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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------
FORM 10-K
(Mark one)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT
OF 1934
for the Fiscal Year Ended June 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ________ to __________
Commission file number 0-19604
AAMES FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 95-4340340
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
350 S. GRAND AVENUE, LOS ANGELES, CALIFORNIA 90071
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (213) 640-5000
Securities registered pursuant to Section 12(b) of the Act:
Title of each Class Name of each exchange on which registered
- ------------------- -----------------------------------------
COMMON STOCK, PAR VALUE $0.001 NEW YORK STOCK EXCHANGE
PREFERRED STOCK PURCHASE RIGHTS NEW YORK STOCK EXCHANGE
10.50% SENIOR NOTES DUE 2002 NEW YORK STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act:
9.125% Senior Notes Due 2003
----------------------------
(Title of Class)
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 the 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.[ ]
At September 2, 1997, there were outstanding 27,771,035 shares of the
Common Stock of Registrant, and the aggregate market value of the shares held on
that date by non-affiliates of the Registrant, based on the closing price
($19.625 per share) of the Registrant's Common Stock on the New York Stock
Exchange was $477,826,340. For purposes of this computation, it has been assumed
that the shares beneficially held by directors and executive officers of
Registrant were "held by affiliates"; this assumption is not to be deemed to be
an admission by such persons that they are affiliates of Registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrant's Proxy Statement relating to its 1997 Annual
Meeting of Stockholders are incorporated by reference in Items 10, 11, 12 and 13
of Part III of this Annual Report.
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PART I
ITEM 1. BUSINESS
GENERAL
Aames Financial Corporation (the "Company") is a consumer finance
company primarily engaged, through its subsidiaries, in the business of
originating, purchasing, selling and servicing home equity mortgage loans
secured by single family residences. In late fiscal 1997, the Company began
offering small commercial loans on a limited basis which it plans to sell on a
whole loan basis servicing released. The Company, upon its formation in 1991,
acquired Aames Home Loan, a home equity lender founded in 1954.
The Company's principal market is borrowers whose financing needs are
not being met by traditional mortgage lenders for a variety of reasons,
including the need for specialized loan products or credit histories that may
limit such borrowers' access to credit. The Company believes these borrowers
continue to represent an underserved niche of the home equity loan market and
present an opportunity to earn a superior return for the risk assumed. The
mortgage loans originated and purchased by the Company, which include fixed and
adjustable rate loans, are generally used by borrowers to consolidate
indebtedness or to finance other consumer needs rather than to purchase homes.
The Company originates and purchases loans on a nationwide basis through
three production channels--retail, broker and correspondent. For the year ended
June 30, 1997, the Company originated and purchased $2.35 billion of mortgage
loans. The Company underwrites and appraises every loan it originates and
generally re-underwrites and reviews appraisals on all loans it purchases. See
"-- Mortgage Loan Production." The Company retains the servicing rights
(collecting loan payments and managing borrower defaults) to substantially all
of the loans it originates or purchases. At June 30, 1997, the Company had a
servicing portfolio of $3.17 billion, of which 53% was subserviced by third
parties. In fiscal 1997, the Company's servicing division implemented systems
and personnel that will allow it to service directly substantially all of its
servicing portfolio by the end of fiscal 1998. See "-- Loan Servicing."
During fiscal 1997, the Company experienced a dramatic shift up the
credit grade spectrum reflecting its previously announced strategic decision to
diversify the loans it originates and purchases to include more of the higher
credit grade loans. In fiscal 1997, of the total loans originated and purchased
by the Company, 82% were A, A-, B and C credit grade loans and 18% were C- and D
credit grade loans, compared to 66% and 34%, respectively, in fiscal 1996. This
diversification was accomplished primarily through the acquisition of One Stop
Mortgage, Inc. ("One Stop") in August 1996, which focuses on the higher credit
grade spectrum, the decrease in C- and D originations in certain non-judicial
foreclosure states and the adoption of pricing structures by credit grade in the
correspondent and retail divisions. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Revenues."
As a fundamental part of its business and financing strategy, the
Company sells substantially all of its loans to third party investors in
securitization transactions. These transactions enhance
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profitability, maximize liquidity and reduce the Company's exposure to
fluctuations in interests rates. The Company securitized and sold in the
secondary market $317 million, $791 million and $2.26 billion of loans in the
fiscal years ended June 30, 1995, 1996 and 1997, respectively. See
"--Securitization of Loans."
RECENT EVENTS
During the fourth quarter of fiscal 1997, two factors caused the Company
to re-evaluate its correspondent bulk purchase program--uncertainties in the
capital markets and the increase in the pricing for bulk loan product. These
uncertainties were evidenced by the sudden decline in common stock prices of
companies in the subprime home equity sector, including the Company, and pricing
sensitivity encountered by companies in the sector in accessing the public
equity and debt markets. Given that the Company funded the significant negative
cash flow associated with the bulk correspondent business in the public equity
and debt markets, the uncertainties in those markets increased the risk to the
Company that its cost of capital would be excessively high. Additionally, the
premiums paid by the Company for bulk product during the 1997 fiscal year
reached a peak of 8.25% in March 1997. These high premiums, together with the
apparent increase in the cost of capital, adversely impacted the projected
profitability of the bulk product. As a result of these developments, the
Company changed the approach used in the pricing of its bulk loan product.
Specifically, the Company established lower prices to be paid for this product
based primarily on its historical performance. This change is expected to
decrease the amount of bulk loans purchased in fiscal 1998 compared to fiscal
1997.
The Company also incorporated the results of the fourth quarter pricing
review into the regular quarterly fair market valuation of the interest-only
strips. The Company determines the fair market value of the interest-only
strips, in part, by applying management's expectations as to future prepayment
rates to the present value of the future cash flows from prior securitizations.
The use of revised prepayment rates resulted in a fourth quarter unrealized loss
of $28.0 million on the valuation of that asset. These same prepayment
assumptions materially lowered the Company's gain on sale expressed as a
percentage of total loans securitized. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Revenue."
In June 1997, the Company retained Donaldson, Lufkin & Jenrette
Securities Corporation to develop a means to maximize opportunities for the
Company and its stockholders. These opportunities include remaining independent
and continuing to grow internally and through acquisition, or selling the
Company or entering into a business combination transaction. While the Company
is in discussions concerning a possible business combination, it also believes
the profit-enhancing steps taken in the fourth quarter create a strong
foundation upon which to remain independent and continue to grow its production
channels and servicing platform.
BUSINESS STRATEGY
The Company continues to build on its position as a leading lender in
its niche market. The expansion of the Company's business over the last three
years has been driven by the growth in the volume of loans originated and
purchased by the Company and by the Company's ability to continue to access the
capital markets to facilitate the sale of these loans through securitizations.
As an
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independent entity, the Company intends to pursue its growth strategy by (i)
continuing to expand its retail loan office network, independent mortgage broker
network and flow and mini-bulk correspondent program; (ii) diversifying the
products offered; (iii) increasing its servicing portfolio and servicing
capabilities; (iv) continuing to enhance its corporate and operating
infrastructure; and (v) diversifying its funding sources. An important long-term
goal of the Company's business strategy is to continue to build its investment
in interest-only strips and mortgage servicing rights. The Company believes that
its investments in these assets yield attractive rates of returns. In addition,
the Company believes its cash flow profile will change over time as the rate of
loan production growth moderates and as the size of its servicing portfolio and
its interest-only strips increase. In particular, the Company intends to employ
the following strategies:
Geographic Diversification. The Company plans to continue the geographic
expansion of its loan production. During fiscal 1997, the Company expanded its
retail loan office network into the Midwest and East. The Company intends to
continue focusing on its nationwide retail expansion and to expand its loan
purchasing capabilities by opening new broker offices and building new
relationships with independent mortgage brokers and flow and mini-bulk loan
correspondents nationwide, with the goal of increasing market share in these
areas. The Company also is considering expanding operations on an international
basis.
Diversification of Loan Products. The Company regularly reviews its loan
offerings and introduces new loan products to attempt to meet the needs of its
customers. In furtherance of this strategy, during the fourth quarter of fiscal
1997, the Company began offering higher credit grade loans with higher
loan-to-value ratios which it intends to include in its securitizations. In
addition, the Company recently began offering 125% loan-to-value home
improvement loans to qualified borrowers which the Company intends initially to
sell on a whole loan basis servicing released. The Company believes these home
improvement loans will enhance cash flow as a result of the origination fees
charged and the cash gain on sale received. It may also slow down prepayment
rates, in cases in which the Company holds both the junior home improvement loan
and the senior loan on the property, by employing more of the borrower's
available equity. The Company also offers commercial loans to qualified
borrowers ranging from $250,000 to $2.0 million. At June 30, 1997, the Company
had $6.85 million in commercial loans, all of which it intends to sell on a
whole loan basis servicing released. The Company is considering establishing a
real estate investment trust to provide another distribution channel for its
commercial loans and certain of its residential loans.
Increase Servicing Portfolio; Increase Margins and Develop Subservicing
Capabilities. The Company plans to continue to build the size of its servicing
portfolio to provide a stable, and ultimately more significant, source of
recurring revenue. At June 30, 1997, the Company's servicing portfolio was $3.17
billion, up 131% from $1.37 billion at the end of the 1996 fiscal year, 53% of
which was subserviced by third parties. The Company expects to increase the size
of its loan servicing portfolio by continuing to increase loan originations and
purchases, completing new securitizations and subservicing on behalf of third
parties. Through December 1996, the Company was capable of servicing loans only
in a limited number of Western states. A new servicing system deployed in
November 1996 allows the Company to service loans in all 50 states. The Company
now services directly substantially all loans originated through its retail
network. In fiscal 1998, the Company intends to service directly substantially
all of its servicing portfolio.
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Continue to Enhance Corporate and Operational Management and
Infrastructure. From June 30, 1995 to June 30, 1997, the Company's loan
origination volume grew 561% and its employee base grew from 370 employees at
June 30, 1995 to 1,385 employees at June 30, 1997. To support this significantly
larger operation, the Company has invested in additional corporate and operating
management. Additionally, to enhance its infrastructure, the Company has
expanded its telemarketing operations, including a predictive dialer system
which became operational in fiscal 1997 and a data warehouse which significantly
enhanced the Company's ability to analyze its loans in fiscal 1997. In fiscal
1998, the Company intends to purchase a new loan origination system which will
further enhance efficiency and loan production capabilities.
Continue to Diversify Funding Sources and Become Self-Financing. The
Company intends to continue to expand and diversify its funding sources by
adding additional warehouse facilities, seeking to increase the advance rates on
existing and new facilities and establishing credit facilities to finance the
interest-only strips and the residual assets. In addition, the Company intends
to seek to obtain higher credit ratings by improving its financial condition and
operating results. The Company believes that achieving higher credit ratings,
obtaining higher advance rates on warehouse facilities and establishing residual
financing facilities will help it attain its goal of becoming self-financing
and, thereby, reduce its dependence on the capital markets. Principally as a
result of the developments described under "-- Recent Events," several rating
agencies have placed certain debt of the Company on credit watch. The Company
continues to improve its cash flows through such mechanisms as whole loan sales
and new securitization structures. The Company also believes it will improve its
cash flow by improving the efficiency of its servicing operations.
The strategies discussed above contain forward-looking statements. Such
statements are based on current expectations and are subject to risks,
uncertainties and assumptions, including those discussed under "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Risk Factors." Should one or more of these risks or uncertainties
materialize, or should underlying assumptions prove incorrect, actual results
may vary materially from those anticipated, estimated or projected. Thus, no
assurance can be given that the Company will be able to accomplish the above
strategies.
ONE STOP ACQUISITION
On August 28, 1996, the Company acquired One Stop, a residential
mortgage lender specializing in originating and purchasing home equity mortgage
loans made to credit-impaired borrowers from a network of independent mortgage
brokers. The acquisition is part of the Company's strategy to diversify its
mortgage loan production sources and to expand the geographic scope of its
operations. The acquisition was accomplished through the merger of a
wholly-owned subsidiary of the Company into One Stop, in a tax-free exchange
accounted for as a pooling-of-interests. See "-- Mortgage Loan Production --
Independent Mortgage Broker Network."
MORTGAGE LOAN PRODUCTION
The Company's principal loan product is a non-conforming home equity
loan with a fixed principal amount and term to maturity which is typically
secured by a first mortgage on the borrower's
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residence with either a fixed or adjustable rate. Non-conforming home equity
loans are loans made to homeowners whose borrowing needs may not be met by
traditional financial institutions due to credit exceptions or other factors and
that cannot be marketed to agencies such as the Federal National Mortgage
Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
In addition, the Company offers junior mortgages and other products in order to
meet a wide variety of borrower needs. In fiscal 1997, the Company obtained its
loans through three primary channels: its retail loan office network,
independent mortgage broker network and correspondent program. In fiscal 1997,
the Company also expanded its retail production to include an outbound
telemarketing loan production capability.
The following table illustrates the sources of the Company's loan
production during the periods indicated:
FISCAL YEARS ENDED JUNE 30,
---------------------------
1995 1996 1997
---- ---- ----
(DOLLARS IN THOUSANDS)
Retail loans:
Total dollar amount .................. $148,200 $ 220,900 $ 436,900
Number of loans ...................... 3,734 4,792 8,565
Average loan amount .................. 40 46 51
Average initial combined loan to value 55% 60% 67%
Weighted average interest rate ....... 11.8% 11.0% 10.5%
Broker loans:
Total dollar amount .................. $ -- $ 319,800 $ 741,000
Number of loans ...................... -- 4,182 8,985
Average loan amount .................. -- 77 83
Average initial combined loan to value -- 68% 71%
Weighted average interest rate ........ -- 10.6% 10.0%
Correspondent program:
Total dollar amount .................. $206,800 $ 628,200 $1,170,000
Number of loans ...................... 2,314 7,166 12,500
Average loan amount .................. 89 88 94
Average initial combined loan to value 65% 66% 71%
Weighted average interest rate ....... 11.4% 11.7% 11.0%
Total loans:
Total dollar amount .................. $355,000 $1,168,900 $2,347,900
Number of loans ...................... 6,048 16,140 30,050
Average loan amount .................. 59 72 78
Average initial combined loan to value 61% 65% 70%
Weighted average interest rate ....... 11.6% 11.3% 10.6%
Retail Loan Office Network. The Company originates home equity mortgage
loans through its network of retail loan offices which, at September 25, 1997,
consisted of 59 retail loan offices located in 23 states. Prior to fiscal year
1994, the retail offices were located only in California. Then, in fiscal year
1994, the Company expanded into two Western states. The Company has been
aggressively pursuing a strategy of expanding its retail loan office network
beyond the offices located in California and the other Western states. Of the
Company's 59 retail loan offices, 16 are located in the Midwest,
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9 in the Central U.S. and 16 in the East. The Company believes that it has
significant additional expansion opportunities in these areas.
The Company selects areas in which to introduce or expand its retail
presence on the basis of selected demographic statistics, marketing analyses and
other criteria developed by the Company. Typically, new office locations have
become profitable within 90 days of opening.
The Company's expansion of its retail loan office network has resulted
in significant increases in retail loan production over the last three fiscal
years. The Company originated $148 million, $221 million and $437 million of
mortgage loans through this network in fiscal 1995, 1996 and 1997, respectively.
The Company generates applications for loans through its retail loan
office network principally through a multimedia advertising program, which
relies primarily on the use of direct mailings to homeowners, television
advertising, yellow-page listings and telemarketing. The Company believes that
its advertising campaigns establish name recognition and serve to distinguish
the Company from its competitors. The Company continually monitors the sources
of its applications to determine the most effective methods and manner of
advertising.
The Company's advertising invites prospective borrowers to call its
headquarters office through the Company's toll-free telephone numbers. On the
basis of an initial screening conducted at the time of the call, the Company's
customer service representative makes a preliminary determination of whether the
customer and the property meet the Company's lending criteria, and schedules an
appointment with a loan officer in the retail loan office most conveniently
located to the customer or in the customer's home. If the customer cannot
schedule an appointment or is located in an area without a retail office, the
representative refers the customer to a loan officer in the "loan-by-phone"
department who takes the loan application by telephone.
The Company's loan officer at the local retail loan office assists the
applicant in completing the loan application, arranges for an appraisal, 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. The loan package is then forwarded to the Company's headquarters
office for review by underwriters and for loan approval. If the loan package is
approved, the loan is funded by the Company. The Company's loan officers are
trained to structure loans that meet the applicant's needs, while satisfying the
Company's lending guidelines.
Through its retail loan office network, the Company also takes
applications from prospective borrowers who respond to the Company's advertising
but fall outside the Company's target market. These loans may be sold to other
institutional lenders or, until August 1997, to private investors. In these
cases, the Company receives commissions on loans sold.
Independent Mortgage Broker Network. Through its independent mortgage
broker network, One Stop funded $320 million and $741 million in loans during
the fiscal years ended June 30, 1996 and 1997, respectively. At August 31, 1997,
One Stop operated 41 offices in 35 states and had 3,700 approved mortgage
brokers. During fiscal 1997, One Stop originated loans through approximately
1,800 brokers, no one of which accounted for
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more than 10% of One Stop's total originations. All loans originated by One Stop
are underwritten in accordance with the Company's underwriting guidelines. Once
approved, the loan is funded or purchased by One Stop directly.
The broker's role is to identify the applicant, assist in completing the
loan application form, gather necessary information and documents and serve as
One Stop's liaison with the borrower through the lending process. One Stop
reviews and underwrites the applications submitted by the broker, approves or
denies the application, sets the interest rate and other terms of the loan and,
upon acceptance by the borrower and satisfaction of all conditions imposed by
One Stop, funds the loan. Because brokers conduct their own marketing and employ
their own personnel to complete loan applications and maintain contact with
borrowers, originating loans through its broker network allows One Stop to
increase its loan volume without incurring the higher marketing, personnel and
other overhead costs associated with increased retail originations.
Because mortgage brokers generally submit loan files to several
prospective lenders simultaneously, consistent underwriting, quick response
times and personal service are critical to successfully producing loans through
independent mortgage brokers. To meet these requirements, One Stop strives to
provide quick response time to the loan application (generally within 24 hours).
In addition, loan consultants and loan processors, including underwriters, are
available in One Stop's branch offices to answer questions, assist in the loan
application process and facilitate ultimate funding of the loan.
Correspondent Program. The Company purchases closed loans from mortgage
bankers and other financial institutions on a continuous or "flow" basis, and
through bulk and mini-bulk purchases. In fiscal 1997, 50% of the Company's loan
production came from these sources. The Company believes that its flow and
mini-bulk correspondent program represents a cost effective means of increasing
loan production.
During the fourth quarter of fiscal 1997, two factors caused the Company
to re-evaluate its correspondent bulk purchase program--uncertainties in the
capital markets and the increase in the pricing for bulk loan product. These
uncertainties were evidenced by the sudden decline in common stock prices of
companies in the subprime home equity sector, including the Company, and pricing
sensitivity encountered by companies in the sector in accessing the public
equity and debt markets. Given that the Company funded the significant negative
cash flow associated with the bulk correspondent business in the public equity
and debt markets, the uncertainties in those markets increased the risk to the
Company that its cost of capital would be excessively high. Additionally, the
premiums paid by the Company for bulk product during the 1997 fiscal year
reached a peak of 8.25% in March 1997. These high premiums, together with the
apparent increase in the cost of capital, adversely impacted the projected
profitability of the bulk product. As a result of these developments, the
Company changed the approach used in the pricing of its bulk loan product.
Specifically, the Company established lower prices to be paid for this product
based primarily on its historical performance. This change is expected to
decrease the amount of bulk loans purchased in fiscal 1998 compared to fiscal
1997.
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Underwriting. The Company underwrites every loan it originates and
generally re-underwrites each loan it purchases. The Company's underwriting
guidelines are designed to assess the adequacy of the real property as
collateral for the loan and the borrower's creditworthiness. An assessment of
the adequacy of the real property as collateral for the loan is primarily based
upon an appraisal of the property and a calculation of the ratio (the "combined
loan-to-value ratio") of all mortgages existing on the property (including the
loan applied for) to the appraised value of the property at the time of
origination. As a lender that specializes in loans made to credit-impaired
borrowers, the Company ordinarily makes home equity mortgage loans to borrowers
with credit histories or other factors that would typically disqualify them from
consideration for a loan from traditional financial institutions. Consequently,
the Company's underwriting guidelines generally require substantially lower
combined loan-to-value ratios than would typically be the case if the borrower
could qualify for a loan from a traditional financial institution.
Creditworthiness is assessed by examination of a number of factors, including
calculation of debt-to-income ratios, which is the sum of the borrower's monthly
debt payments divided by the borrowers's monthly income before taxes and other
payroll deductions, an examination of the borrower's credit history through
standard credit reporting bureaus, and by evaluating the borrower's payment
history with respect to existing mortgages, if any, on the property.
The underwriting of a mortgage loan to be originated or purchased by the
Company includes a review of the completed loan package, which includes the loan
application, a current appraisal, a preliminary title report and a credit
report. All loan applications and all closed loans offered to the Company for
purchase must be approved by the Company in accordance with its underwriting
criteria. On an exception basis, and approval of the Company's underwriters,
home equity mortgage loans may be made that do not conform to the Company's
guidelines but only with the approval of a senior underwriter or by certain
executive officers of the Company. The Company regularly reviews its
underwriting guidelines and makes changes when appropriate to respond to market
conditions, the poor performance of loans representing a particular loan product
or changes in laws or regulations.
Until June 1997, all appraisals in connection with loans originated by
the Company through its retail loan office network were performed by Company
appraisers. Beginning in June 1997, the Company streamlined its retail loan
appraisal department and currently uses Company-qualified contract appraisers
for most of its originations. Appraisers determine a property's value by
reference to the sales prices of comparable properties recently sold, adjusted
to reflect the condition of the property as determined through inspection.
Appraisals on loans purchased as part of the Company's correspondent program are
reviewed by Company appraisers or Company-qualified contract appraisers to
assure that they meet the Company's standards.
The Company requires title insurance coverage issued on an American Land
Title Association form of title insurance on all properties securing mortgage
loans it originates or purchases. The loan originator and its assignees are
generally named as the insured. Title insurance policies indicate the lien
position of the mortgage loan and protect the Company against loss if the title
or lien position is not as indicated. The applicant is also required to maintain
hazard and, in certain instances, flood insurance, in an amount sufficient to
cover the new loan and any senior mortgage, subject to the maximum amount
available under the National Flood Insurance Program.
Quality Control. The Company's quality control program is intended to
(i) monitor and improve the overall quality of loan production generated by the
Company's retail loan office network,
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independent mortgage broker network and correspondent program and (ii) identify
and communicate to management existing or potential underwriting and loan
packaging problems or areas of concern. The quality control file review examines
compliance with the Company's underwriting guidelines and federal and state
regulations. This is accomplished by focusing on: (i) the accuracy of all credit
and legal information; (ii) a collateral analysis which may include a desk or
field re-appraisal of the property and review of the original appraisal; (iii)
employment and/or income verification; and (iv) legal document review to ensure
that the necessary documents are in place.
Credit Grades. The Company believes that it originates a greater
proportion of lower credit quality loans ("C-" and "D" loans) than other lenders
who lend to credit-impaired borrowers and as a result has historically
experienced delinquency rates that are higher than those generally prevailing in
its industry. Although the Company has not historically experienced significant
loan losses because its loan portfolio has been characterized by relatively low
combined loan-to-value ratios, the Company's loan losses may increase in future
periods as a result of its migration to higher credit grade loans and
correspondingly higher permitted combined loan-to-value ratios. During fiscal
1997, the Company increased its provision for loan losses as higher credit grade
loans with higher loan-to-value ratios increased as a percentage of total loans
securitized. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Capital Resources -- Securitization
Program." The weighted average initial combined loan-to-value ratio of loans in
its servicing portfolio at June 30, 1995, 1996 and 1997 was 59%, 64% and 68%,
respectively. The increase in weighted average combined loan-to-value ratios at
June 30, 1997 reflected a changing mix in the mortgage loans in the servicing
portfolio to include a greater proportion of first mortgages and higher credit
grade loans and from 1995 to 1996 a change in underwriting guidelines to remain
competitive.
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The following chart generally outlines certain parameters of the credit
grades of the Company's underwriting guidelines at August 31, 1997:
"A" CREDIT "A-" CREDIT "B" CREDIT "C" CREDIT "C-" CREDIT "D" CREDIT
GRADE GRADE GRADE GRADE GRADE GRADE
---------- ----------- ---------- ---------- ----------- ----------
GENERAL Has good Has good Pays the Marginal credit Marginal credit Designed to
REPAYMENT credit. credit but majority of history which history not provide a
might have accounts on is offset by offset by other borrower with
some minor time but has other positive positive poor credit
delinquency. some 30- attributes. attributes. history an
and/or 60-day opportunity to
delinquency. correct past
credit
problems
through lower
monthly
payments.
EXISTING No delinquen- Current at Current at Can have Must be paid Must be paid
MORTGAGE cies in past application application multiple 30-day in full from from loan
LOANS 12 months. time and a time and a delinquencies loan proceeds proceeds.
maximum of maximum of and one 60-day and no more Rating not a
two 30-day four 30-day delinquency than 120 days factor.
delinquencies delinquencies and one 90-day delinquent.
in the past 12 in the past 12 delinquency
months. months. in the past 12
months; currently
not more than
90 days delinquent
NON-MORTGAGE Major credit Major credit Major credit Major credit Major and Major credit
CREDIT and installment and installment and installment and installment minor credit delinquency is
debt should be debt should be debt can debt can delinquency is acceptable.
current. No current but exhibit some exhibit some acceptable, but
60-day delin- may exhibit minor 30- minor 60- must
quencies in some minor and/or 60-day and/or 90-day demonstrate
past 24 30-day delinquency. delinquency. some payment
months. delinquency. regularity.
Minor credit Minor credit Minor credit
may exhibit may exhibit up may exhibit
some minor to 90-day more serious
delinquency. delinquency. delinquency.
BANKRUPTCY Charge-offs, Charge-offs, Discharged Discharged Discharged Current
FILINGS judgments, judgments, more than two more than two prior to bankruptcy
liens, and liens, and years with years with closing. must be paid
former former reestablished reestablished through loan.
bankruptcies bankruptcies credit. credit.
are are
unacceptable. unacceptable.
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"A" CREDIT "A-" CREDIT "B" CREDIT "C" CREDIT "C-" CREDIT "D" CREDIT
GRADE GRADE GRADE GRADE GRADE GRADE
---------- ----------- ---------- ---------- ----------- ----------
DEBT SERVICE- Generally not Generally not Generally not Generally not Generally not Generally not
TO-INCOME to exceed to exceed to exceed to exceed to exceed to exceed
RATIO 42%. 45%. 50%. 50%. 55%. 60%.
MAXIMUM
COMBINED
LOAN-TO -
VALUE RATIO:
OWNER Generally 90% Generally 90% Generally 80% Generally 75% Generally 70% Generally 65%
OCCUPIED for a 1 to 4 for a 1 to 4 for a 1 to 4 for a 1 to 4 for a 1 to 4 for a 1 to 4
family family family family family family
dwelling. dwelling; dwelling; dwelling; dwelling. dwelling.
70% for a 65% for a 65% for a
condominium. condominium. condominium.
NON- Generally 80% Generally 75% Generally 70% Generally 65% Generally 65% Generally 60%
OWNER for a 1 to 4 for a 1 to 2 for a 1 to 2 for a 1 to 4 for a 1 to 4 for a 1 to 2
OCCUPIED family family family family family family
dwelling. dwelling; 65% dwelling; 60% dwelling; 60% dwelling. dwelling.
for a 3 to 4 for a 3 to 4 for a 3 to 4
family. family. family.
The following tables present certain information about the Company's
loan production through its retail loan office network, independent mortgage
broker network and correspondent program during fiscal 1995, 1996 and 1997:
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1995
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
------------ ------- ----- ------------- -------
A- $111,808,000 31% 63% 10.6%
B 55,338,000 16 65 11.1
C 70,515,000 20 59 11.7
C- 53,635,000 15 62 12.2
D 63,629,000 18 58 13.3
------------ ---
Total $354,925,000 100%
============ ===
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LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1996
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
------------ ------- ----- ------------- -------
A $ 126,790,000 11% 70% 9.4%
A- 224,943,000 19 68 10.2
B 227,117,000 19 69 10.5
C 197,389,000 17 65 11.6
C- 107,039,000 9 63 12.1
D 285,668,000 25 61 13.0
-------------- ---
Total $1,168,946,000 100%
============== ===
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1997
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
------------ ------- ----- ------------- -------
A $ 327,574,000 14% 72% 9.2%
A- 758,842,000 32 73 9.8
B 573,125,000 24 72 10.3
C 277,002,000 12 67 11.2
C- 112,209,000 5 65 12.0
D 299,186,000 13 62 13.4
-------------- ---
Total $2,347,938,000 100%
============== ===
(1) Calculated with respect to the interest rate at the time the loan is
originated or purchased by the Company, as applicable.
SECURITIZATION OF LOANS
The primary funding strategy of the Company is to securitize and sell
mortgage loans originated or purchased by the Company. Securitization is a cost
competitive source of capital compared to other debt financing sources available
to the Company. Through June 30, 1997, the Company had completed 22
securitizations totaling $3.54 billion. The Company's operations have been
restructured in recent years specifically for the purpose of efficiently
originating, purchasing, underwriting and servicing loans for securitization in
order to meet the requirements of rating agencies, credit enhancers and
investors. The Company generally seeks to complete a securitization once each
quarter. The Company applies the net proceeds of the securitization to pay down
its warehouse facilities in order to make these facilities available for future
funding of mortgage loans. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Certain Accounting
Considerations."
The Company securitized and sold in the secondary market $317 million,
$791 million and $2.26 billion of loans in the fiscal years ended June 30, 1995,
1996 and 1997, respectively. Of the 22 securitization transactions completed
through June 30, 1997, 21 have been credit-enhanced by monoline
13
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insurance to receive ratings of "Aaa" by Moody's Investors Service, Inc.
("Moody's") and "AAA" by Standard & Poor's Ratings Group, a Division of The
McGraw-Hill Companies ("S&P") and, in the case of 1997-A, "AAA" by Fitch
Investors Service, Inc. ("Fitch"). For the 1997-B transaction completed in June
1997, the Company utilized a senior/ subordinated structure in which the senior
tranches received ratings of "Aaa" by Moody's, "AAA" by S&P and "AAA" by Fitch.
In a senior/subordinated structure, the senior certificate holders are protected
from losses by outstanding subordinated certificates, rather than a monoline
insurance company.
Each agreement that the Company has entered into in connection with its
securitizations requires either the overcollateralization of the trust or the
establishment of a reserve account that may initially be funded by cash
deposited by the Company. The Company's interest in each overcollateralization
amount and reserve account is reflected on the Company's Consolidated Financial
Statements as "residual assets." If losses exceed the amount of the
over-collateralization or the reserve account, as applicable, the
credit-enhancement aspects of the trust are triggered. In a securitization
credit-enhanced by a monoline insurance policy, any further losses experienced
by holders of the senior interests in the related trust will be paid under such
policy. To date, there have been no claims on any monoline insurance policy
obtained in any of the Company's securitizations. Further, in the event
delinquencies exceed certain specified percentages, the monoline insurer may
terminate the Company as servicer. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Capital Resources
- -- Securitization Program" and " -- Risk Factors -- Delinquencies; Negative
Impact on Cash Flows; Right to Terminate Mortgage Servicing." In a
senior/subordinated structure, losses in excess of the overcollateralization
amount generally are allocated first to the holders of the subordinated
interests and then to the holders of the senior interests of the trust.
LOAN SERVICING
Servicing includes collecting and remitting loan payments, accounting
for principal and interest, contacting delinquent borrowers, managing borrower
defaults and liquidating foreclosed properties. The Company retains the
servicing rights to substantially all of the residential loans it originates or
purchases. The following table sets forth certain information regarding the
Company's servicing portfolio for the periods indicated:
FISCAL YEARS ENDED JUNE 30,
---------------------------
1995 1996 1997
---- ---- ----
(IN THOUSANDS)
Loans added to the servicing portfolio......... $355,000 $1,168,900 $2,347,900
Servicing portfolio (period end)............... 608,700 1,370,000 3,174,000
Loan service revenue (1)....................... 8,246 18,186 25,804
(1) For a description of loan service revenue, see Note 1 of Notes to
Consolidated Financial Statements.
The Company directly services substantially all newly originated or
purchased loans which are secured by mortgaged properties located in 44 states.
Loans secured by properties located in other states are serviced through one or
more subservicers which are paid a fee per loan and a participation in certain
other fees paid by the borrowers. Through December 1996, the Company was capable
of servicing loans in a limited number of Western states. A new servicing system
deployed in November 1996
14
15
allows the Company to service loans in all 50 states. During fiscal 1998, the
Company intends to service directly substantially all of its servicing
portfolio. The Company believes that the successful implementation of its new
servicing system will provide it with improved margins on its servicing and
potentially a new source of servicing revenue through subservicing for third
parties.
The agreements between the Company and the real estate mortgage
investment conduit ("REMIC") or owner trusts established in connection with
securitizations typically require the Company to advance interest (but not
principal) on delinquent loans to the holders of the senior interests in the
related trust. The agreements also require the Company to make certain servicing
advances (e.g., for property taxes or hazard insurance) unless the Company
determines that such advances would not be recoverable. Realized losses on the
loans are paid out of the related loss reserve account or paid out of principal
and interest payments on overcollateralized amounts as applicable, and if
necessary, from the related monoline insurance policy or the subordinated
interests.
In the case of securitizations credit-enhanced by monoline insurance,
the agreements also typically provide that the Company may be terminated as
servicer by the monoline insurance company (or by the trustee with the consent
of the monoline insurance company) upon certain events of default, including the
Company's failure to perform its obligations under the servicing agreement, the
rate of over 90-day delinquency (including properties acquired by foreclosure
and not sold) exceeding specified limits, losses on liquidation of collateral
exceeding certain limits, any payment being made by the monoline insurance
company under its policy, and certain events of bankruptcy or insolvency. At
June 30, 1997, seven trusts representing approximately 21% (by dollar volume)
of the Company's servicing portfolio exceeded the specified delinquency rate,
although the servicing rights of the Company have not been terminated. See "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Capital Resources -- Securitization Program." In the case of the
Company's recent senior/subordinated securitization transactions, holders of 51%
of the certificates may terminate the servicer upon certain events of default.
The senior/subordinated securitization completed in June 1997 provides for
servicer termination upon the occurrence of certain levels of loss experience,
but not in the event of delinquency rates exceeding target percentages. No such
events of default have occurred to date in the Company's senior/subordinated
securitizations. The senior/subordinated securitization completed in September
1997 contains no loss or delinquencies triggers for servicer termination.
The Company receives a servicing fee based on a percentage of the
declining principal balance of each loan serviced. Servicing fees are collected
by the Company out of the borrower's monthly payments. In addition, the Company,
as servicer, generally receives all late and assumption charges paid by the
borrower on loans serviced directly by the Company, as well as other
miscellaneous fees for performing various loan servicing functions. The Company
also generally receives any prepayment fees paid by borrowers.
The Company's servicing portfolio is subject to reduction by normal
monthly principal amortization, by prepayment and by foreclosure. It is the
Company's strategy to build and retain its servicing portfolio. In general,
revenue from the Company's loan servicing portfolio may be adversely affected as
interest rates decline and loan prepayments increase. This effect has
historically been partially offset by
15
16
increases in prepayment fee income received from borrowers. In some states in
which the Company currently operates, prepayment fees may be limited or
prohibited by applicable law. The Company is considering alternative licensing
structures that would eliminate or reduce the effects of such limitations and
prohibitions.
The following table illustrates the mix of credit grades in the
Company's servicing portfolio as of June 30, 1997:
WEIGHTED WEIGHTED
AVERAGE AVERAGE
COMBINED ORIGINAL
DOLLAR AMOUNT INITIAL INTEREST
CREDIT GRADE OF LOAN % OF TOTAL LOAN-TO-VALUE RATE
------------ ------- ---------- ------------- ----
(Dollars in thousands)
A $ 97,900 3% 71% 9.6%
A- 1,205,100 38 71 9.9
B 707,200 22 71 10.6
C 402,000 13 66 11.6
C- 194,700 6 64 12.3
D 474,700 15 61 13.4
Other 92,400 3 54 12.1
---------- ---
Total $3,174,000 100%
========== ===
COLLECTIONS, DELINQUENCIES AND FORECLOSURES
The Company sends borrowers a monthly billing statement approximately
ten days prior to the monthly payment due date. Although borrowers generally
make loan payments within ten to fifteen days after the due date (the "grace
period"), if a borrower fails to pay the monthly payment within the grace
period, the Company commences collection efforts by notifying the borrower of
the delinquency. In the case of borrowers in the "C-" and "D" credit grades,
collection efforts begin immediately after the due date. The Company continues
contact with the borrower to determine the cause of the delinquency and to
obtain a commitment to cure the delinquency at the earliest possible time.
As a general matter, if efforts to obtain payment have not been
successful, a pre-foreclosure notice will be sent to the borrower immediately
after the due date of the next subsequently scheduled installment (five days
after the initial due date for C- and D credit grades), providing 30 days'
notice of impending foreclosure action. During the 30-day notice period,
collection efforts continue and the Company evaluates various legal options and
remedies to protect the value of the loan, including accepting a deed-in-lieu of
foreclosure, entering into a short sale or commencing foreclosure proceedings.
If no substantial progress has been made in collecting delinquent payments from
the borrower, foreclosure proceedings will begin. Generally, the Company will
have commenced foreclosure proceedings when a loan is 45 to 100 days delinquent,
depending upon credit grade.
Servicing and collection practices change over time in accordance with,
among other things, the Company's business judgment, changes in portfolio
performance and applicable laws and regulations.
16
17
Loans originated or purchased by the Company are secured by mortgages,
deeds of trust, security deeds or deeds to secure debt, depending upon the
prevailing practice in the state in which the property securing the loan is
located. Depending on local law, foreclosure is effected by judicial action or
nonjudicial sale, and is subject to various notice and filing requirements. In
general, the borrower, or any person having a junior encumbrance on the real
estate, may cure a monetary default by paying the entire amount in arrears plus
other designated costs and expenses incurred in enforcing the obligation during
a statutorily prescribed reinstatement period. Generally, state law controls the
amount of foreclosure expenses and costs, including attorneys' fees, which may
be recovered by a lender, the minimum time required to foreclose and the
reinstatement or redemption rights of the borrower.
Although foreclosure sales are typically public sales, frequently no
third-party purchaser bids in excess of the lender's lien because of the
difficulty of determining the exact status of title to the property, the
possible deterioration of the property during the foreclosure proceedings and a
requirement that the purchaser pay for the property in cash or by cashier's
check. Thus, the Company often purchases the property from the trustee or
referee through a credit bid in an amount up to the principal amount outstanding
under the loan, accrued and unpaid interest and the expenses of foreclosure.
Depending upon market conditions, the ultimate proceeds of the sale may not
equal the Company's investment in the property.
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18
The following table sets forth delinquency, foreclosure, loss and
reserve information relating to the Company's servicing portfolio for the
periods indicated:
FISCAL YEARS ENDED JUNE 30,
---------------------------
1995 1996 1997
---- ---- ----
(Dollars in thousands)
Percentage of dollar amount of delinquent
loans to loans serviced (period end)(1)(2)(3)
One Month.............................................. 3.9% 4.9% 4.3%
Two Months............................................. 1.6 1.8 1.9
Three or More Months
Not foreclosed (4)................................... 5.0 8.0 8.1
Foreclosed (5)....................................... 1.5 1.0 1.0
---- ---- ----
Total............................................ 12.0% 15.7% 15.3%
==== ==== ====
Percentage of dollar amount of loans
foreclosed to loans serviced (period end)(2)........... 1.2% 1.1% 1.5%
Number of loans foreclosed............................... 159 221(6) 560(6)
Principal amount of foreclosed loans..................... $6,675 $14,349 $48,029
Net losses on foreclosed loans included
in pools (7)........................................... $ 127 $ 931 $ 5,470
Percentage of losses to average servicing
portfolio.............................................. .03% .09% .24%
Liquidation loss reserve (8)............................. $3,371 $10,300 $43,586
(1) Delinquent loans are loans for which more than one payment is past due.
(2) The delinquency and foreclosure percentages are calculated on the basis of
the total dollar amount of mortgage loans originated or purchased by the
Company and, in each case, serviced by the Company and any subservicers as
of the end of the periods indicated. Percentages for fiscal year 1996 have
not been restated to include delinquencies of loans originated by One Stop.
The Company believes any such adjustment would not be material.
(3) At June 30, 1997, the dollar volume of loans delinquent more than 90 days in
the Company's seven REMIC trusts formed during the period from December 1994
to June 1996 exceeded the permitted limit in the related pooling and
servicing agreements. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Capital Resources;" and
"--Risk Factors -- Delinquencies; Negative Impact on Cash Flow; Right to
Terminate Mortgage Servicing".
(4) Represents loans which are in foreclosure but as to which foreclosure
proceedings have not concluded.
(5) Represents properties acquired following a foreclosure sale and still
serviced by the Company.
(6) The increase in the number of loans foreclosed and principal amount of loans
foreclosed in 1997 relative to 1996 is due to the larger and more seasoned
servicing portfolio.
(7) Represents losses net of gains on foreclosed properties in pools sold during
the periods indicated.
(8) Represents period end reserves for future liquidation losses.
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The Company's servicing portfolio has grown over the periods presented.
However, because foreclosures and losses typically occur months or years after a
loan is originated, data relating to delinquencies, foreclosures and losses as a
percentage of the current portfolio can understate the risk of future
delinquencies, losses or foreclosures.
COMPETITION
The Company faces intense competition in the business of originating,
purchasing and selling mortgage loans. The Company's competitors in the industry
include other consumer finance companies, mortgage banking companies, commercial
banks, credit unions, thrift institutions, credit card issuers and insurance
companies. Many of these competitors are substantially larger and have
considerably greater financial, technical and marketing resources than the
Company. In addition, many financial services organizations that are much larger
than the Company have formed national loan origination networks offering loan
products that are substantially similar to the Company's loan programs.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, customer service, marketing and distribution
channels, amount and term of the loan, loan origination fees and interest rates.
In addition, the current level of gains realized by the Company and its
competitors on the sale of subprime loans could attract additional competitors
into this market. Additional competition may lower the rates the Company can
charge borrowers and increase the price paid for purchased loans, thereby
potentially lowering gain on future loan sales and securitizations. To the
extent any of these competitors significantly expand their activities in the
Company's market, the Company could be materially adversely affected.
Fluctuations in interest rates and general economic conditions may also affect
the Company's competition. During periods of rising rates, competitors that have
locked in low borrowing costs may have a competitive advantage. During periods
of declining rates, competitors may solicit the Company's customers to refinance
their loans.
The Company believes its competitive strengths include: (i) its emphasis
on customer service to attract borrowers; (ii) providing a high level of service
to brokers and their customers; (iii) offering competitive loan programs for
borrowers whose needs are not met by conventional mortgage lenders; and (iv) the
convenience of its retail and broker offices.
REGULATION
The Company's operations are subject to extensive regulation,
supervision and licensing by federal, state and local governmental authorities
and are subject to various laws and judicial and administrative decisions
imposing requirements and restrictions on part or all of its operations. The
Company's consumer lending activities are subject to the Federal
Truth-in-Lending Act and Regulation Z (including the Home Ownership and Equity
Protection Act of 1994), the Federal Equal Credit Opportunity Act, as amended,
and Regulation B, the Fair Credit Reporting Act of 1970, as amended, the Federal
Real Estate Settlement Procedures Act and Regulation X, the Home Mortgage
Disclosure Act, the Federal Debt Collection Practices Act and the National
Housing Act of 1934, as well as other federal and state statutes and regulations
affecting the Company's activities. The Company is also subject to the rules and
regulations of, and examinations by, state regulatory authorities with respect
to originating, processing, underwriting, selling, securitizing and servicing
loans. These rules and regulations, among other things, impose licensing
obligations on the Company, establish eligibility
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criteria for mortgage loans, prohibit discrimination, govern inspections and
appraisals of properties and credit reports on loan applicants, regulate
assessment, collection, foreclosure and claims handling, investment and interest
payments on escrow balances and payment features, mandate certain disclosures
and notices to borrowers and, in some cases, fix maximum interest rates, fees
and mortgage loan amounts. Failure to comply with these requirements can lead to
loss of approved status, certain rights of rescission for mortgage loans, class
action lawsuits and administrative enforcement action. See "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations -- Risk
Factors -- Government Regulation."
In the course of its business, the Company may acquire properties as a
result of foreclosure. There is a risk that hazardous or toxic waste could be
found on such properties. In such event, the Company could be held responsible
for the cost of cleaning up or removing such waste, and such cost could exceed
the value of the underlying properties.
The Company is also subject to various other federal and state laws
regulating the issuance and sale of securities, relationships with entities
regulated by the Employee Retirement Income Security Act of 1974, as amended,
and other aspects of its business.
EMPLOYEES
At June 30, 1997, the Company employed 1,385 persons. The Company has
satisfactory relations with its employees.
ITEM 2. PROPERTIES
The executive and administrative offices of the Company are located at
350 S. Grand Avenue, Los Angeles, California, and consist of approximately
178,000 square feet. The lease on these premises extends through February 2012.
The Company also continues to lease space at its former headquarters location at
3731 Wilshire Boulevard, Los Angeles, California, which it uses for its
telemarketing operations. This lease expires in July 2000. The executive and
administrative offices of One Stop are located at 200 Baker Street, Costa Mesa,
California, and consist of approximately 19,544 square feet.
The lease on these premises extends through November 8, 1998.
The Company and One Stop also lease space for their branch offices.
These facilities aggregate approximately 178,000 square feet and are leased
under terms which vary as to duration. In general, the leases expire between
1997 and 2002, and provide for rent escalations tied to either increases in the
lessor's operating expenses or fluctuations in the consumer price index in the
relevant geographical area.
ITEM 3. LEGAL PROCEEDINGS
In September 1997, three purported class actions were filed against the
Company and certain of its directors and officers. One case, filed in the Los
Angeles Superior Court of the State of California (Polin, et al. v. Aames
Financial Corporation, et al., Case No. BC177236), alleges violations of the
California securities laws and the two other cases, filed in the United States
District Court for the
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21
Central District of California (Dauber, et al. v. Aames Financial Corporation,
et al., Case No. 97-6714 and Plaut, et al. v. Aames Financial Corporation, et
al., Case No. 97-6814), allege violations of the federal securities laws. In
these cases, plaintiffs allege that the Company and certain of its directors and
officers issued false and misleading statements regarding the Company's
correspondent bulk purchase program. Plaintiffs further allege that such
directors and officers sold shares of the Company's stock with knowledge of
material non-public information concerning such program. In the California
action, plaintiffs purport to represent a class of persons who purchased the
Company's stock between January 29, 1997 and April 30, 1997. In the federal
actions, plaintiffs purport to represent a class of persons who purchased the
Company's stock between January 23, 1996 and April 30, 1997. In all three cases,
plaintiffs seek unspecified compensatory damages, attorneys' fees and costs. The
Company believes that it has meritorious defenses to these actions and intends
to defend them vigorously.
The Company is involved in litigation arising in the normal course of
business. The Company believes that any liability with respect to such legal
actions, individually or in the aggregate, is not likely to be material to the
Company's consolidated financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of fiscal 1997 to a
vote of the security holders of the Company.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
In November 1995, the Company's common stock began trading under the
symbol AAM on the New York Stock Exchange (NYSE). Prior to that time, the
Company's common stock traded on the NASDAQ National Market under the symbol
AAMS. The following table sets forth the range of high and low sale prices and
per share cash dividends declared for the periods indicated. All share prices
and cash dividends through February 21, 1997 have been adjusted to reflect the
three-for-two stock split in the form of stock dividend effected on that date
and the three-for-two stock split in the form of a stock dividend effected on
May 17, 1996.
CASH
HIGH LOW DIVIDEND
FISCAL 1996*
First Quarter................... $13.000 $ 7.667 $.033
Second Quarter.................. 16.333 10.750 .033
Third Quarter................... 16.750 10.833 .033
Fourth Quarter.................. 24.667 16.083 .033
FISCAL 1997*
First Quarter................... $37.922 $20.750 $.033
Second Quarter.................. 39.328 22.500 .033
Third Quarter................... 32.375 20.250 .033
Fourth Quarter.................. 20.500 10.750 .033
------------------------
* As reported by Bloomberg
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As of September 23, 1997, the Company had 190 stockholders of record.
Since its initial public offering on December 3, 1991, the Company has
consistently paid quarterly cash dividends on its common stock. The Company
declared and subsequently paid an aggregate of $0.13 per share in dividends for
the year ended June 30, 1997, representing approximately 21.4% of its net income
for the period. The Board of Directors of the Company reviews the Company's
dividend policy at least annually in light of the earnings, cash position and
capital needs of the Company, general business conditions and other relevant
factors. Bank agreements generally limit the Company's ability to pay dividends
if such payment would result in an event of default under the agreements. The
Company's Indenture relating to its 9.125% Senior Notes due 2003 (the
"Indenture") prohibits the payment of dividends if the aggregate amount of such
dividends since October 26, 1996 exceeds the sum of (a) 25% of the Company's net
income during that period; (b) net cash proceeds from any securities issuances;
and (c) proceeds from the sale of certain investments. The Company's Indenture
of Trust relating to its 10.50% Senior Notes due 2002 restricts the payment of
dividends to an amount which does not exceed (i) $2.0 million, plus (ii) 50% of
the Company's aggregate net income for each fiscal year after the year ended
June 30, 1994, plus (iii) 100% of the net proceeds received by the Company on
offerings of its equity securities after December 31, 1994.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data for the Company for the five
year period ended June 30, 1997 have been derived from the audited Consolidated
Financial Statements. The selected consolidated financial data should be read in
conjunction with the Consolidated Financial Statements and Notes thereto and
other financial information included herein. Results of operations of the
Company for the year ended June 30, 1997, reflect the Company's adoption of SFAS
No. 125. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations." The selected consolidated financial data
gives pro forma effect to the acquisition of One Stop. See "Item 1.
Business--One Stop Acquisition."
FISCAL YEAR ENDED JUNE 30,
--------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(Dollars in thousands except per share data)
STATEMENT OF INCOME DATA:
Revenue:
Gain on sale of loans............. $ 3,791 $ 8,705 $25,438 $ 95,299 $198,736
Net unrealized loss on valuation
of interest-only strips......... (18,950)
Commissions....................... 18,686 16,432 15,799 21,564 29,250
Loan service...................... 4,377 6,099 8,246 18,186 25,804
Fees and other.................... 4,762 5,595 7,940 15,215 37,679
------- ------- ------- -------- --------
Total revenue................. 31,616 36,831 57,423 150,264 272,519
Total expenses.................... 23,260 27,848 40,272 97,965 239,012
------- ------- ------- -------- --------
Income before income taxes........ 8,356 8,983 17,151 52,299 33,507
Provision for income taxes........ 3,353 3,684 7,117 22,508 16,398
------- ------- ------- -------- --------
Net income........................ $ 5,003 $ 5,299 $10,034 $ 29,791 $ 17,109
======= ======= ======= ======== ========
Net income per share (fully diluted) $ 0.50 $ 0.41 $ 0.74 $ 1.14 $ 0.60
======= ======== ======= ======== ========
Weighted average number of shares
outstanding (in thousands)
(fully diluted)................. 9,935 13,127 13,532 27,248 34,516
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FISCAL YEAR ENDED JUNE 30,
--------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(Dollars in thousands except per share data)
CASH FLOW DATA:
(Used in) operating activities $ (1,490) $(13,857) $(43,375) $ (241,073) $ (280,073)
(Used in) investing activities (489) (870) (988) (5,885) (8,865)
Provided by (used in) financing activities (1,522) 22,855 48,209 250,540 291,899
Net increase (decrease) in cash and
cash equivalents (3,501) 8,128 3,846 3,582 2,961
RATIOS AND OTHER DATA:
Return on average common equity 36% 18% 27% 28% 23%(5)
Return on average managed receivables(1) 2.1% 1.6% 2.0% 3.0% .8%
Loans originated or purchased:
Retail loans $122,200 $130,200 $148,200 $ 220,900 $ 436,900
Broker network -- -- -- 319,800 741,000
Correspondent loans -- 19,700 206,800 628,200 1,170,000
-------- -------- -------- ---------- ----------
Total $122,200 $149,900 $355,000 $1,168,900 $2,347,900
======== ======== ======== ========== ==========
Whole loans sold......................... -- -- -- $ 202,200 $ 7,500
Loans pooled and sold in the secondary
market................................. $ 52,500 $106,800 $316,600 $ 791,300 $2,262,700
Loans serviced (period end).............. $262,100 $381,800 $608,700 $1,370,000 $3,174,000
Weighted average commission rate on
retail loan originations (2) 14.0% 12.0% 9.4% 7.7% 4.9%
Weighted average interest rate (2) 11.2% 10.3% 11.6% 11.3% 10.6%
Weighted average initial combined
loan-to-value ratio (2)(3):
Retail loans........................... 51% 52% 55% 60% 67%
Broker network......................... -- -- 68% 71%
Correspondent loan..................... NM NM 65% 66% 71%
Number of retail loan offices
(period end)........................... 24 27 32 48 56
Number of One Stop branch offices
(period end)........................... -- -- -- 25 37
AT JUNE 30,
-----------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
BALANCE SHEET DATA:
Cash and cash equivalents........... $ 8,385 $ 16,513 $ 20,359 $ 23,941 $ 26,902
Servicing assets (4)................ 7,555 18,780 56,960 184,691 404,890
Total assets........................ 21,307 53,344 114,623 421,475 761,593
------- -------- -------- -------- --------
10.5% Senior Notes due 2002......... -- -- 23,000 23,000 23,000
9.125% Senior Notes due 2003 -- -- -- -- 150,000
5.5% Convertible Subordinated Debentures
due 2006.......................... -- -- -- 115,000 113,990
Other long-term debt................ 944 1,104 144 45 --
------- -------- -------- -------- --------
Total long-term debt.......... 944 1,104 23,144 138,045 286,990
Stockholders' equity................ 15,850 31,669 80,047 133,429 268,354
- ------------
(1) Represents net income divided by the average servicing portfolio for the
fiscal year.
(2) Computed on loans originated or purchased, as the case may be, during the
period.
(3) The weighted average initial combined loan-to-value ratio is determined by
dividing the sum of all loans secured by the junior or senior mortgages on
the property by the appraised value at origination.
(4) Represents the sum of interest-only strips, residual assets and mortgage
servicing rights. See Note 1 of Notes to Consolidated Financial Statements.
(5) Excludes nonrecurring charges of $32 million (pre-tax).
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with Item 6.
Selected Financial Data and Item 8. Financial Statements and Supplementary Data.
This Report contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Such statements are indicated by words or
phrases such as "anticipate," "estimate," "project," "management believes," "the
Company believes" and similar words or phrases. Such statements are based on
current expectations and are subject to risks, uncertainties and assumptions,
including those discussed under "--Risk Factors." Should one or more of these
risks or uncertainties materialize, or should underlying assumptions prove
incorrect, actual results may vary materially from those anticipated, estimated
or projected.
OVERVIEW
The Company is a consumer finance company primarily engaged, through its
subsidiaries, in the business of originating, purchasing, selling and servicing
home equity mortgage loans secured by single family residences. In late fiscal
1997, the Company began offering commercial loans on a limited basis which it
plans to sell on a whole loan basis servicing released. The Company, upon its
formation in 1991, acquired Aames Home Loan, a home equity lender founded in
1954.
The Company's principal market is borrowers whose financing needs are
not being met by traditional mortgage lenders for a variety of reasons,
including the need for specialized loan products or credit histories that may
limit such borrowers' access to credit. The Company believes these borrowers
continue to represent an underserved niche of the home equity loan market and
present an opportunity to earn a superior return for the risk assumed. The
mortgage loans originated and purchased by the Company, which include fixed and
adjustable rate loans, are generally used by borrowers to consolidate
indebtedness or to finance other consumer needs rather than to purchase homes.
The Company originates and purchases loans on a nationwide basis through
three production channels--retail, broker and correspondent. For the year ended
June 30, 1997, the Company originated and purchased $2.35 billion of mortgage
loans. The Company underwrites and appraises every loan it originates and
generally re-underwrites and reviews appraisals on all loans it purchases. See
"Item 1. Business--Mortgage Loan Production." The Company retains the servicing
rights (collecting loan payments and managing borrower defaults) to
substantially all of the loans it originates or purchases. At June 30, 1997, the
Company had a servicing portfolio of $3.17 billion, of which 53% was subserviced
by third parties. In fiscal 1997, the Company's servicing division implemented
systems and personnel that will allow it to service directly substantially all
of its servicing portfolio by the end of fiscal 1998. See "Item 1.
Business--Loan Servicing."
During fiscal 1997, the Company experienced a dramatic shift up the
credit grade spectrum reflecting its previously announced strategic decision to
diversify the loans it originates and purchases to include more of the higher
credit grade loans. In fiscal 1997, of the total loans originated and purchased
by the Company, 82% were A, A-, B and C credit grade loans and 18% were C- and D
credit grade loans, compared to 66% and 34%, respectively, in fiscal 1996. This
diversification was
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accomplished primarily through the acquisition of One Stop in August 1996, which
focuses on the higher credit grade spectrum, the decreasing of C- and D
originations in certain non-judicial foreclosure states and the adoption of
pricing structures by credit grade in the correspondent and retail divisions.
As a fundamental part of its business and financing strategy, the
Company sells substantially all of its loans to third party investors in
securitization transactions. These transactions enhance profitability, maximize
liquidity and reduce the Company's exposure to fluctuations in interests rates.
The Company securitized and sold in the secondary market $317 million, $791
million and $2.26 billion of loan in the fiscal years ended June 30, 1995, 1996
and 1997, respectively. See "Item 1. Business-- Securitization of Loans."
The Company has experienced significant growth in the last three years.
Management believes that this growth is primarily attributable to (i) the
Company's geographic expansion of its retail loan office network from 21 offices
in California at July 1, 1993 to 58 offices located in 25 states at August 31,
1997, (ii) the Company's acquisition of One Stop, (iii) the commencement of the
Company's correspondent program in fiscal 1994, (iv) the Company's ability to
complete mortgage loan securitizations on a quarterly basis, (v) the Company's
increased access to warehouse and other credit facilities over this period, and
(vi) the Company's ability to effect additional debt and equity financings over
this period, which in the aggregate raised net proceeds of approximately $279
million and $179 million, respectively. The Company has managed its growth by
employing experienced senior management, regularly monitoring its underwriting
guidelines, strengthening quality control procedures and enhancing technology.
In June 1997, the Company retained Donaldson, Lufkin & Jenrette
Securities Corporation to develop a means to maximize opportunities for the
Company and its stockholders. These opportunities include remaining independent
and continuing to grow internally and through acquisition, or selling the
Company or entering into a business combination transaction. While the Company
is in discussions concerning a possible business combination, it also believes
the profit-enhancing steps taken in the fourth quarter create a strong
foundation upon which to remain independent and continue to grow its production
channels and servicing platform. See "-- Revenue."
CERTAIN ACCOUNTING CONSIDERATIONS
As a fundamental part of its business and financing strategy, the
Company sells substantially all of its loans in securitization transactions. In
a securitization, the Company conveys loans that it has originated or purchased
to a separate entity (such as a trust or trust estate) in exchange for cash
proceeds and an interest in the loans securitized represented by the gain on
sale of loans. The cash proceeds are raised through an offering of the
pass-through certificates or bonds evidencing the right to receive principal
payments on the securitized loans and the interest rate on the certificate
balance or on the bonds. The gain on sale of loans (net of the unrealized gain
or loss on valuation of interest-only strips) represents, over the estimated
life of the loans, the present value of the excess of the weighted average
coupon on each pool of loans sold over the sum of the interest rate paid to
investors, the contractual servicing fee (currently 0.50%) and a monoline
insurance fee, if any. The gain on sale of loans provides the basis for the
calculation of the interest-only strips, which are recorded as an asset on the
Company's consolidated balance sheet. The interest-only strips represent the
present value of
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the future cash flows, adjusted for the provision for loan losses. The Company
determines the present value of the cash flows at the time each securitization
transaction closes using certain estimates made by management at the time the
loans are sold. These estimates include the following: (i) rate of prepayment;
(ii) discount rate used to calculate present value; and (iii) the provision for
credit losses on loans sold. There can be no assurance of the accuracy of
management's estimates.
Rate of Prepayment. The estimated life of the securitized loans depends
on the assumed annual prepayment rate which is a function of estimated voluntary
(full and partial) and involuntary (liquidations) prepayments. The prepayment
rate represents management's expectations of future prepayment rates based on
prior and expected loan performance, the type of loans in the relevant pool
(fixed or adjustable rate) and industry data. The rate of prepayment may be
affected by a variety of economic and other factors, including the production
channel which produced the loan, prevailing interest rates, the presence of
prepayment penalties, the loan-to-value ratios and the credit grades of the
loans included in the securitization. Generally, a declining interest rate
environment will encourage prepayments. Lower credit grade loans tend to be more
payment and less interest rate sensitive than higher credit grade loans. The
valuation adjustment recorded in the fourth quarter of fiscal 1997 was due to
the continued acceleration of prepayment rates of adjustable rate loans included
in the Company's earlier pools. For fiscal 1996 and 1997, prepayment rates used
in the valuation of the interest-only strips ranged from 22.0% to 25.5% and
23.5% to 38.3%, respectively. These rates represent a weighted average loan life
of approximately 2.8 to 4.3 years and 2.6 to 3.9 years for fiscal 1996 and 1997,
respectively. See "-- Revenue" and "-- Risk Factors -- Prepayment and Credit
Risk."
Discount Rate. In order to determine the present value of the cash flow
from the interest-only strips, the Company discounts the cash flows based upon
rates prevalent in the market. See Note 3 to Notes to Consolidated Financial
Statements.
Provision for credit losses on loans sold. In determining the provision
for credit losses on loans sold, the Company uses assumptions that it believes
are reasonable based on information from its prior securitizations and the
loan-to-value ratios of the loans included in the current securitizations. At
June 30, 1997, the Company had reserves of $43.6 million related to these credit
risks, or 1.6% of the outstanding balance of loans securitized as of that date.
Cumulative net losses to date from the Company's securitization transactions
since June 1992 have totaled $6.49 million. Losses ranged from .03% to .24% of
the average servicing portfolio for the fiscal years ended June 1995, 1996 and
1997. The weighted average loan-to-value ratio of the loans serviced by the
Company was 68% as of June 30, 1997.
The interest-only strips are amortized over the expected lives of the
related loans and a corresponding reduction in servicing fee income is recorded.
On a quarterly basis, the Company reviews the fair value of the interest-only
strips by analyzing its prepayment and other assumptions in relation to its
actual experience and current rates of prepayment prevalent in the industry. See
"-- Risk Factors -- Prepayment and Credit Risk." The interest-only strips are
marked to market through a charge to earnings. See "-- Revenue."
Additionally, upon sale or securitization of servicing retained
mortgages, the Company capitalizes the fair value of mortgage servicing rights
assets separate from the loan. The Company
26
27
determines fair value based on the present value of estimated net future cash
flows related to servicing income. The cost allocated to the servicing rights is
amortized over the period of estimated net future servicing fee income. The
Company periodically reviews the valuation of capitalized servicing fees
receivable. This review is performed on a disaggregated basis for the
predominant risk characteristics of the underlying loans which are loan type and
origination date. The Company generally makes loans to credit-impaired borrowers
whose borrowing needs may not be met by traditional financial institutions due
to credit exceptions. The Company has found that credit impaired borrowers are
payment sensitive rather than interest rate sensitive. As such, the Company does
not consider interest rate a predominant risk characteristic for purposes of
valuation. As the Company increases the amount of higher credit grade loans it
originates and purchases, it may find that interest rate sensitivity among its
borrower base also increases.
The Company adopted Statement of Financial Accounting Standards No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities" ("SFAS 125") effective January 1, 1997. The adoption of SFAS 125
did not have a material effect on the Company's results of operations for the
year ended June 30, 1997. As a result of the adoption of FAS 125, the Company
records amounts previously categorized as "Excess servicing gains" in the
Consolidated Statements of Income as "Gain on sale of loans." Additionally, the
Company now records the right to future interest income that exceeds
contractually specified servicing fees and previously recorded as "Excess
servicing receivable" as an investment security called "Interest-only strips."
The Company has classified this asset as a trading security and, through June
30, 1997, recorded a mark-to-market loss of $19.0 million on this security
consisting of a $9.05 million gain on securitizations completed since March 1997
and a $28 million loss on securitizations recorded prior to March 1997. SFAS 125
requires that this mark-to-market adjustment be reported separately from "Gain
on sale of loans" and the adjustment has been labeled "Net unrealized loss on
valuation of interest-only strips" in the Consolidated Statements of Income.
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS
128"). SFAS 128 establishes standards for computing and presenting earnings per
share ("EPS") by replacing the presentation of primary EPS with a presentation
of basic EPS. Primary EPS included common stock equivalents while basic EPS
excludes them. This change simplifies the computation of EPS, while making the
United States computation more compatible to the standards of other countries.
It also requires dual presentation of basic and fully diluted EPS on the face of
the income statement for all entities with complex capital structures. The
Company will adopt SFAS 128 effective December 31, 1997 and does not expect the
adoption of SFAS 128 to have a material impact on its financial statements.
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 129, "Disclosure of Information
about Capital Structure" ("SFAS 129"). SFAS 129 establishes disclosure
requirements regarding pertinent rights and privileges of outstanding
securities. Examples of disclosure items regarding securities include, though
are not limited to, items such as dividend and liquidation preferences,
participation rights, call prices and dates, conversion or exercise prices or
rates. The number of shares issued upon conversion, exercise or satisfaction of
required conditions during at least the most recent annual fiscal period and any
subsequent interim period must also be disclosed. Disclosure of liquidation
preferences of preferred stock in the equity
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section of the statement of financial condition is also required. SFAS 129 is
effective for financial periods beginning after December 15, 1997.
In October 1995, the FASB released SFAS No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"). This statement establishes methods of
accounting for stock-based compensation plans. SFAS 123 is effective for fiscal
years beginning after December 15, 1995. The Company adopted SFAS 123 in fiscal
year 1997. The adoption of SFAS 123 did not have a material effect on the
financial position of the Company.
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RESULTS OF OPERATIONS -- FISCAL YEARS 1995, 1996 AND 1997
The following table sets forth information regarding the components of
the Company's revenue and expenses in fiscal 1995, 1996 and 1997:
1995 1996 1997
---------------------- ---------------------- --------------------
(Dollars in thousands)
Dollars Percentage Dollars Percentage Dollars Percentage
------- ---------- ------- ---------- ------- ----------
Revenue:
Gain on sale of loans........ $ 25,438 44.3% $ 95,299 63.4% $198,736 72.9%
Net unrealized loss on valuation
of interest-only strips -- -- -- -- (18,950) (6.9)
Commissions................... 15,799 27.5 21,564 14.4 29,250 10.7
Loan Service:
Servicing spread............ 4,399 7.7 12,667 8.4 16,265 6.0
Prepayment fees............. 1,974 3.4 3,229 2.1 5,815 2.1
Late charges and
other servicing fees 1,873 3.3 2,290 1.5 3,724 1.4
Fees and other:
Closing..................... 2,077 3.6 2,512 1.7 2,723 1.0
Appraisal................... 988 1.7 1,167 0.8 1,854 0.7
Underwriting................ 1,091 1.9 1,600 1.1 1,382 0.5
Interest income............. 2,339 4.1 9,127 6.1 31,160 11.4
Other....................... 1,445 2.5 809 0.5 560 0.2
-------- ----- -------- ----- -------- -----
Total revenue........... $ 57,423 100.0% $150,264 100.0% $272,519 100.0%
======== ===== ======== ===== ======== =====
Expenses:
Compensation and
related expenses.......... $ 17,610 30.7% $ 40,758 27.1% $ 81,021 29.7%
Sales and
advertising costs......... 9,906 17.2 19,036 12.7 27,229 10.0
General and administrative
expenses.................. 7,067 12.3 17,377 11.6 31,716 11.6
Interest expense............ 3,205 5.6 12,370 8.2 33,105 12.2
Provision for loan losses 2,484 4.3 8,424 5.6 33,941 12.5
Nonrecurring charges -- -- -- -- 32,000 11.7
-------- ----- -------- ----- -------- -----
Total expenses......... $40,272 70.1% $ 97,965 65.2% $239,012 87.7%
======== ===== ======== ===== ======== =====
Income before income taxes 17,151 29.9 52,299 34.8 33,507 12.3
Income taxes.................... 7,117 12.4 22,508 15.0 16,398 6.0
-------- ----- -------- ----- -------- -----
Net income.............. $ 10,034 17.5% $ 29,791 19.8% $ 17,109 6.3%
======== ===== ======== ===== ======== =====
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REVENUE
Total revenue for fiscal 1997 increased $122 million, or 81%, from total
revenue for fiscal 1996 which, in turn, increased $92.8 million, or 162%, over
total revenue in fiscal 1995. The 1997 revenue includes a net unrealized loss on
the valuation of the Company's interest-only strips (see below). Increases in
total revenue for these periods were primarily the result of higher gain on sale
and loan service revenue resulting from increased volumes of mortgage loans
originated and purchased by the Company and securitized and sold. The Company
originated and purchased $355 million, $1.17 billion and $2.35 billion of
mortgage loans during fiscal 1995, 1996 and 1997, respectively. The substantial
increase from 1995 to 1996 was primarily the result of the increase in loans
purchased through the Company's correspondent loan division and, to a lesser
extent, the national expansion of the Company's retail division. The substantial
increase in 1997 over 1996 was due primarily to the increase in loans purchased
through the Company's correspondent loan division, loans originated through the
independent mortgage broker network and, to a lesser extent, the further
expansion of the retail network.
Gain on sale increased by $84.5 million, or 89%, in fiscal 1997 compared
to fiscal 1996 and $69.9 million, or 275%, in fiscal 1996 compared to fiscal
1995. These increases resulted primarily from the greater size of the mortgage
loan pools securitized and sold by the Company and, in fiscal 1996, increased
servicing spreads and the recognition of mortgage servicing rights pursuant to
SFAS 122 (see "--Certain Accounting Considerations"). The Company securitized
and sold $317 million, $791 million and $2.26 billion of loans during fiscal
1995, 1996 and 1997, respectively. The weighted average servicing spread (the
weighted average interest rate on the pool of loans sold over the sum of the
investor pass-through or bond rate and the monoline insurance fee, if any) on
loans securitized and sold during these periods was 3.91%, 4.93% and 4.16% for
fiscal 1995, 1996 and 1997, respectively. The lower weighted average servicing
spread in 1997 reflected a decrease in weighted average interest rates on pooled
loans due primarily to the higher percentage of higher credit grade loans
included in the loans securitized during the year and, to a lesser degree,
increased pass-through or bond rates due to the current interest rate
environment. The larger percentage of higher credit grade loans included in the
loans securitized during fiscal 1997 reflects the Company's previously announced
diversification of its loan originations and purchases to include more A, A-, B
and C credit grade loans. In addition, in the fourth quarter, the Company
increased the prepayment rate assumption used to record the gain on sale,
thereby reducing the total amount of gain recorded in the fourth quarter
securitization.
The $19.0 million net unrealized loss on the valuation of the Company's
interest-only strips in fiscal 1997 resulted from the Company's quarterly review
of that asset to determine its current fair market value. The Company determines
the fair market value of the interest-only strips, in part, by applying
management's expectations as to future prepayment rates to the present value of
the future cash flows from prior securitizations. In conjunction with its bulk
pricing strategy change in the fourth quarter of fiscal 1997, management revised
its expectations as to future prepayment rates based primarily on the continued
acceleration of prepayment rates in adjustable rate loans included in some of
the Company's earlier pools. As a result, the Company recorded a $28 million
loss adjustment which is included in the $19 million unrealized loss on the
Company's interest-only strips. See "--Certain Accounting Considerations" and
"Item 1. Business -- Recent Events."
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Commissions earned on loan originations continue to be an important
component of total revenue, although to a lesser degree than in prior years,
comprising 28%, 14% and 11% of total revenue in fiscal 1995, 1996 and 1997,
respectively. Commissions increased $7.69 million, or 36%, in fiscal 1997
compared to fiscal 1996, and increased $5.77 million, or 36%, in fiscal year
1996 compared to fiscal 1995. Commission revenue is primarily a function of the
volume of mortgage loans originated by the Company through its retail loan
office network and the weighted average commission rate charged on such loans.
The increase in commissions in fiscal year 1997 was a result of increased
origination volume, offsetting a decline in weighted average commission rate.
The weighted average commission rate was 9.4%, 7.7% and 4.9% during fiscal 1995,
1996 and 1997, respectively. The lower weighted average commission rate in 1997
reflected the increase of higher credit grade loans originated through the
Company's retail loan office network, which generally carry lower commission
rates, and competitive factors. Commissions do not include $1.0 million and
$1.18 million of commissions on loans which were held for sale as of June 30,
1996 and 1997, respectively.
Loan service revenue increased $7.62 million, or 42%, in fiscal 1997
compared to fiscal 1996 and $9.94 million, or 121%, in fiscal 1996 compared to
fiscal 1995. Loan service revenue consists of net servicing spread earned on the
principal balances of the loans in the Company's loan servicing portfolio,
prepayment fees, late charges and other fees retained by the Company in
connection with the servicing of loans reduced by the amortization of the
interest-only strips. The increases in fiscal 1997 and 1996 were due primarily
to the greater size of the portfolio of loans serviced in each of these periods
offset by increased amortization of the interest-only strips. The Company's loan
servicing portfolio increased to $3.17 billion at June 30, 1997, up 131% from
the June 30, 1996 balance of $1.37 billion which, in turn, increased 125% over
the June 30, 1995 balance. At June 30, 1997, 53% of the Company's servicing
portfolio was subserviced by third parties. In fiscal 1998, the Company intends
to service directly substantially all the loans in its servicing portfolio.
Management believes that the business of loan servicing provides a more
consistent revenue stream and is less cyclical than the business of loan
origination and purchasing.
Fees and other revenue increased by $22.5 million, or 148%, in fiscal
1997 compared to fiscal 1996 and increased $7.28 million, or 92%, in fiscal 1996
compared to fiscal 1995. Fees and other revenue consist of fees received by the
Company through its retail loan office network in the form of closing,
appraisal, underwriting and other fees, plus interest income. The dollar amount
of these fees increased in each of the years presented due to the larger number
of mortgage loans originated through the Company's retail loan office network
during the respective periods. Interest income increased in fiscal 1997 and 1996
due to interest earned on larger amounts of loans held by the Company during the
period from origination or purchase of the loans until the date sold by the
Company.
EXPENSES
Compensation and related expenses increased $40.3 million, or 99%, in
fiscal 1997 compared to fiscal 1996. This increase was primarily due to the
continued effort to accommodate increased origination volumes and origination
channel expansion. Compensation and related expenses as a percentage of total
loan originations and purchases were 5.0%, 3.5% and 3.5% for fiscal 1995, 1996
and 1997, respectively.
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32
Sales and advertising costs increased $8.19 million, or 43%, in fiscal
1997 compared to fiscal 1996 and $9.13 million, or 92%, in fiscal 1996 compared
to fiscal 1995. This increase was primarily due to increased origination volume
and continued expansion into new geographical areas requiring concentrated
marketing efforts. Sales and advertising costs as a percentage of origination
volume were 2.8%, 1.6% and 1.2% for fiscal 1995, 1996 and 1997, respectively.
General and administrative expenses increased $14.3 million, or 83%, in
fiscal 1997 compared to fiscal 1996 and $10.3 million, or 146%, in fiscal 1996
compared to fiscal 1995. These increases were primarily the result of increased
occupancy and communication costs related to the Company's expansion and
increased origination volumes.
Interest expense increased to $33.1 million in fiscal 1997 compared to
$12.4 million in fiscal 1996 and $3.2 million in fiscal 1995. The increase was
primarily the result of increased borrowings under various financing
arrangements used to fund the origination and purchase of mortgage loans prior
to their securitization and sale in the secondary market and as a result of the
Company's sale of $115 million of its 5.5% Convertible Subordinated Debentures
due 2006 in the third quarter of fiscal 1996 and $150 million of its 9.125%
Senior Notes due 2003 in the second quarter of fiscal 1997. Interest expense is
expected to increase in future periods due to the Company's continued reliance
on warehousing arrangements to fund increased originations and purchases of
loans pending their securitization.
The provision for loan losses for fiscal 1997 increased to $33.9
million, up 303% when compared to fiscal 1996. The provision for loan losses
represents 1.50% of the loans securitized during fiscal 1997 compared to 1.06%
of the loans securitized during fiscal 1996. This increase reflects the greater
amount of higher credit grade loans with generally higher loan-to-value ratios
originated during fiscal 1997.
In fiscal 1997, the Company incurred $32.0 million of nonrecurring
charges. Approximately $25 million of these charges were recognized in August
1996 directly related to the acquisition of One Stop. The remaining amount
relates to a reserve for vacating corporate headquarters recorded in the first
quarter and to severance and other strategic decisions made in the fourth
quarter.
INCOME TAXES
The Company's provision for income taxes decreased to $16.4 million in
fiscal 1997 from $22.5 million in fiscal 1996 and increased from $7.1 million in
fiscal 1995, primarily as a result of the fluctuation in pre-tax income after
consideration of the tax impact of nonrecurring charges.
FINANCIAL CONDITION
Loans held for sale. The Company's portfolio of loans held for sale
increased to $243 million at June 30, 1997 from $186 million at June 30, 1996.
This increase is directly related to production volume and the size of the
Company's securitizations. In the quarter ended June 30, 1997, the Company
securitized only $500 million of its $644 million of loan production, increasing
the amount
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33
of loans carried over to the first quarter of fiscal 1998 to $243 million. This
represents an increase in loan carryover of approximately $136 million, or 127%,
over the third fiscal quarter's carryover amount. Management believes the
increase in the carryover amount will provide the Company with additional cash
flows, efficiencies and flexibility in the future.
Accounts receivable. Accounts receivable representing servicing fees and
advances and other receivables, increased from $9.7 million at June 30, 1996 to
$59.2 million at June 30, 1997. This increase was primarily the result of larger
pools serviced and increases in related advances and receivables.
Interest-only strips. Interest-only strips increased from $129 million
at June 30, 1996 to $270 million at June 30, 1997 reflecting the increased size
of the Company's securitizations during 1997.
See "-- Certain Accounting Considerations."
Mortgage servicing rights. Mortgage servicing rights increased from
$10.9 million at June 30, 1996 to $21.6 million at June 30, 1997 reflecting the
increased size of the Company's securitizations during 1997. See "-- Certain
Accounting Considerations."
Residual assets. Residual assets represent the reserve accounts and
overcollateralization amounts required to be maintained in connection with the
securitization of loans. Residual assets include cash and mortgage loans in
excess of the principal amounts of the senior and subordinated certificates or
bonds of the securitization trusts. Residual assets increased from $44.7 million
at June 30, 1996 to $113 million at June 30, 1997 due to the size of the
Company's recent securitizations.
Equipment and improvements, net. Primarily as a result of the Company's
expansion and the associated investment in technology, equipment and
improvements, net, increased from $6.7 million at June 30, 1996 to $12.7 million
at June 30, 1997.
Prepaid and other assets. Prepaid and other assets increased from $10.3
million at June 30, 1996 to $14.9 million at June 30, 1997 primarily as a result
of the capitalization, net of amortization, of debt issuance costs related to
the issuance of the Company's 9.125% Senior Notes due 2003.
Borrowings. Borrowings increased from $138 million at June 30, 1996 to
$287 million at June 30, 1997. This increase was the result of the sale in
October 1996 of $150 million of the Company's 9.125% Senior Notes due 2003.
Revolving warehouse facilities. Amounts outstanding under warehouse
facilities increased from $112 million at June 30, 1996 to $138 million at June
30, 1997 primarily as a result of the larger amount of loans held for sale at
such dates. Proceeds from the Company's securitizations are used to pay down the
Company's warehouse facilities.
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LIQUIDITY
The Company's operations require continued access to short-term and
long-term sources of cash. The Company's operating cash requirements include the
funding of: (i) mortgage loan originations and purchases prior to their
securitization and sale, (ii) fees and expenses incurred in connection with the
securitization and sale of loans, (iii) cash reserve accounts or
overcollateralization requirements in connection with the securitization and
sale of mortgage loans, (iv) tax payments due on recognition of gain on sale
other than in a debt-for-tax securitization structure (see below), (v) ongoing
administrative and other operating expenses, and (vi) interest and principal
payments under the Company's warehouse credit facilities and other existing
indebtedness.
The Company has operated on a negative operating cash flow basis and
expects to continue to do so for as long as the Company's cash requirements
necessitated by the growth in volume of its securitization program continue to
grow at rates in excess of the cash generated by the Company from its
operations, including its servicing activities. To increase the cash generated
from operations, the Company may increase the volume of whole loans sold in bulk
to other mortgage lenders. Unlike a securitization, a whole loan sale generates
cash at the closing of the sale; however, such sales may generate less profit
than a securitization.
The Company is continuing efforts to enhance cash flow with the ultimate
goal of reducing dependence on external sources. Historically, the Company
funded its negative operating cash flow principally through borrowings from
financial institutions, sales of equity securities and sales of senior and
subordinated notes, among other sources. The Company expects to continue to fund
its negative operating cash flows, subject to limitations under the Company's
existing credit facilities, principally from borrowings from financial
institutions and, to a lesser extent, sales of equity securities and public
debt. There can be no assurance that the Company will have access to the capital
markets in the future or that financing will be available to satisfy the
Company's operating and debt service requirements or to fund its future growth.
The Company anticipates that its sources of liquidity, assuming access to
residual financing, will be sufficient to fund the Company's liquidity
requirements for the next 12 months, if the Company's future operations are
consistent with management's current growth expectations. There can be no
assurance that the Company will be successful in consummating any such financing
transaction in the future on terms the Company would consider to be favorable.
Further, primarily as a result of the events described under "Item 1. Business
- -- Recent Events," certain rating agencies have placed certain issues of the
Company's debt under credit watch. This may affect the ability of the Company to
secure credit facilities on favorable terms. See "--Capital Resources" and "Item
1. Business "--Recent Events" and "--Business Strategy."
Under the terms of the Indenture, the Company's ability to incur certain
additional indebtedness, including residual financing, is limited to two times
stockholders' equity. Further, until the Company receives investment grade
ratings for the notes issued under the Indenture, the amount of residual
financing the Company may incur on its residuals (interest-only strips)
allocable to post-September 1996 securitizations is limited to 75% of the
difference between such post-September 1996 residuals and $225 million.
Warehouse indebtedness is not included in the indebtedness limitations.
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New loan originations and purchases represent the Company's most
significant cash flow requirement. The Company pays a premium on loans purchased
through its correspondent program and on loans purchased from independent
mortgage brokers. The amount of cash used to pay premiums approximated $76.9
million in 1997 and $33.7 million in 1996. This increase is primarily related to
the increase in the amount of loans purchased in bulk through the correspondent
program and, to a lesser extent, the higher premiums paid per loan. See "Item 1.
Business -- Recent Events."
The Company securitized and sold in the secondary market $317 million,
$791 million and $2.26 billion of loans in fiscal 1995, 1996 and 1997,
respectively. In connection with securitization transactions completed during
these periods, the Company was required to provide credit enhancements in the
form of overcollateralization amounts or reserve accounts. In addition, during
the life of the related securitization trusts, the Company subordinates a
portion of the excess cash flow otherwise due it to the rights of holders of
senior interests as a credit enhancement to support the sale of the senior
interests. The terms of the securitization trusts generally require that all
excess cash flow otherwise payable to the Company during the early months of the
trusts be used to increase the cash reserve accounts, or to repay the senior
interests in order to increase overcollateralization to specified maximums. The
accumulated amounts of such overcollateralization amounts and cash reserve
accounts are reflected on the Company's balance sheet as "residual assets." At
June 30, 1997, the residual assets balance was $113 million.
In addition, the increasing use of securitization transactions as a
funding source by the Company has resulted in a significant increase in the
amount of gain on sale of loans recognized by the Company. During fiscal 1995,
1996 and 1997, the Company recognized gain on sale of loans in the amounts of
$25.4 million, $95.3 million and $199 million, respectively. In addition, the
Company recognized $19.0 million in net unrealized loss on valuation of
interest-only strips in accordance with SFAS 125 implemented in the quarter
ended March 31, 1997. In the Company's securitizations structured as a REMIC,
the recognition of gain on sale had a negative impact on the cash flow of the
Company since the Company is required to pay federal and state taxes on a
portion of these amounts in the period recognized although it does not receive
the cash representing the gain until later periods as the related service fees
are collected and applicable reserve or overcollateralization requirements are
met. In its operations, the Company employs various tax planning strategies,
including the debt-for-tax structure, which allows the Company to defer the
payment of taxes until income is distributed or received by the trust. In March
1997, the Company completed its first securitization using the debt-for-tax
structure. This had a positive effect on the Company's cash flows without
materially changing the reported earnings.
The Company also incurs certain expenses in connection with
securitizations, including underwriting fees, credit enhancement fees, trustee
fees, hedging and other costs, which in fiscal 1997 approximated .62% of the
principal amount of the securitized mortgage loans.
CAPITAL RESOURCES
The Company finances its operating cash requirements primarily through
(i) warehouse facilities, (ii) the securitization and sale of mortgage loans,
and (iii) the issuance of debt and equity securities.
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Warehouse Facilities. At June 30, 1997, the Company had two warehouse
facilities in place. On January 15, 1997, the Company amended and restated its
warehouse and working capital line of credit with a syndicate of eight
commercial banks. The facility provides for a maximum borrowing amount of $350
million, is secured by loans originated and purchased by the Company as well as
certain servicing receivables, and bears an interest rate of either 1.05% over
the federal funds rate or .80% over one-month LIBOR. This line is currently
scheduled to expire on January 13, 1998 and is subject to renewal. There is an
additional warehouse line of credit from an investment bank that is secured by
loans originated and purchased by the Company. This line of $250 million bears
interest at a rate of 0.70% over one-month LIBOR and expires on December 30,
1997. The Company has a commitment from an investment bank for a warehouse
facility with a maximum borrowing amount of $400 million. Management expects,
although there can be no assurance, that the Company will be able to maintain
these or similar facilities in the future. See "-- Risk Factors -- Dependence on
Funding Sources."
Securitization Program. The Company's most important capital resource
has been its ability to sell loans originated and purchased by it in the
secondary market in order to generate cash proceeds to pay down its warehouse
facilities and fund new originations and purchases. The value of and market for
the Company's loans are dependent upon a number of factors, including general
economic conditions, interest rates and governmental regulations. Adverse
changes in such factors may affect the Company's ability to securitize and sell
loans for acceptable prices within a reasonable period of time. The ability of
the Company to sell loans in the secondary market on acceptable terms is
essential for the continuation of the Company's loan origination and purchase
operations. A reduction in the size of the secondary market for loans of the
types originated or purchased by the Company may adversely affect the Company's
ability to sell loans in the secondary market with a consequent adverse impact
on the Company's profitability and ability to fund future originations and
purchases. See "-- Risk Factors--Dependence on Funding Sources."
In addition, in order to gain access to the secondary market, the
Company has principally utilized monoline insurance companies to provide
financial guarantee insurance on senior interests in the securitization trusts
established by the Company. Although the Company completed its first
securitization utilizing a senior/subordinated structure in June 1997, which
relied on the internal credit enhancements of the pool rather than monoline
insurance, the Company expects to utilize monoline insurance companies for at
least a portion of its future securitizations. Any substantial reduction in the
size or availability of the secondary market for the Company's loans or the
unwillingness of monoline insurance companies to provide financial guarantee
insurance for the senior interests in the securitization trusts could have a
material adverse effect on the Company's financial position and results of
operations. At June 30, 1997, the dollar volume of loans delinquent more than 90
days on the Company's seven securitization trusts formed during the period from
December 1994 to June 1996 exceeded the permitted limit in the related pooling
and servicing agreements. The higher delinquency rates could negatively affect
the Company's cash flows and adversely influence the Company's assumptions
underlying the gain on sale. Additionally, the higher delinquency rates permit
the monoline insurance company to terminate the Company's servicing rights with
respect to the affected trust. To date, no servicing rights have been
terminated, and the Company believes that the likelihood of such an event is
remote. The Company has implemented various plans to lower the delinquency rates
in its future trusts, including diversifying the loans it originates and
purchases to include higher credit
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grade loans. However, the Company has not yet experienced the benefit of the
migration of credit grades to levels with lower expected delinquency. Further,
the monoline insurance companies agreed to higher permitted delinquency limits
in the five securitizations completed in fiscal year 1997. See "-- Risk Factors
- - Delinquencies; Negative Impact on Cash Flow; Right to Terminate Mortgage
Servicing."
Other Capital Resources. The Company has funded negative cash flow
primarily from the sale of its equity and debt securities. In December 1991,
July 1993, June 1995 and October 1996, the Company effected offerings of its
Common Stock with net proceeds to the Company aggregating $179 million. In
March 1995, the Company completed an offering of its 10.5% Senior Notes due 2002
with net proceeds to the Company of $22.2 million. In February 1996, the Company
completed an offering of its 5.5% Convertible Subordinated Debentures due 2006
with net proceeds to the Company of $112 million. In October 1996, the Company
completed an offering of its 9.125% Senior Notes due 2003 with net proceeds to
the Company of $145 million. Under the agreements relating to these debt
issuances, the Company is required to comply with various operating and
financial covenants including covenants which may restrict the Company's ability
to pay certain distributions, including dividends. See "Item 5. Market for
Registrant's Common Equity and Related Stockholder Matters." At June 30, 1997,
the Company had available $5.1 million for the payment of such distributions
under the most restrictive of such covenants.
The Company had cash and cash equivalents of approximately $26.9 million
(of which $12.9 million was restricted) at June 30, 1997. See "-- Risk Factors -
Negative Cash Flow and Capital Needs."
RISK MANAGEMENT
The Company's earnings may be directly affected by the level of and
fluctuation in interest rates and the level of prepayment in the Company
securitizations. The Company currently hedges its fixed rate pipeline and
continues to explore other avenues of risk mitigation, although none have been
employed to date. The current fixed rate hedge products utilized are swap
agreements with third parties that sell United States Treasury securities not
yet purchased and the purchase of Treasury put options. The amount and timing of
hedging transactions are determined by members of the Company's senior
management. While the Company monitors the interest rate environment and employs
fixed rate hedging strategies, there can be no assurance that the earnings of
the Company would not be adversely affected during any period of unexpected
changes in interest rates or prepayment rates.
The Company may also mitigate its exposure to interest rate risk through
a pre-funding strategy in which it agrees to sell loans to the securitization
trust in the future at an agreed-upon price. The pre-funding locks in the price
agreed upon with investors on the pricing date (typically five business days
prior to the closing date of the securitization) for a period of generally 30
days. In a pre-funding arrangement, the Company typically delivers approximately
75% of the loans sold at the closing and the remainder generally within 30 days
after the closing.
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RISK FACTORS
Forward Looking Statements. This Report contains forward looking
statements relating to such matters as anticipated financial performance,
business prospects and similar matters. The Private Securities Litigation Reform
Act of 1995 provides a safe harbor for forward-looking statements. In order to
comply with the terms of the safe harbor, the Company notes that a variety of
factors could cause the Company's actual results and experience to differ
materially from the anticipated results or other expectation expressed in the
Company's forward-looking statements. The risks and uncertainties that may
affect the operations, performance and results of the Company's business include
the following: negative cash flows and capital needs, delinquencies, prepayment
and credit risk, risks of contracted servicing, dependence on funding sources,
capitalized interest-only strips, recent acquisition of One Stop, dependence on
broker network, impact of increases in correspondent pricing, risks associated
with high loan-to-value loan products, competition, concentration of operations,
timing of loan sales, economic conditions, contingent risks and government
regulation. These risk factors are set forth below.
Negative Cash Flow and Capital Needs. In a securitization, the Company
recognizes a gain on sale of the loans securitized upon the closing of the
securitization, but does not receive the cash representing such gain until it
receives the excess cash flow, which in general is payable over the actual life
of the loans securitized. The Company incurs significant expense in connection
with a securitization and generally incurs both current and deferred tax
liabilities as a result of the gain on sale. Net cash used in operating
activities for fiscal 1995, 1996 and 1997 was $43.4 million, $241 million and
$280 million, respectively. Therefore, the Company requires continued access to
short- and long-term external sources of cash to fund its operations. The
Company expects to continue to operate on a negative cash flow basis as the
volume of the Company's loan purchases and originations increases and its
securitization program grows. However, the Company is continuing efforts to
enhance cash flow with the ultimate goal of reducing dependence on external
sources. The Company's primary cash requirements include the funding of: (i)
mortgage loan originations and purchases pending their securitization and sale;
(ii) fees and expenses incurred in connection with the securitization of loans;
(iii) reserve account or overcollateralization requirements in connection with
the securitization and sale of the loans; (iv) tax payments due on recognition
of gain on sale, other than in a debt-for-tax securitization structure; (v)
ongoing administrative and other operating expenses; and (vi) interest and
principal payments under the Company's warehouse credit facilities and other
existing indebtedness.
The Company's primary sources of liquidity in the future are expected to
be existing cash, fundings under warehouse facilities, access to residual
financing, sales of mortgage loans through securitizations, whole loan sales and
further issuances of debt or equity. See "--Liquidity" and "--Capital
Resources."
The Company's primary sources of liquidity as described in the paragraph
above are expected to be sufficient to fund the Company's liquidity requirements
through at least the next 12 months if the Company's future operations are
consistent with management's current growth expectations. However, because the
Company expects to continue to operate on a negative cash flow basis for the
foreseeable future, it may need to effect additional debt or equity financings.
The type, timing and terms of
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financing selected by the Company will be dependent upon the Company's cash
needs, the availability of other financing sources, limitations under debt
covenants and the prevailing conditions in the financial markets. There can be
no assurance that any such sources will be available to the Company at any given
time or as to the favorableness of the terms on which such sources may be
available. As a result of the limitations described above, the Company may be
restricted in the amount and type of future debt it may issue.
Delinquencies; Negative Impact on Cash Flow; Right to Terminate Mortgage
Servicing. A substantial majority of the Company's servicing portfolio consists
of loans securitized by the Company and sold to REMIC or owner trusts.
Generally, the form of agreement entered into in connection with these
securitizations contains specified limits on the 90-day (or 60-day, in the case
of the senior/ subordinated securitization structure) delinquency rate
(including properties acquired upon foreclosure and not sold) prevailing on the
loans included in each trust. If, at any measuring date, the 90-day delinquency
rate with respect to any trust credit-enhanced by monoline insurance were to
exceed the limit applicable to such trust, provisions of the agreements permit
the monoline insurance company to terminate the Company's servicing rights to
the pool as more fully described below. In addition, high delinquency rates have
a negative impact on cash flow.
At June 30, 1997, seven of the Company's trusts credit-enhanced by
monoline insurance (representing 20.5% of the dollar volume of the Company's
servicing portfolio) exceeded the applicable 90-day delinquency standard. These
seven trusts were formed during the period from December 1994 to June 1996. At
June 30, 1997, the 90-day delinquency rate on these seven trusts ranged from
15.2% to 36.2% of the remaining pool balance. The Company believes that the high
delinquency rates it has experienced are primarily due to the higher proportion
of lower credit grade loans ("C-" and "D" loans) included in these pools and the
seasoning of the portfolio. However, the Company believes its historical loan
losses have been below those experienced by most other lenders to
credit-impaired borrowers as a result of the lower initial combined
loan-to-value ratios which it requires on its lower credit grade loans. At June
30, 1997, the weighted average of the initial combined loan-to-value ratio on
loans in the seven trusts was 65.0%.
Although the monoline insurance company has the right to terminate
servicing with respect to the seven trusts referred to above, no servicing
rights have been terminated. There can be no assurance that the Company's
servicing rights with respect to the mortgage loans in such trusts, or any other
trust which exceeds the specified limits in future periods, will not be
terminated. The monoline insurance company has other rights to terminate
servicing if the Company were to breach its obligations under the agreement,
losses on foreclosure were to exceed specified limits, the insurance company
were required to make payments under its policy or certain bankruptcy or
insolvency events were to occur. None of these events has occurred with respect
to any of the trusts formed by the Company.
The Company implemented a variety of measures designed to reduce
delinquency rates on loans included in securitizations in future periods,
including the implementation of new procedures designed to shorten the time
required to transfer servicing on loans purchased through the Company's
correspondent program and the elimination of its loan program which has
experienced the highest delinquency rates. In addition, as a result of the
expansion of the Company's loan production capacity,
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including the acquisition of One Stop, the proportion of higher credit grade
loans originated or purchased by the Company is increasing. The Company expects
that the combined effect of these developments will have a positive impact on
delinquency rates experienced in trusts formed by the Company in future periods,
although average combined loan-to-value ratios are likely to increase. Despite
the Company's migration to higher credit grades loans, it has not yet
experienced the benefit of lower expected delinquencies. Further, delinquency
rates and losses on the Company's existing trusts and future trusts could
increase. Although the trust formed by the Company in September 1996 had
delinquency rates at June 30, 1997 within expectations and below the applicable
90-day delinquency standard (which were raised to 13.5% with respect to the June
1996 trust and 17% with respect to the trusts formed since that date), the loans
included in this trust were originated or purchased prior to these developments
and have been outstanding for a relatively short period of time and there can be
no assurance that delinquency rates on this trust will not increase in future
periods.
The Company's cash flow is also adversely impacted by high delinquency
rates in its trusts. Generally, provisions in the agreement have the effect of
requiring the overcollateralization account, which is funded primarily by the
excess spread on the loans held in the trust, to be increased when the
delinquency rates exceed the specified limit. As of June 30, 1997, the Company
was required to maintain an additional $19.5 million in overcollateralization
amounts as a result of the level of its delinquency rates above that which would
have been required to be maintained if the applicable delinquency rates had been
below the specified limit. Of this amount, at June 30, 1997, $7.96 million
remains to be added to the overcollateralization amounts from future spread
income on the loans held by these trusts. If delinquencies continue at this
level, the overcollateralization requirement will increase in the future. Loss
rates also could affect the Company's ability to effect securitizations in the
capital markets.
Prepayment and Credit Risk. Gain on sale is the most significant
component of the Company's reported revenues. Gain on sale represents the
recognition of the present value of the excess cash flow, which is based on
certain estimates made by management at the time loans are sold, including
estimates regarding prepayment rates. The rate of prepayment of loans may be
affected by a variety of economic and other factors, as discussed above. The
effects of these factors may vary depending on the particular type of loan.
Estimates of prepayment rates are made based on management's expectations of
future prepayment rates, which are based, in part, on the historic performance
of the Company's loans and other considerations. There can be no assurance of
the accuracy of management's estimates. If actual prepayments occur more quickly
than was projected at the time loans were sold, the carrying value of the
interest-only strips may have to be adjusted through a charge to earnings in the
period of adjustment. See "-- Revenue."
Loans made to borrowers who are unable or unwilling to obtain mortgage
financing from conventional mortgage sources may entail a higher risk of
delinquency and higher losses than loans made to borrowers who utilize
conventional mortgage sources. While the Company believes that the underwriting
criteria and collection methods it employs enable it to mitigate the higher
risks inherent in loans made to these borrowers, no assurance can be given that
such criteria or methods will afford adequate protection against such risks. In
the event that loans originated and purchased by the
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Company experience higher delinquencies, foreclosures or losses than
anticipated, the Company's results of operations or financial condition could be
adversely affected.
Generally, the Company's higher credit grade loans have higher
loan-to-value ratios than its lower credit grade loans. In such cases, the
collateral of such loans may not be sufficient to cover the principal amount of
the loans in the event of default. Losses not covered by the underlying
properties, if in excess of the Company's provision for such losses, could have
a material adverse effect on the Company's results of operations and financial
condition. In addition, historical loss rates affect the assumptions used by the
Company in computing its gain on sale. See " -- Revenue."
Risks of Contracted Servicing. At June 30, 1997, the Company's
subservicing arrangements accounted for approximately 53% of the Company's $3.17
billion servicing portfolio at June 30, 1997. The Company is subject to risks
associated with inadequate or untimely service rendered by subservicers. Many of
the Company's borrowers require notices and reminders to keep their loans
current and to prevent delinquencies and foreclosures. Any failure by a
subservicer to provide adequate or timely service could result in higher
delinquency rates and foreclosure losses on the portfolio of loans. The Company
intends to service directly substantially all loans in its servicing portfolio
commencing in fiscal 1998 (regardless of the location of the mortgaged
property). The transfer of servicing files could lead to temporary disruptions
in servicing. To the extent the Company terminates its subservicing
arrangements, the Company would be required to pay a termination fee.
Dependence on Funding Sources. The Company is dependent upon its access
to warehouse and other credit facilities in order to fund new originations and
purchases of mortgage loans pending securitization. At June 30, 1997, the
Company had warehouse facilities with certain financial institutions and
investment banks with aggregate borrowing capacity of $600 million and a
commitment from an investment bank for a $400 million facility. The Company's
warehouse facilities expire between December 1997 and January 1998. In
addition, the Company's growth strategies will require significant increases in
the amount of the Company's warehouse and other credit facilities. The Company
is currently negotiating with various investment banks to obtain additional
warehouse facilities. There can be no assurance that the Company will be able to
secure such financing on affordable terms, or at all. The Company expects to be
able to maintain existing warehouse and other credit facilities (or to obtain
replacement or additional financing) as current arrangements expire or become
fully utilized; however, there can be no assurance that such financing will be
obtainable on favorable terms. To the extent that the Company is unable to
extend or replace existing facilities, and arrange new warehouse or other credit
facilities, the Company may have to curtail loan origination and purchasing
activities, which would have a material adverse effect on the Company's
financial position and results of operations. Further, principally as a result
of the events described under "Item 1. Business -- Recent Events," certain
rating agencies have placed certain issues of the Company's debt under credit
watch. This may affect the ability of the Company to secure credit facilities on
favorable terms.
The Company relies on its ability to securitize and sell its mortgage
loans in the secondary market in order to generate cash proceeds for repayment
of its warehouse facilities. Accordingly, adverse changes in the Company's
securitization program or in the secondary mortgage market could
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impair the Company's ability to originate, purchase and sell mortgage loans on a
favorable or timely basis. Any such impairment could have a material adverse
effect upon the Company's financial position and results of operations. In
addition, in order to gain access to the secondary market, the Company has
utilized monoline insurance companies to provide financial guarantee insurance
on the senior interests in loans sold in the secondary market in order to obtain
ratings for such interests. Although the Company completed its first
securitization utilizing a senior/ subordinated structure in June 1997, which
relied on the internal credit enhancements of the pool rather than monoline
insurance, the Company expects to utilize monoline insurance companies for at
least a portion of its future securitizations. Any substantial reduction in the
size or availability of the secondary market of the Company's loans, or the
unwillingness of the monoline insurance companies to provide financial guarantee
insurance for the senior interests in loans sold in the secondary market, or
other accounting, tax or regulatory changes adversely affecting the Company's
securitization program, could have a material adverse effect on the Company's
financial position and results of operations.
Capitalized Interest-only strips; Mortgage Servicing Rights. The
majority of the Company's revenue is recognized as gain on sale (net of
unrealized gain or loss on valuation of interest-only strips), which represents,
over the estimated life of the loans, the present value of the weighted average
coupon on each pool of loans sold over the sum of the interest rate paid to
investors, the contractual servicing fee (currently 0.50%) and a monoline
insurance fee, if any. The gain on sale of loans provides the basis for the
calculation of the interest-only strips, which is recorded as an asset on the
Company's consolidated balance sheet. The interest-only strips represents the
present value of the future cash flows, adjusted for the provision for loan
losses. The Company determines the present value of the cash flows at the time
each securitization transaction closes using certain estimates made by
management at the time the loans are sold.
The estimated life of the securitized loans depends on the assumed
annual prepayment rate which is a function of estimated voluntary (full and
partial) and involuntary (liquidations). The prepayment rate represents
management's expectations of future prepayment rates based on prior and expected
loan performance, the type of loans in the relevant pool (fixed or adjustable
rate) and industry data. The rate of prepayment may be affected by a variety of
economic and other factors, including the production channel which produced the
loan, prevailing interest rates, the presence of prepayment penalties, the
loan-to-value ratios and the credit grades of the loans included in the
securitization. Generally, a declining interest rate environment will encourage
prepayments. Lower credit grade loans tend to be more payment sensitive and less
interest rate sensitive than higher credit grade loans.
In determining the adjustment for credit risk for a particular
securitization, the Company utilizes assumptions that it believes are reasonable
based on the information on its prior securitizations and the loan-to-value
ratios of the loans included in the current securitizations. At June 30, 1997,
the Company had reserves of $43.6 million related to these credit risks, or 1.6%
of the outstanding balance of loans securitized as of that date. Cumulative
losses to date from the Company's securitization transactions dating back to
June 1992 have totaled $6.49 million. Losses ranged from .03% to .24% of the
average servicing portfolio for the fiscal years ended June 30, 1995, 1996 and
1997. The weighted average initial combined loan-to-value ratio of the loans
serviced by the Company was 68% as of June 30, 1997. Accordingly, the Company
believes its allowance for credit losses is adequate to cover anticipated losses
on
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previously securitized pools determined on a pool-by-pool basis. However, with
the Company's recent migration to higher credit grade loans, the average
loan-to-value ratio of its servicing portfolio has increased. At June 30, 1995,
1996 and 1997, the average initial combined loan-to-value ratio of the Company's
servicing portfolio was 59%, 64% and 68%, respectively. Therefore, the Company's
low historical loan loss rates may not be an accurate indication of anticipated
future losses.
The interest-only strips are amortized over the expected lives of the
related loans and a corresponding reduction in servicing fee income is recorded.
On a quarterly basis, the Company reviews the fair value of the interest-only
strips by analyzing its prepayment and other assumptions in relation to its
actual experience and current rates of prepayment prevalent in the industry. See
"-- Prepayment and Credit Risk." The interest-only strips are marked to market
through a charge to earnings. See "-- Revenue."
Recent Acquisition of One Stop. On August 28, 1996, the Company acquired
One Stop in a merger transaction. One Stop is operated as a wholly-owned
subsidiary of the Company. The Company acquired One Stop with the expectation
that the acquisition will result in beneficial synergies for the combined
business. Since commencement of operations in October 1995, One Stop's rate of
growth in originating and purchasing loans has been significant. The loans
originated and purchased by One Stop and included in the Company's
securitization have been outstanding for a relatively short period of time.
Consequently, the delinquency and loss experience of One Stop's loans to date
may not be indicative of that to be achieved in future periods, and One Stop may
not be able to maintain delinquency and loan loss ratios at their present levels
as One Stop's loan portfolio becomes more seasoned.
Dependence on Broker Network. The Company depends on independent
mortgage brokers for the origination and purchase of its broker loans, which
constitute a significant portion of the Company's loan production. These
independent mortgage brokers negotiate with multiple lenders for each
prospective borrower. The Company competes with these lenders for the
independent brokers' business on pricing, service, loan fees, costs and other
factors. The Company's competitors also seek to establish relationships with
such brokers, who are not obligated by contract or otherwise to do business with
the Company. The Company's future results of operations and financial condition
may be vulnerable to changes in the volume and cost of its broker loans
resulting from, among other things, competition from other lenders and
purchasers of such loans.
Impact of Increases in Correspondent Pricing. The Company has
implemented a program for purchasing mortgage loans in bulk as well as on an
ongoing or "flow" basis from mortgage bankers and financial institutions. This
program accounted for 50% of all mortgage loans originated or purchased by the
Company in fiscal 1997. During the fourth quarter of fiscal 1997, two factors
caused the Company to re-evaluate its correspondent bulk purchase
program--uncertainties in the capital markets and the increase in the pricing
for bulk loan product. These uncertainties were evidenced by the sudden decline
in common stock prices of companies in the subprime home equity sector,
including the Company, and pricing sensitivity encountered by companies in the
sector in accessing the public equity and debt markets. Given that the Company
funded the
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significant negative cash flow associated with the bulk correspondent business
in the public equity and debt markets, the uncertainties in those markets
increased the risk to the Company that its cost of capital would be excessively
high. Additionally, the premiums paid by the Company for bulk product during the
1997 fiscal year reached a peak of 8.25% in March 1997. These high premiums,
together with the apparent increase in the cost of capital, adversely impacted
the projected profitability of the bulk product. As a result of these
developments, the Company changed the approach used in the pricing of its bulk
loan product. Specifically, the Company established lower prices to be paid for
this product based primarily on its historical performance. This change is
expected to decrease the amount of bulk loans purchased in fiscal 1998 compared
to fiscal 1997.
Risks Associated with High Loan-To-Value Loan Products. The Company
recently commenced offering loans with loan-to-value ratios of up to 125%.
Although the Company intends to sell these loans on a whole loan basis, the
Company is subject to the risk of borrower default and foreclosure on these
loans during the period of time that the loans are held for sale or if the
Company is required to repurchase any such loans. To the extent that borrowers
with high loan-to-value ratios default on their loan obligations while the loans
are held by the Company, the Company would be unable to rely on equity in the
collateral property to reduce the Company's loss exposure. Under these
circumstances, the Company might be required to absorb any losses and such
absorption, if the losses exceed the Company reserves for such losses, could
have a material adverse effect on the Company's financial condition and results
of operations.
Competition. The Company faces intense competition in the business of
originating, purchasing and selling mortgage loans. Competition among industry
participants can take many forms, including convenience in obtaining a loan,
customer service, marketing and distribution channels, amount and term of the
loan, loan origination fees and interest rates. Many of the Company's
competitors are substantially larger and have considerably greater financial,
technical and marketing resources than the Company. The Company's competitors in
the industry include other consumer finance companies, mortgage banking
companies, commercial banks, credit unions, thrift institutions, credit card
issuers and insurance companies. In the future, the Company may also face
competition from government- sponsored entities, such as FNMA and FHLMC. These
government-sponsored entities may enter the subprime mortgage market and target
potential customers in the Company's highest credit grades, who constitute a
significant portion of the Company's customer base.
The current level of gains realized by the Company and its competitors
on the sale of subprime mortgage loans could attract additional competitors into
this market. Certain large finance companies and conforming mortgage originators
have announced their intention to originate non-conforming mortgage loans, and
some of these large mortgage companies, thrifts and commercial banks have begun
offering non-conforming loan products to customers similar to the borrowers
targeted by the Company. In addition, establishing a broker-sourced loan
business requires a substantially smaller commitment of capital and human
resources than a direct-sourced loan business. This relatively low barrier to
entry permits new competitors to enter this market quickly and compete with the
Company's wholesale lending business.
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45
Additional competition may lower the rates the Company can charge
borrowers and increase the cost to purchase loans, thereby potentially lowering
the gain on future loan sales or securitizations. Increased competition may also
reduce the volume of the Company's loan origination and loan sales and increase
the demand for the Company's experienced personnel and the potential that such
personnel will leave the Company for the Company's competitors.
Fluctuations in interest rates and general and localized economic
conditions may also affect the competition the Company faces. Competitors with
lower costs of capital have a competitive advantage over the Company. During
periods of declining rates, competitors may solicit the Company's customers to
refinance their loans. In addition, during periods of economic slowdown or
recession, the Company's borrowers may face financial difficulties and be more
receptive to the offers of the Company's competitors to refinance their loans.
The Company plans to expand into new geographic markets, where it will
face additional competition from lenders already established in these markets.
There can be no assurance that the Company will be able to successfully compete
with these lenders.
The Company's correspondent program depends largely on independent
mortgage bankers and other financial institutions for the purchases of new
loans. The Company's competitors also seek to establish relationships with the
same mortgage bankers and other financial institutions. The Company's future
results may become more exposed to fluctuations in the volume and cost of the
Company's correspondent program resulting from competition from other purchasers
of such loans, market conditions and other factors.
Concentration of Operations in California. At June 30, 1997, a
significant portion of the loans serviced by the Company were secured by
properties located in California. Because the Company's servicing portfolio is
currently concentrated in California, the Company's financial position and
results of operations have been and are expected to continue to be influenced by
general trends in the California economy and its residential real estate market.
Residential real estate market declines may adversely affect the values of the
properties securing loans such that the principal balances of such loans,
together with any primary financing on the mortgaged properties, will equal or
exceed the value of the mortgaged properties. In addition, California
historically has been vulnerable to certain natural disaster risks, such as
earthquakes and erosion-caused mudslides, which are not typically covered by the
standard hazard insurance policies maintained by borrowers. Uninsured disasters
may adversely impact the Company's ability to recover losses on properties
affected by such disasters and adversely impact the Company's results of
operations.
Timing of Loan Sales. The Company endeavors to effect the securitization
and sale of a loan pool each quarter. However, market and other considerations,
including the conformity of loan pools to monoline insurance company and rating
agency requirements, could affect the timing of such transactions. Any delay in
the sale of a loan pool beyond a quarter-end would postpone the recognition of
gain on sale related to such loans until their sale and would likely result in
losses for such quarter being reported by the Company.
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Economic Conditions. The risks associated with the Company's business
become more acute in any economic slowdown or recession. Periods of economic
slowdown or recession may be accompanied by decreased demand for consumer credit
and declining real estate values. Any material decline in real estate values
reduces the ability of borrowers to use home equity to support borrowings and
increases the current combined loan-to-value ratios of loans previously made by
the Company, thereby weakening collateral coverage and increasing the
possibility of a loss in the event of liquidation. Further, delinquencies,
foreclosures and losses generally increase during economic slowdowns or
recessions. Because of the Company's focus on credit-impaired borrowers, the
actual rates of delinquencies, foreclosures and losses on such loans could be
higher than those generally experienced in the mortgage lending industry. In
addition, in an economic slowdown or recession, the Company's servicing costs
may increase. Any sustained period of increased delinquencies, foreclosure,
losses or increased costs could adversely affect the Company's ability to
securitize or sell loans in the secondary market and could increase the cost of
securitizing and selling loans in the secondary market. See "-- Prepayment and
Credit Risk."
The Company's earnings may be directly affected by the level of and
fluctuation in interest rates and the level of prepayment in the Company
securitizations. The Company currently hedges its fixed rate pipeline and
continues to explore other avenues of risk mitigation, although none have been
employed to date. The current fixed rate hedge products utilized are swap
agreements with third parties that sell United States Treasury securities not
yet purchased and the purchase of Treasury put options. The amount and timing of
hedging transactions are determined by members of the Company's senior
management. While the Company monitors the interest rate environment and employs
fixed rate hedging strategies, there can be no assurance that the earnings of
the Company would not be adversely affected during any period of unexpected
changes in interest rates or prepayment rates.
The Company introduced adjustable rate mortgages as a new product in
January 1994. Adjustable rate loans account for a substantial portion of the
mortgage loans originated or purchased by the Company. Substantially all such
adjustable rate mortgages include a "teaser" rate, i.e., an initial interest
rate significantly below the fully indexed interest rate at origination.
Although these loans are underwritten at the indexed rate as of the first
adjustment date, credit-impaired borrowers may encounter financial difficulties
as a result of increases in the interest rate over the life of the loan.
Contingent Risks. Although the Company sells substantially all the
mortgage loans which it originates or purchases, the Company retains some degree
of credit risk on substantially all loans sold. During the period of time that
loans are held pending sale, the Company is subject to the various business
risks associated with the lending business including the risk of borrower
default, the risk of foreclosure and the risk that a rapid increase in interest
rates would result in a decline in the value of loans to potential purchasers.
See "-- Risk Management." The documents governing the Company's securitization
program require the Company to establish deposit accounts or build
overcollateralization levels through retention of excess cash flow distributions
in such accounts or application of excess cash flow distributions to reduce the
principal balances of the senior interests issued by the related trust,
respectively. Such amounts serve as credit enhancement for the related trust and
are therefore available to fund losses realized on loans held by such trust. The
Company continues to be subject to the risks of default and foreclosure
following securitization and the sale of loans to the extent of excess cash flow
46
47
distributions required to be retained or applied to reduce principal from time
to time. Such amounts are a condition to obtaining the requisite rating on the
related interests in each trust. In addition, documents governing the Company's
securitization program require the Company to commit to repurchase or replace
loans which do not conform to the representations and warranties made by the
Company at the time of sale.
When borrowers are delinquent in making monthly payments on loans
included in a securitization trust, the Company is required to advance interest
payments with respect to such delinquent loans. These advances require funding
from the Company's capital resources but have priority of repayment from
collections or recoveries on the loans in the related pool in the succeeding
month.
In the ordinary course of its business, the Company is subject to claims
made against it by borrowers and private investors arising from, among other
things, losses that are claimed to have been incurred as a result of alleged
breaches of fiduciary obligations, misrepresentations, errors and omissions of
employees and officers of the Company, incomplete documentation and failures by
the Company to comply with various laws and regulations applicable to its
business. The Company believes that liability with respect to any currently
asserted claims or legal actions is not likely to be material to the Company's
financial position or results of operations; however, any claims asserted in the
future may result in legal expenses or liabilities which could have a material
adverse effect on the Company's financial position and results of operations.
See "Item 3. Legal Proceedings."
Government Regulation. The Company's operations are subject to extensive
regulation, supervision and licensing by federal, state and local governmental
authorities and are subject to various laws and judicial and administrative
decisions imposing requirements and restrictions on part or all of its
operations. The Company's consumer lending activities are subject to the Federal
Truth-in-Lending Act and Regulation Z (including the Home Ownership and Equity
Protection Act of 1994), the Federal Equal Credit Opportunity Act, as amended,
and Regulation B, the Fair Credit Reporting Act of 1970, as amended, the Federal
Real Estate Settlement Procedures Act and Regulation X, the Home Mortgage
Disclosure Act, the Federal Debt Collection Practices Act and the National
Housing Act of 1934, as well as other federal and state statutes and regulations
affecting the Company's activities. The Company is also subject to the rules and
regulations of, and examinations by, state regulatory authorities with respect
to originating, processing, underwriting, selling, securitizing and servicing
loans. These rules and regulations, among other things, impose licensing
obligations on the Company, establish eligibility criteria for mortgage loans,
prohibit discrimination, govern inspections and appraisals of properties and
credit reports on loan applicants, regulate assessment, collection, foreclosure
and claims handling, investment and interest payments on escrow balances and
payment features, mandate certain disclosures and notices to borrowers and, in
some cases, fix maximum interest rates, fees and mortgage loan amounts. Failure
to comply with these requirements can lead to loss of approved status, certain
rights of rescission for mortgage loans, class action lawsuits and
administrative enforcement action.
Members of Congress and government officials have from time to time
suggested the elimination of the mortgage interest deduction for federal income
tax purposes, either entirely or in part, based on
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borrower income, type of loan or principal amount. Because many of the Company's
loans are made to borrowers for the purpose of consolidating consumer debt or
financing other consumer needs, the competitive advantages of tax deductible
interest, when compared with alternative sources of financing, could be
eliminated or seriously impaired by such government action. Accordingly, the
reduction or elimination of these tax benefits could have a material adverse
effect on the demand for loans of the kind offered by the Company.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are attached to this report:
Reports of Independent Accountants
Consolidated Balance Sheets at June 30, 1996 and 1997
Consolidated Statements of Income for Fiscal Years Ended June 30, 1995,
1996 and 1997 Consolidated Statements of Stockholders' Equity for Fiscal
Years Ended June 30, 1995, 1996 and 1997
Consolidated Statements of Cash Flows for Fiscal Years Ended June 30,
1995, 1996 and 1997 Notes to Consolidated Financial Statements
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
Information regarding directors and executive officers of the Registrant
will appear in the proxy statement for the 1997 Annual Meeting of Stockholders,
and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation will appear in the proxy
statement for the 1997 Annual Meeting of Stockholders, and is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
Information regarding security ownership of certain beneficial owners
and management will appear in the proxy statement for the 1997 Annual Meeting of
Stockholders, and is incorporated herein by reference.
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49
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions
will appear in the proxy statement for the 1997 Annual Meeting of Stockholders,
and is incorporated by this reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
8-K.
(a) Financial Statements:
See Financial Statements listed as part of Item 8. Financial
Statements and Supplementary Data.
(b) Financial Statement Schedules:
Schedule 6 Property, Plant and Equipment.
Schedule 7 Accumulated Depreciation, Depletion and Amortization
of Property, Plant and Equipment.
See pages F-19 and F-20 attached to this report.
(c) Exhibits - Management Contracts and Compensatory Plans:
10.1 Form of Director and Officer Indemnification Agreement
10.2(a) Amended and Restated Employment Agreement between Registrant and
Gary K. Judis (10)
10.2(b) Severance Agreement between Registrant and Gary K. Judis
10.2(c) Consulting Agreement between Registrant and Gary K. Judis
10.3(a) Second Amended and Restated Employment between Registrant and
Cary H. Thompson
10.3(b) Stock Option Agreement between Registrant and Cary H. Thompson(10)
10.4(a) Employment Agreement between Registrant and Neil Kornswiet
10.4(b) Amendment No. 1 to Exhibit 10.4(a)
10.5 Executive Severance Agreement between Registrant and Gregory
Witherspoon
10.6 Second Amended and Restated Employment Agreement between Registrant
and Barbara Polsky
10.7 Employment Agreement between Registrant and Mark Costello
10.8 1991 Stock Incentive Plan, as amended (2)
10.9 1995 Stock Incentive Plan (10)
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10.10(a) 1996 Stock Incentive Plan (12)
10.10(b) Amendment No. 1 to Exhibit 10.10(a)
10.11 1995 Employee Stock Purchase Plan (3)
10.20 Variable Deferred Compensation Plan
(d) Other Exhibits:
2.1 Agreement and Plan of Reorganization, dated as of
August 12, 1996, as amended by Amendment No. 1, dated
August 28, 1996 by and among Registrant, Aames
Acquisition Corporation, One Stop Mortgage, Inc. and
Neil B. Kornswiet (14)
3.1 Certificate of Incorporation of Registrant, as amended
3.2 Bylaws of Registrant, as amended
4.1 Specimen certificate evidencing Common Stock of Registrant
4.2 Rights Agreement, dated as of June 21, 1996 between Registrant and
Wells Fargo Bank, as rights agent (4)
10.12(a) Office Lease, dated December 13, 1989, between State
Street Bank and Trust Company of California, N.A.
and Aames Home Loan, Registrant's wholly owned
subsidiary, for the premises located at 3731
Wilshire Boulevard, Los Angeles, California (1)
10.12(b) Amendments dated August 1, 1991, March 15, 1992,
June 30, 1993 and September 7, 1993 to Exhibit
10.12(b) (5)
10.13(a) Office Building Lease, dated as of August 7, 1996, between Registrant
and California Plaza IIA, LLC, for the premises located at
350 S. Grand Avenue, Los Angeles, California
10.13(b) First Amendment, dated as of August 15, 1997, to Exhibit 10.13(a)
10.14(a) Indenture of Trust, dated February 1, 1995, between Registrant and
Bankers Trust Company of California, N.A., relating to Registrant's
10.50% Senior Notes due 2002 (5)
10.14(b) Supplemental Indenture of Trust, dated as of April 25, 1995 to Exhibit
10.14(a) (6)
10.15 Indenture, dated as of February 26, 1996, between
Registrant and The Chase Manhattan Bank, N.A.,
relating to Registrant's 5.5% Convertible
Subordinated Debentures due 2006 (7)
10.16 First Supplemental Indenture, dated as of October
21, 1996, between Registrant, The Chase Manhattan
Bank and certain wholly owned subsidiaries of
Registrant, relating to Registrant's 9.125% Senior
Notes due 2003 (11)
10.17(a) Interim Loan and Security Agreement, dated as of
November 22, 1996, between Aames Capital
Corporation, Registrant's wholly owned subsidiary
("ACC") and Prudential Securities Credit Corporation
10.17(b) Notice of Extension of Agreement No. 1, dated as of May 15, 1997,
with effect as of March 31, 1997, to Exhibit 10.17(a)
10.17(c) Amendment, dated as of August 19, 1997, to Exhibit 10.17(a)
10.18 Amended and Restated Mortgage Loan Warehousing Agreement, dated
as of January 15, 1997, among Registrant; ACC; the
lenders from time
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to time a party thereto; and NationsBank of Texas,
N.A., as administrative agent for the lenders (13)
10.19(a) Aircraft Lease Agreement, dated as of March 8, 1996,
between C.I.T. Leasing Corporation and Oxford
Aviation Corporation, Inc., Registrant's wholly
owned subsidiary (7)
10.19(b) Corporate Guaranty Agreement, dated as of March 8,
1996, between Registrant and C.I.T. Leasing
Corporation, with respect to Exhibit 10.19(a) (7)
11 Statement re computation of per share earnings
21 Subsidiaries of the Registrant
23.1 Consent of Price Waterhouse LLP
23.2 Consent of KPMG Peat Marwick LLP
27 Financial Data Schedule
1 Incorporated by reference from Registrant's Registration Statement on Form
S-1, File No. 33-43237.
2 Incorporated by reference from Registrant's Registration Statement on Form
S-1, File No. 33-62400.
3 Incorporated by reference from Registrant's Registration Statement, File No.
333-01312.
4 Incorporated by reference from Registrant's Registration Statement on Form
8-A, File No. 33-13660.
5 Incorporated by reference from Registrant's Registration Statement on Form
S-2, File No. 33-88516.
6 Incorporated by reference from Registrant's Annual Report on Form 10-K for
the year ended June 30, 1995.
7 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1996.
8 Incorporated by reference from Registrant's Registration Statement on Form
S-2, File No. 33-91640.
9 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended December 31, 1995.
10 Incorporated by reference from Registrant's Annual Report on Form 10-K for
the year ended June 30, 1996, filed with the Commission on September 16,
1996.
11 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1996.
12 Incorporated by reference from Registrant's Registration Statement on Form
S-8 dated January 6, 1997.
13 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended December 31, 1996.
14 Incorporated by reference from Registrant's Current Report on Form 8-K
dated September 11, 1996.
(e) Reports on Form 8-K:
During the last quarter of the fiscal year ended June 30, 1997,
the Company filed a Current Report on Form 8-K dated May 12, 1997
(earliest event reported April 30, 1997), reporting information
under Item 5 with respect to third quarter results, a cash
dividend and management succession.
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To the Board of Directors
and Stockholders of
Aames Financial Corporation
In our opinion, based upon our audits and the report of other auditors, the
accompanying consolidated balance sheets and the related consolidated statements
of income, of stockholders' equity and of cash flows present fairly, in all
material respects, the financial position of Aames Financial Corporation and its
subsidiaries (the "Company") at June 30, 1996 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
June 30, 1997, in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We did not audit the financial statements of One Stop Mortgage,
Inc., a wholly-owned subsidiary, which statements reflect total assets of $127
million at June 30, 1996 and total revenues of $7 million for the period from
August 24, 1995 (inception) through June 30, 1996. Those statements were audited
by other auditors whose report thereon has been furnished to us, and our opinion
expressed herein, insofar as it relates to the amounts included for One Stop
Mortgage, Inc. is based solely on the report of the other auditors. We conducted
our audits of these statements in accordance with generally accepted auditing
standards which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits and the report of other auditors provide a reasonable basis for the
opinion expressed above.
As discussed in Note 1 to the consolidated financial statements, the Company
adopted accounting standards that changed its method of accounting for transfers
and servicing of financial assets during the year ended June 30, 1997 and its
method of accounting for mortgage servicing rights for the year ended June 30,
1996.
The audits referred to above also included an audit of the financial statement
schedules listed in Item 14. In our opinion, these financial statement schedules
present fairly, in all material respects, the information set forth therein when
read in conjunction with the related consolidated financial statements.
/s/Price Waterhouse LLP
Los Angeles, California
August 25, 1997
F-1
53
INDEPENDENT AUDITORS' REPORT
The Board of Directors
One Stop Mortgage, Inc.:
We have audited the accompanying balance sheet of One Stop Mortgage, Inc. (the
Company) as of June 30, 1996 and the related statements of operations, changes
in stockholders' equity and cash flows for the period January 1, 1996 through
June 30, 1996 and the period August 24, 1995 (inception) through December 31,
1995. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit also 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 financial statements referred to above presents fairly, in
all material respects, the financial position of One Stop Mortgage, Inc. as of
June 30, 1996 and the results of its operations and its cash flows for the
period January 1, 1996 through June 30, 1996 and the period August 24, 1995
(inception) through December 31, 1995 in conformity with generally accepted
accounting principles.
KPMG PEAT MARWICK LLP
Orange County, California
August 16, 1996
F-2
54
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, JUNE 30,
1996 1997
------------ ------------
ASSETS
Cash and cash equivalents $ 23,941,000 $ 26,902,000
Loans held for sale, at lower of cost or market 186,189,000 242,987,000
Accounts receivable 9,685,000 59,180,000
Interest-only strips, at estimated fair market value (Note 3) 129,113,000 270,422,000
Mortgage servicing rights (Note 3) 10,902,000 21,641,000
Residual assets 44,676,000 112,827,000
Equipment and improvements, net (Note 4) 6,674,000 12,685,000
Prepaid and other 10,295,000 14,949,000
------------ ------------
Total assets $421,475,000 $761,593,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Borrowings (Note 5) $138,045,000 $286,990,000
Revolving warehouse facilities (Note 5) 112,363,000 137,500,000
Accounts payable and accrued expenses 11,380,000 23,219,000
Accrued compensation and related expenses 4,427,000 6,078,000
Income taxes payable (Note 6) 21,831,000 39,452,000
------------ ------------
Total liabilities 288,046,000 493,239,000
------------ ------------
Commitments and contingencies (Note 7)
Stockholders' equity:
Preferred stock, par value $.001 per
share, 1,000,000 shares authorized;
none outstanding -- --
Common stock, par value $.001 per share
50,000,000 shares authorized;
23,845,300 and 27,758,800 shares outstanding
(Note 10) 24,000 28,000
Additional paid-in capital 88,134,000 209,358,000
Retained earnings 45,271,000 58,968,000
------------ ------------
Total stockholders' equity 133,429,000 268,354,000
------------ ------------
Total liabilities and stockholders' equity $421,475,000 $761,593,000
============ ============
The accompanying notes are an integral part of these financial statements.
F-3
55
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FISCAL YEARS ENDED
JUNE 30,
---------------------------------------------------
1995 1996 1997
------------- ------------- -------------
Revenue:
Gain on sale of loans (Note 3) $ 25,438,000 $ 95,299,000 $ 198,736,000
Net unrealized loss on valuation
of interest-only strips (Note 3) -- -- (18,950,000)
Commissions 15,799,000 21,564,000 29,250,000
Loan service 8,246,000 18,186,000 25,804,000
Fees and other 7,940,000 15,215,000 37,679,000
------------- ------------- -------------
Total revenue 57,423,000 150,264,000 272,519,000
------------- ------------- -------------
Expenses:
Compensation and related expenses 17,610,000 40,758,000 81,021,000
Sales and advertising costs 9,906,000 19,036,000 27,229,000
General and administrative expenses 7,067,000 17,377,000 31,716,000
Interest expense (Note 5) 3,205,000 12,370,000 33,105,000
Provision for loan losses 2,484,000 8,424,000 33,941,000
Nonrecurring charges (Note 2) -- -- 32,000,000
------------- ------------- -------------
Total expenses 40,272,000 97,965,000 239,012,000
------------- ------------- -------------
Income before income taxes 17,151,000 52,299,000 33,507,000
Provision for income taxes 7,117,000 22,508,000 16,398,000
============= ============= =============
Net income $ 10,034,000 $ 29,791,000 $ 17,109,000
============= ============= =============
Net income per share
Primary $ 0.74 $ 1.18 $ 0.60
============= ============= =============
Fully diluted $ 0.74 $ 1.14 $ 0.60
============= ============= =============
Dividends per share $ 0.13 $ 0.13 $ 0.13
============= ============= =============
Weighted average number
of shares outstanding
Primary 13,532,000 25,194,000 28,371,000
============= ============= =============
Fully Diluted 13,532,000 27,248,000 34,516,000
============= ============= =============
The accompanying notes are an integral part of these financial statements.
F-4
56
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FISCAL YEARS ENDED
JUNE 30,
-----------------------------------------------------
1995 1996 1997
--------------- --------------- ---------------
Operating activities:
Net income $ 10,034,000 $ 29,791,000 $ 17,109,000
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Provision for loan losses 2,484,000 8,424,000 33,941,000
Depreciation and amortization 606,000 1,275,000 2,853,000
Deferred income taxes 3,972,000 15,369,000 17,915,000
Gain on sale of loans (36,375,000) (112,399,000) (262,811,000)
Net unrealized loss on valuation of interest-only strips -- -- 18,950,000
Amortization of interest-only strips 4,402,000 16,940,000 68,611,000
Mortgage servicing rights originated (11,759,000) (16,251,000)
Amortization of mortgage servicing rights 857,000 5,512,000
Changes in assets and liabilities:
Loans originated or purchased (387,600,000) (1,168,945,000) (2,347,938,000)
Proceeds from sale of loans 373,609,000 1,006,887,000 2,291,139,000
(Increase) in:
Accounts receivable (2,663,000) (3,595,000) (49,495,000)
Prepaid and other (2,217,000) (5,276,000) (4,654,000)
Residual assets (8,691,000) (29,794,000) (68,151,000)
Increase (decrease) in:
Accounts payable and accrued expenses 534,000 5,554,000 11,839,000
Accrued compensation and related expenses 581,000 2,724,000 1,651,000
Income taxes payable (2,051,000) 2,874,000 (293,000)
--------------- --------------- ---------------
Net cash used in operating activities (43,375,000) (241,073,000) (280,073,000)
--------------- --------------- ---------------
Investing activities:
Purchases of property and equipment (988,000) (5,885,000) (8,864,000)
--------------- --------------- ---------------
Net cash used in investing activities (988,000) (5,885,000) (8,864,000)
--------------- --------------- ---------------
Financing activities:
Proceeds from sale of stock or exercise of options 40,087,000 26,280,000 121,228,000
Proceeds from borrowings 19,540,000 114,901,000 148,945,000
Increase (decrease) in amounts outstanding under
warehouse facilities (9,675,000) 112,048,000 25,137,000
Dividends paid (1,743,000) (2,689,000) (3,412,000)
--------------- --------------- ---------------
Net cash provided by financing activities 48,209,000 250,540,000 291,898,000
--------------- --------------- ---------------
Net increase in cash and cash equivalents 3,846,000 3,582,000 2,961,000
Cash and cash equivalents at beginning of period 16,513,000 20,359,000 23,941,000
--------------- --------------- ---------------
Cash and cash equivalents at end of period $ 20,359,000 $ 23,941,000 $ 26,902,000
=============== =============== ===============
Supplemental disclosures
Interest paid $ 3,225,000 $ 6,633,000 $ 30,207,000
Taxes paid (refunded) 4,843,000 4,354,000 (1,197,000)
The accompanying notes are an integral part of these financial statements.
F-5
57
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Additional
Common Paid-in Retained
Stock Capital Earnings Total
----------------------------------------------------------
As of June 30, 1994 $ 13,500 $ 21,777,500 $ 9,878,000 $ 31,669,000
Issuance of common stock 7,500 40,079,500 40,087,000
Dividends (1,743,000) (1,743,000)
Net income 10,034,000 10,034,000
----------------------------------------------------------
As of June 30, 1995 $ 21,000 $ 61,857,000 $ 18,169,000 $ 80,047,000
Issuance of common stock 2,064,000 2,064,000
Shares issued in merger
transaction 3,000 (3,000) -
Dividends (2,689,000) (2,689,000)
Issuance of common stock
warrants 24,216,000 24,216,000
Net income 29,791,000 29,791,000
----------------------------------------------------------
As of June 30, 1996 $ 24,000 $ 88,134,000 $ 45,271,000 $ 133,429,000
Issuance of common stock 4,000 121,224,000 121,228,000
Dividends (3,412,000) (3,412,000)
Net income 17,109,000 17,109,000
----------------------------------------------------------
AS OF JUNE 30, 1997 $ 28,000 $209,358,000 $ 58,968,000 $ 268,354,000
----------------------------------------------------------
F-6
58
Notes to Consolidated Financial Statements
Note 1 Summary of Significant Accounting Policies
OPERATIONS
Aames Financial Corporation (the "Company" or "Aames") is a consumer finance
company primarily engaged, through its subsidiaries, in the business of
originating, purchasing, selling, and servicing home equity mortgages secured by
single family residences. At June 30, 1997, Aames operated 56 retail loan
offices located in 24 states. At June 30, 1997, 14 of the 56 branches were
located in California. Its wholly- owned subsidiary, One Stop Mortgage, Inc.
("One Stop") operated 37 offices located in 33 states. At June 30, 1997, 7 of
the 37 branches were located in California. The Company originates and purchases
loans on a nationwide basis through three production channels -- retail, broker
and correspondent. For the years ended June 30, 1996 and 1997, the Company
originated and purchased $1.17 billion and $2.35 billion of mortgage loans,
respectively. The Company's principal market is borrowers whose financing needs
are not being met by traditional mortgage lenders for a variety of reasons,
including the need for specialized loan products or credit histories that may
limit such borrowers' access to credit. Loans originated by the Company are
primarily extended on the basis of the equity in the borrower's property and, to
a lesser extent, the creditworthiness of the borrower. The aggregate outstanding
balance of loans serviced by the Company was $1.37 billion and $3.17 billion at
June 30, 1996 and June 30, 1997, respectively (which include $456 million and
$1.67 billion of loans at June 30, 1996 and June 30, 1997, respectively,
serviced for the Company by unaffiliated subservicers under subservicing
agreements).
The Company's most important capital resource has been its ability to sell loans
originated and purchased by it in the secondary market in order to generate cash
proceeds to pay down its warehouse facilities and fund new originations and
purchases. The value of and market for the Company's loans are dependent upon a
number of factors, including general economic conditions, competition, interest
rates and governmental regulations. Adverse changes in such factors may affect
the Company's ability to securitize or sell loans for acceptable prices within a
reasonable period of time.
ACQUISITION OF ONE STOP
On August 28, 1996, the Company acquired One Stop, through the merger of a
wholly-owned subsidiary of the Company into One Stop, in a tax-free exchange
accounted for as a pooling of interests, in which the Company issued
approximately 3.49 million shares (adjusted for the three-for-two stock split in
the form of a stock dividend in February 1997) of its common stock, par value
$.001 per share ("common stock"), and assumed options granted to key employees
to purchase approximately 563,000 shares (adjusted for the three-for-two stock
split in the form of a stock dividend in February 1997) of common stock. Under
the pooling rules, the costs incurred by the Company and One Stop in
consummating the merger were expensed in the first quarter of fiscal 1997. All
prior years financial statements have been restated to include One Stop.
The following table shows the pro-forma effect of the merger:
(Dollars in thousands, except per share amounts)
Fiscal Year Ended June 30, 1996
==============================================================
Net income by entity
Aames as previously reported $ 31,048
One Stop (1,257)
--------------------------------------------------------------
Restated June 30, 1996 net income 29,791
--------------------------------------------------------------
Net income per fully diluted share
Previously reported (2/97 split adj.) $ 1.39
Restated $ 1.14
One Stop's operations, from the period July 1, 1996 through August 28, 1996,
were immaterial to restate separately.
F-7
59
PRINCIPLES OF ACCOUNTING AND CONSOLIDATION
The consolidated financial statements of the Company include the accounts of
Aames and its wholly-owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
CASH IN TRUST
The Company services loans on behalf of customers. In such capacity, certain
monies are collected and placed in segregated trust accounts, which totaled
$26.8 million and $28.3 million at June 30, 1996 and June 30, 1997,
respectively. These accounts and corresponding liabilities are not included in
the accompanying balance sheet.
EQUIPMENT AND IMPROVEMENTS
Equipment and improvements are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are being recorded utilizing
straight-line and accelerated methods over the following estimated useful lives:
Data processing equipment Five years
Furniture Five to seven years
Data processing software Three years
Leasehold improvements Lower of life of lease or asset
Equipment under capital leases Five years
Automobiles Five years
REVENUE RECOGNITION
The Company adopted Statement of Financial Accounting Standard ("SFAS") 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities" ("SFAS 125") effective January 1, 1997. The adoption of SFAS 125
did not have a material effect on the Company's results of operations for the
year ended June 30, 1997. As a result of the adoption of SFAS 125, the Company
records amounts previously categorized as "Excess servicing gains" in the
Consolidated Statements of Income as "Gain on sale of loans." Additionally, the
Company now records the right to future interest income that exceeds
contractually specified servicing fees and previously recorded as "Excess
servicing receivable" as an investment security called "Interest-only strips."
The Company has classified this asset as a trading security and during the year
ended June 30, 1997, recorded a mark-to-market loss of $19.0 million on this
security. Of this amount, $9.05 million represents unrealized gains on the
interest-only strips created in March and June of 1997 offset by a $28.0 million
unrealized loss on the interest-only strips as of June 1997. SFAS 125 requires
that this mark-to-market adjustment be reported separately from "Gain on sale of
loans," and the adjustment has been labeled " Net unrealized loss on valuation
of interest-only strips" in the Consolidated Statements of Income. SFAS 125
supersedes SFAS 122, "Accounting for Mortgage Servicing Rights" ("SFAS 122").
In fiscal year 1996, the Company adopted SFAS 122. Under SFAS 122, the Company
recognized mortgage servicing rights ("MSR's") as assets separate from the
mortgage loans to which the MSR's relate based on their respective fair values.
Prior to SFAS 122, the Company allocated the entire cost of originating or
purchasing mortgage loans to the carrying value of such mortgage loans. The
effect of adopting SFAS 122 was to increase the net income of the Company for
the fiscal year ended June 30, 1996, by $5.7 million, or $0.21 per fully diluted
weighted average share.
As a fundamental part of its business and financing strategy, the Company sells
substantially all of its loans in securitization transactions. In a
securitization, the Company conveys loans that it has originated or purchased to
a separate entity (such as a trust or trust estate) in exchange for cash
proceeds and an interest in the loans
F-8
60
securitized represented by the gain on sale of loans. The cash proceeds are
raised through an offering of the pass-through certificates or bonds evidencing
the right to receive principal payments on the securitized loans and the
interest rate on the certificate balance or on the bonds. The gain on sale of
loans (net of the unrealized gain or loss on valuation of the interest-only
strips) represents, over the estimated life of the loans, the present value of
the excess of the weighted average coupon on each pool of loans sold over the
sum of the interest rate paid to investors, the contractual servicing fee
(currently 0.50%) and a monoline insurance fee, if any. The gain on sale of
loans provides the basis for the calculation of the interest-only strips, which
is recorded as an asset on the Company's consolidated balance sheet. The
interest-only strips represents the present value of the future cash flows,
adjusted for the provision for loan losses. The Company determines the present
value of the cash flows at the time each securitization transaction closes using
certain estimates made by management at the time the loans are sold. These
estimates include the following: (i) rate of prepayment; (ii) discount rate used
to calculate present value; and (iii) the provision for credit losses on loans
sold. There can be no assurance of the accuracy of management's estimates.
Additionally, upon sale or securitization of servicing retained mortgages, the
Company capitalizes mortgage servicing rights separate from the loan. The
Company determines fair value based on the present value of estimated net future
cash flows related to servicing income. The cost allocated to the servicing
rights is amortized in proportion to and over the period of estimated net future
servicing fee income. The Company periodically reviews capitalized servicing fee
receivable for valuation impairment. This review is performed on a disaggregated
basis for the predominant risk characteristics of the underlying loans which are
loan type and origination date. At June 30, 1996 and 1997, there were no
valuation allowances on mortgage servicing rights.
INCOME TAXES
Taxes are provided on substantially all income and expense items included in
earnings, regardless of the period in which such items are recognized for tax
purposes. The Company uses an asset and liability approach that requires the
recognition of deferred tax assets and liabilities for the expected future tax
consequences of events that have been recognized in the Company's financial
statements or tax returns. In estimating future tax consequences, the Company
generally considers all expected future events other than the enactment of
changes in the tax law or rates.
RISK MANAGEMENT
The Company's earnings may be directly affected by the level of and fluctuation
in interest rates and the level of prepayment in the Company's securitizations.
The Company currently hedges its fixed rate pipeline and continues to explore
other avenues of risk mitigation, although none have been employed to date. The
current fixed rate hedge products utilized are swap agreements with third
parties that sell United States Treasury securities not yet purchased and the
purchases of United States Treasury put options. The amount and timing of
hedging transactions are determined by members of the Company's senior
management. While the Company monitors the interest rate environment and employs
fixed rate hedging strategies there can be no assurance that the earnings of the
Company would not be adversely affected during any period of unexpected changes
in interest rates or prepayment rates. At June 30, 1996 and 1997, the Company
had open hedging positions with notional balances of $40.0 million and $135
million, respectively.
The Company also mitigates its exposure to interest rate risk through a
pre-funding strategy in which it agrees to sell loans to the securitization
trust in the future at an agreed-upon price. The pre-funding locks in the price
agreed upon with investors on the pricing date (typically five business days
prior to the closing date of the securitization) for a period of generally 30
days. In a pre-funding arrangement, the Company typically delivers approximately
75% of the loans sold at the closing and the remainder generally within 30 days
after the closing.
CASH AND CASH EQUIVALENTS
At June 30, 1997, the Company had $26.9 million in cash, of which $12.9 million
was held in a restricted account in connection with the securitization closed in
June 1997. These funds were released to the Company in July 1997.
F-9
61
LOANS HELD FOR SALE
Loans held for sale are carried at the lower of aggregate cost or market value.
Market value is determined by current investor yield requirements.
ACCOUNTS RECEIVABLE
Accounts receivable primarily consisted of pool related advances, accrued
interest receivable and various servicing advances.
RESIDUAL ASSETS
In connection with its securitization transactions, the Company initially
deposits with a trustee cash or the required overcollateralization amount, and
subsequently deposits a portion of the servicing spread collected on the related
loans. The amounts set aside ($44.7 million at June 30, 1996 and $113 million at
June 30, 1997) are available for distribution to investors in the event of
certain shortfalls in amounts due to investors. These amounts are subject to
increase up to maximum subordination amounts as specified in the related
securitization documents. Cash amounts on deposit are invested in certain
instruments as permitted by the related securitization documents. To the extent
amounts on deposit exceed specified levels, distributions are made to the
Company and, at the termination of the related trust, any remaining amounts on
deposit are distributed to the Company.
DEBT ISSUANCE COSTS
At June 30, 1997, the Company had an unamortized balance of debt issuance costs
of $8.41 million related to the issuance of $23.0 million of 10.5% Senior Notes
due 2002, the issuance of $115 million of 5.5% Convertible Subordinated
Debentures due 2006 and the issuance of $150 million of 9.125% Senior Notes due
2003. This balance is included in "Prepaid and other" on the Consolidated
Balance Sheets and is amortized into expense over the life of the related debt.
EARNINGS PER SHARE
Earnings per share of common stock is computed using the weighted average number
of shares of common stock outstanding during each period, after giving effect to
the assumed exercise of certain stock options and warrants, and in addition, for
fully diluted earnings per share, the conversion of shares related to the
Company's 5.5% Convertible Subordinated Debentures due 2006.
All references in the accompanying Consolidated Balance Sheets, Consolidated
Statements of Earnings and Notes to Consolidated Financial Statements to the
number of common shares and share amounts have been restated to reflect the
three-for-two stock splits in the form of stock dividends effected on February
21, 1997 and May 17, 1996.
RECLASSIFICATIONS
Certain amounts related to 1995 and 1996 have been reclassified to conform to
the 1997 presentation.
ADOPTION OF RECENT ACCOUNTING STANDARDS
In October 1995, the Financial Accounting Standards Board ("FASB") released SFAS
123, "Accounting for Stock-Based Compensation" ("SFAS 123"). This statement
establishes methods of accounting for stock-based compensation plans. SFAS 123
is effective for fiscal years beginning after December 15, 1995. The Company
adopted SFAS 123 in fiscal year 1997. The adoption of SFAS 123 did not have a
material effect on the financial position of the Company. See Note 9.
In February 1997, the FASB issued SFAS 128, "Earnings Per Share" ("SFAS 128")
which establishes standards for computing and presenting earnings per share
("EPS") by replacing the presentation of primary EPS with a presentation of
basic EPS. Primary EPS includes common stock equivalents while basic EPS
excludes them. This change simplifies the computation of EPS. It also requires
dual presentation of basic and fully diluted EPS on the face of the income
statement for all entities with complex capital structures. The Company will
adopt SFAS 128 effective December 31, 1997 and does not expect the adoption of
SFAS 128 to have a material impact on its financial statements.
F-10
62
In February 1997, the FASB issued SFAS 129, "Disclosure of Information about
Capital Structure" ("SFAS 129"). SFAS 129 establishes disclosure requirements
regarding pertinent rights and privileges of outstanding securities. Examples of
disclosure items regarding securities include, though are not limited to, items
such as dividend and liquidation preferences, participation rights, call prices
and dates, conversion or exercise prices or rates. The number of shares issued
upon conversion, exercise or satisfaction of required conditions during at least
the most recent annual fiscal period and any subsequent interim period must also
be disclosed. Disclosure of liquidation preferences of preferred stock in the
equity section of the Balance Sheet is also required. SFAS 129 is effective for
financial periods beginning after December 15, 1997.
In June 1997, FASB issued SFAS 130, "Reporting Comprehensive Income" ("SFAS
130"). SFAS 130 establishes disclosure standards for reporting comprehensive
income in a full set of general purpose financial statements. SFAS 130 is
effective for fiscal years beginning after December 15, 1997. The adoption of
this standard is not expected to have an impact on the Company's financial
position or results of operations.
In June 1997, the FASB issued SFAS 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131") which is effective for periods
beginning after December 15, 1997. SFAS 131 establishes standards for the way
that public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
stockholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. The adoption of
this standard is not expected to have an impact on the Company's financial
position or results of operations.
Note 2 Nonrecurring Charges
In fiscal 1997, the Company incurred $32.0 million of nonrecurring charges.
Approximately $25.0 million of these charges were recognized in August 1996
directly related to the acquisition of One Stop. The remaining amount relates to
a reserve for vacating corporate headquarters recorded in the first quarter and
to severance and other strategic decisions made in the fourth quarter.
Note 3 Interest-only Strips and Mortgage Servicing Rights
The activity in the interest-only strips is summarized as follows:
June 30,
---------------------------------
1996 1997
---------------------------------
Balance, beginning of year $ 42,078,000 $ 129,113,000
Gain on sale of loans 112,399,000 262,811,000
Provision for loan losses (8,424,000) (33,941,000)
Amortization of receivable (16,940,000) (68,611,000)
Net unrealized loss on valuation
of interest-only strips -- (18,950,000)
---------------------------------
Balance, end of year $ 129,113,000 $ 270,422,000
F-11
63
The activity in mortgage servicing rights is summarized as follows:
June 30,
-------------------------------
1996 1997
-------------------------------
Balance, beginning of year $ -- $ 10,902,000
Gain on sale of loans 11,759,000 16,251,000
Amortization of receivable (857,000) (5,512,000)
-------------------------------
Balance, end of year $ 10,902,000 $ 21,641,000
The Company determines fair value for both the interest-only strips and the
mortgage servicing rights based on rates used to discount the future cash flows,
which were 11.8% and 11.4% for the years ended June 30, 1996 and 1997,
respectively. The Company retains a certain amount of credit risk on loans
securitized. The Company had reserves of $10.3 million and $43.6 million at June
30, 1996 and 1997, respectively, related to these credit risk obligations, which
are netted against the interest-only strips. The weighted average loss reserves
were 1.06% and 1.50% of the amount securitized for the years ended June 30, 1996
and 1997, respectively.
The interest-only strips and the mortgage servicing rights are amortized over
the estimated lives of the loans to which they relate. At June 30, 1996 and
1997, the unamortized balance of the interest-only strips was $129 million and
$290 million, respectively.
The Company determines the fair market value of the interest-only strips, in
part, by applying management's expectations as to future prepayment rates to the
present value of the future cash flows from prior securitizations. The use of
revised prepayment rates, resulted in a fourth quarter unrealized loss of $28.0
million on the valuation of that asset.
Note 4 Equipment and Improvements
Equipment and improvements consisted of the following:
June 30,
-------------------------------
1996 1997
-------------------------------
Data processing equipment $ 4,937,000 $ 8,239,000
Furniture and fixtures 3,554,000 5,892,000
Data processing software 242,000 1,756,000
Leasehold improvements 242,000 1,666,000
Equipment under capital leases 806,000 806,000
Automobiles 256,000 497,000
-------------------------------
Total 10,037,000 18,856,000
Accumulated depreciation and amortization (3,363,000) (6,171,000)
-------------------------------
Net $ 6,674,000 $ 12,685,000
F-12
64
Note 5 Borrowings and Revolving Warehouse Facilities
Borrowings consist of the following:
June 30,
------------------------------
1996 1997
------------------------------
9.125% Senior Notes due 2003, guaranteed by each of the Restricted Subsidiaries
of the Company. Principal payments of $37,500,000 in each of calendar years
2000 through 2003 -- $150,000,000
5.5% Subordinated Convertible Debentures due 2006 convertible to 6.2 million
shares of the common stock at $19 per share. The Subordinated Convertible
Debentures are subordinated to all existing and future senior debt of the
Company (as defined in the Indenture) $115,000,000 113,990,000
10.5% Senior Notes due 2002, collateralized by certain residual certificates
Principal payments of $5,750,000 in each of calendar years 1999 through 2002 23,000,000 23,000,000
Obligations under capital leases 45,000 --
------------------------------
Total borrowings $138,045,000 $286,990,000
Maturities on borrowings are as follows:
Total
Borrowings
------------
Fiscal Years Ended June 30,
1998 -
1999 $5,750,000
2000 43,250,000
2001 43,250,000
2002 43,250,000
2003 37,500,000
Thereafter 113,990,000
------------
Total $286,990,000
Amounts outstanding under revolving warehouse facilities:
June 30,
-------------------------------
1996 1997
-------------------------------
Warehouse facility with investment bank collateralized by mortgages/deeds of
trust; expired March 31, 1997 with interest at 0.875% over applicable LIBOR
rate; total credit available $150 million. Applicable LIBOR
rate was 5.5% at June 30, 1996 $ 11,026,000
Warehouse facility with a syndicate of eight commercial banks collateralized by
loans originated and purchased by the Company as well as certain servicing
receivables; expires January 13, 1998 with interest at the option of the Company
of either 1.05% over Fed Funds rate, or .80% over one-month LIBOR rate. Total
credit available $350 million. Fed Funds rate was 5.4% and one-month LIBOR was
5.7% at June 30, 1997 $137,500,000
F-13
65
June 30,
---------------------------------
1996 1997
---------------------------------
Warehouse facility from an investment bank collateralized by loans originated
and purchased by the Company. This line of $125 million (which increased to $250
million at August 19, 1997) bears interest at a rate of .70% over one-month
LIBOR and expires on December 31, 1997. One-month LIBOR rate was 5.7% at June
30, 1997
$250,000,000 revolving warehouse line of credit with an
investment bank secured by the loans held for sale. Interest
accrued based on LIBOR, which varied based on the outstanding
balance of the line of credit. Expired September 1996 122,765,000
$5,000,000 unsecured working capital note with an investment
bank which expired September 1996. Interest accrued at 12% and
was paid monthly 2,000,000
Prepaid commitment fee related to issuance of common stock
warrants to investment bank, net of amortization of $788,000 (23,428,000)
---------------------------------
Total amounts outstanding under
warehouse facilities $ 112,363,000 $ 137,500,000
Note 6 Income Taxes
The provision for income taxes consists of the following:
June 30,
---------------------------------------------
1995 1996 1997
---------------------------------------------
Current:
Federal $ 2,154,000 $ 6,344,000 $ 203,000
State 992,000 2,212,000 262,000
---------------------------------------------
3,146,000 8,556,000 465,000
Deferred:
Federal 2,891,000 10,212,000 13,081,000
State 1,080,000 3,740,000 2,852,000
---------------------------------------------
3,971,000 13,952,000 15,933,000
---------------------------------------------
Total $ 7,117,000 $22,508,000 $16,398,000
The financial statement balances at June 30, 1996 and 1997 are as follows:
June 30,
------------------------------
1996 1997
------------------------------
Current taxes payable (receivable):
Federal $ 2,668,000 $ 4,431,000
State 706,000 (1,350,000)
------------------------------
3,374,000 3,081,000
Deferred taxes payable:
Federal 13,451,000 26,930,000
State 5,006,000 9,441,000
------------------------------
18,457,000 36,371,000
------------------------------
Total $ 21,831,000 $ 39,452,000
F-14
66
Deferred tax liabilities (assets) consists of the following:
June 30,
-------------------------------
1996 1997
-------------------------------
Deferred tax liabilities
Interest-only strips $ 16,851,000 $ 35,505,000
Depreciation 412,000 440,000
Deferred loan fees -- 1,346,000
Mortgage servicing rights 5,015,000 9,116,000
-------------------------------
Total deferred tax liabilities 22,278,000 46,407,000
Deferred tax assets
Sec. 475 mark-to-market -- (2,870,000)
State taxes (2,471,000) (3,396,000)
Vacation accrual (298,000) (701,000)
Allowance for doubtful accounts (218,000) (435,000)
Lease cancellation accrual -- (920,000)
Other accruals (834,000) (1,714,000)
-------------------------------
Total deferred tax assets (3,821,000) (10,036,000)
Valuation allowance -- --
-------------------------------
Net deferred tax liabilities $ 18,457,000 $ 36,371,000
Effective tax rate calculation for fiscal year ended June 30, 1997:
Tax Affected Effective
Permanent Permanent Tax Rate
Differences Differences Calculation
---------------------------------------------
Tax provision $16,398,000
Pretax income 33,507,000
Effective tax rate 48.939%
Federal statutory rate 35.000%
State pre-tax after permanent difference $36,558,000 $2,654,000 7.921%
Pooling of interests 5,156,000 1,805,000 5.385%
Stock options (2,227,000) (779,000) (2.326%)
Other (net) 2.959%
-----------
48.939%
For 1995 and 1996 the Company's effective tax rate was computed using the
appropriate statutory rates with no significant differences.
Note 7 Commitments and Contingencies
The Company leases office space under operating leases expiring at various dates
through February 2012. In addition, in February 1996, the Company entered into
an operating lease for an airplane, which expires February 2006. Total rent
expense related to operating leases amounted to $1.5 million, $3.2 million and
$5.3 million, for the years ended June 30, 1995, 1996 and 1997, respectively.
Certain leases have provisions for renewal options and/or rental increases at
specified increments or in relation to increases in the Consumer Price Index (as
defined). As of June 30, 1997, listed below are future minimum rental payments
required under non-cancelable operating leases that have initial or remaining
terms in excess of one year:
F-15
67
Fiscal Years Ended June 30,
- ---------------------------
1998 $ 4,886,000
1999 5,061,000
2000 5,851,000
2001 4,294,000
2002 3,577,000
Thereafter 35,342,000
-----------
$59,011,000
LITIGATION
In the ordinary course of its business, the Company is subject to claims made
against it by borrowers and private investors arising from, among other things,
losses that are claimed to have been incurred as a result of alleged breaches of
fiduciary obligations, misrepresentations, errors and omissions of employees and
officers of the Company, incomplete documentation and failures by the Company to
comply with various laws and regulations applicable to its business. The Company
believes that liability with respect to any currently asserted claims or legal
action is not likely to be material to the Company's financial position or
results of operations; however, any claims asserted in the future may result in
legal expenses which could have a material adverse effect on the Company's
financial position and results of operations.
EMPLOYMENT AND SEVERANCE AGREEMENTS
Certain members of management have employment or severance agreements which
provide for enhanced severance and other benefits upon a change in control,
as defined in the agreements.
Note 8 Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments as
of June 30, 1996 and 1997 are made by the Company using available market
information, historical data, and appropriate valuation methodologies. However,
considerable judgment is required to interpret market and historical data to
develop the estimates of fair value. Accordingly, the estimates presented herein
are not necessarily indicative of the amounts the Company could realize in a
current market exchange. The use of different market assumptions and/or
estimation methodologies may have a material effect on the estimated fair value
amounts.
June 30, 1996 June 30, 1997
------------------------------ ------------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------------ ------------ ------------ ------------
Balance Sheet:
Cash and cash equivalents $ 23,941,000 $ 23,941,000 $ 26,902,000 $ 26,902,000
Loans held for sale 186,189,000 198,507,000 242,987,000 255,136,000
Interest-only strips at fair market value 129,113,000 129,113,000 270,422,000 270,422,000
Mortgage servicing rights 10,902,000 10,902,000 21,641,000 21,641,000
Amounts outstanding under revolving
warehouse facilities 135,791,000 135,791,000 137,500,000 137,500,000
Borrowings 138,045,000 139,035,000 286,990,000 284,735,000
Off Balance Sheet:
Hedge position notional amount outstanding 40,000,000 40,000,000 135,000,000 135,246,000
The fair value estimates as of June 30, 1996 and 1997 are based on pertinent
information available to management as of the respective dates. Although
management is not aware of any factors that would significantly affect the
estimated fair value amounts, such amounts have not been revalued for purposes
of these financial statements since those dates and, therefore, current
estimates of fair value may differ significantly from the amounts presented
herein.
The following describes the methods and assumptions used by the Company in
estimating fair values:
Cash and cash equivalents are based on the carrying amount which is a reasonable
estimate of the fair value.
F-16
68
Loans held for sale are based on current investor yield requirements.
Interest-only strips and mortgage servicing rights are based on the expected
future cash flows using industry assumptions as well as the Company's historical
experience.
Amounts outstanding under revolving warehouse facilities are short-term in
nature and generally bear market rates of interest.
Borrowings are based on the quoted market prices for the same or similar issues
or on the current rates offered to the Company for debt of the same remaining
maturities.
Hedge positions are based on quoted market prices.
Note 9 Employee Benefit Plans
401(K) RETIREMENT SAVINGS PLAN
The Company sponsors a 401(k) Retirement Savings Plan, a defined contribution
plan. Substantially all employees are eligible to participate in the plan after
reaching the age of 21 and completion of six months of service. Contributions
are made from employees' elected salary deferrals. Employer contributions are
determined at the beginning of the plan year at the option of the employer. For
fiscal years 1995, 1996 and 1997, the Company's contribution to the plan
aggregated $46,000, $252,000 and $432,000, respectively.
DEFERRED COMPENSATION PLAN
In April 1997, the Company implemented a Deferred Compensation Plan for highly
compensated employees and directors of the Company. The plan is unfunded and
non-qualified. Eligible participants may defer a portion of their compensation
and receive a Company matching amount up to 4% of their annual base salary. The
Company may also make discretionary contributions to the plan. For the 1997
fiscal year, the Company made no matching or discretionary contributions to the
plan.
STOCK BASED COMPENSATION
The Company has reserved 3,750,000 shares of the common stock for issuance under
its 1991 Stock Incentive Plan, 1995 Stock Incentive Plan and 1996 Stock
Incentive Plan. Under these plans, the Company may grant incentive and
non-qualified options to eligible participants that may vest immediately on the
date of grant or in accordance with a vesting schedule, as determined in the
sole discretion of the Compensation Committee of the Company's Board of
Directors. The exercise price for each option is based on the closing price of
the common stock on the day before the date of grant. Each option plan provides
for a term of 10 years. The Company has also granted options outside of these
plans, on terms established by the Compensation Committee.
A summary of the Company's stock option plans and arrangements as of June 30,
1995, 1996 and 1997 and changes during the years then ended are as follows:
Option Option
Shares Price Range
------------------------------
1995
Outstanding at beginning of year 447,749 $3.33 - $5.11
Granted 286,875 3.89 - 3.89
Exercised (17,246) 3.33 - 3.89
Forfeited (4,382) 3.33 - 3.89
---------- -------------
Outstanding at end of year 712,996 3.33 - 5.11
---------- -------------
1996
Outstanding at beginning of year 712,996 3.33 - 5.11
Granted 2,464,049 0.19 - 18.61(1)
Exercised (223,148) 3.33 - 7.95
Forfeited (13,175) 3.33 - 7.95
---------- -------------
Outstanding at end of year 2,940,722 0.19 - 18.61
---------- -------------
1997
Outstanding at beginning of year 2,940,722 0.19 - 18.61
Granted 1,647,733 12.0 - 29.70
Exercised (325,049) 3.33 - 11.50
Forfeited (80,915) 3.89 - 28.92
---------- -------------
Outstanding at end of year 4,182,491 0.19 - 29.70
---------- -------------
(1) Includes options assumed in One Stop acquisition.
The number of options exercisable at June 30, 1996 and 1997, was 670,988 and
1,563,722, respectively. The weighted-average fair value of options granted
during 1996 and 1997 was $5.62 and $13.83, respectively.
F-17
69
The Company applies APB Opinion 25 and related interpretations in accounting for
its stock-based compensation plans. No compensation cost has been recognized for
its stock option plans and arrangements. If compensation cost for the stock
option plans and arrangements had been determined based on the fair value at the
grant dates for awards under this plan consistent with the method prescribed by
SFAS 123, the Company's net income and earnings per share would have been
reduced to the pro forma amounts indicated below:
June 30,
1996 1997
-------------- --------------
Net income
As reported $ 29,791,000 $ 17,109,000
Pro forma 29,295,000 13,194,000
Primary earnings per share
As reported 1.18 .60
Pro forma 1.16 .46
Fully diluted earnings per share
As reported 1.14 .60
Pro forma 1.12 .49
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:
June 30,
1996 1997
------- -------
Dividend yield 1.22% .54%
Expected volatility 45.42 47.98
Risk-free interest rate 6.26 6.30
Expected life of option 6 years 6 years
Note 10 Stockholders' Equity
The Company issued a three-for-two stock split in the form of a stock dividend
on February 21, 1997 to stockholders of record on February 10, 1997. The split
was effected as a dividend of one share of common stock for every two shares of
common stock outstanding. After giving effect to this stock split, the Company
had 27.8 million shares outstanding at June 30, 1997.
The Company issued a three-for-two stock split in the form of a stock dividend
on May 17, 1996 to stockholders of record on May 6, 1996. The split was effected
as a dividend of one share of common stock on every two shares of common stock
outstanding. After giving effect to this stock split, the Company had 23.8
million shares outstanding at June 30, 1996.
On October 10, 1996, the Company completed the sale of 3.62 million shares of
common stock in a public offering. The proceeds to the Company from the
offering, net of expenses, were $118 million.
The Company's bank agreements generally limit the Company's ability to pay
dividends to an amount equal to 85% of its net income. In addition, the
Company's indentures relating to its 10.5% Senior Notes due 2002 and 9.125%
Senior Notes due 2003 place certain restrictions on the payment of dividends and
the encumbrance of additional indebtedness based on the Company's net worth.
In June 1996, the Board of Directors of the Company declared a dividend
distribution of one preferred stock purchase right ("Right") on each share of
the Company's common stock outstanding on July 12, 1996. Each
F-18
70
Right, when exercisable, entitles the holder to purchase from the Company one
one-hundredth of a share of Preferred Stock, par value $0.001 per share, of the
Company at a price of $100.00, subject to adjustments in certain cases to
prevent dilution.
The Rights will become exercisable (with certain limited exceptions provided in
the Rights agreement) following the 10th day after (a) a person or group
announces acquisition of 15 percent or more of the common stock, (b) a person or
group announces commencement of a tender offer, the consummation of which would
result in ownership by the person or group of 15 percent or more of the common
stock, (c) the filing of a registration statement for an exchange offer of 15
percent or more of the common stock under the Securities Act of 1933, as
amended, or (d) the Company's board of continuing directors determines that a
person is an "adverse person," as defined in the Rights agreement.
Note 11 Subsidiary Guarantors
In October 1996, the Company completed an offering of its 9.125% Senior Notes
due 2003 which were guaranteed by all of the Company's subsidiaries, all of
which are wholly-owned. The guarantees are joint and several, full, complete and
unconditional. There are no restrictions on the ability of such subsidiaries to
transfer funds to the Company in the form of cash dividends, loans or advances.
The Company is a holding company with limited assets or operations other than
its investments in its subsidiaries. Separate financial statements of the
guarantors are not presented because the aggregate total assets, net earnings
and net equity of such subsidiaries are substantially equivalent to the total
assets, net earnings and net equity of the Company on a consolidated basis.
Note 12 Quarterly Financial Data (unaudited)
Three Months Ended
---------------------------------------------------
Sept 30 Dec 31 Mar 31 Jun 30
-------- -------- -------- --------
(In thousands, except per share amounts)
Fiscal 1996
Revenue $ 23,921 $ 34,079 $ 40,603 $ 51,661
Income before income taxes 9,758 12,190 14,823 15,528
Net income 5,659 7,289 8,564 8,279
Earnings per share - fully diluted 0.23 0.29 0.33 0.29
Fiscal 1997
Revenue $ 75,641 $ 80,028 $ 84,080 $ 32,772
Income before income taxes (4,053) 31,510 30,309 (24,258)
Net income (4,624) 18,274 17,575 (14,115)
Earnings per share - fully diluted (.11) 0.53 0.51 (.37)
F-19
71
AAMES FINANCIAL
CORPORATION
RULE 12-06 PROPERTY PLANT AND EQUIPMENT
FISCAL YEARS 1995, 1996 AND 1997
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
- -------- ----------- ---------- ----------- ---------- -----------
OTHER
CHANGES-
BALANCE AT ADD BALANCE
BEGINNING ADDITIONS (DEDUCT)- AT END OF
CLASSIFICATION OF PERIOD AT COST RETIREMENTS DESCRIBE PERIOD
- -------------- ----------- ---------- ----------- ---------- -----------
1995
Automobile $ 202,000 $ 69,000 $ 76,000 $ 195,000
Furniture & Fixtures 1,237,000 349,000 125,000 1,461,000
Leasehold Improvements 113,000 20,000 133,000
Data Processing Equipment 1,116,000 538,000 1,654,000
Capital Leases 797,000 797,000
----------- ---------- -------- --------- -----------
Total $ 3,465,000 $ 976,000 $201,000 $ 4,240,000
=========== ========== ======== ========= ===========
1996
Automobile $ 195,000 $ 154,000 $ 93,000 $ 256,000
Furniture & Fixtures 1,461,000 2,163,000 70,000 3,554,000
Leasehold Improvements 133,000 109,000 242,000
Data Processing Equipment 1,654,000 3,341,000 58,000 4,937,000
Data Processing Software 242,000 242,000
Capital Leases 797,000 9,000 806,000
----------- ---------- -------- --------- -----------
Total $ 4,240,000 $6,018,000 $221,000 $10,037,000
=========== ========== ======== ========= ===========
1997
Automobile $ 256,000 $ 241,000 $ 497,000
Furniture & Fixtures 3,554,000 2,366,000 $ 28,000 5,892,000
Leasehold Improvements 242,000 1,424,000 1,666,000
Data Processing Equipment 4,937,000 3,308,000 6,000 8,239,000
Data Processing Software 242,000 1,514,000 1,756,000
Capital Leases 806,000 806,000
----------- ---------- -------- --------- -----------
Total $10,037,000 $8,853,000 $ 34,000 $18,856,000
=========== ========== ======== ========= ===========
F-20
72
AAMES FINANCIAL
CORPORATION
RULE 12-07 ACCUMULATED DEPRECIATION
DEPLETION AND AMORTIZATION OF PROPERTY
PLANT AND EQUIPMENT
FISCAL YEARS 1995, 1996 AND 1997
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
- -------- ----------- ------------ ----------- --------- ------------
OTHER
ADDITIONS CHANGES-
BALANCE AT CHARGED TO ADD BALANCE
BEGINNING COSTS & (DEDUCT)- AT END OF
DESCRIPTION OF PERIOD EXPENSES RETIREMENTS DESCRIBE PERIOD
- ----------- ----------- ------------ ----------- --------- ------------
1995
Automobile $ 88,000 $ 9,000 $ 76,000 $ 21,000
Furniture & Fixtures 646,000 175,000 125,000 696,000
Leasehold Improvements 100,000 12,000 112,000
Data Processing Equipment 395,000 263,000 658,000
Capital Leases 555,000 130,000 685,000
---------- ---------- -------- -------- ----------
Total $1,784,000 $ 589,000 $201,000 - $2,172,000
========== ========== ======== ======== ==========
1996
Automobile $ 21,000 $ 102,000 $ 72,000 $ 51,000
Furniture & Fixtures 696,000 377,000 1,073,000
Leasehold Improvements 112,000 21,000 133,000
Data Processing Equipment 658,000 668,000 1,326,000
Data Processing Software - 22,000 22,000
Capital Leases 685,000 73,000 758,000
---------- ---------- -------- -------- ----------
Total $2,172,000 $1,263,000 $ 72,000 - $3,363,000
========== ========== ======== ======== ==========
1997
Automobile $ 51,000 $ 94,000 $ 145,000
Furniture & Fixtures 1,073,000 793,000 1,866,000
Leasehold Improvements 133,000 63,000 196,000
Data Processing Equipment 1,326,000 1,467,000 $ 10,000 2,783,000
Data Processing Software 22,000 353,000 375,000
Capital Leases 758,000 48,000 806,000
---------- ---------- -------- -------- ----------
Total $3,363,000 $2,818,000 $ 10,000 - $6,171,000
========== ========== ======== ======== ==========
F-21
73
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
AAMES FINANCIAL CORPORATION
(Registrant)
Dated: September 26, 1997 By: /s/ Cary H. Thompson
------------------------------------
Cary H. Thompson
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 TITLE DATE
--------- ----- ----
/s/ Gary K. Judis Chairman of the Board September 26, 1997
- ------------------------------
Gary K. Judis
/s/ Cary H. Thompson Chief Executive Officer, September 26, 1997
- ------------------------------ Director (Principal Executive Officer)
Cary H. Thompson
/s/ Neil B. Kornswiet President, Director September 26, 1997
- ------------------------------
Neil B. Kornswiet
/s/ Gregory J. Witherspoon Executive Vice President-- September 26, 1997
- ------------------------------ Finance, Chief Financial
Gregory J. Witherspoon Officer, Director
/s/ Mark E. Elbaum Senior Vice President-- September 26, 1997
- ------------------------------ Finance (Principal Accounting Officer)
Mark E. Elbaum
/s/ Joseph R. Cerrell Director September 26, 1997
- ------------------------------
Joseph R. Cerrell
/s/ John Getzelman Director September 26, 1997
- ------------------------------
John C. Getzelman
/s/ Dennis F. Holt Director September 26, 1997
- ------------------------------
Dennis F. Holt
/s/ Melvyn Kinder Director September 26, 1997
- ------------------------------
Melvyn Kinder
/s/ Lee Masters Director September 26, 1997
- ------------------------------
Lee Masters
74
EXHIBIT INDEX
Management Contracts and Compensatory Plans:
10.1 Form of Director and Officer Indemnification Agreement
10.2(a) Amended and Restated Employment Agreement between Registrant
and Gary K. Judis (10)
10.2(b) Severance Agreement between Registrant and Gary K. Judis
10.2(c) Consulting Agreement between Registrant and Gary K. Judis
10.3(a) Second Amended and Restated Employment between Registrant and
Cary H. Thompson
10.3(b) Stock Option Agreement between Registrant and Cary H.
Thompson(10)
10.4(a) Employment Agreement between Registrant and Neil Kornswiet
10.4(b) Amendment No. 1 to Exhibit 10.4(a)
10.5 Executive Severance Agreement between Registrant and Gregory
Witherspoon
10.6 Second Amended and Restated Employment Agreement between
Registrant and Barbara Polsky
10.7 Employment Agreement between Registrant and Mark Costello
10.8 1991 Stock Incentive Plan, as amended (2)
10.9 1995 Stock Incentive Plan (10)
10.10(a) 1996 Stock Incentive Plan (12)
10.10(b) Amendment No. 1 to Exhibit 10.10(a)
10.11 1995 Employee Stock Purchase Plan (3)
10.20 Variable Deferred Compensation Plan
Other Exhibits:
2.1 Agreement and Plan of Reorganization, dated as of
August 12, 1996, as amended by Amendment No. 1, dated
August 28, 1996 by and among Registrant, Aames
Acquisition Corporation, One Stop Mortgage, Inc. and
Neil B. Kornswiet (14)
3.1 Certificate of Incorporation of Registrant, as amended
3.2 Bylaws of Registrant, as amended
4.1 Specimen certificate evidencing Common Stock of Registrant
4.2 Rights Agreement, dated as of June 21, 1996 between Registrant and
Wells Fargo Bank, as rights agent (4)
10.12(a) Office Lease, dated December 13, 1989, between State
Street Bank and Trust Company of California, N.A. and
Aames Home Loan, Registrant's wholly owned subsidiary,
for the premises located at 3731 Wilshire Boulevard,
Los Angeles, California (1)
10.12(b) Amendments dated August 1, 1991, March 15, 1992, June 30, 1993
and September 7, 1993 to Exhibit 10.12(b) (5)
10.13(a) Office Building Lease, dated as of August 7, 1996, between Registrant
and California Plaza IIA, LLC, for the premises located at
350 S. Grand Avenue, Los Angeles, California
10.13(b) First Amendment, dated as of August 15, 1997, to Exhibit 10.13(a)
75
10.14(a) Indenture of Trust, dated February 1, 1995, between
Registrant and Bankers Trust Company of California,
N.A., relating to Registrant's 10.50% Senior Notes due
2002 (5)
10.14(b) Supplemental Indenture of Trust, dated as of April 25, 1995 to Exhibit
10.14(a) (6)
10.15 Indenture, dated as of February 26, 1996, between
Registrant and The Chase Manhattan Bank, N.A.,
relating to Registrant's 5.5% Convertible Subordinated
Debentures due 2006 (7)
10.16 First Supplemental Indenture, dated as of October 21,
1996, between Registrant, The Chase Manhattan Bank and
certain wholly owned subsidiaries of Registrant,
relating to Registrant's 9.125% Senior Notes due 2003 (11)
10.17(a) Interim Loan and Security Agreement, dated as of
November 22, 1996, between Aames Capital Corporation,
Registrant's wholly owned subsidiary ("ACC") and
Prudential Securities Credit Corporation
10.17(b) Notice of Extension of Agreement No. 1, dated as of May 15, 1997,
with effect as of March 31, 1997, to Exhibit 10.17(a)
10.17(c) Amendment, dated as of August 19, 1997, to Exhibit 10.17(a)
10.18 Amended and Restated Mortgage Loan Warehousing Agreement,
dated as of January 15, 1997, among Registrant; ACC;
the lenders from time to time a party thereto; and
NationsBank of Texas, N.A., as administrative agent
for the lenders (13)
10.19(a) Aircraft Lease Agreement, dated as of March 8, 1996,
between C.I.T. Leasing Corporation and Oxford
Aviation Corporation, Inc., Registrant's wholly owned
subsidiary (7)
10.19(b) Corporate Guaranty Agreement, dated as of March 8,
1996, between Registrant and C.I.T. Leasing
Corporation, with respect to Exhibit 10.19(a) (7)
11 Statement re computation of per share earnings
21 Subsidiaries of the Registrant
23.1 Consent of Price Waterhouse LLP
23.2 Consent of KPMG Peat Marwick LLP
27 Financial Data Schedule
1 Incorporated by reference from Registrant's Registration Statement on Form
S-1, File No. 33-43237.
2 Incorporated by reference from Registrant's Registration Statement on Form
S-1, File No. 33-62400.
3 Incorporated by reference from Registrant's Registration Statement, File No.
333-01312.
4 Incorporated by reference from Registrant's Registration Statement on Form
8-A, File No. 33-13660.
5 Incorporated by reference from Registrant's Registration Statement on Form
S-2, File No. 33-88516.
6 Incorporated by reference from Registrant's Annual Report on Form 10-K for
the year ended June 30, 1995.
76
7 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1996.
8 Incorporated by reference from Registrant's Registration Statement on Form
S-2, File No. 33-91640.
9 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended December 31, 1995.
10 Incorporated by reference from Registrant's Annual Report on Form 10-K for
the year ended June 30, 1996, filed with the Commission on September 16,
1996.
11 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1996.
12 Incorporated by reference from Registrant's Registration Statement on Form
S-8 dated January 6, 1997.
13 Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended December 31, 1996.
14 Incorporated by reference from Registrant's Current Report on Form 8-K
dated September 11, 1996.