% of the amount initially securitized. We apply a default or
loss rate to the excess cashflow certificate because it is the
"first-loss" piece and is subordinated in right of payment to all
other securities issued by the securitization trust. If defaults are
higher than we anticipate, we will receive less income and less
excess cash flow than expected in the future. Conversely, if
defaults are lower than we expected, we will receive more income and
more excess cash flow than expected in the future, subject to the
other factors that can affect the cash flows from, and our valuation
of, the excess cashflow certificates.
(c) LIBOR Forward Curve. The LIBOR forward curve is used to project
future interest rates, which affects both the rate paid to the
floating rate pass-through security investors (which primarily use
one-month LIBOR as a base) and the adjustable rate mortgage loans
sold to the securitization trust (which have a fixed rate of
interest for either the first 24 or 36 months then a variable rate
of interest thereafter using six-month LIBOR as a base). A
significant portion of our loans are fixed-rate mortgages, and a
significant amount of the securities sold by the securitization
trust are floating-rate securities (the interest rate adjusts based
upon an index, such as one-month LIBOR). As such, our excess
cashflow certificates are subject to significant basis risk and a
change in LIBOR will, impact our excess spread. If LIBOR is lower
than anticipated, we will receive more income and more excess cash
flows than expected in the future, subject to the other factors that
can affect the cash flows from, and our valuation of, the excess
cashflow certificates. Conversely, if LIBOR is higher than expected,
we will receive less income and less excess cash flows than expected
in the future. In each of our securitizations in which we sold NIM
note(s), we purchased an interest rate cap, which helps mitigate the
basis risk for the approximate time that the NIM notes are
outstanding.
(d) Discount Rate. We use a discount rate that we believe reflects the
risks associated with our excess cashflow certificates. Because
quoted market prices on comparable excess cashflow certificates are
not available, we compare our valuation assumptions and performance
experience to our competitors in the non-conforming mortgage
industry. Our discount rate takes into account the asset quality and
the performance of our securitized mortgage loans compared to that
of the industry and other characteristics of our securitized loans.
We quantify the risks associated with our excess cashflow
certificates by comparing the asset quality and payment and loss
performance experience of the underlying securitized mortgage pools
to comparable industry performance. The discount rate we use to
determine the present value of cash flows from excess
71
cashflow certificates reflects increased uncertainty surrounding
current and future market conditions, including without limitation,
uncertainty concerning inflation, recession, home prices, interest
rates and conditions in the equity markets.
We utilized a discount rate of 15% at December 30, 2003 and 2002 on
all excess cashflow certificates. Prior to the quarter ended
September 30, 2001, we used an 18% discount rate on a NIM
transaction we consummated in November 2000. We increased the
discount rate on these excess cashflow certificates during the
period that the senior NIM securities remained outstanding, to
account for the potentially higher risk associated with the residual
cash flows expected to be received by the holder of the certificated
interest in the NIM trust, which was subordinated to the multiple
senior securities sold in the NIM transaction. As part of the Second
Exchange Offer, all of the excess cashflow certificates that were
subject to the November 2000 NIM transaction were transferred to the
LLC. We did not increase the discount rate on the excess cashflow
certificates from our latest securitizations despite issuing NIM
securities because the NIM securities in the most recent
transactions were:
o issued from a single securitization as compared to the
November 2000 NIM transaction, which was backed by a
combination of six securitizations issued between September
1997 and March 1999 resulting in more volatility or
variability in determining the timing of cash flows to be
received by the NIM; and
o issued from a new securitization as compared to the November
2000 NIM transaction, which was backed by several seasoned
securitization trusts. The predictability in determining the
timing of cash flows for the first two years on a newly issued
securitization is typically higher than securitizations that
have been outstanding for a greater period of time because
defaults or losses to the trust within the first few years of
issuance are typically lower and more predictable compared to
a securitization that has been outstanding for a longer period
of time (a more seasoned transaction). Additionally,
prepayment speeds are more predictable compared to more
seasoned transactions, which is aided by the presence of
prepayment penalties, which typically expire within the first
few years after a mortgage loan is originated. Therefore,
there is a higher probability in determining the timing of
cash flows to the NIM investor on a new issuance
securitization as compared to a seasoned transaction.
At March 2001, we sold five of our excess cashflow certificates with a
carrying value of $40.4 million for $15.0 million resulting in a loss of
$25.4 million.
At September 30, 2001, we recorded a charge to impairment of excess
cashflow certificates to reflect a fair value adjustment to our remaining excess
cashflow certificates totaling $19.7 million. Our change in assumptions at
September 30, 2001, primarily reflect recent unforeseen market events relating
to the terrorist attacks on September 11, 2001, that further accelerated an
economic downturn in the U.S. economy, and which we believe may have a
significant adverse impact on the economy for the foreseeable future.
At March 31, 2002, we recorded a charge to impairment of excess cashflow
certificates to reflect a fair value adjustment to our excess cashflow
certificates, totaling $2.1 million, relating to the timing of excess cash flows
that are to be received by the excess cashflow certificate after the release or
"step-down" of the overcollateralization account.
In August 2003, we sold three of our excess cashflow certificates, which
had a $10.0 million carrying value in the aggregate, for $10.2 million in cash.
We recorded the gain earned from the sale in gain (loss) of certificates, and
reduced the value of our excess cashflow certificates on our balance sheet
accordingly. The net impact was an increase to income of $0.2 million in the
quarter ended September 30, 2003.
The activity related to our excess cashflow certificates for the years
ended December 31, is as follows:
(Dollars in thousands) 2003 2002 2001
- --------------------------------------------------------------------------------
Balance, beginning of year $ 24,565 16,765 216,907
New excess cashflow certificates 6,941 10,499 11,081
Net accretion/(amortization) of excess
cashflow certificates (1,653) (614) 1,945
Fair value adjustments -- (2,085) (19,676)
Sales (10,000) -- (40,402)
Second Exchange Offer (1) -- -- (153,090)
- --------------------------------------------------------------------------------
Balance, end of year $ 19,853 24,565 16,765
================================================================================
72
(1) The Second Exchange Offer was consummated on August 29, 2001. In the
Second Exchange Offer, holders of approximately $138.1 million (of $148.2
million) in principal amount of our senior secured notes and $1.1 million (of
$1.8 million) in principal amount of our senior notes exchanged their notes for
commensurate interests in voting membership interests in the LLC (which is not
our affiliate), to which we transferred all of the mortgage-related securities
previously securing the senior secured notes (primarily comprised of excess
cashflow certificates).
Our valuation of retained excess cashflow certificates is highly dependent
upon the reasonableness of our assumptions and the predictiveness of the
relationships that drive the results of our valuation model. The assumptions we
utilize, described above, are complex, as we must make judgment calls about the
effect of matters that are inherently uncertain. As the number of variables and
assumptions affecting the possible future resolution of the uncertainties
increase, those judgments become even more complex.
In volatile markets, like those we have experienced over the past several
years, there is increased risk that our actual results may vary significantly
from our assumed results. The longer the time period over which the uncertainty
will exist, the greater the potential volatility for our valuation assumptions
and the fair value of our excess cashflow certificates.
The table below demonstrates the sensitivity, at December 31, 2003, of the
estimated fair value of our excess cashflow certificates caused by an immediate
10% and 20%, respectively, adverse change in the key assumptions we use to
estimate fair value:
FAIR VALUE OF EXCESS IMPACT TO
(Dollars in thousands) CASHFLOW CERTIFICATES EARNINGS
-------------------- -------
Fair value as of 12/31/03: $19,853
10% increase in prepayment speed 17,318 2,534
20% increase in prepayment speed 15,866 3,987
10% increase in credit losses 15,820 4,033
20% increase in credit losses 12,492 7,361
10% increase in discount rates 19,067 786
20% increase in discount rates 18,358 1,495
10% increase in one- & six-month LIBOR 17,246 2,607
20% increase in one- & six-month LIBOR 15,066 4,787
These sensitivities are hypothetical and are presented for illustrative
purposes only. Changes in the fair value resulting from a change in assumptions
generally cannot be extrapolated because the relationship of the change in
assumption to the resulting change in fair value may not be linear. Each change
in assumptions presented above was calculated independently without changing any
other assumption. However, in reality, changes in one assumption may result in
changes in another assumption, which may magnify or counteract the
sensitivities. For example, a change in market interest rates may simultaneously
impact prepayment speeds, credit losses and the discount rate. It is impossible
to predict how one change in a particular assumption may impact other
assumptions.
(8) HEDGING TRANSACTIONS
For the year ended December 31, 2003 we recorded hedge gain of $0.4
million. We entered into interest rate swap agreements for the purpose of
hedging our mortgage loans in inventory. We did not hedge during the years ended
December 31, 2002 and 2001, respectively.
73
(9) WAREHOUSE FINANCING
The warehouse lines are collateralized by specific mortgage loans, the
balances of which are equal to or greater than the outstanding balances under
the line at any point in time. Available borrowings under these lines are based
on the amount of the collateral pledged.
The following table summarizes certain information regarding warehouse
financing at the respective dates:
(Dollars in millions)
FACILITY BALANCE AT DECEMBER 31, EXPIRATION
FACILITY DESCRIPTION AMOUNT FINANCING TERM 2003 2002 DATE
- -----------------------------------------------------------------------------------------------------------------------
Warehouse line of credit $250.0 Margin over LIBOR $ 94.8 -- October 2004
Warehouse line of credit $250.0 Margin over LIBOR 50.0 -- April 2004
Warehouse line of credit n/a Margin over LIBOR n/a 13.8 May 2003
- -----------------------------------------------------------------------------------------------------------------------
Total $ 144.8 13.8
=======================================================================================================================
In March 2004, our warehouse line of credit that was due to expire in
April 2004 was extended to March 2005.
Our warehouse agreements require us to comply with various operating and
financial covenants. The continued availability of funds under these agreements
is subject to, among other conditions, our continued compliance with these
covenants. We believe that we are in compliance with these covenants as of
December 31, 2003.
INTEREST EXPENSE
The following table is a summary of interest expenses:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
(DOLLARS IN THOUSANDS)
Interest expense for loans finance in warehouse $4,390 3,602 5,480
Capital leases ................................ 255 461 813
Senior notes (1) .............................. 854 1,030 9,201
Other ......................................... 10 180 638
------ ----- ------
Total interest expense ..................... $5,509 5,273 16,132
====== ===== ======
(1) In August 2001, we completed our Second Exchange Offer, which extinguished
substantially all of our long-term debt, leaving approximately $11 million
out of $150 million of our notes still outstanding.
(10) OTHER BORROWINGS
The following table summarizes certain information regarding other
borrowings at the respective dates:
(Dollars in thousands)
BALANCE AT DECEMBER 31, EXPIRATION
FACILITY DESCRIPTION RATE 2003 2002 DATE
- ---------------------------------------------------------------------------------------------------------
Capital leases 2.00% - 12.45% $ 2,362 2,595 July 2004 - Dec 2006
=========================================================================================================
Future contractual obligations related to principal balances for capital
leases are as follows:
(Dollars in thousands)
BALANCE AT DECEMBER 31,
-----------------------
PERIOD 2003 2002
- --------------------------------------------------------------------------------
Less than 1 year $1,204 1,953
1-3 years 1,158 642
================================================================================
Total $2,362 2,595
- --------------------------------------------------------------------------------
(11) WARRANTS
In December 2000, as part of our First Exchange Offer, we issued warrants
to purchase 1,569,193 shares of our common stock, at an initial exercise price
of $9.10 per share, subject to adjustment. In December 2002, the exercise
74
price for the warrants was adjusted to $0.01 per share in accordance with the
terms of the warrant agreement under which the warrants were granted.
During the twelve months ended December 31, 2003, 862,403 warrants were
exercised for 862,406 shares of common stock and 706,790 warrants remained
unexercised. Following our redemption, on October 30, 2003, of the Senior Notes
issued on December 21, 2000, all unexercised warrants expired pursuant to their
terms.
(12) PREFERRED STOCK - SERIES A
In August 2001, as part of our Second Exchange Offer, the holders of
approximately $139.2 million (of the initial $150.0 million) principal amount of
our 9.5% senior notes due 2004 exchanged their notes for, among other interests,
139,156 shares of our newly issued Series A preferred stock, having an aggregate
preference amount of $13.9 million.
Holders of the Series A preferred stock are entitled to receive cumulative
preferential dividends at the rate of 10% per annum of the preference amount,
payable in cash semi-annually on the first business date of January and July,
commencing in July 2003. We paid $1.4 million of dividends to the Series A
holders in 2003. We are required to comply with restrictive covenants in
connection with our Series A preferred stock. We believe we are in compliance
with these covenants as of December 31, 2003.
(13) SENIOR NOTES
On October 30, 2003, we redeemed, at par, all of our outstanding 9.5% senior
notes due August 2004. The aggregate redemption price, including principal and
accrued interest, was approximately $11.0 million. We used our existing cash to
fund the redemption. The outstanding balance of the notes totaled $10.8 million
as of December 31, 2002.
(14) BANK PAYABLE
In order to maximize our cash management practices, we have instituted a
procedure whereby checks written against our operating account are covered as
they are presented to the bank for payment, either by drawing down our lines of
credit or from subsequent deposits of operating cash. Bank payable represents
the checks outstanding at December 31, 2003 and 2002, to be paid in this manner.
(15) EMPLOYEE BENEFIT PLANS
We sponsor a 401(k) Retirement Savings Plan. Substantially all our
employees who are at least 21 years old are eligible to participate in the plan
after completing one year of service. Contributions are made from employees'
elected salary deferrals. We elected to make discretionary contributions to the
Plan of $0.5 million, $0.3 million and $0.5 million for 2003, 2002 and 2001,
respectively.
(16) COMMITMENTS AND CONTINGENCIES
We have repurchase agreements with certain of the institutions that have
previously purchased our mortgages. Some of the agreements provide for the
repurchase by us of any of the mortgage loans that go to foreclosure sale. At
the foreclosure sale, we will repurchase the mortgage, if necessary, and make
the institution whole. The dollar amount of loans that were previously sold with
recourse and are still outstanding totaled $1.8 million at December 31, 2003 and
$2.6 million at December 31, 2002.
Included in accounts payable is an allowance for recourse losses of $1.1
million at December 31, 2003 and $1.2 million at December 31, 2002,
respectively. We recognized, as a charge to operations, a provision for recourse
losses of approximately $88,175, $73,500, and $311,000 for the years 2003, 2002
and 2001, respectively. Additions to the allowance for loan losses are provided
by charges to income based upon various factors, which, in management's
judgment, deserve current recognition in estimating probable losses. The loss
factors are determined by management based upon an evaluation of historical loss
experience, delinquency trends, loan volume and the impact of economic
conditions in our market area.
We provide commitments to fund mortgage loans to customers as long
as all of the proper conditions are met. Our commitments have fixed expiration
dates. We quote interest rates to customers, which are generally subject to
change by us. Although, we typically honor such interest rate quotes, the quotes
do not constitute future cash requirements, minimizing the potential interest
rate risk exposure. These non-conforming
75
mortgage loan commitments do not meet the definition of a derivative under
accounting principles generally accepted in the United States of America.
Accordingly, they are not recorded in the consolidated financial statements. At
December 31, 2003 and 2002, we had outstanding origination commitments to fund
approximately $52.8 million and $27.2 million in mortgage loans, respectively.
Our rental expense, net of sublease income, for the years ended December
31, 2003, 2002 and 2001 amounted to $5.2 million, $4.5 million and $5.0 million,
respectively.
Minimum future rentals under non-cancelable operating leases as of
December 31, 2003 are as follows:
(Dollars in thousands)
- --------------------------------------------------------------------------------
YEAR AMOUNT
- --------------------------------------------------------------------------------
2004 $ 4,612
2005 4,670
2006 4,604
2007 4,469
2008 1,508
2009 187
- --------------------------------------------------------------------------------
Total $ 20,050
================================================================================
Because the nature of our business involves the collection of numerous
accounts, the validity of liens and compliance with various state and federal
lending laws, we are subject, in the normal course of business, to numerous
legal proceedings and claims, including several class action lawsuits. The
resolution of these lawsuits, in management's opinion, will not have a material
adverse effect on our financial position or results of operations.
(17) STOCK BASED COMPENSATION
The 1996 Stock Option Plan (the "1996 Plan") authorized the reserve of
2,200,000 shares of unissued common stock for issuance pursuant to the 1996
Plan. The 2001 Stock Option Plan (the "2001 Plan," collectively with the 1996
Plan, the "Plans") authorized the reserve of 1,500,000 shares of unissued common
stock for issuance pursuant to the 2001 Plan. Substantially all of the options
issued vest over a five-year period at 20% per year and expire seven years from
the grant date.
The following table summarizes certain information regarding the Plans at
December 31:
- -------------------------------------------------------------------------------------------------------------------------------
2003 2002 2001
- -------------------------------------------------------------------------------------------------------------------------------
NUMBER WTD-AVG NUMBER WTD-AVG NUMBER WTD-AVG
OF EXERCISE OF EXERCISE OF EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
- -------------------------------------------------------------------------------------------------------------------------------
Balance, beginning of year 2,515,050 $2.01 2,179,000 $4.25 990,700 $12.38
Options granted 126,000 6.32 815,500 1.84 1,658,300 .50
Options exercised 147,300 0.79 21,800 .50 --
Options canceled 256,800 4.89 457,650 12.48 470,000 8.17
- -------------------------------------------------------------------------------------------------------------------------------
Balance at end of year 2,236,950 $2.00 2,515,050 $2.01 2,179,000 $4.25
===============================================================================================================================
Options exercisable 755,805 $2.86 519,380 $4.79 515,650 $13.97
- -------------------------------------------------------------------------------------------------------------------------------
The weighted-average fair value of options granted during 2003, 2002 and
2001 was $4.25 $1.25 and $1.21, respectively. For purposes of the pro forma
calculation under SFAS No. 123, the fair value of the options granted is
estimated using the Black-Scholes option-pricing model with the following
weighted-average assumptions used for the 2003, 2002 and 2001 grants:
2003 2002 2001
- -------------------------------------------------------------------------------------------------------------------------------
Dividend yield 0% 0% 0%
Expected volatility 84% 103% 164%
Risk-free interest rate 3.17% 2.87% 4.22%
Expected life 5 years 5 years 5 years
Average remaining contractual life 4.56 years 5.37 years 5.28 years
76
(18) INCOME TAXES
The provision (benefit) for income taxes for the years ended December 31,
2003, 2002 and 2001 is as follows:
(Dollars in thousands) 2003 2002 2001
- --------------------------------------------------------------------------------
Current: Federal $ (267) (1,121) 1,847
State & Local 180 (648) 1,029
- --------------------------------------------------------------------------------
Total current income taxes $ (87) (1,769) 2,876
- --------------------------------------------------------------------------------
Deferred: Federal $ 12,716 3,560 (31,053)
State & Local 4,352 848 (7,393)
- --------------------------------------------------------------------------------
Valuation allowance (42,335) (4,408) 38,446
- --------------------------------------------------------------------------------
Total deferred income taxes (25,267) -- --
- --------------------------------------------------------------------------------
Total tax provision (benefit) $(25,354) (1,769) 2,876
================================================================================
Significant components (temporary differences and carryforwards) that give
rise to our net deferred tax asset as of December 31, 2003 and 2002 were as
follows:
(Dollars in thousands) 2003 2002
---- ----
DEFERRED TAX ASSETS:
- --------------------------------------------------------------------------------
Book/tax difference in excess cashflow
certificates, net carrying amount $ 2,266 14,832
Loss reserves 1,386 1,879
Capitalized origination fees and related cost 196 --
Book over tax depreciation 341 419
Federal and State net operating loss carryforwards 26,995 30,905
- --------------------------------------------------------------------------------
Gross deferred tax assets $31,184 48,035
Less: Valuation Allowance -- 42,335
- --------------------------------------------------------------------------------
Deferred tax assets net of valuation allowance $31,184 5,700
================================================================================
DEFERRED TAX LIABILITIES:
- --------------------------------------------------------------------------------
Capitalized origination fees and related cost $ -- 100
- --------------------------------------------------------------------------------
Gross deferred tax liabilities -- 100
================================================================================
Net deferred tax assets $31,184 5,600
================================================================================
We are required to recognize all or a portion of our gross deferred tax
assets if we believe that it is more likely than not, given the weight of all
available evidence, that all or a portion of the benefits of the carryforward
losses and other deferred tax assets will be realized. Management believes that,
based on the available evidence, it is more likely than not that we will realize
the benefit from our gross deferred tax assets.
At September 30, 2003, we reversed a valuation allowance that we had
established in 2000 against our deferred tax asset. Management believed that the
reversal was appropriate at the time principally because of our eight
consecutive quarters of profitability and positive cash flow, together with the
planned retirement of all our long-term unsecured debt. We have recorded minimal
taxes in our results of operations over the prior seven quarters - from the
fourth quarter of 2001 through the second quarter of 2003 - as a result of the
valuation allowance against our deferred tax asset, which was primarily
generated by net operating losses ("NOLs") in 2000 and 2001.
As of December 31, 2003, Federal and state NOLs totaled approximately
$27.0 million, principally expiring in 2021.
77
A reconciliation of the statutory income tax rate to the effective income
tax rate, as applied to income (loss) for the years ended December 31, 2003,
2002 and 2001 is as follows:
2003 2002 2001
- -----------------------------------------------------------------------------------------------
Tax at statutory rate 35.0% 35.0% 35.0%
State & local taxes, net of Federal benefit 7.0 0.8 4.3
Change in valuation allowance for deferred tax assets (100.7) (27.7) (39.7)
Non-deductible expenses and other (1.6) (19.2) (2.6)
- -----------------------------------------------------------------------------------------------
Total tax rate (60.3)% (11.1)% (3.0)%
===============================================================================================
(19) EARNINGS PER SHARE
The following is a reconciliation of the denominators used in the
computations of basic and diluted EPS. The numerator for calculating both basic
and diluted EPS is net income.
For the years ended December 31:
(Dollars in thousands, except EPS data) 2003 2002 2001
- -----------------------------------------------------------------------------------
Net income (loss) $67,406 17,637 (99,790)
Less: Preferred stock dividends 1,391 -- --
- -----------------------------------------------------------------------------------
Net income available to commons stockholders 66,015 17,637 n/a
===================================================================================
Weighted-average shares - basic 16,309 15,895 15,884
Incremental shares-options 2,098 1,076 --
- -----------------------------------------------------------------------------------
Weighted-average shares - diluted 18,407 16,971 15,884
- -----------------------------------------------------------------------------------
Basic earnings per share:
- -----------------------------------------------------------------------------------
Net income (loss) $ 4.05 1.11 (6.28)
===================================================================================
Diluted earnings per share:
- -----------------------------------------------------------------------------------
Net income (loss) $ 3.59 1.04 (6.28)
===================================================================================
For 2001, approximately 23,000 stock options are excluded from the
calculation of diluted EPS because their effect is antidilutive in periods where
losses are reported.
(20) GENERAL AND ADMINISTRATIVE EXPENSES
The following table is a summary of general and administrative expenses:
YEAR ENDED DECEMBER 31,
-----------------------------
2003 2002 2001
---- ---- ----
(DOLLARS IN THOUSANDS)
Rent and occupancy $ 5,200 4,450 5,025
Telephone 2,861 2,240 2,431
Fees and licenses 2,034 2,002 2,715
Depreciation and amortization (1) 1,634 3,236 8,301
Computer expenses 1,615 1,583 1,276
Management and consulting 1,472 1,052 613
Other administrative expenses (1) 8,644 8,122 27,972
------- ------ ------
Total general and administrative expenses (1) $23,460 22,685 48,333
======= ====== ======
(1) The year ended December 31, 2001 included expenses primarily associated with
(1) our disposition and transfer of our servicing portfolio in May 2001 to
Ocwen, (2) capital charges previously associated with our interest and servicing
advance securitizations prior to the sale of the servicing portfolio, (3) a
change in accounting estimates regarding the life expectancy of our
computer-related equipment, and (4) a charge for reserves primarily against a
pool of non-performing loans, which we ultimately sold in July 2001.
78
(21) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table is a summary of financial data by quarter for the
years ended December 31, 2003 and 2002:
For the quarters ended:
(Dollars in thousands, except per share data) March 31, June 30, Sept. 30, Dec. 31,
- -------------------------------------------------------------------------------------------------------
2003
Revenues $21,832 28,833 29,333 30,170
Expenses 14,867 17,097 18,193 17,959
Net income(a) 6,697 11,701 41,595 7,413
Earnings per share basic(a) 0.42 0.68 2.55 0.40
Earnings per share diluted(a) 0.36 0.58 2.24 0.37
2002
Revenues(b) $16,058 17,811 18,181 18,896
Expenses 13,693 13,707 13,619 14,059
Net income(b)(c) 2,245 3,972 6,698 4,722
Earnings per share basic(b)(c) 0.14 0.25 0.42 0.30
Earnings per share diluted(b)(c) 0.14 0.23 0.39 0.28
- -----------------------------
(a) In the third quarter of 2003, we recorded an income tax benefit, which was
primarily related to the reversal of a valuation that we had established
in 2000 against our deferred tax asset.
(b) The quarter ended March 31, 2002 includes a charge of $2.1 million, which
represents a fair value adjustment to our excess cashflow certificates.
(c) The quarter ended September 30, 2002 includes a special tax benefit of
$2.2 million related to us obtaining a favorable resolution to tax issue
for which we had previously reserved and do not expect to recur.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
At December 31, 2003 management, including the Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness and operation of our
disclosure controls and procedures. Our Chief Executive Officer and Chief
Financial Officer concluded that, as of December 31, 2003, these disclosure
controls and procedures were effective to ensure that information required to be
disclosed in the reports we file and submit under the Securities and Exchange
Act is recorded, processed, summarized and reported as and when required. There
have been no significant changes in our internal controls or in other factors
that could significantly affect these internal controls following the date that
we performed our evaluation. There were no significant deficiencies or material
weaknesses identified during the course of this evaluation and therefore, no
corrective actions were taken.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
We incorporate by reference information in our proxy statement that
complies with the information called for by Item 10 of Form 10-K. The proxy will
be filed within 120 days of December 31, 2003.
ITEM 11. EXECUTIVE COMPENSATION
We incorporate by reference information in our proxy statement that
complies with the information called for by Item 11 of Form 10-K. The proxy will
be filed within 120 days of December 31, 2003.
79
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
We incorporate by reference information in our proxy statement that
complies with the information called for by Item 12 of Form 10-K. The proxy will
be filed within 120 days of December 31, 2003.
ITEMS 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We incorporate by reference information in our proxy statement that
complies with the information called for by Item 13 of Form 10-K. The proxy will
be filed within 120 days of December 31, 2003.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
We incorporate by reference information in our proxy statement that
complies with the information called for by Item 14 of Form 10-K. The proxy will
be filed within 120 days of December 31, 2003.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a)(1) Financial Statements:
PAGE(S)
-------
The following Consolidated Financial Statements of Delta Financial
Corporation and Subsidiaries are included in Part II, Item 8 of this
report
Independent Auditors' Report............................................................. xx
Consolidated Balance Sheets--December 31, 2003 and 2002.................................. xx
Consolidated Statements of Operations--Years ended December 31, 2003, 2002 and 2001...... xx
Consolidated Statement of Changes in Stockholders' Equity--Years ended
December 31, 2003, 2002 and 2001..................................................... xx
Consolidated Statements of Cash Flows--Years ended December 31, 2003, 2002 and 2001...... xx
Notes to Consolidated Financial Statements............................................... xx
(a)(3) Exhibits:
EXH.
NO. FILED DESCRIPTION
--- ----- ----------
3.1 (a) -- Certificate of Incorporation of Delta Financial Corporation
3.2 (b) -- Second Amended Bylaws of Delta Financial Corporation
3.3 (c) -- Certificate of Designations, Voting Powers, Preferences and Rights of Series A Preferred Stock of
Delta Financial Corporation
10.1 (c) -- Employment Agreement dated February 27, 2002 between the Registrant and Hugh Miller
10.2 (d) -- Employment Agreement dated September 12, 2002 between the Registrant and Sidney A. Miller.
10.3 (h) -- Employment Agreement dated August 13, 2003 between the Registrant and Randall F. Michaels
10.4 (c) -- Employment Agreement dated February 27, 2002 between the Registrant and Richard Blass
10.5 (e) -- Registration Rights Agreement, dated as of December 21, 2000, between the Registrant and Mellon Investor
Services, LLC, as warrant agent
10.6 (a) -- Lease Agreement between Delta Funding Corporation and the Tilles Investment Company, and the Second,
Third and Fourth Amendments to Lease Agreement
10.7 (f) -- Fifth, Sixth and Seventh Amendments to Lease Agreement between Delta Funding Corporation and the
Tilles Investment Company
10.8 (g) -- Eighth Amendment to Lease Agreement between Delta Funding Corporation and the Tilles Investment Company
10.9 (c) -- Ninth Amendment to Lease Agreement between Delta Funding Corporation and the Tilles Investment Company
10.10 (a) -- 1996 Stock Option Plan of Delta Financial Corporation
10.11 (c) -- 2001 Stock Option Plan of Delta Financial Corporation
21.1 (i) -- Subsidiaries of Registrant
23.1 (i) -- Consent of Independent Auditors
80
31.1 (i) -- Rule 13a-14(a)/15d-14(a) Certification of the Chief Executive Officer
31.2 (i) -- Rule 13a-14(a)/15d-14(a) Certification of the Chief Financial Officer
32.1 (i) -- Section 1350 Certification of the Chief Executive Officer
32.2 (i) -- Section 1350 Certification of the Chief Financial Officer
- ---------------
(a) Incorporated by reference from our Registration Statement on Form S-1 (No.
333-11289), filed with the Commission on September 3, 1996, and related
amendments to the Form S-1.
(b) Incorporated by reference from our Annual Report on Form 10-K for the year
ended December 31, 1998 (File No. 1-12109), filed with the Commission on
March 31, 1999.
(c) Incorporated by reference from our Annual Report on Form 10-K for the year
ended December 31, 2001 (File No. 1-12109), filed with the Commission on
April 1, 2002.
(d) Incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2002 (File No. 1-12109), filed with the
Commission on November 13, 2002.
(e) Incorporated by reference from our Current Report on Form 8-K (File No.
1-12109), filed with the Commission on January 10, 2001.
(f) Incorporated by reference from our Annual Report on Form 10-K for the year
ended December 31, 1997 (File No. 1-12109), filed with the Commission on
March 31, 1998.
(g) Incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended March 31, 1998 (File No. 1-12109), filed with the Commission
on May 12, 1998.
(h) Incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2003 (File No. 1-12109), filed with the Commission
on August 14, 2003.
(o) (i) Filed herewith
(b) Reports on Form 8-K.
On October 31, 2003, we furnished a Form 8-K containing our October 30,
2003 earnings press release.
On November 4, 2003, we furnished a Form 8-K containing a press release
announcing that, on October 30, 2003, we redeemed all of our outstanding 9.5%
Senior Notes due 2004.
81
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, thereto duly authorized.
DELTA FINANCIAL CORPORATION
(Registrant)
Dated: March 29, 2004 By: /s/ HUGH MILLER
---------------------------------------
Hugh Miller
President and Chief Executive Officer
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 CAPACITY IN WHICH SIGNED DATE
- --------- ------------------------ ----
/s/ SIDNEY A. MILLER Chairman of the Board of Directors March 29, 2004
- ------------------------------------
Sidney A. Miller
/s/ HUGH MILLER President, Chief Executive Officer and Director March 29, 2004
- ------------------------------------ (Principal Executive Officer)
Hugh Miller
/s/ RICHARD BLASS Executive Vice President, Chief Financial Officer March 29, 2004
- ------------------------------------ and Director (Principal Financial Officer)
Richard Blass
/s/ MARTIN D. PAYSON Director March 29, 2004
- ------------------------------------
Martin D. Payson
/s/ ARNOLD B. POLLARD Director March 29, 2004
- ------------------------------------
Arnold B. Pollard
/s/ MARGARET A. WILLIAMS Director March 29, 2004
- ------------------------------------
Margaret A. Williams
/s/ SPENCER I. BROWNE Director March 29, 2004
- -------------------------------------
Spencer I. Browne
82