Back to GetFilings.com
1
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, 1999
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: (323) 210-5000
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: None
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of 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 August 18, 1999, there were outstanding 31,016,964 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
($1.4375 per share) of the Registrant's Common Stock on the New York Stock
Exchange was $41,869,205.75. 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 1999 Annual
Meeting of Stockholders or an amendment to this Form 10-K are incorporated by
reference in Items 10, 11, 12 and 13 of Part III of this Annual Report.
2
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. Upon its formation in 1991, the Company
acquired Aames Home Loan, a home equity lender founded in 1954. In August 1996,
the Company acquired One Stop Mortgage, Inc. ("One Stop") which originates
mortgage loans primarily through a broker network. In August 1999, One Stop
began operating under the name "Aames Home Loan."
On December 23, 1998 as amended February 10, 1999, June 9, 1999 and July
16, 1999, the Company entered into a Preferred Stock Purchase Agreement (the
"Preferred Stock Purchase Agreement") with Capital Z Financial Services Fund,
II, L.P., a Bermuda limited partnership ("Capital Z"), pursuant to which Capital
Z has agreed to make an equity investment of up to $126.5 million in the Company
(the "Investment"). The Investment is to be made as follows: (i) on February 10,
1999 (the "Initial Closing"), Capital Z (through a partnership majority-owned by
Capital Z) and certain other investors designated by Capital Z purchased 26,704
shares of the Series B Convertible Preferred Stock of the Company and 49,796
shares of the Series C Convertible Preferred Stock of the Company for $1,000 per
share, or an aggregate purchase price of $76.5 million; (ii) on August 3, 1999,
Capital Z (through a partnership majority-owned by Capital Z) purchased an
additional 25,000 shares of Series C Convertible Preferred Stock of the Company
for $1,000 per share, or an aggregate purchase price of $25 million (the
"Additional Investment'); (iii) subject to receiving stockholder approval of
amendments to the Company's Certificate of Incorporation to increase the
authorized common and preferred stock and effect a 1,000-for-1 forward stock
split of the outstanding preferred stock (the "Recapitalization") at a meeting
of stockholders scheduled for September 13, 1999, the Company will offer in a
public offering to the holders of the common stock of the Company
non-transferable subscription rights (the "Rights Offering") to purchase up to
approximately 31 million shares of Series C Convertible Preferred Stock for
$1.00 per share, and (iv) if less than 25 million shares of Series C Convertible
Preferred Stock is purchased by the stockholders, Capital Z has agreed to
purchase the difference (up to 25 million additional shares of Series C
Convertible Preferred Stock) for $1.00 per share (the "Standby Commitment").
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
residential 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.
2
3
The Company originates and purchases loans nationally through three
production channels retail, broker and correspondent. For the year ended June
30, 1999, the Company originated and purchased $2.19 billion of mortgage loans.
The Company underwrites and appraises every loan it originates and generally
reviews appraisals and re-underwrites all loans it purchases.
As a fundamental part of its business and financing strategy, the
Company sells its loans to third party investors in the secondary market as
market conditions allow. The Company maximizes opportunities in its loan
disposition transactions by disposing of its loan production through a
combination of securitizations and whole loan sales, depending on market
conditions, profitability and cash flows. The Company sold $1.89 billion, $2.45
billion and $2.27 billion of loans in the fiscal years ended June 30, 1999, 1998
and 1997, respectively. Of the total amount of loans sold during the fiscal
years ended June 30, 1999, 1998 and 1997, $650 million, $2.03 billion and $2.26
billion were sold in securitizations, respectively. During those same fiscal
years, the Company sold $1.24 billion, $416 million and $7.5 million,
respectively, in whole loan sales for cash. The Company did not complete a
securitization during the quarters ended December 31, 1998, March 31, 1999 and
June 30, 1999 due to adverse market conditions for asset-backed securitizations.
In August 1999, the Company completed a mortgage loans securitization of $400
million. See "- Loan Disposition."
The Company retains the servicing on the loans it originates or
purchases and securitizes. In April 1999, the Company entered into a
sub-servicing arrangement with a loan servicing company with respect to $388
million of loans primarily to reduce the burden on its cash resources caused by
its obligation to advance interest on delinquent loans in its servicing
portfolio.
BUSINESS STRATEGY
Fiscal 1999's results reflect the impact on the Company of the global
economic crises that existed early in the year and the continuing effects of
those crises on the credit, capital and asset-backed markets. From October
through the Initial Closing, the Company was dependent on one $300 million
warehouse line to fund its loan production. In conjunction with the Initial
Closing, the Company obtained an additional $400 million in committed warehouse
and repurchase facilities and an additional $100 million in an uncommitted
facility. The limited warehouse capacity during the second and part of the third
fiscal quarters severely constrained the Company's loan production capability.
Further, the public equity and debt markets on which the Company had
historically relied to satisfy its cash flow needs were not available during the
whole of the fiscal year. Additionally, the asset-backed markets on which the
Company had historically and primarily relied for its loan disposition strategy
remained weak, and inaccessible to, or impracticable for, the Company,
throughout the last three fiscal quarters. The Company, therefore, relied solely
on whole loan sales for cash during that period. The gains recorded for whole
loan sales are generally lower than the gains recorded for securitizations.
However, this difference in gain was exacerbated during the year by the
over-supply of whole loan product as other home equity lenders who had
traditionally securitized their production also sold loans in the whole loan
market. The gain on sale from the securitization completed during the first
fiscal quarter was significantly reduced due to a loss on the Company's hedge
position which was not offset by enhanced securitization execution. These
negative market conditions adversely affected the prepayment, loss and discount
rate assumptions applied by the Company in estimating the value of its
interest-only strips.
3
4
The application of these revised assumptions resulted in the Company recording a
$194 million net loss in valuation of its interest-only strips during the second
fiscal quarter of 1999 (the "Write-Down").
For the three years prior to fiscal 1998, the Company's significant
year-over-year growth was driven primarily by the increases in the volume of
loans purchased in the bulk correspondent business facilitated by the sale of
the Company's loan production in securitization transactions. These business
strategies significantly contributed to the Company's operating on a negative
cash flow basis which was funded by the Company regularly accessing the public
equity and debt markets. In the fourth quarter of fiscal 1997, primarily as a
reaction to the uncertainties in those capital markets, the Company decided to
reduce its bulk loan purchases and focus on the less cash intensive core retail
and broker loan production units and its servicing divisions. Fiscal 1998's
results reflect these strategic decisions in the record levels of retail and
broker loan production, increased expenses for retail and broker loan office
expansion and increased expenses to accommodate the significant increase in the
Company's in-house servicing portfolio.
The Company believes that the Investment by Capital Z and its current
warehouse capacity permits the Company to resume its growth strategy. This
growth strategy consists of: (i) continuing to focus on its core loan production
units; (ii) increasing its servicing portfolio and servicing capabilities; and
(iii) diversifying its funding sources to become self-financing (i.e., the
ability to obtain sufficient lines of credit to provide financing for assets
created by the Company and the reduction of reliance on the public equity and
debt markets). In particular, the Company intends to employ the following
strategies:
Focus on Core Loan Production. The Company intends to evaluate expansion
opportunities in its retail and broker operations and to expand its loan
purchasing capabilities by building new relationships with independent mortgage
brokers, with the goal of increasing market share in these areas. The Company
regularly reviews its loan offerings and introduces new loan products to further
meet the needs of its customers and increase its core loan production volume.
However, no assurance as to the Company's ability to accomplish these goals can
be given.
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 significant source of recurring revenue. At
June 30, 1999, the Company's servicing portfolio was $3.84 billion. 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. However, no assurance as to the
Company's ability to accomplish these goals can be given.
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 or repurchase facilities, disposing of a portion of
its loan production for cash in the whole loan market, and developing new
sources for working capital. However, no assurance as to the Company's ability
to accomplish these goals can be given.
4
5
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.
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 residence with either a fixed or
adjustable interest 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 generally 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 1999, the Company obtained its residential
loans through three primary channels: retail, broker and correspondent.
The following table illustrates the sources of the Company's loan
production during the periods indicated:
FISCAL YEARS ENDED JUNE 30,
1999 1998 1997
---- ---- ----
(DOLLARS IN THOUSANDS)
Retail loans:
Total dollar amount.............................. $770,000 636,100 436,900
Number of loans................................. 12,214 11,531 8,565
Average loan amount............................ 63 55 51
Average initial combined loan to value........... 72% 70 67
Weighted average interest rate(1)................ 9.5% 10.3 10.5
Broker loans(2):
Total dollar amount.............................. $1,182,100 1,101,200 741,000
Number of loans.................................. 14,006 12,763 8,985
Average loan amount.............................. 84 86 83
Average initial combined loan to value........ 76% 75 71
Weighted average interest rate(1)................ 9.9% 9.8 10.0
Correspondent program:
Total dollar amount.............................. $ 241,500 646,300 1,170,000
Number of loans.................................. 2,219 6,252 12,500
Average loan amount.............................. 109 103 94
Average initial combined loan to value........... 80% 79 71
Weighted average interest rate(1)................ 10.0% 10.2 11.0
Total loans:
Total dollar amount.............................. $2,193,600 2,383,600 2,347,900
Number of loans.................................. 28,439 30,546 30,050
Average loan amount.............................. 77 78 78
Average initial combined loan to value........... 75% 75 70
Weighted average interest rate(1)................ 9.8% 10.1 10.6
- ----------------
5
6
(1) Calculated with respect to the interest rate at the time the loan is
originated or purchased by the Company.
(2) Includes commercial loans. In late fiscal 1997, the Company began
originating small commercial loans on a limited basis. In January 1999,
the Company discontinued its commercial loan operation.
Retail Loan Office Network. The Company originates home equity mortgage
loans through its network of retail loan offices. At June 30, 1999, the Company
had 101 offices serving borrowers in 37 states. Prior to fiscal year 1994, the
Company's retail offices were located only in California. Commencing fiscal
1996, the Company aggressively pursued a strategy of expanding its retail loan
office network nationwide. The Company's retail office network increased by 16
offices and 53 offices in fiscal 1997 and 1998, respectively. However, primarily
due to market conditions, during fiscal 1999, the Company closed 20 retail
offices. The Company's network of retail loan offices includes two different
retail operations - a centralized network which operates under the name "Aames
Home Loan" and uses a centralized marketing approach, and a decentralized
network which now operates under the name "Aames Funding Corporation" and uses a
decentralized marketing approach at the branch level. During the current fiscal
year, the Company intends to evaluate opportunities for further retail office
expansion.
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.
The Company's expansion of its retail loan office network during fiscal
1997 and 1998 resulted in significant increases in retail loan production over
those fiscal years. The Company originated $636 million and $437 million of
mortgage loans through this network in fiscal 1998 and 1997, respectively.
Despite the adverse market conditions that existed during most of the year,
retail production increased to $770 million during fiscal 1999. Most of the
increase resulted from the Company's decentralized retail network which
commenced operations in March 1998.
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, yellow-page
listings and telemarketing. In the past, the Company has also used television
and radio advertising. 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 the
Company to apply for a loan. On the basis of an initial screening conducted at
the time of the call, the Company 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.
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 underwritten for loan approval. If the
loan package is
6
7
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.
Centralized Retail Network. The Company's direct mail advertising for
the centralized retail network is produced by the Company and distributed to
prospective borrowers based upon Company derived models and commercially
developed customer lists. The direct mail invites prospective borrowers to call
its headquarters office through the Company's toll-free telephone numbers, where
the customer is prequalified and scheduled for 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 customer is referred to a loan
officer who takes the loan application by telephone. The loan package is then
forwarded to the Company's headquarters office for review by underwriters and
for loan approval. At June 30, 1999, the Company had 80 centralized retail
offices serving borrowers in 32 states. During the years ended June 30, 1999,
1998, and 1997, $639 million, $635 million and $437 million in loans were
originated through this network, respectively.
Decentralized Retail Direct Network. In March 1998, the Company
established a separate decentralized retail production unit to enable the
Company to further penetrate the non-conforming home equity loan market. The
Company's advertising for the decentralized retail network is generated by the
local branch by the loan officers who are familiar with the local area. Direct
mail is often followed up by telephone calls to potential customers. All contact
with the customer is handled through the local branch. At June 30, 1999, the
Company had 21 decentralized retail offices serving borrowers in 13 states.
During the years ended June 30, 1999 and 1998, $131 million and $1.5 million in
loans were originated through this network, respectively.
Independent Mortgage Broker Network. Through its independent mortgage
broker network, the Company funded $1.18 billion, $1.10 billion and $741 million
in residential loans during the fiscal years ended June 30, 1999, 1998 and 1997,
respectively. At June 30, 1999, the Company operated 35 broker offices in 28
states and had approximately 7,100 approved mortgage brokers. During fiscal
1999, the Company originated loans through approximately 4,200 brokers, no one
of which accounted for more than 3% of total broker originations. All broker
loans originated by the Company are underwritten in accordance with the
Company's underwriting guidelines. Once approved, the loan is funded by the
Company 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
the Company's liaison with the borrower through the lending process. The Company
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
the Company, 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 the Company
to increase its loan volume without incurring the higher marketing costs
associated with increased retail originations.
7
8
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, the Company 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 the Company's broker offices to answer questions, assist in the
loan application process and facilitate ultimate funding of the loan.
Correspondent Channel. The Company purchases closed loans from mortgage
bankers and other financial institutions on a continuous or "flow" basis, and
through mini-bulk purchases. During the fiscal years ended June 30, 1999, 1998
and 1997, $241 million, $646 million and $1.17 billion in loans were purchased
through the correspondent channel. The Company believes that its flow and
mini-bulk correspondent program represents a cost effective means of increasing
loan production. In the fourth quarter of fiscal 1997, primarily as a reaction
to the uncertainties in the public equity and debt markets, the Company decided
to emphasize its mini-bulk and flow purchases, rather than its bulk loan
purchases. This strategic decision eliminated bulk purchases in fiscal 1999 and
decreased the amount of bulk loans purchased in fiscal 1998 compared to fiscal
1997. Additionally, the Company's limited warehouse capacity during the second
and part of the third fiscal quarters constrained its ability to purchase loans
and contributed to the decline in fiscal 1999.
Underwriting. The Company underwrites every residential 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 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. The Company regularly reviews its underwriting guidelines and makes
changes when appropriate to
8
9
respond to market conditions, the performance of loans representing a particular
loan product or changes in laws or regulations.
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 (or similar) form of title insurance on all residential
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 networks, 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 assigns a credit grade (A, A-, B, C, C- and
D) to each loan it originates or purchases depending on the risk profile of the
loan, with the higher credit grades exhibiting a lower risk profile and the
lower credit grades exhibiting increasingly higher risk profiles. Generally, the
higher credit grade loans have higher loan-to-value ratios and carry a lower
interest rate. The following chart generally outlines certain parameters of the
credit grades of the Company's underwriting guidelines for its residential loans
at August 12, 1999:
"A" CREDIT "A-" CREDIT "B" CREDIT "C" CREDIT "C-" CREDIT "D" CREDIT
GRADE GRADE GRADE GRADE GRADE GRADE
---------- ---------- ---------- ---------- ----------- ----------
GENERAL Has good Has good credit Generally good Marginal credit Marginal credit Designed to
REPAYMENT credit. but might have mortgage pay history which is history not offset provide a borrower
some minor history but may offset by other by other positive with poor credit
delinquency. have marginal positive attributes. history an
consumer credit attributes. opportunity to
history. correct past credit
problems.
9
10
"A" CREDIT "A-" CREDIT "B" CREDIT "C" CREDIT "C-" CREDIT "D" CREDIT
GRADE GRADE GRADE GRADE GRADE GRADE
---------- ----------- ---------- ---------- ----------- ----------
EXISTING No lates in No more than 59 No more than 89 Can have No more than Greater than
MORTGAGE past 12 months. days late at days late at multiple 30-day 149 days 150 days
LOANS closing and a closing and a lates and two delinquent in delinquent in
maximum of maximum of 60-day lates the past 12 the past 12
two 30-day lates four 30-day lates or one 90-day months. Can months.
in the past 12 in the past 12 late in the past have multiple
months. months or one 12 months; 90-day lates
60-day late currently not or one 120 day
and two 30-day more than 119 late in the past
lates. days late at 12 months.
closing.
CONSUMER Consumer credit Consumer credit Consumer credit Consumer credit Consumer credit Consumer credit
CREDIT is good in the is good in the must be is fair in the last is poor in the is poor in the
last 12 months. last 12 months. satisfactory in 12 months. The last 12 months last 12 months.
Less than 25% Less than 35% the last 12 majority of the with currently The majority of
of credit report of credit report months. Less credit is not delinquent the credit is
items derogatory items derogatory than 40% of currently accounts. Less derogatory (more
with no 60-day with no 90-day credit report delinquent. Less than 60% of than 60%).
or more lates. or more lates. items derogatory. than 50% of credit report Percentage of
credit report items derogatory. derogatory items
items derogatory not a factor.
BANKRUPTCY 2 years since 2 years since 1 year since Bankruptcy Bankruptcy Current
discharge or discharge or discharge with filing 12 months filed within bankruptcy
dismissal with dismissal with reestablished old, discharged last 12 months must be paid
reestablished reestablished "B" credit or 18 or dismissed and discharged through loan.
"A" credit. "A-" credit. months since prior to or dismissed
discharge application. prior
without to
reestablished application.
credit.
DEBT SERVICE- Generally not to Generally not to Generally not to Generally not to Generally not Generally not to
TO-INCOME exceed 45%. exceed 45%. exceed 50%. exceed 55%. to exceed 60%. exceed 60%.
RATIO
MAXIMUM
LOAN-TO-VALUE
RATIO:
OWNER
OCCUPIED Generally 90% Generally 90% Generally 80% Generally 75% Generally 70% Generally 65%
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 dwelling. family dwelling. family dwelling. family dwelling. family dwelling. family dwelling.
NON-OWNER Generally 80% Generally 70% Generally 65% Generally 65% Generally 65% Generally 60%
OCCUPIED for a 1 to 4 for a 1 to 4 for a 1 to 2 for a 1 to 4 for a 1 to 4 for a 1 to 4
family dwelling. family dwelling. family dwelling. family dwelling. family dwelling. family dwelling.
10
11
The following tables present certain information about the Company's
loan production through its retail loan office networks, independent mortgage
broker network and correspondent program during fiscal 1999, 1998 and 1997:
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1999
WEIGHTED
WEIGHTED AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
A $ 707,644,000 32% 79% 9.1%
A- 729,237,000 33 77 9.4
B 475,370,000 22 75 10.1
C 119,730,000 5 68 11.1
C- 37,990,000 2 65 12.3
D 123,665,000 6 62 12.9
-------------- ------- ----- -------
Total $2,193,636,000 100% 75% 9.8%
============== ------- ===== =======
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1998
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
A $ 651,303,000 27% 77% 9.3%
A- 835,834,000 35 78 9.7
B 560,710,000 24 74 10.2
C 159,652,000 7 67 11.2
C- 45,378,000 2 65 12.2
D 130,761,000 5 61 13.2
-------------- ------- ----- -------
Total $2,383,638,000 100% 75% 10.1%
============== ------- ===== =======
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% 70% 10.6%
============== ------- ===== =======
--------------
(1)Calculated with respect to the interest rate at the time the loan is
originated or purchased by the Company, as applicable.
11
12
LOAN DISPOSITION
The Company sells loans to third party investors in the secondary market
as market conditions allow. The Company maximizes opportunities in its loan
disposition transactions by selling its loan production through a combination
of securitizations and whole loan sales, depending on market conditions,
profitability and cash flows. As discussed in "- Business Strategy," during the
1999 fiscal year, the Company relied primarily on whole loan sales to dispose
of its loans. The Company generally seeks to dispose of substantially all of
its production within 90 days. The Company applies the net proceeds of the loan
dispositions, whether through securitizations or whole loan sales, to pay down
its warehouse and repurchase facilities in order to make these facilities
available for future funding of mortgage loans.
The Company sold $1.89 billion, $2.45 billion and $2.27 billion of loans
in the fiscal years ended June 30, 1999, 1998 and 1997, respectively. Of the
total amount of loans sold during the fiscal years ended June 30, 1999, 1998
and 1997, $650 million, $2.03 billion and $2.26 billion were sold in
securitizations, respectively. During those same fiscal years, the Company sold
$1.24 billion, $416 million and $7.5 million, respectively, in whole loan sales
for cash. The Company did not complete a securitization during the quarters
ended December 31, 1998, March 31, 1999 and June 30, 1999. In August 1999, the
Company completed a securitization of $400 million of mortgage loans. See "-
Loan Disposition."
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. If losses exceed the amount of the
overcollateralization 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. 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. See "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Capital Resources -- Loan Sales" and "- Risk Factors -- Our Right to Service
Loans May be Terminated Because of the High Delinquencies and Losses on the
Loans in Our Servicing Portfolio."
In a whole loan sale for cash, the Company generally enters into an
agreement to sell the loans for cash on a servicing released basis. After the
sale, the Company retains no interest in the underlying loans.
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 the residential loans it originates or
12
13
purchases and securitizes. In its whole loan sale strategy, the Company
evaluates the feasibility of selling loans on a servicing retained or servicing
released basis. To date, all of the Company's whole loan sales have been done
on a servicing released basis. The following table sets forth certain
information regarding the Company's servicing portfolio for the periods
indicated:
FISCAL YEARS ENDED JUNE 30,
1999 1998 1997
---- ---- ----
(IN THOUSANDS)
Servicing portfolio (period end) ................... $3,841,000(1) 4,147,000(2) 3,174,000
Serviced in-house .................................. 3,428,000(1) 3,941,000(2) 1,506,000
Loan service revenue .............................. 49,900 51,642 31,131
- --------------------
(1) Includes $84 million in loans subserviced for others on an interim basis
and approximately $413 million subserviced by others.
(2) Includes $82 million in loans subserviced for others on an interim
basis.
The Company believes that continued technology and processing
enhancements will provide it with improved margins on its servicing. The
Company anticipates that during fiscal 2000 it will begin subservicing for
third parties which will provide a new source of servicing revenue. However, no
assurance can be given that the Company will be successful in its attempts to
generate subservicing business.
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 reserves established by the
Company at the time of securitization 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, 1999, ten trusts representing approximately 20% (by
dollar volume) of the Company's servicing portfolio exceeded the specified
delinquency rate. Four of the ten trusts representing approximately 16% (by
dollar volume) of the Company's servicing portfolio exceeded specified loss
limits at June 30, 1999. None of the servicing rights of the Company have been
terminated. Additionally, during July 1999, one additional trust exceeded the
specified delinquency
13
14
level and one of the four trusts that exceeded its loss limit was cured. See
"Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations - Risk Factors -- Our Right to Service Loans May be
Terminated Because of the High Delinquencies and Losses on the Loans in Our
Servicing Portfolio." In the case of the Company's senior/subordinated
securitization transactions, holders of 51% of the certificates may terminate
the servicer upon certain events of default generally relating to certain
levels of loss experience, but not delinquency rates. No such events of default
have occurred to date in the Company's senior/subordinated securitizations.
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 fees 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. Under an
arrangement entered into in June 1999, the Company's right to receive the fees
and charges collected on loans in pre-1999 securitization trusts has been
subordinated to the right to such fees and charges as payment to the investment
bank which has agreed to make a significant portion of future advances on loans
included in those trusts. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations - Capital Resources."
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 core servicing portfolio.
In general, revenue from the Company's loan servicing portfolio may be
adversely affected by competitive market conditions that result in lower
mortgage interest rates or accelerated prepayment activity, subject to the
receipt by the Company of prepayment fee income. In some states in which the
Company currently operates, prepayment fees may be limited or prohibited by
applicable law.
The following table illustrates the mix of credit grades in the
Company's servicing portfolio as of June 30, 1999:
14
15
WEIGHTED WEIGHTED
AVERAGE AVERAGE
COMBINED ORIGINAL
DOLLAR AMOUNT INITIAL INTEREST
CREDIT GRADE OF LOAN % OF TOTAL LOAN-TO-VALUE RATE
A $ 680,204,000 18% 78% 9.3%
A- 1,515,062,000 40 76 9.9
B 885,208,000 23 74 10.6
C 303,425,000 8 67 11.6
C- 118,865,000 3 64 12.5
D 324,909,000 8 62 13.4
Other 13,618,000 - 58 10.8
--------------- -------- ----------- --------
Total $3,841,291,000 100% 73% 10.5%
=============== ======== =========== =======
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 "B," "C," "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 arranging for extended
prepayment terms, accepting a deed-in-lieu of foreclosure, entering into a
short sale (a sale for less than the outstanding principal amount) 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, other credit
considerations or borrower bankruptcy status.
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.
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
15
16
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, servicing advances 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.
The Company has historically experienced delinquency rates that are
higher than those prevailing in its industry due to its origination of lower
credit grade loans. At the end of calendar year 1996, the Company started to
focus more on higher credit grade loans which should cause delinquencies in the
Company's servicing portfolio to decrease in the future. If the Company were to
sell 100% of its loans in the whole loan market on a servicing released basis,
the Company would not be adding new loans to the servicing portfolio. The
seasoning of the old portfolio without the addition of new loans could cause
delinquency rates to rise. The delinquency rate at June 30, 1999 was 15.7%
compared to 15.6% at June 30, 1998.
During the fiscal year ended June 30, 1999, losses increased to $52
million from $26 million in the prior year primarily due to the seasoning of
the lower credit grade loans purchased in bulk and included in the Company's
earlier trusts. The Company has eliminated its bulk purchase program. The
seasoning of the lower credit grade bulk portfolio may continue to contribute
to an increase in losses over time. Further, the adverse market conditions that
existed during the fall of 1998 resulted in the tightening in underwriting
guidelines by purchasers of whole loans and the insolvency of several large
subprime home equity lenders. These factors have had the effect of decreasing
the availability of credit to delinquent lower credit grade borrowers who in
the past had avoided default by refinancing. Management believes that this will
increase the Company's level of losses in future periods.
16
17
The following table sets forth delinquency, foreclosure and loss
information relating to the Company's servicing portfolio as of or for the
periods indicated:
AS OF OR FOR THE FISCAL YEARS ENDED JUNE 30,
1999 1998 1997
------------- ------------- -------------
(Dollars in thousands)
Percentage of dollar amount of delinquent
loans to loans serviced (period end)(1)(2)(3)(4)
One Month ................................... 2.4% 3.8 4.3
Two Months .................................. 1.0 1.3 1.9
Three or More Months
Not foreclosed (5) ........................ 10.3 9.0 8.1
Foreclosed (6) ............................ 2.0 1.5 1.0
------------- ------------- -------------
Total ..................................... 15.7% 15.6 15.3
============= ============= =============
Percentage of dollar amount of loans foreclosed
during the period to loans serviced (2)(4) .... 3.0% 2.0 1.5
Number of loans foreclosed
during the period(7) ........................ 1,613 1,125 560
Principal amount of foreclosed loans
during the period(7) ........................ $ 117,015 84,613 48,029
Net losses on liquidations
during the period(8) ........................ $ 51,730 26,488 5,470
Percentage of losses to average servicing
portfolio (4) ............................... 1.31% .72 .24
Servicing portfolio at period end ............. $ 3,841,300 4,147,000 3,174,000
(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.
(3) At June 30, 1999, the dollar volume of loans delinquent more than 90
days in the Company's 10 REMIC trusts formed in December 1992 and during
the period from March 1995 to March 1997 exceeded the permitted limit in
the related pooling and servicing agreements. Four of those trusts
exceeded certain loss limits. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Capital
Resources;" and "- Risk Factors -- Our Right to Service Loans May Be
Terminated Because of the High Delinquencies and Losses on the Loans in
Our Servicing Portfolio".
(4) The servicing portfolio used in percentage calculations includes $84
million and $82 million of loans subserviced by the Company on an
interim basis at June 30, 1999 and 1998.
(5) Represents loans which are in foreclosure but as to which foreclosure
proceedings have not concluded.
(6) Represents properties acquired following a foreclosure sale and still
serviced by the Company at period end.
(7) The increase in the number of loans foreclosed and principal amount of
loans foreclosed in the periods presented is due to the larger and more
seasoned servicing portfolio.
(8) Represents losses net of gains on foreclosed properties sold during the
period indicated.
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.
17
18
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,
investment banks, 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 or purchased home equity lenders offering loan products
directed at the target market of the Company. 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
non-conforming 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 lower rates to
potential borrowers 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) emphasizing
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; (iv)
providing convenient locations for its retail and broker offices and national
geographic coverage in origination channels; and (v) emphasizing customer
service in its loan servicing division.
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,
18
19
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. A significant portion of the Company's mortgage loans are
so-called "high cost mortgage loans" where the borrower is charged points and
fees or interest rates above certain levels. Such high cost mortgage loans are
subject to special disclosure requirements and certain substantive prohibitions
under the Home Ownership and Equity Protection Act of 1994 and regulations
thereunder, and certain state laws. The federal regulations governing high cost
mortgage loans establish guidelines for determination of whether an individual
loan is a high cost mortgage loan. Such guidelines may be interpreted
differently by different lenders. Federal regulations on high cost mortgage
loans make assignees of such mortgage loans liable for violations of the
regulations. As a result of the increased regulation and scrutiny of high cost
mortgage loans, certain lenders, including certain purchasers of the Company's
loans, will not purchase high cost mortgage loans. In addition, there has been
recent class action litigation and regulatory actions by certain state agencies
against lenders for violations of high cost mortgage regulations. The Company
has not to date been subject to any such class action litigation or regulatory
action.
Failure to comply with these requirements can lead to loss of approved
status, certain rights of rescission for mortgage loans, individual and class
action lawsuits and administrative enforcement action. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Risk Factors -- If We are Unable to Comply with Mortgage Banking
Rules and Regulations, Our Ability to Make Mortgage Loans May be Restricted."
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, 1999, the Company employed 1,305 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 Company is attempting to sublet a significant amount
of these premises. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations - Expenses." The lease on these
premises extends through February 2012. The Company also continues to lease
space at its former
19
20
headquarters location at 3731 Wilshire Boulevard, Los Angeles, California,
which it will use for its telemarketing operations and future expansion of
production related operations. This lease expires in December 2008. The
executive and administrative offices of the Company's Irvine office are located
at 3347 Michaelson Drive, Irvine, California, and consist of approximately
46,911 square feet. The lease on these premises extends through July 31, 2003.
The Company also leases space for its branch offices. These facilities
aggregate approximately 319,462 square feet and are leased under terms which
vary as to duration. In general, the leases expire between 1999 and 2004, 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
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 1999 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.
CASH
HIGH LOW DIVIDEND
FISCAL 1999*
First Quarter .............................. 13.375 6.063 .033
Second Quarter ............................. 4.813 1.250 --
Third Quarter .............................. 3.438 1.375 --
Fourth Quarter ............................. 2.000 1.313 --
FISCAL 1998*
First Quarter .............................. 23.250 15.875 .033
Second Quarter ............................. 17.125 10.625 .033
Third Quarter .............................. 15.250 11.438 .033
First Quarter ............................. 15.562 13.625 .033
* As reported by Bloomberg
20
21
As of August 18, 1999, the Company had 338 stockholders of record. From
its initial public offering on December 3, 1991 and through the first fiscal
quarter of 1999, the Company consistently paid quarterly cash dividends on its
common stock. The Company accrued and subsequently paid an aggregate of $0.033
per common share in dividends for the fiscal year ended June 30, 1999. The
Company declared and subsequently paid an aggregate of $0.13 per share in
dividends for the fiscal year ended June 30, 1998, representing approximately
13.7% 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. In November 1998, the Board of Directors
decided to suspend cash dividends on the common stock until the Company's
earnings and cash flows improved. Credit agreements generally limit the
Company's ability to pay dividends if such payment would result in an event of
default under the agreements or would otherwise cause a breach of a net worth
or liquidity covenants. The Company's Indenture relating to its 9.125% Senior
Notes due 2003 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 (minus 100% of any deficit); (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 (minus 100% of
net losses for any fiscal year), plus (iii) 100% of the net proceeds received
by the Company on offerings of its equity securities after December 31, 1994.
Under the most restrictive of these limitations, the Company will be prohibited
from paying cash dividends on its capital stock for the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below with respect to
the Company for the five years ended June 30, 1999 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. The selected
consolidated financial data gives effect to the acquisition of One Stop in
August 1996.
21
22
FISCAL YEAR ENDED JUNE 30,
1999 1998 1997 1996 1995
--------- ------- ------- ------- ------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF INCOME DATA:
Revenue:
Gain on sale of loans ........................... $ 44,855 120,828 135,421 71,255 15,870
Valuation (write-down) of interest-only strips .. (186,451) 19,495 (18,950) -- --
Commissions ..................................... 33,034 27,664 29,250 21,564 15,799
Loan service .................................... 49,900 51,642 31,131 20,394 8,791
Interest income and fees ........................ 42,509 46,860 37,679 15,215 7,940
----------- --------- --------- --------- -------
Total revenue including write-down ......... (16,153) 266,489 214,531 128,428 48,400
Total expenses .................................. 261,996 213,683 205,071 89,541 37,788
--------- --------- --------- --------- -------
Income (loss) before income taxes ............... (278,149) 52,806 9,460 38,887 10,612
Provision (benefit) for income taxes ............ (30,182) 25,243 7,982 17,814 4,828
--------- --------- --------- --------- -------
Net income (loss) .............................. $(247,967) 27,563 1,478 21,073 5,784
--------- --------- --------- --------- -------
Net income (loss) per share (diluted) ........... $ (8.00) 0.87 0.05 0.82 0.43
=========== ========= ========= ========= =======
Weighted average number of shares outstanding
(in thousands) (diluted) ........................ 31,000 35,749 28,371 27,248 13,532
=========== ========= ========= ========= =======
Cash dividends declared per common share ........ $ 0.03 .13 .13 .13 .13
=========== ========= ========= ========= =======
CASH FLOW DATA:
Used in operating activities ...................... $ (466,966) (49,661) (280,073) (241,073) (43,375)
Used in investing activities ...................... (5,229) (5,163) (8,864) (5,885) (988)
Provided by financing activities .................. 480,637 40,244 291,898 250,540 48,209
Net increase (decrease) in
cash and cash equivalents ........................ 8,442 (14,580) 2,961 3,582 3,846
RATIOS AND OTHER DATA:
Return on average common equity(1) ................. (149.3)% 10.1 18.6 21.5 10.8
Return on average managed receivables(2) ........... (5.9)% 0.8 0.1 2.1 1.2
Loans originated or purchased:
Broker network ................................ $ 1,182,100 1,101,200 741,000 319,800 --
Retail loans .................................. 770,000 636,100 436,900 220,900 148,200
Correspondent loans ........................... 241,500 646,300 1,170,000 628,200 206,800
----------- --------- --------- --------- -------
Total ...................................... 2,193,600 2,383,600 2,347,900 1,168,900 355,000
=========== ========= ========= ========= =======
Whole loans sold .................................... $ 1,236,050 416,390 7,500 202,200 --
Loans pooled and sold in securitizations ........... 649,999 2,034,300 2,262,700 791,300 316,600
Loans serviced at period end ....................... 3,841,300 4,147,100 3,174,000 1,370,000 608,700
Weighted average commission rate on
retail loan originations(3)........................ 4.1% 4.3 4.9 7.7 9.4
Weighted average interest rate(3) .................. 9.8 10.1 10.6 11.3 11.6
Weighted average initial combined
loan-to-value ratio(3)(4):
Retail loans .................................... 72 70 67 60 55
Broker network .................................. 76 75 71 68 --
Correspondent loans ............................. 80 79 71 66 65
At period end:
Number of retail loan offices ...................... 101 103 56 48 32
Number of One Stop branch offices .................. 35 52 37 25 --
AT JUNE 30,
---------------------------------------------------------------------
1999 1998 1997 1996 1995
--------- ------- ------- ------- -------
BALANCE SHEET DATA:
Cash and cash equivalents .......................... $ 20,764 12,322 26,902 23,941 20,359
Interest-only strips and mortgage servicing rights.. 353,255 522,632 360,892 167,740 50,421
Total assets ....................................... 1,021,097 815,187 717,595 401,524 108,084
--------- ------- ------- ------- -------
10.5% Senior Notes due 2002 ........................ 17,250 23,000 23,000 23,000 23,000
9.125% Senior Notes due 2003 ....................... 150,000 150,000 150,000 -- --
5.5% Convertible Subordinated Debentures due 2006... 113,970 113,990 113,990 115,000 --
Other long-term debt ............................... -- -- -- 45 144
--------- ------- ------- ------- -------
Total long-term debt ........................ 281,220 286,990 286,990 138,045 23,144
Stockholders' equity ............................... 145,556 304,051 239,755 120,461 75,797
(1) Excludes nonrecurring charges in the pre-tax amount of $32 million during
the year ended June 30, 1997.
(2) Represents net income divided by the average servicing portfolio during
the fiscal year presented.
(3) Computed on loans originated or purchased during the fiscal year
presented.
(4) 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.
22
23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
The following discussion should be read in conjunction with Item 6. Selected
Financial Data and Item 8. Financial Statements and Supplementary Data.
SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION
This Report contains statements that constitute "forward-looking
statements" within the meaning of Section 21E of the Securities Exchange Act of
1934 and Section 27A of the Securities Act of 1933. The words "expect,"
"estimate," "anticipate," "predict," "believe," and similar expressions and
variations thereof are intended to identify forward-looking statements. Such
statements appear in a number of places in this filing and include statements
regarding the intent, belief or current expectations of the Company, its
directors or officers with respect to, among other things (a) market conditions
in the securitization, capital, credit and whole loan markets and their future
impact on the Company's operations, (b) trends affecting the Company's liquidity
position, including, but not limited to, its access to warehouse and other
credit facilities and its ability to effect whole loan sales, (c) the impact of
the various cash savings plans and other restructuring strategies being
considered by the Company, (d) the Company's on-going efforts in improving its
equity position, (e) trends affecting the Company's financial condition and
results of operations, (f) the Company's plans to address the Year 2000 problem
and (g) the Company's business and liquidity strategies. The stockholders of the
Company are cautioned not to put undue reliance on such forward-looking
statements. Such forward-looking statements are not guarantees of future
performance and involve risks and uncertainties. Actual results may differ
materially from those projected in this Report, for the reasons, among others,
discussed under the captions "Item 1. Business - Business Strategy" and "- Risk
Factors." The Company undertakes no obligation to publicly revise these
forward-looking statements to reflect events or circumstances that arise after
the date hereof. Readers should carefully review the factors referred to above
and the other documents the Company files from time to time with the Securities
and Exchange Commission, including the quarterly reports on Form 10-Q filed by
the Company during fiscal 2000 and any current reports on Form 8-K filed by the
Company.
OVERVIEW
Fiscal 1999's results reflect the impact on the Company of the global
economic crises that existed early in the year and the continuing effects of
those crises on the credit, capital and asset-backed markets. From October
through the Initial Closing, the Company was dependent on one $300 million
warehouse line to fund its loan production. In conjunction with the Initial
Closing, the Company obtained an additional $400 million in committed warehouse
and repurchase facilities and an additional $100 million in an uncommitted
facility. The limited warehouse capacity during the second and part of the third
fiscal quarters severely constrained the Company's loan production capability.
Further, the public equity and debt markets on which the Company had
historically relied
23
24
to satisfy its cash flow needs were not available during the whole of the fiscal
year. Additionally, the asset-backed markets on which the Company had
historically and primarily relied for its loan disposition strategy remained
weak, and inaccessible to, or impracticable for, the Company, throughout the
last three fiscal quarters. The Company, therefore, relied solely on whole loan
sales for cash during that period. The gains recorded for whole loan sales are
generally lower than the gains recorded for securitizations. However, this
difference in gain was exacerbated during the year by the over-supply of whole
loan product as other home equity lenders who had traditionally securitized
their production also sold loans in the whole loan market. The gain on sale from
the securitization completed during the first fiscal quarter was significantly
reduced due to a loss on the Company's hedge position which was not offset by
enhanced securitization execution. These negative market conditions adversely
affected the prepayment, loss and discount rate assumptions applied by the
Company in estimating the value of its interest-only strips. The application of
these revised assumptions resulted in the Company recording a $194 million net
loss in valuation of its interest-only strips during the second fiscal quarter
of 1999.
For the three years prior to fiscal 1998, the Company's significant year
over year growth was driven primarily by the increases in the volume of loans
purchased in the bulk correspondent business facilitated by the sale of the
Company's loan production in securitization transactions. The combination of
these business strategies significantly contributed to the Company's operating
on a negative cash flow basis which was funded by the Company regularly
accessing the public equity and debt markets. In the fourth quarter of fiscal
1997, primarily as a reaction to the uncertainties in those capital markets, the
Company decided to reduce its bulk loan purchases and focus on the less cash
intensive core retail and broker loan production units and its servicing
division. Fiscal 1998's results reflect these strategic decisions in the record
levels of retail and broker loan production, increased expenses due to expedited
retail and broker loan office expansion and increased expenses to accommodate
the significant increase in the Company's in-house servicing portfolio.
CERTAIN ACCOUNTING CONSIDERATIONS
In December 1998, the FASB staff issued, in question and answer format,
"A Guide to Implementation of Statement 125 on Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, Questions and
Answers, Second Edition" (the "Special Report"). The Special Report indicates
that two methods have arisen in practice for accounting for credit enhancements
relating to securitization. These methods are the cash-in method and the
cash-out method. The cash-in method treats credit enhancements (pledged loans or
cash) as belonging to the Company. As such, these assets are recorded at their
face value as of the time they are received by the trust. The cash-out method
treats credit enhancements as assets owned by the related securitization trust.
As such, these assets are treated as part of the interest-only strips and are
recorded at a discounted value for the period between when collected by the
trust and released to the Company. The Special Report indicates that if no true
market exists for credit enhancement assets, the cash-out method should be used
to measure the fair value of credit enhancements.
Restatement of Prior Period Results. The Company had historically used
the cash-in method to account for its interest-only strips. However, during the
three months ended December 31, 1998,
24
25
the Company retroactively changed its practice of measuring and accounting for
its interest-only strips to the cash-out method in response to the FASB's
Special Report and to public comments from the staff of the Securities and
Exchange Commission released on December 8, 1998.
Under the cash-in method previously used by the Company, the assumed
discount period for measuring the present value of the interest-only strips
ended when the cash flows were received by the securitization trust; and, the
initial deposits to overcollateralization accounts were recorded at face value.
Under the cash-out method now required by the FASB and Securities and Exchange
Commission, the assumed discount period for measuring the present value of the
interest-only strips ends when cash, including the return of any initial
deposits, is distributed to the Company on an unrestricted basis.
The change to the cash-out method results only in a difference in the
timing of revenue recognition from a securitization and has no effect on the
total cash flows of securitization transactions. While the total amount of
revenue recognized over the term of a securitization is the same under either
method, the cash-out method results in lower initial gains on the sale of loans
due to the longer discount period, and higher subsequent loan service revenue
resulting from the impact of discounting cash flows. See "- Revenue."
As a result, the Company's consolidated results of operations for all
prior periods have been restated.
The restatement resulted in the following changes to prior financial
information (Dollars in thousands, except per share amounts):
YEAR ENDED JUNE 30,
--------------------------------------------
1998 1997 1996 1995
-------- ------- ------- ------
Revenue:
Previous $286,110 238,578 141,840 54,939
As restated 266,489 214,531 128,428 48,400
Net income:
Previous 40,317 17,109 29,791 10,034
As restated 27,563 1,478 21,073 5,784
Earnings per share:
Basic:
Previous 1.41 0.65 1.37 0.74
As restated 0.97 0.06 0.97 0.43
Diluted:
Previous 1.23 0.60 1.14 0.74
As restated 0.87 0.05 0.82 0.43
Interest-only strips:
(end of period)
Previous 554,161 383,249 173,789 56,960
As restated 490,542 339,251 153,838 50,421
25
26
Year Ended June 30,
----------------------------------------
1998 1997 1996 1995
------- ------- ------- -------
Stockholders' equity:
(end of period)
Previous 345,403 268,354 133,429 80,047
As restated 304,051 239,755 120,461 75,797
Accounting for Securitizations. Although the Company's loan disposition
strategy relies on a combination of securitization transactions and whole loan
sales, the Company relied solely on whole loan sales during the quarters ended
December 31, 1998, March 31, 1999 and June 30, 1999. The following discusses
certain accounting considerations which arise only in the context of
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
non-cash 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 non-cash gain on sale of loans
represents the difference between the proceeds (including premiums) from the
sale, net of related transaction costs, and the allocated carrying amount of the
loans sold. The allocated carrying amount is determined by allocating the
original amount of loans (including premiums paid on loans purchased) between
the portion sold and any retained interests (interest-only strip), based on
their relative fair values at the date of transfer. The interest-only strip
represents, over the estimated life of the loans, the present value of the
estimated cash flows. These cash flows are determined by 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 .50%), a
monoline insurance fee, if any, a back-up servicer fee, if any, and an estimate
for loan losses. In quarters where the Company engaged in a securitization
transaction, net gains or losses in valuation of interest-only strips and
mortgage servicing rights include the recognition of a gain or loss which
represents the initial difference between the allocated carrying amount and the
fair market value of the interest-only strip at the date of sale. Additionally,
increases or decreases in valuation of the interest-only strips are also
recognized as net gains or losses. 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 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: (i) future
rate of prepayment; (ii) discount rate used to calculate present value; and
(iii) credit losses on loans sold. The future cash flows represent management's
best estimate. Management monitors the performance of the loans, and any changes
in the estimates are reflected in earnings. 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), the production channel which produced the loan,
prevailing interest rates, the presence of prepayment penalties, the
loan-to-
26
27
value ratios and the credit grades of the loans included in the
securitization and other industry data. The rate of prepayment may be
affected by a variety of economic and other factors.
Discount Rate. In order to determine the fair value of the cash flow
from the interest-only strips, the Company discounts the cash flows
based upon rates prevalent in the market.
Credit Losses. In determining the estimate for credit losses on loans
securitized, the Company uses assumptions that it believes are
reasonable based on information from its prior securitizations, the
loan-to-value ratios, credit grades of the loans included in the
current securitizations and other industry data.
The interest-only strips are recorded at estimated fair value and are
marked to market through a charge (or credit) to earnings. On a quarterly basis,
the Company reviews the fair value of the interest-only strips by analyzing its
prepayment, discount rate and loss assumptions in relation to its actual
experience and current rates of prepayment and loss prevalent in the industry
and may adjust or take a charge to earnings through an adjustment to net gain or
loss on valuation of interest-only strips.
In the quarterly review of its interest-only strip for the quarter ended
December 31, 1998, the Company determined that it should adjust each of its
assumptions (rate of prepayment, discount rate and credit loss) to reflect
current market conditions. This change in estimates resulted in the Write-Down
in the quarter ended December 31, 1998. The components of this adjustment were
as follows:
Rate of Prepayment. In its valuation analysis of prepayment speeds, the
Company considered the relationship between the rate paid on the certificates or
bonds issued in the securitization and the weighted average coupons on the
mortgages outstanding in each securitization pool from time to time.
Additionally, for the quarters up to and including September 30, 1998,
prepayment rates used by the Company were held constant, e.g. flat, over the
life of the pool. The estimates used by the Company for the quarters up to and
including September 30, 1998 were flat prepayment rates ranging from 26% for
fixed to 30.5% for adjustable and hybrid loan products. These rates represented
a weighted average loan life of approximately 2.6 to 3.8 years. During the
quarter ended December 31, 1998, the Company finalized the development of an
enhanced analytical model which more precisely reflected the performance of the
securitized loans. This analytical model enabled the Company to refine its
estimate of the prepayment rates associated with the performance of its
securitized loans. Additionally, data and information received from market
participants (credit and capital providers) assisted the Company in its
assessment of current market conditions which resulted in the Company applying a
more precise valuation estimate to its prepayment assumptions. The Company
incorporated this new information in developing its improved judgment as to
prepayment speeds and changed its estimate of prepayment rates from a flat
constant prepayment rate to a vectored rate, which more closely approximates the
performance of the securitized loans. These revised prepayment rates resulted in
a weighted average life of 2.86 years. The impact of the change in prepayment
speeds amounted to approximately $62 million, which was included in the
Write-Down recorded for the quarter ended December 31, 1998.
Discount Rate. For the quarters up to and including September 30, 1998,
the Company used the weighted average interest rates of the loans included in
the pool as the best estimate available as an appropriate discount rate to
determine fair value. As the market deteriorated in the quarter ended December
31, 1998, it became apparent that a change in discount rate would be required in
order for the estimate of fair value to be consistent with market conditions. To
determine the appropriate discount rate, the Company reviewed general market
conditions as reflected by market sales of senior tranche asset-backed
securities. Management believed that the pass-through rate on senior tranche
27
28
securities should be lower than the discount rate applied to the subordinate,
and higher risk, interest-only strips. However, the adversity of the market
during the quarter ended December 31, 1998 was so severe that, in some
instances, transactions of senior tranche asset-backed securities could not even
be completed. Accordingly, the Company incorporated this current market
information in developing its judgment as to the appropriate risk adjusted rate
of return in establishing its change in estimate of the discount rate to be used
in estimating the fair value of the interest-only strips. For the quarter ended
December 31, 1998, the Company increased its discount rate to 15% to reflect
current market conditions. The impact of this change in discount rate amounted
to approximately $65 million, which was included in the Write-Down recorded for
the quarter ended December 31, 1998.
Credit Losses. For the quarter up to and including September 30, 1998,
the Company used a prospective cumulative loan loss estimate of 1.4% of the
balance of the loans in the securitization pools as an appropriate estimate to
determine fair value. This estimate was developed through a review of the credit
performance of securitized loans in the aggregate. In conjunction with its
previous quarterly review of loss estimates, the Company considered the level of
delinquency of securitized loans and the percentage of annualized losses to
securitized loans in the aggregate. As market conditions deteriorated in the
quarter ended December 31, 1998, the Company refined its estimate of credit
losses by expanding the factors it considered in developing its credit loss
estimates to include loss and delinquency information by channel, credit grade
and product, and information available from other market participants such as
investment bankers, credit providers and credit agencies. For the quarter ended
December 31, 1998, the percentage of losses to average servicing portfolio
amounted to 1.08%, a significant increase from the previous quarter's level of
.80%. The Company had seen levels spike to .96% in the quarter ended June 30,
1998 but then subside to the .80% previously noted. This trend was in line with
the Company's assumption that losses were being realized as the servicing
portfolio was transferred in-house from sub-servicers. Management believes the
increase in losses in the December 1998 quarter reflected general market
conditions rather than the continuing effects of the transfer of servicing
in-house. Publicly available information from investment banking firms and
credit agencies began to indicate a market expectation that credit losses within
the sub-prime home equity sector would rise. Those indications, in part, arise
from the impact of the adverse market conditions on severely delinquent
borrowers who, in a more favorable market, would avoid default by refinancing
with other lenders. In the current market, with competition lessening and
underwriting guidelines tightening, these borrowers are much more likely to
default. Accordingly, the Company increased its prospective cumulative loan loss
estimate to 2.7% (discounted back at 15%) of the balance of the loans in the
securitization pools at December 31, 1998. This change in credit loss estimate
resulted in a valuation adjustment of $67 million, which was included in the
Write-Down recorded for the quarter ended December 31, 1998.
Additionally, upon sale or securitization of servicing retained
mortgages, the Company capitalizes the fair value of mortgage servicing rights
("MSRs") assets 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 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.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." In July 1999, the FASB issued SFAS 137
which deferred the effective date of SFAS 133 to fiscal years beginning after
June 15, 2000. SFAS No. 133 requires companies to record derivatives on the
balance sheet as assets and liabilities, measured at fair value. Gains and
losses resulting from changes in the values of those derivatives would be
accounted for in earnings. Depending on the use of the derivative and the
satisfaction of other requirements, special hedge accounting may apply.
28
29
The Company has not determined the impact that adoption of their
standard will have on its future consolidated financial statements.
RESULTS OF OPERATIONS -- FISCAL YEARS 1999, 1998 AND 1997
The following table sets forth information regarding the components of
the Company's revenue and expenses in fiscal 1999, 1998 and 1997:
1999 1998 1997
---------------------- ------------------ --------------------
(Dollars in thousands)
Dollars Percentage Dollars Percentage Dollars Percentage
------- ---------- ------- ---------- ------- ----------
Percentage
Revenue:
Gain on sale of loan ........ $ 44,855 (277.7)% $ 120,828 45.3% $ 135,421 63.1%
Valuation (write-down) of
interest-only strips ...... (186,451) 1,154.3 19,495 7.3 (18,950) (8.8)
Commissions ................. 33,034 (204.5) 27,664 10.4 29,250 13.6
Loan Service:
Servicing spread .......... 27,798 (172.1) 32,392 12.2 21,592 10.1
Prepayment fees ........... 13,772 (85.3) 11,761 4.4 5,815 2.7
Late charges and
other servicing fees ..... 8,330 (51.6) 7,489 2.8 3,724 1.7
Interest income and fees:
Interest income ........... 35,853 (221.9) 40,110 15.1 31,160 14.5
Closing ................... 1,325 (8.2) 2,668 1.0 2,723 1.3
Appraisal ................. 2,822 (17.5) 2,617 1.0 1,854 0.9
Underwriting .............. 1,839 (11.4) 1,085 0.4 1,382 0.6
Other ..................... 670 (4.1) 380 0.1 560 0.3
--------- ------- --------- ----- --------- -----
Total revenue including
write-down .......... $ (16,153) 100.0% $ 266,489 100.0% $ 214,531 100.0%
========= ======= ========= ===== ========= =====
Expenses:
Compensation .............. $ 80,167 (496.3)% $ 94,820 35.6% $ 81,021 37.8%
Production ................ 40,061 (248.0) 34,195 12.8 27,229 12.7
General and
administrative .......... 60,635 (375.4) 40,686 15.3 31,716 14.8
Interest .................. 44,089 (272.9) 43,982 16.5 33,105 15.4
Nonrecurring charges ...... 37,044 (229.3) -- -- 32,000 14.9
--------- -------- --------- ----- --------- -----
Total expenses ........ $ 261,996 (1,622.0)% $ 213,683 80.2% $ 205,071 95.6%
========= ======== ========= ===== ========= =====
Income (loss) before
income taxes ................. (278,149) 1,722.0 52,806 19.8 9,460 4.4
Provision (benefit) for
income taxes ................. (30,182) 186.8 25,243 9.5 7,982 3.7
--------- -------- --------- ----- --------- -----
Net income (loss) ..... $(247,967) 1,535.2% $ 27,563 10.3% $ 1,478 0.7%
========= ======== ========= ===== ========= =====
REVENUE
Total revenue, including the effects of the Write-Down for fiscal 1999,
was $(16 million), as compared to $266 million in fiscal 1998. Fiscal 1998's
total revenue increased $52 million, or 24.2%, from total revenue of $214
million for fiscal 1997. Total revenues include the Write-Down, net of a
positive valuation adjustment of $5.2 million recorded in the quarter ended
September 30, 1998 in connection with the Company's securitization, a $19
million net unrealized gain and a $19 million net unrealized loss (see below) on
valuation of the Company's interest-only strips for the fiscal years ended June
30, 1999, 1998 and 1997, respectively. The Write-Down reflected the impact of
negative market conditions that existed in the quarter ended December 31,
29
30
1998 on the prepayment, loss and discount rate assumptions applied by the
Company in estimating the fair value of its interest-only strips. See "- Certain
Accounting Considerations -- Accounting for Securitizations."
Revenues for the fiscal year ended June 30, 1999 (excluding the
Write-Down) were $170 million, a 36% decrease from 1998. The decrease in total
revenue during fiscal year 1999 from the amount reported in fiscal year 1998
primarily reflects the Company's reliance on whole loan sales for cash during
the last three fiscal quarters of 1999. Gains associated with whole loans for
cash are generally lower than those recognized when such loans are securitized.
This disparity was exacerbated during the second fiscal quarter as a consequence
of the over-supply of product for sale in the marketplace due to weaknesses in
the asset-backed market during the same period, as well as the Company's limited
warehouse capacity during the quarter which necessitated the expedited sale of
loans. This continued during the March 31, 1999 quarter and part of the June 30,
1999 quarter as substantially all of the whole loan sales were closed under a
forward commitment entered into in the prior quarter when whole loan prices were
at their lowest level. During the quarter ended December 31, 1998, the Company
entered into the mandatory forward commitment to sell $500 million, subsequently
amended to $750 million, of loans. The commitment, which expired in May 1999,
reflected the lower whole loan prices that existed during the quarter. During
the fourth fiscal quarter of 1999, the Company entered into a new mandatory
forward commitment to sell loans. The pricing formula in the new commitment
reflects the improved market conditions in the fourth fiscal quarter. Terms of
the new forward commitment, which expires on May 16, 2000, include provisions
for the Company to sell a minimum of $500 million and a maximum of $1.50 billion
of loans to the purchaser on a servicing released basis. At June 30, 1999, the
Company had fulfilled approximately $80 million of loans held for sale under
this commitment.
Further contributing to the results for the fiscal year ended June 30,
1999 was the decrease in total loan production, from $2.38 billion during 1998
to $2.19 billion during 1999. The decrease in total revenue during the 1999
fiscal year also reflects the lower gains on sale resulting from hedge losses
and lower than historical spreads on the Company's $650 million securitization
closed in the quarter ended September 30, 1998. In addition, the Company did not
complete a securitization in the last three quarters of fiscal year 1999, and it
did not dispose of all loans produced in the whole loan market in anticipation
of the August 1999 securitization. This increase in loans held for sale further
reduced gain on sale revenue.
During the first fiscal quarter, the Company, as it had historically,
hedged its fixed rate pipeline by purchasing hedges against U.S. Treasuries. In
the past, changes in Treasury rates were generally reflected in the pass-through
rates of the fixed rate portion of the Company's securitization. During fiscal
1999's first quarter, unsettled market conditions resulted in a $15 million loss
on the Company's hedge position without an equivalent benefit from reductions in
the pass-through rate paid on certificates sold in the fixed rate portion of the
Company's securitization.
The increase in total revenue from the year ended June 30, 1997 to the
year ended June 30, 1998 was primarily due to an increase in net gain (loss) on
valuation of interest-only strips and the increase in loan service revenue,
offset by a decline in gain on sale of loans. The net loss on valuation of
interest-only strips during the year ended June 30, 1997 was due primarily to
the $28 million net unrealized loss on its interest-only strips recorded by the
Company in the fourth quarter of fiscal 1997. This unrealized loss was due
primarily to an increase in prepayment rates in certain of the Company's
adjustable rate loans in some of its earlier pools. Increased loan service
revenues during the year ended June 30, 1998 were a result of the continued
growth in the
30
31
Company's servicing portfolio and the successful transfer in-house of $1.47
billion of mortgage loans previously subserviced by others.
Gain on sale, net of gain or loss on valuation of interest-only strips
for the fiscal year ended 1999 was $(142 million), as compared to $140 million
for the fiscal year ended 1998. Net gain (loss) on valuation of interest-only
strips and mortgage servicing rights for the fiscal year ended June 30, 1999
primarily reflects the impact of the Write-Down recorded in the quarter ended
December 31, 1998. The Company determines the fair value of the interest-only
strips by applying certain assumptions as to prepayments, losses and discount
rate to the future cash flows from prior securitizations. The negative market
conditions that existed during the quarter, as well as the performance of the
Company's pools of securitized loans, caused management to adjust these
assumptions which resulted in the Write-Down. See "- Certain Accounting
Considerations - Accounting for Securitizations." Gain on sale for the fiscal
year ended 1999 also reflects the Company's reliance primarily on the whole loan
market for its loan disposition strategy. During the fiscal year ended 1998, the
Company relied almost completely on the securitization market for its loan
disposition strategy. The gains associated with the whole loan sales were
substantially less than the gains associated with the earlier year's
securitizations. Gain on sale in fiscal year 1999 was also adversely affected by
the $14 million hedge loss recorded in the period. (See above.) Although market
conditions have recently improved, asset-backed market participants, whole loan
purchasers and the Company's warehouse lenders continue to impose more
restrictions on the Company's loan production than was the case prior to the
onset of the adverse market conditions in October 1998. These restrictions may
adversely affect the gain on sale recorded by the Company in the securitization
and whole loan market, and may require the Company to fund certain loans with
equity. The Company did complete a securitization in August 1999. The gain on
sale recognized was lower than historical gains due to market conditions at the
time of the securitization, higher margins paid by the Company on the
certificates issued by the securitization trust and the Company's adoption of
the revised assumptions during the quarter ended December 31, 1998.
Gain on sale, net of gain or loss on valuation of interest-only strips,
increased by $24 million, or 20.5% in fiscal 1998 compared to fiscal 1997. The
increase in fiscal 1998 over fiscal 1997 was primarily due to the net loss on
valuation on interest-only strips recorded in fiscal 1997. Fiscal 1998's gain on
sale, net of gain or loss on valuation of interest-only strips, as compared to
fiscal 1997's, reflects gains recorded on substantially the same total volumes
of loan production but with a larger percentage of the volume comprised of more
profitable retail and broker loan production as opposed to less profitable bulk
correspondent loan production. Premiums paid on the purchase of correspondent
loans are recorded as an offset to gain on sale. Total loan production for
fiscal 1998 was $2.38 billion. See "Item 1. Business - Mortgage Loan
Production." However, the 1998 gains reflect the lower gain on sale recorded on
whole loan sales closed during the 1998 fiscal year. Generally, the gain
recorded in a whole loan sale is less than that recorded in a securitization.
During fiscal 1998, the Company sold a total of $2.45 billion of loans, $2.03
billion of which was sold in securitization transactions and $416 million of
which was sold in whole loan sales for cash. During fiscal 1997, the Company
sold a total of $2.27 billion of loans, substantially all of which were sold in
securitization transactions. Further, gains recorded on loans securitized in
fiscal 1998 were negatively affected by reduced spreads and increased prepayment
rate assumptions established in the fourth fiscal quarter of 1997. 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% and 4.16% for fiscal 1998 and 1997, respectively. The
decreased weighted average servicing spread reflects a decrease in weighted
average interest rates on pooled loans due primarily to the higher percentage of
higher credit
31
32
grade loans included in the loans securitized during the year and the then
current interest rate environment. The larger percentage of higher credit grade
loans included in the loans securitized during fiscal 1998 and 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.
Commissions earned on loan originations continue to be an important
component of total revenue comprising 19.4%, 10.4% and 13.6% of total revenue in
fiscal 1999 (excluding the Write-Down), 1998 and 1997, respectively. Commissions
increased $5.4 million, or 19.4%, in fiscal year 1999 compared to fiscal year
1998 and decreased $1.6 million, or 5.4%, in fiscal year 1998 compared to fiscal
1997. Commission revenue is primarily a function of the volume of mortgage loans
originated by the Company through its retail loan office network, the credit
grade of the loans originated and the weighted average commission rate charged
on such loans. The increase in fiscal 1999 reflects higher retail loan
origination volume primarily in the Company's decentralized retail loan
origination channel. The decrease in fiscal 1998 reflects the lower weighted
average commission rate charged. The weighted average commission rate was 4.1%,
4.3% and 4.9% during fiscal 1999, 1998 and 1997, respectively. The lower
weighted average commission rate in fiscal 1998 and fiscal 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 and commission rates do not include $3.2
million, $2.7 million and $1.2 million of commissions on loans which were held
for sale as of June 30, 1999, 1998 and 1997, respectively and deferred in
accordance with generally accepted accounting principles.
Loan servicing revenue for the fiscal year ended June 30, 1999 amounted
to $50 million as compared to $52 million in fiscal 1998 and $31 million in
fiscal 1997. Loan servicing 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, increased by the accretion of the
interest-only strips and reduced by the amortization of the MSRs. See "- Certain
Accounting Considerations." Future loan servicing revenue will be negatively
impacted by the costs associated with the arrangement the Company entered into
to reduce servicing advances on pre-1999 securitization trusts. See "Item 1.
Business - Loan Servicing."
The Company's loan servicing portfolio at June 30, 1999 declined 7.4%,
or approximately $306 million, from the $4.15 billion reported at June 30, 1998
reflecting the Company's recent reliance on whole loan sales with servicing
released. In April 1999, the Company entered into a subservicing arrangement
with a loan servicing company with respect to two pools containing an aggregate
of $388 million in principal amount of loans. The loan servicing company agreed
to make future servicing advances on the loans included in the two pools. The
Company entered into the subservicing arrangement primarily to reduce the burden
of making servicing advances on the loans in the two pools. The growth of the
Company's servicing portfolio will be negatively impacted by the Company's
reliance on sales of whole loans on a servicing released basis and subservicing
arrangements. Nevertheless, 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. See "- Risk Factors -- Our
Right to Service Loans May be Terminated Because of the High Delinquencies and
Losses on the Loans in Our Servicing Portfolio."
Loan service revenue increased $21 million, or 65.9% in fiscal 1998
compared to fiscal 1997. The increase in loan service revenue in fiscal 1998
primarily reflects the successful transfer of $1.47 billion of loans previously
subserviced by third parties and, to a lesser extent, interest-only strip
accretion offset by amortization of the Company's MSRs. As of June
32
33
30, 1998, of the Company's $4.15 billion servicing portfolio, 95% was serviced
in-house. At June 30, 1997, 47% of the Company's $3.17 billion servicing
portfolio was serviced in-house.
Interest income and fees, which consist of interest earned on loans held
for sale and fees received by the Company through its retail loan office network
in the form of closing, appraisal, underwriting and other fees, for 1999
decreased 9.3% to $43 million from $47 million during 1998. The dollar amount of
interest income and fees decreased during 1999 from 1998 primarily due to
interest earned on lower amounts of loans held by the Company during the period
from origination or purchase of the loans until the date sold by the Company,
offset by increasing weighted average interest rates on loans held. Interest
income should continue to decline so long as the Company uses whole loan sales
which decreases the average number of days loans are held by the Company prior
to sale.
Interest income and fees increased by $9.2 million, or 24.4%, in fiscal
1998 compared to fiscal 1997. The dollar amount of the fees increased due to the
larger number of mortgage loans originated through the Company's retail loan
office network during the respective periods. Interest income increased during
the period 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, offset by declining weighted average interest rates on loans
held.
EXPENSES
Compensation expense for the fiscal year ended June 30, 1999 decreased
15.5% from $95 million for 1998 to $80 million for 1999. This decrease was
primarily due to the Company's reduction in force in February 1999, a decrease
in compensation incentives as a consequence of the decline in loan origination
during 1999 and a significant reduction in incentive compensation due to the
Company's results of operations. During 1999, compensation as a percentage of
loan originations and purchases declined to 3.6% from the 4.0% reported for
1998. The decline is due to the decrease in compensation expense during 1999
from 1998 offset by a decrease in total origination volume in 1999 from levels
reported during 1998. In mid-February, 1999 and subsequent to the Initial
Closing, management commenced a cost savings program designed to reduce the
Company's operating expenses. The implementation of this recent cost savings
plan included personnel reductions on a Company-wide basis. The effects of these
reductions are expected to reduce compensation costs on an annualized basis in a
pre-tax amount of approximately $6.7 million. Severance costs of approximately
$500 thousand were recognized in the fiscal year ended June 30, 1999.
Compensation and related expenses increased $14 million, or 17%, in fiscal 1998
compared to fiscal 1997. The increases were primarily due to the continued
effort to accommodate increased origination volumes, core origination channel
expansion and increased in-house servicing. Compensation and related expenses as
a percentage of total loan originations and purchases was 3.5% for fiscal 1997.
Additionally, in fiscal 1999, the Company deferred $5.6 million for the direct
expenses of loans originated but not yet sold primarily due to the higher amount
of loans held for sale at June 30, 1999. The higher amount reflects the
Company's decision to delay its securitization until August 1999.
Production expense, primarily advertising, outside appraisal costs,
travel and entertainment, and credit reporting fees, increased 17.2% to $40
million during 1999, from $34 million last year. The increase in total
production expense primarily reflects a rise in advertising and the additional
cost of outsourcing appraisal services offset by a decline in travel and
entertainment costs. Production expenses increased $7.0 million, or 25.6%, in
fiscal 1998 compared to fiscal 1997. This increase was primarily due to
increased origination volume and continued expansion into new geographical areas
requiring concentrated marketing efforts. Production costs as a percentage of
total origination volume were 1.8%, 1.4% and 1.2% for fiscal 1999, 1998 and
1997, respectively. The increase in the
33
34
percentage of production costs to total loan originations and purchases for 1999
is due to the decline in the level of loan originations and purchases.
General and administrative expenses increased $20 million, or 49.0% in
fiscal 1999 over fiscal 1998. General and administrative expenses in fiscal 1998
increased $9.0 million or 28.3%, over fiscal 1997. These increases were
primarily the result of increased occupancy and communication costs related to
the Company's core origination channel expansion, and increases in legal and
other professional costs related primarily to the negotiation and closing of the
Preferred Stock Purchase Agreement. As part of the costs savings program
implemented in the quarter ended March 31, 1999, the Company ceased activities
in certain retail and broker branches that were deemed unprofitable by
management. The office space for such branches remains subject to operating
leases that management is attempting to sublease or terminate. The Company is
also attempting to sublet significant space at its headquarter office located at
350 South Grand Avenue in downtown Los Angeles. If such office space is
subleased at lease rates less than existing base lease terms or if the lease
commitments are bought out as a consequence of a negotiated lease termination,
the Company could incur a significant one-time charge.
Interest expense during 1999 remained constant over fiscal 1998.
Interest expense increased in fiscal 1998 to $43.9 million from $33.1 million in
fiscal 1997. This 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 or 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 external financing to fund operations.
During the fiscal year ended June 30, 1999, the Company recorded a $37
million nonrecurring charge related to the Company's servicing advances which
are recorded as accounts receivable on the Company's balance sheet. The
nonrecurring charge relates to payments made by the Company to the
securitization trusts for which it acts as servicer. As servicer of the loans it
securitizes, the Company is obligated to advance, or "loan," to the trusts
delinquent interest. In addition, as servicer, the Company advances to the
trusts foreclosure-related expenses and certain tax and insurance remittances
relating to loans in securitized pools. The Company, as servicer, is then
entitled to recover these advances from regular monthly cash flows into the
trusts, including monthly payments, pay-offs and liquidation proceeds on the
related loan. Until recovered, the Company records the cumulative advances as
accounts receivable on the balance sheet. In addition, the Company, as servicer,
is obligated to make additional payments into the trusts which are not
recoverable from monthly cash flows. These payments, for example, relate to
compensating interest payments for loans that pay-off other than at a month's
end. As servicer, the Company is required to pay into the trust that portion of
a monthly interest payment that is not included in the pay-off amount. However,
payments into a trust that are not recovered from monthly cash flows may be
recoverable from the trust's distributions to the Company, as residual
certificate holder.
In early 1999, the Company began to explore ways to reduce the cash
burden of its servicing advance obligations through various financing
techniques. At the same time, the Company determined that certain amounts
recorded as accounts receivable associated with the Company's securitization
trusts were not recoverable from the trusts' monthly cash flows. As a result,
accounts receivable were written-down by $37 million. This write-down represents
the nonrecurring charge. See "- Liquidity."
34
35
In fiscal 1997, the Company incurred $32 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 relocating corporate headquarters recorded in the first
quarter and to severance and other strategic decisions made in the fourth
quarter.
INCOME TAXES
During the fiscal year ended June 30, 1999, the Company recorded an
estimated tax benefit of $30.2 million due to its net operating losses during
the year. The income tax benefit for the 1999 fiscal year reflects an effective
rate of (10.9%) and is net of tax valuation adjustments recorded to account for
estimated nonrealizable deferred tax assets. The investment in the Company by
Capital Z results in a change in control for income tax purposes thereby
limiting the Company's ability to use future net operating loss carryforwards
and certain other future deductions. The Company's provision for income taxes
increased to $25 million in fiscal 1998 from $8.0 million in fiscal 1997,
primarily as a result of the fluctuation in pre-tax income after consideration
of tax impact of nonrecurring charges. The effective tax rate declined to 47.8%
in fiscal 1998 from 84.4% in fiscal 1997 as a result of an adjustment in the
Company's tax reserve to more accurately reflect the risk of assessments on
previously filed tax returns.
FINANCIAL CONDITION
Loans Held for Sale. The Company's portfolio of loans held for sale
increased to $559.9 million at June 30, 1999, from $198 million at June 30,
1998. This substantial increase was due to the Company's decision to postpone
its securitization until August 1999.
Accounts Receivable. Accounts receivable, representing servicing fees,
advances, other receivables and accrued capital proceeds receivable, increased
to $57 million at June 30, 1999, from $51 million at June 30, 1998. The increase
reflects the accrual of capital proceeds received in the Additional Investment
which were recorded by the Company at June 30, 1999 and subsequently received in
August 1999, net of the sale of accounts receivable in June 1999. See "-
Liquidity" and "- Capital Resources." Otherwise, the level of servicing related
advances, in any given period, is dependent on portfolio delinquencies, the
levels of REO and loans in the process of foreclosure and the timing of cash
collections.
Interest-Only Strips. Interest-only strips were $332 million at June 30,
1999 compared to $491 million at June 30, 1998 reflecting the Write-Down in the
December quarter, offset by the non-cash gain recognized on the Company's
securitization in the quarter ended September 30, 1998, net of accretion and
amortization.
Mortgage Servicing Rights, net. Mortgage servicing rights, net were $21
million at June 30, 1999 compared to $32 million at June 30, 1998 reflecting the
charge-off of mortgage servicing rights resulting from the Company outsourcing
certain loan servicing to subservicers, the capitalization of mortgage servicing
rights on the securitization in the quarter ended September 30, 1998, net of
amortization.
Equipment and Improvements, net. Equipment and improvements, net,
decreased slightly to $13 million at June 30, 1999 from $14 million at June 30,
1998.
Prepaid and Other Assets. Prepaid and other assets decreased to $15
million at June 30, 1999 from $17 million at June 30, 1998.
35
36
Income Tax Refund Receivable. At June 30, 1999, the Company had a state
income tax refund receivable in the amount of $1.7 million which was received
subsequent to year-end.
Borrowings. Borrowings at June 30, 1999 decreased to $281.2 million from
$287.0 million at June 30, 1998 and reflects the scheduled $5.8 million
principal reduction to the Company's 10.5% Senior Notes.
Revolving Warehouse and Repurchase Facilities. Amounts outstanding under
warehouse and repurchase facilities increased to $536 million at June 30, 1999
from $141 million at June 30, 1998, primarily as a result of the increase in
mortgage loans held for sale and from the negative cash flow from operations
during the 1999 fiscal year, and the resulting decrease in equity capital. At
June 30, 1999, the Company was holding mortgages for sale in anticipation of
closing a securitization during the summer. The Company completed a
securitization of approximately $400 million of mortgage loans in August 1999.
Proceeds from the Company's whole loan sales and securitizations are used to pay
down the Company's warehouse and repurchase facilities.
LIQUIDITY
The Company's operations require continued access to short-term and
long-term sources of cash. The Company's primary operating cash requirements
include the funding of: (i) mortgage loan originations and purchases prior to
their securitization or sale, (ii) fees, expenses and hedging costs, if any,
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 non-cash gain on sale other than in a debt-for-tax securitization structure,
(v) ongoing administrative and other operating expenses, (vi) interest and
principal payments under the Company's warehouse credit facilities and other
existing indebtedness, (vii) advances in connection with the Company's servicing
portfolio, and (viii) costs associated with expanding the Company's core
production units.
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
deterioration of the credit and capital markets severely restricted the
Company's access to these markets during the second and third fiscal quarters
until the Initial Closing on February 10, 1999. The $76.5 million ($67.4 million
net of issuance expenses) in equity capital from the Initial Investment
augmented the Company's negative operating cash until additional working capital
facilities were established. On February 10, 1999, the Company entered into a
$300 million committed repurchase facility and a $100 million (subsequently
reduced to $90 million) committed warehouse line provided from two separate
counterparties. The committed warehouse line also includes a $100 million
uncommitted warehouse facility. The repurchase facility and the warehouse
facility expire on March 31, 2000 and February 9, 2000, respectively. On April
8, 1999, the Company obtained an additional $175 million committed repurchase
facility, which was subsequently increased to $200 million when a $25 million
working capital facility with the same lender was paid off. (See below.) On
April 8, 1999, the Company's pre-existing $300 million syndicated warehouse
facility which had included a working capital sublimit expired.
The Company has historically relied on working capital lines to help it
fund its servicing advance obligations. See "- Expenses." Certain of the
warehouse and repurchase facilities require the Company to obtain an additional
working capital facility. In September 1998, the Company entered into a
revolving line of credit with a maximum borrowing capacity of $50 million
secured by certain of the Company's interest-only strips. Access to this line
originally depended upon the
36
37
Company completing a new securitization and pledging the related interest-only
strips. However, during each of the months of December 1998 and January and
February 1999, the lender allowed the Company to borrow $20 million on a
short-term basis to satisfy the Company's obligation as servicer of the loans it
securitizes to advance interest on delinquent loans. On April 9, 1999, this line
was amended to provide for a maximum borrowing capacity of $25 million secured
by certain of the Company's interest-only strips and certain of its servicing
receivables. This satisfied the working capital requirements of the warehouse
and repurchase facilities. This line was paid off and terminated in June 1999
with the proceeds from the Company's sale of servicing advances. The facility
established in June 1999 also satisfied the working capital requirements of the
warehouse and repurchase facilities. See "- Capital Resources."
In April 1999, the Company reduced its servicing advance obligations by
engaging a loan servicing company to subservice two of the Company's
securitization trusts. Further, the loan service company assumed the obligations
to make all future advances on those two trusts. The Company also sold to the
loan servicing company the outstanding servicing advances on those two trusts
for approximately $13 million. In June 1999, the Company entered into an
arrangement with an investment bank pursuant to which the bank purchased certain
cumulative advances and undertook the obligation to make a substantial portion
of the Company's advance obligations on its pre-1999 securitization trusts. As a
result of this arrangement, the Company received approximately $50 million for
certain servicing advances carried on its books. Part of these proceeds were
used to pay off the Company's existing working capital line.
Under the terms of the Company's Indenture, dated October 21, 1996 with
respect to its 9.125% Senior Notes due 2003, the Company's ability to incur
certain additional indebtedness, including residual financing, is limited to two
times adjusted stockholders' equity. Warehouse indebtedness is not included in
the indebtedness limitations. The Company's new repurchase and warehouse
facilities contain similar limits on the Company's ability to incur additional
indebtedness. Further, until the Company receives investment grade ratings for
the notes issued under the Indenture, the amount of residual and servicing
advance financing the Company may incur on such assets allocable to
post-September 1996 securitizations is limited to 75% of the difference between
such post-September 1996 residuals and servicing advances and $225 million.
Although the Company's loan disposition strategy consists of a
combination of securitizations and whole loan sales, whole loan sales were the
sole disposition method during the last three fiscal quarters of 1999. The
Company did complete a securitization in August 1999. The gain on sale
recognized was lower than historical gains due to market conditions at the time
of the securitization, higher margins paid by the Company on the certificates
issued by the securitization trust and the Company's adoption of the revised
assumptions during the quarter ended December 31, 1998. See "- Certain
Accounting Considerations -- Accounting for Securitizations." During fiscal
1999, 1998 and 1997, the Company securitized $650 million, $2.03 billion and
$2.26 billion of loans, 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. Overcollaterization requirements increase up to
approximately twice the level otherwise required when the delinquency rates
exceed the specified limit. As of June 30, 1999, the Company was required to
maintain an additional $89 million in overcollateralization amounts as a result
of the level of its delinquency rates
37
38
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, 1999, $48 million remains to be added to the overcollateralization amounts
from future spread income on the loans held by these trusts.
In the Company's securitizations structured as a REMIC, the recognition
of non-cash gain on sale has 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.
The Company's primary sources of liquidity are expected to be cash from
the Rights Offering, fundings under warehouse and repurchase facilities, whole
loan sales and the monetization of the Company's servicing advances.
The Company had originally anticipated that the Rights Offering would be
completed in the quarter ending June 30, 1999. However, the Company was delayed
in making the required filings with the Securities and Exchange Commission
pending completion of the restatement of its financial statements. See "-
Certain Accounting Considerations." Further, the closing of the Rights Offering
is subject to receiving stockholder approval of the Recapitalization at a
stockholders' meeting scheduled for September 13, 1999. Subject to receiving the
requisite stockholder approval, the Company currently expects the Rights
Offering to be completed in September 1999.
Under one of the Company's repurchase lines, the Company is required to
have cash and cash equivalents on and after October 1, 1999 of $15 million. It
is possible that if the Rights Offering does not close prior to that date, the
Company will not be able to maintain compliance with that covenant and would be
in default under the repurchase line. The Company believes that the Rights
Offering will be closed by that date, subject to receiving stockholder approval
of the Recapitalization at the stockholders' meeting scheduled for September 13,
1999. However, the Company has requested the necessary waiver from the lender
and expects that the waiver will be forthcoming.
The Company's primary and potential sources of liquidity as described
above (assuming continued access to working capital financing, completion of the
Rights Offering, access to the securitization and whole loan markets, and
implementation of the cash savings plans which by no means can be assured) 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. If the Company's access to
working capital or the securitization or whole loan markets is restricted, or
the cash savings are not realized, the Company may have to seek additional
equity. Further, if available at all, the type, timing and terms of 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. See "- Capital Resources --
Warehouse, Repurchase and Working Capital Facilities." There can be no assurance
that any such sources will be available to the Company at any given time or that
favorable terms will be available. As a result of the limitations described
above, the Company may be restricted in the amount of loans that it will be able
to produce and dispose of.
CAPITAL RESOURCES
The Company has historically financed its operating cash requirements
primarily through (i) warehouse and repurchase facilities and working capital
lines of credit, (ii) the securitization and sale of mortgage loans, and (iii)
the issuance of debt and equity securities.
38
39
Warehouse, Repurchase and Working Capital Facilities. Through February
10, 1999, the Company retained access to warehouse and other credit facilities
with borrowing limits aggregating in excess of $1.0 billion. Changes in advance
rates imposed by lenders effectively limited the Company to a single $300
million committed warehouse line. The warehouse line included a working capital
line of credit with a syndicate of ten commercial banks. This facility was
secured by loans originated and purchased by the Company, as well as certain
servicing receivables. This line expired on April 8, 1999.
On February 10, 1999, and conditioned upon the Initial Closing
occurring, the Company entered into a $100 million (subsequently reduced to $90
million) committed warehouse facility and a $300 million committed repurchase
facility and one uncommitted warehouse facility in the amount of $100 million.
These facilities are each secured by the Company's home equity mortgage loans.
One of the committed facilities, in the amount of $300 million, bears interest
at rates of from 1.50% to 2.00% over one month LIBOR depending upon selected
sublimits under the facility and expires on March 31, 2000. The other committed
facility in the amount of $90 million bears interest at a rate of 1.50% over one
month LIBOR and expires on February 9, 2000. The $100 million uncommitted
facility bears interest at 1.50% over one month LIBOR and expires on February 9,
2000. On April 8, 1999, the Company entered into a second committed repurchase
facility in the amount of $175 million, which was subsequently increased to $200
million. This facility is secured by the Company's home equity mortgage loans,
bears interest at a rate of from 1.25% to 1.50% over one month LIBOR depending
on selected submits, and expires on April 7, 2000. If the Company is unable to
maintain existing warehouse or repurchase lines, it would have to cease loan
production operations which would negatively impact profitability and jeopardize
the Company's ability to continue to operate as a going concern.
In September 1998, the Company entered into a revolving line of credit
with a maximum borrowing capacity of $50 million secured by certain of the
Company's interest-only strips. Access to this line originally depended upon the
Company completing a new securitization and pledging the related interest-only
strips. However, during each of the months of December 1998 and January and
February 1999, the lender allowed the Company to borrow $20 million on a
short-term basis to satisfy the Company's obligation as servicer of the loans it
securitizes to advance interest on delinquent loans. On April 9, 1999, this line
was amended to provide for a maximum borrowing capacity of $25 million secured
by certain of the Company's interest-only strips and certain of its servicing
receivables. This line was paid off and terminated in June 1999 with the
proceeds from the Company's sale of servicing advances. See "- Liquidity."
Loan Sales. The Company's ability to sell loans originated and purchased
by it in the secondary market is necessary to generate cash proceeds to pay down
its warehouse and repurchase facilities and fund new originations and purchases.
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. See"- Risk Factors -- A Prolonged Interruption or Reduction
in the Secondary Market Would Hurt Our Financial Performance."
Other Capital Resources. The Company has historically funded negative
cash flow primarily from the sale of its equity and debt securities. However,
current market conditions have restricted the Company's ability to access its
traditional public equity and debt sources. In December 1991, July 1993, June
1995, October 1996 and April 1998, the Company effected public offerings of its
common stock with net proceeds to the Company aggregating $217 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%
39
40
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. At June 30, 1999, under the most restrictive of such covenants, the
Company had no money available for the payment of such distributions and does
not expect to have the ability to pay dividends for the foreseeable future.
On April 27, 1998, the Company issued 2.78 million shares of its common
stock, or 9.9% of the Company's outstanding shares, to private entities
controlled by Ronald Perelman and Gerald Ford, at an aggregate purchase price of
approximately $38 million. The Company also issued warrants to these entities to
purchase an aggregate additional 6.3 million shares (as adjusted) of the
Company's common stock at an exercise price of $7.67 (as adjusted), subject to
customary anti-dilution provisions. The warrants are exercisable only upon a
change in control of the Company and expire in three years from issuance.
During the fiscal year ended June 30, 1999, the Company raised an
additional $76.8 million ($67.4 million net of issuance expenses) in the Initial
Investment by Capital Z. In August 1999, Capital Z (through a partnership
majority-owned by it) invested an additional $25 million in the Company. Net of
costs of issuance, the additional proceeds to the Company were $24.8 million and
were accrued at June 30, 1999. Subject to receiving stockholder approval of the
Recapitalization, the Company will close the Rights Offering. If less than 25
million shares of Series C Convertible Preferred Stock are purchased in the
Rights Offering, Capital Z has agreed to purchase the difference (up to 25
million shares of the Series C Preferred Stock) for $1.00 per share.
If the Company's stockholders do not adopt the amendments before the
earlier of September 30, 1999 or September 13, 1999, the date of the scheduled
stockholders' meeting (if, in the latter case, any of the proposed amendments to
the Certificate of Incorporation is defeated at the meeting), the dividend rate
on the Series B and Series C Convertible Preferred Stock held by Capital Z will
increase from 6.5% to 15% per annum and Capital Z will be able to exercise a
warrant to purchase up to 3,000,000 additional shares of common stock at an
exercise price of $1.00 per share.
The Company had cash and cash equivalents of approximately $21 million
at June 30, 1999. See "- Risk Factors -- If Outside Sources of Cash are Not
Sufficient, Our Ability to Make and Service Loans will be Impaired and Our
Revenues will Suffer."
YEAR 2000 COMPLIANCE AND TECHNOLOGICAL ENHANCEMENT
Readers are cautioned that forward-looking statements contained in this
Year 2000 disclosure should be read in conjunction with the Company's
disclosures under the heading, "Special Note on Forward-looking Statements,"
beginning on page 23 above. Readers should understand that the dates on which
the Company believes the Year 2000 project will be completed are based upon
management's best estimates, which were derived utilizing numerous assumptions
of future events, including the availability of certain resources, third-party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved, or that there will not be a delay in, or
increased costs associated with, the implementation of the Company's Year 2000
Compliance Project. A delay in specific factors that might cause differences
between the estimates and actual results include, but are not limited to, the
availability and cost of personnel trained in these areas, the ability of
locating and correcting all relevant computer codes, timely responses to and
corrections by third parties and suppliers, the ability to implement interfaces
between the new systems
40
41
and the systems not being replaced, and similar uncertainties. Due to the
general uncertainty inherent in the Year 2000 problem, resulting in part from
the uncertainty of the Year 2000 readiness of third parties and the
inter-connection of national and international businesses, the Company cannot
ensure its ability to timely and cost effectively resolve problems associated
with the Year 2000 issue that may effect its operations and business, or expose
it to third party liability.
The Company's Year 2000 compliance program consists of four
phases--inventory, risk assessment process, corrective action and testing. The
Company has completed the inventory phase which included the identification of
all computer hardware and software, electronic data exchanges, operating
systems, communications systems and non-information items. As a corollary to the
inventory phase, the Company has made inquiries of its significant vendors as to
their Year 2000 readiness.
The Company has also completed the risk assessment process of assigning
risk factors to each system used by the Company to determine the priority and
resource allocation of its Year 2000 efforts. The Company expects to complete
the corrective action and testing phases with respect to mission critical
systems by September 30, 1999. The Company will complete any remaining testing
and compliance by the end of 1999.
Costs to Address the Company's Year 2000 Issues. The Company anticipates
that costs relating to Year 2000 issues are not expected to be material since
the Company primarily relies on third party software for its primary information
technology systems and does not require significant internal reprogramming
resources to change program codes. The Company has partially converted and is
scheduled to complete the conversion of its major computer systems, including
the loan origination system and the financial system from in-house to
vendor-supported systems. These conversions were planned to upgrade and improve
functionality rather than as a result of Year 2000 issues.
Risks of the Company's Year 2000 Issues. The most significant risk
associated with the Company's Year 2000 compliance would result from the loss of
the Company's vendor supported servicing system and the inability to maintain
the ongoing loan service operations, including payment processing, collections
and investor remittance processing. The Company's servicing platform uses
software supplied by a subsidiary of Fiserv, Inc. To reduce the risk of
non-compliance, the Company intends to rely on the vendor's representations
regarding Year 2000 compliance, the Company's testing efforts, as well as the
testing results of other companies that use the same software. The testing and
other costs relating to the Company's Year 2000 compliance program are not
expected to be material.
Another Year 2000 risk relates to the Company's vendor supported loan
origination system. In the event of Year 2000 issues with respect to the
software used with such system (also supplied by a subsidiary of Fiserv, Inc.),
the Company's ability to originate loans would be diminished and may result in
reduced loan production until the problem is resolved. The Company intends to
rely on the vendor's assurances and Company testing to minimize the risk of
non-compliance of this system.
Contingency Plans. The Company has no reason to believe that its most
significant systems will not be Year 2000 compliant. If testing indicates any of
the systems are not compliant, the Company will develop appropriate contingency
plans.
41
42
RISK MANAGEMENT
The Company is currently re-evaluating its current hedging policy, and
at June 30, 1999 had no hedge transactions in place. While the Company monitors
the interest rate environment and has employed 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.
FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET ACTIVITIES
Sale of Loans - Securitizations and Whole Loan Sales - Interest Rate
Risk. The most significant variable in the determination of gain on sale in a
securitization is the spread between the weighted average coupon on the
securitized loans and the pass-through interest rate. In the interim period
between loan origination or purchase and securitization of such loans, the
Company is exposed to interest rate risk. The majority of loans are securitized
within 90 days of origination or purchase. However, a portion of the loans are
held for sale or securitization for as long as 12 months (or longer, in very
limited circumstances) prior to securitization or sale. If interest rates rise
during the period that the mortgage loans are held, the spread between the
weighted average interest rate on the loans to be securitized and the
pass-through interest rates on the securities to be sold (the latter having
increased as a result of market rate movements) would narrow. Upon
securitization, this would result in a reduction of the Company's related gain
on sale. The Company is also exposed to rising interest rates for loans
originated or purchased which are held pending sale in the whole loan market. In
the past, the Company mitigated exposure to rising interest rates through swap
agreements with third parties that sell United States Treasury securities not
yet purchased and the purchase of Treasury Put Options. Hedge gains or losses
are initially deferred and subsequently included in gain on sale upon completion
of the securitization or whole loan sale. With respect to the Company's
securitizations, gain on sale included hedge losses of $13.5 million and $1.30
million in fiscal 1999 and 1998, respectively. These hedging activities help
mitigate the risk of absolute movements in interest rates but they do not
mitigate the risk of a widening in the spreads between pass-through certificates
and U.S. Treasury securities with comparable maturities.
At June 30, 1999, the Company did not have any hedge transactions in
place. At June 30, 1998, the Company had outstanding notional balances of
Treasury swap agreements in the amount of $250 million. This position expired on
September 30, 1998 and had a market value at June 30, 1998 of $248 million. The
Company had a similar position at June 30, 1997 in the notional amount of $135
million. This position expired on September 30, 1997 and had a market value at
June 30, 1997 of $135 million. These transactions were subject to Treasury
interest rate fluctuation and required cash settlement at expiration or
voluntary termination.
The Company also had LIBOR cap contracts outstanding at June 30, 1998
and 1997 in the notional amount of $17.5 million and $106 million, respectively.
These positions were valued at par at both fiscal year ends as their contractual
cap (strike price) exceeded the LIBOR market rate at June 30, 1998 and 1997. The
June 30, 1998 position expired December 23, 1998 and the June 30, 1997 position
had expiration dates from March 30, 1998 to December 23, 1998. These instruments
had no negative risk above the original premiums paid in cash.
42
43
2000 2001 2002 2003 2004 Thereafter Total Fair Value
------ ------ ------ ------ ------ ------ ------- -------
(Dollars in thousands)
RATE SENSITIVE ASSETS:
Loans held for sale:
Fixed rate mortgage loan $ 48,902 77,550 61,407 43,657 30,892 73,513 335,921 $345,707
Weighted average rate 10.48% 10.48 10.48 10.48 10.48 10.48 10.48
Variable rate mortgage loan $ 41,922 54,747 57,559 17,170 12,972 39,578 223,948 $230,471
Weighted average rate 10.35% 10.35 11.83 11.83 11.83 11.83 10.35
RATE SENSITIVE LIABILITIES
Borrowings:
Fixed rate $ 5,750 5,750 5,750 -- 150,000 113,970 281,220 $171,888
Weighted average rate 7.68% 7.62 7.56 7.56 5.50 5.50 7.74
Variable rate $535,997 -- -- -- -- -- 535,997 $535,997
Weighted average rate 6.39% -- -- -- -- 6.39
RATE SENSITIVE
DERIVATIVE FINANCIAL
INSTRUMENTS
None
Interest-Only Strips and MSRs. The Company had interest-only strips of
$332.3 million and $490.5 million outstanding at June 30, 1999 and 1998,
respectively. The Company also had MSRs outstanding at June 30, 1999 and 1998 in
the amount of $20.9 million and $32.1 million, respectively. Both of these
instruments are valued at market at June 30, 1999 and 1998. The Company values
these assets based on the present value of future revenue streams net of
expenses using various assumptions. The discount rate used to calculate the
present value of the interest-only strips and MSRs was 15.0% and 10.8% at June
30, 1999 and 1998, respectively. The weighted average life used for valuation at
June 30, 1999 was 2.86 years and at June 30, 1998 was 2.6 to 3.8 years.
These assets are subject to risk in accelerated mortgage prepayment or
losses in excess of assumptions used in valuation. Ultimate cash flows realized
from these assets would be reduced should prepayments or losses exceed
assumptions used in the valuation. Conversely, cash flows realized would be
greater should prepayments or losses be below expectations.
Fair Value of Financial Instruments. The Company's financial instruments
recorded at contractual amounts that approximate market or fair value primarily
consist of trade receivables, accounts payable and trade receivables sold under
agreements to repurchase. As these amounts are short term in nature and/or
generally bear market rates of interest, the carrying amounts of these
instruments are reasonable estimates of their fair values. The carrying amount
of the Company's long-term debt approximates fair value when valued using
available quoted market prices.
Credit Risk. The Company is exposed to on-balance sheet credit risk
related to its loans held for sale and interest-only strips. The Company is
exposed to off-balance sheet credit risk related to loans which the Company has
committed to originate or purchase.
The Company is a party to financial instruments with off-balance sheet
credit risk in the normal course of business. These financial instruments
include commitments to extend credit to
43
44
borrowers and commitments to purchase loans from correspondents. The Company has
a first or second lien position on all of its loans, and the combined
loan-to-value ratio ("CLTV") permitted by the Company's mortgage underwriting
guidelines generally may not exceed 90%. In some cases, the Company originates
loans up to 95% CLTV that are insured down to approximately 65% with mortgage
insurance. The CLTV represents the combined first and second mortgage balances
as a percentage of the appraised value of the mortgaged property, with the
appraised value determined by an appraiser with appropriate professional
designations. A title insurance policy is required for all loans.
Warehousing Exposure. The Company utilizes warehouse and repurchase
financing facilities to facilitate the holding of mortgage loans prior to
securitization. As of June 30, 1999 and 1998, the Company had total warehouse
and repurchase facilities available in the amount of $590 million and $950
million, respectively; the total outstanding related to these facilities was
$536 million and $141 million at June 30, 1999 and 1998, respectively. Warehouse
and repurchase facilities are typically for a term of one year or less and are
designated to fund mortgages originated within specified underwriting
guidelines. The majority of the assets remain in the facilities for a period of
up to 90 days at which point they are securitized and sold to institutional
investors. As these amounts are short term in nature and/or generally bear
market rates of interest, the contractual amounts of these instruments are
reasonable estimates of their fair values.
RISK FACTORS
IF OUTSIDE SOURCES OF CASH ARE NOT SUFFICIENT, OUR ABILITY TO MAKE AND
SERVICE LOANS WILL BE IMPAIRED AND OUR REVENUES WILL SUFFER.
We operate on a negative cash flow basis, which means our cash
expenditures exceed our cash earnings. Therefore, we need continued access to
short- and long-term external sources of cash to fund our operations.
Our primary uses of cash include:
o mortgage loan originations and purchases before their
securitization and sale;
o fees, expenses and hedging costs, if any, incurred for the
securitization of loans;
o cash reserve accounts or overcollateralization required in the
securitization and sale of loans;
o tax payments generally due on recognition of non-cash gain on
sale recorded in the securitizations;
o ongoing administrative and other operating expenses;
o interest and principal payments under our credit facilities and
other existing indebtedness;
o cash advances made on delinquent loans included in our loan
servicing portfolio; and
o costs of expanding our loan production units.
Our primary sources of cash are expected to be cash from the Rights
Offering, warehouse and repurchase facilities, transactions by which we monetize
our servicing advance receivables,
44
45
securitizations and whole loan sales.
Our primary and potential sources of cash as described in the paragraph
above should be sufficient to fund our cash requirements through at least the
next 12 months, but only if our future operations are consistent with our
current growth expectations. Further, the closing of the Rights Offering is
subject to receiving stockholder approval of the Recapitalization at the
stockholders' meeting scheduled for September 13, 1999. If available at all, the
type, timing and terms of financing selected by us will be dependent upon our
cash needs, the availability of other financing sources, limitations under debt
covenants and the prevailing conditions in the financial markets. However, we
are not sure that these sources of cash will be available when needed. Even if
the sources of cash are available, the providers of cash may impose terms that
are not favorable to us. As a result of the limitations described above, we may
be restricted in the amount of loans that we will be able to produce and dispose
of.
OUR RIGHT TO SERVICE LOANS MAY BE TERMINATED BECAUSE OF THE HIGH
DELINQUENCIES AND LOSSES ON THE LOANS IN OUR SERVICING PORTFOLIO.
If, at any measuring date, the delinquencies or losses with respect to
any of our securitization trusts credit-enhanced by monoline insurance were to
exceed the delinquency or loss limits applicable to that trust, our rights to
service the loans in the affected trust may be terminated.
A substantial majority of our servicing portfolio consists of loans
securitized by us and sold to real estate mortgage investment conduits or owner
trusts in securitization transactions. Generally, the agreement entered into in
connection with these securitizations contains specified limits on
delinquencies, which means loans past due 90, or in some cases past due 60, days
or more, and losses that may be incurred in each trust. Losses occur when the
cash we receive from the sale of foreclosed properties, less sales expenses, is
less than the principal balances of the loans previously secured by those
properties and related interest and servicing advances. See below.
A majority of our securitization transactions were credit-enhanced by an
insurance policy issued by a monoline insurance company. That insurance policy
protects the securitization investor against certain losses. The monoline
insurance company can terminate us as servicer if delinquencies or losses are
over a specified limit.
At June 30, 1999, the dollar volume of loans delinquent more than 90
days in our 10 securitization trusts formed in December 1992 and during the
period from March 1995 to March 1997 exceeded the permitted limit in the related
securitization agreements.
We have implemented various plans to lower the delinquency rates in our
future trusts, including diversifying the loans we originate and purchase to
include higher credit grade loans. The delinquency rate at June 30, 1999 was
15.7% and at June 30, 1998 was 15.6%.
Four of the ten trusts referred to above, which represent in the
aggregate 16% of the dollar volume of our servicing portfolio, exceeded loss
limits at June 30, 1999. The limit that has been exceeded provides that losses
may not exceed a certain threshold, which ranges from .50% to .77% of the
original pool balances in the relevant securitization trusts, on a rolling 12
month basis. Additionally, during July 1999, one additional trust exceeded the
specified delinquency level and one of the four trusts that exceeded its loss
limit was cured.
Although the monoline insurance company has the right to terminate
servicing with respect to the trusts that exceed the delinquency and loss
limits, no servicing rights have been terminated and we believe that it is
unlikely that we will be terminated as servicer. We cannot be sure, however,
that our servicing rights with respect to the mortgage loans in such trusts, or
any other trusts which exceed
45
46
the specified delinquency or loss limits in future periods, will not be
terminated.
HIGH DELINQUENCIES ON THE LOANS IN OUR SERVICING PORTFOLIO MAY HURT OUR
CASH FLOWS.
High delinquency rates hurt our cash flows. When delinquency rates
exceed the limit specified in the securitization agreement, our right to receive
cash from the trust is delayed. When delinquency rates exceed the specified
amount, we are required to use the cash flows from the trust to make accelerated
payments of principal on the certificates or bonds issued by the trust. These
accelerated payments increase the overcollateralization levels. The
overcollateralization level represents the amount that the principal balance of
the loans in the trust exceeds the principal balance of the certificates or
bonds issued by the trust. We do not receive distributions from the trust until
after the required overcollateralization levels are met. Generally, provisions
in the securitization agreements have the effect of requiring the
overcollateralization amount to be increased up to approximately twice the level
otherwise required when the delinquency rates do not exceed the specified limit.
As of June 30, 1999, we were required to maintain an additional $89 million in
overcollateralization amounts as a result of the level of the 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, 1999, $48 million remains to be added to the overcollateralization amounts
from future spread income on the loans held by these trusts.
High delinquency rates also negatively affect our cash flows because we
act as servicer of the loans in the trust. As the servicer, we are required to
use our cash to advance to the trust past due interest.
HIGH DELINQUENCIES AND LOSSES MAY HURT OUR EARNINGS.
Higher delinquency and loss levels may also affect our reported
earnings. We apply certain assumptions with respect to expected losses on loans
in a securitization trust to determine the amount of non-cash gain on sale that
we record at the closing of a securitization transaction. If actual losses
exceed those assumptions, we may be required to take a charge to earnings. The
charge to earnings would result in an adjustment to the carrying value of the
interest-only strips recorded on our balance sheet.
OUR LOANS ARE SUBJECT TO HIGHER RISKS OF DELINQUENCY AND LOSS THAN THOSE
MADE BY CONVENTIONAL MORTGAGE SOURCES.
Loans made to borrowers in the lower credit grades have historically
resulted in a higher risk of delinquency and loss than loans made to borrowers
who use conventional mortgage sources. We believe that the underwriting criteria
and collection methods we use permit us to mitigate the higher risks inherent in
loans made to these borrowers. However, we cannot be sure that those criteria or
methods will protect us against those risks.
All of our loans are collateralized by residential property. The value
of the property collateralizing our loans may not be sufficient to cover the
principal amount of the loans in the event of liquidation. Losses not covered by
the underlying properties could have a material adverse effect on our results of
operations and financial condition. In addition, historical loss rates affect
the assumptions used by us in computing our non-cash gain on sale. If actual
losses exceed those assumptions, we may be required to take a charge to
earnings.
Adjustable rate loans account for a substantial portion of the mortgage
loans that we originate
46
47
or purchase. Substantially all of the 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.
IF WE ARE UNABLE TO MAINTAIN ADEQUATE FINANCING SOURCES, OUR ABILITY TO
MAKE MORTGAGE LOANS WILL BE IMPAIRED AND OUR REVENUES WILL SUFFER.
We use cash draws under credit facilities, referred to as warehouse and
repurchase facilities, to fund new originations and purchases of mortgage loans
before securitization or sale. We currently have three committed lines with
aggregate borrowing capacity of $590 million and one $100 million uncommitted
warehouse line. We recently entered into a transaction pursuant to which we sold
certain accounts receivable representing servicing advances we had previously
made and engaged an investment bank to make a substantial portion of future
servicing advances on substantially all of the loans in our servicing portfolio.
As servicer of the loans we securitize, we are required to advance, or loan, to
the trusts delinquent interest. In addition, as servicer , we advance to the
trusts foreclosure related expenses, and certain tax and insurance remittances
relating to loans serviced. To the extent that we are unable to maintain
existing credit facilities, arrange new warehouse, repurchase or other credit
facilities or obtain additional commitments to sell whole loans for cash, we may
have to curtail making loans. This would have a material adverse effect on our
financial position and results of operations and jeopardize our ability to
continue to operate as a going concern.
OUR BUSINESS OPERATIONS MAY BE INTERRUPTED IF WE EXPERIENCE UNEXPECTED
YEAR 2000 PROBLEMS.
Many existing computer systems and software products do not properly
recognize dates after December 31, 1999. This Year 2000 problem could result in
data corruption, system failures or disruptions of operations. We are subject to
potential Year 2000 problems affecting our products and services, our internal
systems and the systems of third parties on whom we rely. As part of our overall
systems enhancement program, we are using both internal and external resources
to identify, correct, reprogram or replace, and test our systems for Year 2000
compliance. One of our financing facilities requires us to be Year 2000
compliant by September 30, 1999. It is anticipated that all of our Year 2000
compliance efforts will be completed on time. We use third-party equipment,
software and content that may not be Year 2000 compliant. Although we have
received assurances from third parties that they are Year 2000 compliant, we
generally do not independently verify their Year 2000 compliance. If third
parties on whom we rely are not Year 2000 compliant, our business could be
adversely affected later this year.
Certain state regulatory authorities have imposed early deadlines for
Year 2000 compliance. We are unable to meet those deadlines. If we are unable to
satisfy those regulators that our Year 2000 compliance effort is adequate, our
license to conduct business in a state could be revoked or not renewed.
We have recently installed and are testing a Year 2000 compliant loan
origination system that is expected to add approximately $2 million per year to
our technology costs over the next three years. Other technology enhancements
are being reviewed but, to date, the costs for those enhancements have not been
determined.
FASTER THAN EXPECTED PREPAYMENT RATES ON OUR LOANS WILL HURT EARNINGS.
47
48
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. The rate of
prepayment of loans may be affected by a variety of economic and other factors.
We estimate prepayment rates based on our expectations of future prepayment
rates, which are based, in part, on the historic performance of our loans and
other considerations.
OUR OPERATIONS MAY BE HURT BY A SUBSTANTIAL AND SUSTAINED INCREASE OR
DECREASE IN INTEREST RATES.
A substantial and sustained increase in long-term interest rates could,
among other things:
o decrease the demand for consumer credit;
o adversely affect our ability to make loans; and
o reduce the average size of loans we underwrite.
A significant decline in long-term interest rates could increase the
level of loan prepayments. An increase in prepayments would decrease the size
of, and servicing income from, our servicing portfolio. Our expectations as to
prepayment are used to determine the amount of non-cash gain on sale recorded at
the closing of a securitization transaction. An increase in prepayment rates
could result in a charge to earnings if the rate is faster than originally
expected.
A substantial and sustained increase in short-term interest rates could,
among other things,
o increase our borrowing costs, most of which are tied to those
rates; and
o reduce the gains recorded by us upon the securitization and sale
of loans.
IN AN INCREASING INTEREST RATE ENVIRONMENT, OUR EARNINGS COULD SUFFER
BECAUSE OF ADJUSTABLE RATE LOANS THAT WE SECURITIZED.
The value of our interest-only strips created as a result of the
securitization of adjustable rate mortgage loans is subject to so-called basis
risk. Basis risk arises when the adjustable rate mortgage, including fixed
initial rate mortgage, loans in a securitization trust bear interest based on an
index or adjustment period that is different from the certificates or bonds
issued by the trust. In the absence of effective hedging, or loss mitigation,
strategies, in a period of increasing interest rates, the value of the
interest-only strips would be adversely affected because the interest rates on
the certificates or bonds issued by a securitization trust could adjust faster
than the interest rates on our adjustable rate mortgage loans in the trust.
Adjustable rate mortgage loans are typically subject to periodic and lifetime
interest rate caps, which limit the amount an adjustable rate mortgage loan's
interest rate can change during any given period. In a period of rapidly
increasing interest rates, the value of the interest-only strips could be
adversely affected in the absence of effective hedging strategies because the
interest rates on the certificates or bonds issued by a securitization trust
could increase without limitation by caps, while the interest rates on our
adjustable rate mortgage loans would be so limited.
A PROLONGED INTERRUPTION OR REDUCTION IN THE SECONDARY MARKET WOULD HURT
OUR FINANCIAL PERFORMANCE.
We must be able to sell loans we make in the securitization and whole
loan market to generate cash proceeds to pay down our warehouse and repurchase
facilities and fund new loans. Our ability to sell loans in the securitization
and whole loan markets on acceptable terms is essential for the
48
49
continuation of our loan origination and purchase operations. The value of and
market for our loans are dependent upon a number of factors, including general
economic conditions, interest rates and governmental regulations. Adverse
changes in these factors may affect our ability to securitize or sell whole
loans for acceptable prices within a reasonable period of time.
To facilitate the sale of certificates or bonds issued by the
securitization trust, we must obtain investment grade ratings for the
certificates or bonds. To obtain those credit ratings, we credit-enhance the
securitization trust. The overcollateralization amount is one form of credit
enhancement. Additionally, we either obtain an insurance policy to protect
holders of the certificates or bonds against certain losses, or sell
subordinated interests in the securitization trusts.
Our financial position and results of operations would be materially
affected if investors were unwilling to purchase interests in our securitization
trusts or monoline insurance companies were unwilling to provide financial
guarantee insurance for the certificates or bonds sold. Other accounting, tax or
regulatory changes could also adversely affect our securitization program.
We rely on institutional purchasers, such as investment banks, financial
institutions and other mortgage lenders, to purchase our loans in the whole loan
market. We cannot be sure that the purchasers will be willing to purchase loans
on satisfactory terms or that the market for such loans will continue. Our
results of operations and financial condition could be materially adversely
affected if we could not successfully identify whole loan purchasers or
negotiate favorable terms for loan purchases.
IF WE ARE UNABLE TO SELL A SIGNIFICANT PORTION OF OUR LOANS ON AT LEAST
A QUARTERLY BASIS, OUR EARNINGS WOULD BE SIGNIFICANTLY AFFECTED.
Any delay in the sale of a significant portion of our loan production
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 the quarter.
Our loan disposition strategy calls for substantially all of our production to
be sold in the secondary market within 90 days of origination. However, market
and other considerations, including the conformity of loan pools to monoline
insurance company and rating agency requirements, could affect the timing of the
sale transactions.
CHANGES IN THE VOLUME AND COST OF OUR BROKER LOANS MAY DECREASE OUR LOAN
PRODUCTION.
We depend on independent mortgage brokers for the origination and
purchase of our broker loans, which constitute a significant portion of our loan
production. Our future results of operations and financial condition may be
vulnerable to changes in the volume and cost of our broker loans resulting from,
among other things, competition from other lenders and purchasers of such loans.
These independent mortgage brokers negotiate with multiple lenders for each
prospective borrower. We compete with these lenders for the independent brokers'
business on pricing, service, loan fees, costs and other factors. Our
competitors also seek to establish relationships with such brokers, who are not
obligated by contract or otherwise to do business with us.
OUR COMPETITORS IN THE MORTGAGE BANKING MARKET ARE OFTEN LARGER AND
HAVE GREATER FINANCIAL RESOURCES THAN WE DO, WHICH WILL MAKE IT DIFFICULT FOR
US TO SUCCESSFULLY COMPETE.
We face intense competition in the business of originating, purchasing
and selling mortgage loans. Competition among industry participants can take
many forms, including convenience in
49
50
obtaining a loan, customer service, marketing and distribution channels, amount
and term of the loan, loan origination fees and interest rates. Many of our
competitors are substantially larger and have considerably greater financial,
technical and marketing resources than we do. Our competitors in the industry
include other consumer finance companies, mortgage banking companies, commercial
banks, investment banks, credit unions, thrift institutions, credit card issuers
and insurance companies. In the future, we 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 our highest credit grades, who constitute a significant
portion of our customer base.
The historical level of gains realized 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, or have purchased companies that originate and purchase,
subprime mortgage loans, and some of these large mortgage companies, thrifts and
commercial banks have begun offering subprime loan products to customers similar
to our targeted borrowers. 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 our
broker lending business.
Additional competition may lower the rates we can charge borrowers and
increase the cost to purchase loans, which could potentially lower the gain on
future loan sales or securitizations. Increased competition may also reduce the
volume of our loan origination and loan sales and increase the demand for our
experienced personnel and the potential that such personnel will leave for
competitors.
Competitors with lower costs of capital have a competitive advantage
over us. During periods of declining rates, competitors may solicit our
customers to refinance their loans. In addition, during periods of economic
slowdown or recession, our borrowers may face financial difficulties and be more
receptive to the offers of our competitors to refinance their loans.
Our correspondent and broker programs depend largely on independent
mortgage bankers and brokers and other financial institutions for the purchases
of new loans. Our competitors also seek to establish relationships with the same
sources.
BECAUSE A SIGNIFICANT AMOUNT OF THE LOANS WE SERVICE ARE IN CALIFORNIA,
OUR OPERATIONS COULD BE HURT BY ECONOMIC DOWNTURNS OR NATURAL DISASTERS IN
THE STATE.
At June 30, 1999, 21.4% of the loans we serviced were collateralized by
residential properties located in California. Because of this concentration in
California, our 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 collateralizing
loans. If the principal balances of our loans, together with any primary
financing on the mortgaged properties, equal or exceed the value of the
mortgaged properties, we could incur higher losses on sales of properties
collateralizing foreclosed loans. 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 our ability to recover losses on properties affected by such disasters
and adversely impact our results of operations.
50
51
THE RISKS ASSOCIATED WITH OUR 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. Material declines in real estate values also
weakens collateral coverage and increases the possibility of a loss in the event
of liquidation. Further, delinquencies, foreclosures and losses generally
increase during economic slowdowns or recessions. Because of our 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,
our servicing costs may increase. Any sustained period of increased
delinquencies, foreclosure, losses or increased costs could adversely affect our
ability to securitize or sell loans in the secondary market and could increase
the cost of these transactions.
EVEN AFTER WE SELL OUR LOANS, WE REMAIN SUBJECT TO RISKS FROM
DELINQUENCIES AND LOSSES ON THE LOANS WE SERVICE.
Although we sell substantially all the mortgage loans which we originate
or purchase, we retain some degree of credit risk on substantially all loans
sold where we continue to service those loans. During the period of time that
loans are held before sale, we are 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. Cash flows
from the securitization trust are represented by the interest rate earned on the
loans in the trust over the amount of interest paid by the trust to the holders
of the certificates or bonds issued by the trust, plus certain monoline and
servicing fees. The agreements governing our securitization program require us
to credit-enhance the securitization trust by either establishing deposit
accounts or building overcollateralization levels. Deposit accounts are
established by maintaining a portion of the excess cash flows in a trust deposit
account. Overcollateralization levels are built up by applying these excess cash
flows to reduce the principal balances of the certificates or bonds issued by
the trust. Those amounts are available to fund losses realized on loans held by
such trust. We continue to be subject to the risks of default and foreclosure
following securitization and the sale of loans to the extent excess cash flows
are required to be maintained in the deposit account or applied to build up
overcollateralization, as opposed to being distributed to us.
When borrowers are delinquent in making monthly payments on loans
included in a securitization trust, as servicer of the loans in the trust, we
are required to advance interest payments with respect to such delinquent loans.
These advances require funding from our capital resources, but have priority of
repayment from collections or recoveries on the loans in the related pool in the
succeeding month.
WE MAY BE REQUIRED TO REPURCHASE LOANS OR INDEMNIFY INVESTORS IF WE
BREACH REPRESENTATIONS AND WARRANTIES.
In the ordinary course of our business, we are subject to claims made
against us 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 our employees
and officers, incomplete documentation and failures to comply with various laws
and regulations applicable to our business. In addition, agreements governing
our securitization program and whole loan sales require us to commit to
repurchase or replace loans which do not conform to
51
52
our representations and warranties at the time of sale. We believe that
liability with respect to any currently asserted claims or legal actions is not
likely to be material to our 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 our financial position
and results of operations.
IF WE ARE UNABLE TO COMPLY WITH MORTGAGE BANKING RULES AND REGULATIONS,
OUR ABILITY TO MAKE MORTGAGE LOANS MAY BE RESTRICTED.
Our operations are subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and are subject
to various laws, regulations and judicial and administrative decisions imposing
requirements and restrictions on part or all of our operations. 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. Our consumer lending activities are subject
to various federal laws and regulations. We are 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 us, 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. Because our
business is highly regulated, the laws, rules and regulations applicable to us
are subject to regular modification and change. There are currently proposed
various laws, rules and regulations which, if adopted, could impact us.
CHANGES IN THE MORTGAGE INTEREST DEDUCTION COULD HURT OUR FINANCIAL
PERFORMANCE.
Members of Congress and government officials have from time-to-time
suggested the elimination of the mortgage interest deduction for federal income
tax purposes, either entirely or in part, based on borrower income, type of loan
or principal amount. Because many of our 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 us.
WE WILL BE UNABLE TO PAY DIVIDENDS ON OUR CAPITAL STOCK FOR THE
FORESEEABLE FUTURE.
The indentures governing certain of our outstanding indebtedness as well
as our other credit agreements limit our ability to pay cash dividends on our
capital stock. Under the most restrictive of these limitations, we will be
prevented from paying cash dividends on our capital stock for the foreseeable
future.
THE CONCENTRATED OWNERSHIP OF OUR VOTING STOCK BY OUR CONTROLLING
STOCKHOLDER MAY HAVE AN ADVERSE EFFECT ON YOUR ABILITY TO INFLUENCE THE
DIRECTION WE WILL TAKE.
Following completion of the Rights Offering, Capital Z will beneficially
own senior preferred stock representing 61.1% of our combined voting power if
all the Series C Convertible Preferred Stock offered in the Rights Offering is
purchased by our common stockholders and 78.2% of our
52
53
combined voting power if none of the Series C Convertible Preferred Stock
offered in the Rights Offering is purchased by our common stockholders and 25
million shares of the Series C Convertible Preferred Stock are purchased by
Capital Z pursuant to the Standby Commitment. The Series C Convertible Preferred
Stock does not vote in the election of directors. Representatives or nominees of
Capital Z have five seats on our nine person Board of Directors. As a result of
its beneficial ownership and Board representation, Capital Z has, and will
continue to have, sufficient power to determine our direction and policies.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are attached to this report:
Reports of Independent Auditors (Ernst & Young LLP,
PricewaterhouseCoopers LLP)
Consolidated Balance Sheet at June 30, 1999 and 1998
Consolidated Statement of Operations for the Years Ended
June 30, 1999, 1998 and 1997
Consolidated Statement of Stockholders' Equity for the Years Ended
June 30, 1999, 1998 and 1997
Consolidated Statement of Cash Flows for the Years Ended June 30, 1999,
1998 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 1999 Annual Meeting of Stockholders
or an amendment to this Form 10-K, and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation will appear in the proxy
statement for the 1999 Annual Meeting of Stockholders or an amendment to this
Form 10-K, 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 1999 Annual Meeting of
Stockholders or an amendment to this Form 10-K, and is incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions
will appear in the proxy statement for the 1999 Annual Meeting of Stockholders
or an amendment to this Form 10-K, and is incorporated by this reference.
53
54
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:
None.
(c) Exhibits - Management Contracts and Compensatory Plans:
10.1 Form of Director and Officer Indemnification Agreement(14)
10.2(a) Second Amended and Restated Employment, dated as of May 8,
1997, between Registrant and Cary H. Thompson(14)
10.2(b) Stock Option Agreement between Registrant and Cary H.
Thompson(10)
10.2(c) Amendment No. 1, dated as of August 26, 1998, to Exhibit
10.2(a)(19)
10.3(a) Employment Agreement, dated as of August 28, 1996, between
Registrant and Neil Kornswiet(14)
10.3(b) Amendment No. 1, dated as of June 1, 1997, to Exhibit
10.3(a)(14)
10.3(c) Amended and Restated Employment Agreement, dated as of
August 26, 1998, between Registrant and Neil B.
Kornswiet(19)
10.4 Employment Agreement, dated as of May 12, 1997, between
the Registrant and David A. Sklar
10.5 Second Amended and Restated Employment Agreement, dated as
of June 1, 1997, between Registrant and Barbara Polsky(14)
10.6(a) Employment Agreement, dated as of June 1, 1997, between
Registrant and Mark Costello(14)
10.6(b) Performance Bonus Plan for Mark Costello(20)
10.7 1991 Stock Incentive Plan, as amended(2)
10.8 1995 Stock Incentive Plan(10)
10.9(a) 1996 Stock Incentive Plan(12)
10.9(b) Amendment No. 1 to Exhibit 10.9(a)(14)
10.10 1997 Stock Option Plan(15)
10.11 1997 Non-Qualified Stock Option Plan (amended and restated
effective May 22, 1998)(15)
10.20 Variable Deferred Compensation Plan(14)
10.21(a) Employment Agreement between Registrant and Cary H.
Thompson(21)
10.21(b) Amendment No. 1, dated as of December 23, 1998, to Exhibit
10.21(a)(21)
10.22 Management Investment Agreement, dated as of February 10,
1999, between Registrant and Cary H. Thompson(21)
10.23 Employment Agreement between Registrant and Neil B.
Kornswiet(21)
10.24 Management Investment Agreement, dated as of February 10,
1999, between Registrant and Neil B Kornswiet(21)
(d) Other Exhibits:
54
55
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(13)
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(14)
4.2(a) Rights Agreement, dated as of June 21, 1996 between
Registrant and Wells Fargo Bank, as rights agent(4)
4.2(b) Amendment to Rights Agreement, dated as of April 27,
1998(17)
4.2(c) Amendment to Rights Agreement, dated as of December 23,
1998(22)
4.3 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)
4.4(a) 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)
4.4(b) Second Supplemental Indenture, dated as of February 10,
1999, between Registrant, The Chase Manhattan Bank and
certain wholly owned subsidiaries of Registrant, relating
to Registrant's 9.125% Senior Notes due 2003(21)
10.12 Office Lease, dated as of September 15, 1998, between
Colonnade Wilshire Corp. and the Registrant, for the
premises located at 3731 Wilshire Boulevard, Los Angeles,
California.
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(14)
10.13(b) First Amendment, dated as of August 15, 1997, to Exhibit
10.13(a)(14)
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 Reserved
10.16 Reserved
10.17 Reserved
10.18(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)
10.18(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)
10.19 Management Voting Agreement between Registrant, Cary H.
Thompson and Neil B. Kornswiet, dated as of February 10,
1999(21)
10.25(a) Preferred Stock Purchase Agreement, dated as of December
23, 1998, between Registrant and Capital Z Financial
Services Fund II, L.P.(22)
10.25(b) Amendment No. 1 to Exhibit 10.25(a)(21)
10.25(c) Amendment No. 2 to Exhibit 10.25(a)
10.25(d) Amendment No. 3 to Exhibit 10.25(a)
10.25(e) Amendment No. 4 to Exhibit 10.25(a)
10.26(a) Amended and Restated Master Repurchase Agreement Governing
Purchase and Sales of Mortgage Loans, dated as of February
10, 1999, between Aames
55
56
Capital Corporation, Registrant's wholly owned subsidiary
("ACC") and Lehman Commercial Paper, Inc.(25)
10.26(b) Amendment, dated as of June 30, 1999, to Exhibit 10.26(a)
10.26(c) Second Amendment, dated as of June 30, 1999, to Exhibit
10.26(a)
10.26(d) Guaranty, dated as of March 8, 1996, between Registrant
and Lehman Commercial Paper, Inc., with respect to Exhibit
10.26(a)(25)
10.27(a) Master Loan and Security Agreement, dated as of February
10, 1999, between ACC and Greenwich Capital Financial
Products, Inc.(25)
10.27(b) Amendment No. 1, dated as of June 10, 1999, to Exhibit
10.27
10.27(c) Amendment No. 2, dated as of June 30, 1999, to Exhibit
10.28(a)
10.27(d) Guaranty, dated as of February 10, 1999, between
Registrant and Greenwich Capital Financial Products, Inc.,
with respect to Exhibit 10.28(a)(25)
10.27(e) Amendment No. 1, dated as of June 30, 1999, to Exhibit
10.28(d)
10.28(a) Master Repurchase Agreement, dated as of April 8, 1999,
between ACC and NationsBank, N.A.(25)
10.28(b) Guaranty, dated as of April 8, 1999, between Registrant
and NationsBank, N.A., with respect to Exhibit
10.28(a)(25)
10.28(c) First Amendment, dated as of June 30, 1999, to Exhibit
10.28(a) and Exhibit 10.28(b)
10.29 Agreement for Management Advisory Services, dated as of
February 10, 1999 between Registrant and Equifin Capital
Management, LLC(25)
10.30 Historical Advance Purchase Agreement, dated as of June
10, 1999, between ACC and Steamboat Financial Partnership
I, L.P.
10.31 Historical Advance Purchase Agreement, dated as of June
17, 1999, between ACC and Steamboat Financial Partnership
I, L.P.
10.32 Limited Partnership Agreement of Steamboat Financial
Partnership I, L.P., dated as of June 10, 1999, between
Random Properties Acquisition Corp. IV, ACC and Greenwich
Capital Derivatives, Inc.
10.33 Reserved
10.34 Delinquency Advance Purchase Agreement, dated as of May
13, 1999, between ACC and Fairbanks Capital Corp.
10.35 Sub-Servicing Agreement 1997-1, dated as of April 21,
1999, between ACC and Fairbanks Capital Corp.
10.36 Sub-Servicing Agreement 1996-D, dated as of April 21,
1999, between ACC and Fairbanks Capital Corp.
11 Computation of Per Share Earnings (Loss)
21 Subsidiaries of the Registrant
23.1 Consent of Ernst & Young LLP
23.2 Consent of PricewaterhouseCoopers 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.
56
57
(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 Current Report on Form 8-K
dated September 11, 1996.
(14) Incorporated by reference from Registrant's Annual Report on Form 10-K
for the year ended June 30, 1997.
(15) Incorporated by reference from Registrant's Registration Statement on
Form S-8 dated July 24, 1998.
(16) Incorporated by reference from Registrant's Current Report on Form 8-K
dated April 27, 1998.
(17) Incorporated by reference from Registrant's Registration Statement on
Form 8-A/A dated April 27, 1998.
(18) Incorporated by reference from Registrant's Current Report on Form 8-K
dated March 25, 1998.
(19) Incorporated by reference from Registrant's Quarterly Report on Form
10-Q for the quarter ended September 30, 1998.
(20) Incorporated by reference from Registrant's Annual Report on Form 10-K
for the year ended June 30, 1998.
(21) Incorporated by reference from Registrant's Quarterly Report on Form
10-Q for the quarter ended December 31, 1998.
(22) Incorporated by reference from Registrant's Current Report on Form 8-K
dated December 31, 1998.
(23) Incorporated herein by reference to the Form of Warrant to Purchase
Common Stock of the Registrant, filed as Exhibit C to Exhibit 10.1 of
the Registrant's Current Report on Form 8-K, filed with the Commission
on December 31, 1998.
(24) Incorporated herein by reference to the Form of Contingent Warrant to
Purchase Common Stock of the Registrant, filed as Exhibit E to Exhibit
10.1 of the Registrant's Current Report on Form 8-K, filed with the
Commission on December 31, 1998.
(25) Incorporated by reference from Registrant's Quarterly Report on Form
10-Q for the quarter ended March 31, 1999.
(e) Reports on Form 8-K:
During the last quarter of the fiscal year ended June 30, 1999,
the Company filed (i) a Current Report on Form 8-K filed on May 18, 1999
(earliest event reported May 14, 1999), reporting information under Item 5 with
respect to the appointment of Mani A. Sadeghi as interim Chief Executive Officer
and the appointment of Cary H. Thompson as Vice-Chairman; (ii) a Current Report
on Form 8-K filed on May 21, 1999 (earliest event reported May 17, 1999)
reporting earnings (losses) for the third fiscal quarter; and (iii) a Current
Report on Form 8-K (earliest event reported July 1, 1999) reporting the
structure to monetize servicing receivables and reduce future servicing advances
on loans in the Company's servicing portfolio and provide approximately $50
million to the Company.
57
58
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 1, 1999 By: /s/ Mani Sadeghi
---------------------------
Mani Sadeghi
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/ Mani Sadeghi Chief Executive Officer, September 1, 1999
- ------------------------------- Director (Principal Executive Officer)
Mani Sadeghi
/s/ David A. Sklar Executive Vice President-- September 1, 1999
- ------------------------------- Finance and Chief Financial
David A. Sklar Officer (Principal Financial and
Accounting Officer)
/s/ George W. Coombe, Jr. Director September 1, 1999
- -------------------------------
George W. Coombe, Jr.
/s/ Steven M. Gluckstern Chairman of the Board and Director September 1, 1999
- -------------------------------
Steven M. Gluckstern
/s/ Neil B. Kornswiet President and Director September 1, 1999
- -------------------------------
Neil B. Kornswiet
/s/ Adam M. Mizel Director September 1, 1999
- -------------------------------
Adam M. Mizel
/s/ Eric Rahe Director September 1, 1999
- -------------------------------
Eric Rahe
/s/ Cary H. Thompson Director September 1, 1999
- -------------------------------
Cary H. Thompson
/s/ David A. Spuria Director September 1, 1999
- -------------------------------
David A. Spuria
/s/ George C. St. Laurent, Jr. Director September 1, 1999
- -------------------------------
George C. St. Laurent, Jr.
58
59
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
Aames Financial Corporation
We have audited the accompanying consolidated balance sheet of Aames
Financial Corporation and subsidiaries (the Company) as of June 30, 1999 and the
related consolidated statement of operations, changes in stockholders' equity
and cash flows for the year then ended. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based upon our
audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Aames Financial Corporation and subsidiaries at June 30, 1999, and the
consolidated results of their operations and their cash flows for the year then
ended in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Los Angeles, California
August 26, 1999
F-1
60
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
and Stockholders of
Aames Financial Corporation
In our opinion, based upon our audits , the accompanying consolidated
balance sheet at June 30, 1998 and the related consolidated statement of
operations, changes in stockholders' equity and cash flows present fairly, in
all material respects, the financial position of Aames Financial Corporation and
its subsidiaries (the "Company") at June 30, 1998, and the results of their
operations and their cash flows for each of the two years in the period ended
June 30, 1998, 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 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 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 provide a reasonable basis for the opinion expressed
above.
As discussed in Note 1, 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.
As discussed in Note 2, the consolidated financial statements have been
restated to reflect a change in the method of measuring and accounting for
credit enhancement assets.
/s/ PRICEWATERHOUSECOOPERS LLP
Los Angeles, California
August 6, 1998, except as to the information presented in Note 2 for which the
date is August 5, 1999.
F-2
61
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
ASSETS
JUNE 30, JUNE 30,
1999 1998
--------------- ---------------
Cash and cash equivalents ................................................................ $ 20,764,000 12,322,000
Loans held for sale, at lower of cost or market .......................................... 559,869,000 198,202,000
Accounts receivable ...................................................................... 56,964,000 51,072,000
Interest-only strips, at estimated fair market value ..................................... 332,327,000 490,542,000
Mortgage servicing rights, net ........................................................... 20,928,000 32,090,000
Equipment and improvements, net .......................................................... 13,495,000 13,939,000
Prepaid and other ........................................................................ 15,013,000 17,020,000
Income tax refund receivable ............................................................. 1,737,000 --
--------------- ---------------
Total assets .................................................................... $ 1,021,097,000 815,187,000
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Borrowings ............................................................................... $ 281,220,000 286,990,000
Revolving warehouse and repurchase facilities ............................................ 535,997,000 141,012,000
Accounts payable and accrued expenses .................................................... 50,505,000 49,964,000
Income taxes payable ..................................................................... 7,819,000 33,170,000
--------------- ---------------
Total liabilities .............................................................. 875,541,000 511,136,000
--------------- ---------------
Commitments and contingencies
Stockholders' equity:
Series A Preferred Stock, par value .001 per share; 500,000 shares authorized
none outstanding ......................................................................... -- --
Series B Convertible Preferred Stock, par value $0.001 per share;
100,000 shares authorized; 26,704 and -0- shares outstanding ............................. 26,704,000 --
Series C Convertible Preferred Stock, par value $0.001 per share; 100,000 shares
authorized; 75,046 and -0- shares outstanding (includes 25,000
shares issued August 3, 1999) ............................................................ 65,475,000 --
Common Stock, par value $.001 per share; 50,000,000 shares
authorized; 31,016,964, and 30,962,578 shares outstanding ................................ 31,000 31,000
Additional paid-in capital ............................................................... 250,116,000 249,851,000
Retained earnings (deficit) .............................................................. (196,770,000) 54,169,000
--------------- ---------------
Total stockholders' equity ..................................................... 145,556,000 304,051,000
--------------- ---------------
Total liabilities and stockholders' equity ..................................... $ 1,021,097,000 815,187,000
=============== ===============
See accompanying notes to consolidated financial statements.
F-3
62
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
TWELVE MONTHS ENDED JUNE 30,
---------------------------------------------------
1999 1998 1997
-------------- -------------- --------------
Revenue:
Gain on sale of loans ................................... $ 44,855,000 120,828,000 135,421,000
Valuation (write-down) of interest-only strips .......... (186,451,000) 19,495,000 (18,950,000)
Commissions ............................................. 33,034,000 27,664,000 29,250,000
Loan service ............................................ 49,900,000 51,642,000 31,131,000
Interest income and fees ................................ 42,509,000 46,860,000 37,679,000
-------------- -------------- --------------
Total revenue including write-down .............. (16,153,000) 266,489,000 214,531,000
-------------- -------------- --------------
Expenses:
Compensation ............................................ 80,167,000 94,820,000 81,021,000
Production .............................................. 40,061,000 34,195,000 27,229,000
General and administrative .............................. 60,635,000 40,686,000 31,716,000
Interest ................................................ 44,089,000 43,982,000 33,105,000
Nonrecurring charges .................................... 37,044,000 -- 32,000,000
-------------- -------------- --------------
Total expenses .................................... 261,996,000 213,683,000 205,071,000
-------------- -------------- --------------
Income (loss) before income taxes ......................... (278,149,000) 52,806,000 9,460,000
Provision (benefit) for income taxes ...................... (30,182,000) 25,243,000 7,982,000
-------------- ============== --------------
Net income (loss) ......................................... $ (247,967,000) 27,563,000 1,478,000
============== ============== ==============
Net income (loss) per share:
Basic ................................................... $ (8.00) 0.97 0.06
============== ============== ==============
Diluted ................................................. $ (8.00) 0.87 0.05
============== ============== ==============
Dividends per common share .............................. $ 0.03 0.13 0.13
============== ============== ==============
Weighted average number of shares outstanding:
Basic ................................................... 31,000,000 28,548,000 26,400,000
============== ============== ==============
Diluted ................................................. 31,000,000 35,749,000 28,371,000
============== ============== ==============
See accompanying notes to consolidated financial statements.
F-4
63
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
SERIES B SERIES C
CONVERTIBLE CONVERTIBLE ADDITIONAL RETAINED
COMMON PREFERRED PREFERRED PAID-IN EARNINGS
STOCK STOCK STOCK CAPITAL (DEFICIT) TOTAL
------- ----------- ----------- ----------- ------------ ------------
As of June 30, 1996 .................. $24,000 -- -- 88,134,000 32,303,000 120,461,000
Issuance of Common Stock ........... 4,000 -- -- 121,224,000 -- 121,228,000
Dividends .......................... -- -- -- -- (3,412,000) (3,412,000)
Net income ......................... -- -- -- -- 1,478,000 1,478,000
------- ---------- ---------- ----------- ------------ ------------
As of June 30, 1997 .................. 28,000 -- -- 209,358,000 30,369,000 239,755,000
Issuance of Common Stock ........... 3,000 -- -- 40,493,000 10,000 40,506,000
Dividends .......................... -- -- -- -- (3,773,000) (3,773,000)
Net income ......................... -- -- -- -- 27,563,000 27,563,000
------- ---------- ---------- ----------- ------------ ------------
As of June 30, 1998 .................. 31,000 -- -- 249,851,000 54,169,000 304,051,000
Issuance of Common Stock ........... -- -- -- 265,000 -- 265,000
Issuance of Series B Convertible
Preferred Stock ................. -- 26,704,000 -- -- -- 26,704,000
Issuance of Series C Convertible
Preferred Stock ................. -- -- 65,475,000 -- -- 65,475,000
Dividends paid ..................... -- -- -- -- (1,022,000) (1,022,000)
Dividends accrued .................. -- -- -- -- (1,950,000) (1,950,000)
Net loss ........................... -- -- -- -- (247,967,000) (247,967,000)
------- ---------- ---------- ----------- ------------ ------------
As of June 30, 1999 .................. $31,000 26,704,000 65,475,000 250,116,000 (196,770,000) 145,556,000
======= ========== ========== =========== ============ ============
See accompanying notes to consolidated financial statements.
F-5
64
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
TWELVE MONTHS ENDED JUNE 30,
-----------------------------------------------------
1999 1998 1997
--------------- -------------- --------------
Operating activities:
Net income (loss) ............................................. $ (247,967,000) 27,563,000 1,478,000
Adjustments to reconcile net income (loss) to
net cash used in operating activities:
Depreciation and amortization .............................. 5,673,000 3,909,000 2,853,000
Gain on sale of loans ...................................... (35,716,000) (121,098,000) (194,026,000)
Valuation (write-down) of interest-only strips ............. 186,451,000 (19,495,000) 18,950,000
Accretion of interest-only strips .......................... (34,671,000) (41,008,000) (30,834,000)
Mortgage servicing rights originated ....................... (6,194,000) (19,513,000) (16,251,000)
Mortgage servicing rights amortized ........................ 11,431,000 9,064,000 5,512,000
Mortgage servicing rights charged-off ...................... 8,100,000 -- --
Accrual of 6.5% preferred stock dividend ................... (1,950,000) -- --
Changes in assets and liabilities:
Loans held for sale originated or purchased .............. (2,193,635,000) (2,383,638,000) (2,347,938,000)
Proceeds from sale of loans held for sale ................ 1,831,968,000 2,428,423,000 2,291,140,000
Decrease (increase) in:
Accounts receivable ................................... (5,892,000) 8,108,000 (49,495,000)
Interest-only strips .................................. 39,976,000 30,310,000 20,497,000
Prepaid and other ..................................... 2,007,000 (2,071,000) (4,654,000)
Income tax refund receivable .......................... (1,737,000) -- --
Increase (decrease) in:
Accounts payable and accrued expenses ................. 541,000 20,667,000 13,490,000
Deferred income taxes ................................. (25,351,000) 9,118,000 9,205,000
--------------- -------------- --------------
Net cash used in operating activities .......................... (466,966,000) (49,661,000) (280,073,000)
--------------- -------------- --------------
Investing activities:
Purchases of equipment and improvements ..................... (5,229,000) (5,163,000) (8,864,000)
Financing activities:
Net proceeds from issuance of convertible preferred stock ..... 92,179,000 -- --
Proceeds from sale of common stock or exercise of options ..... 265,000 40,505,000 121,228,000
Proceeds from (reductions in) borrowings ...................... (5,770,000) -- 148,945,000
Proceeds from revolving warehouse and
repurchase facilities ....................................... 394,985,000 3,512,000 25,137,000
Dividends paid ................................................ (1,022,000) (3,773,000) (3,412,000)
--------------- -------------- --------------
Net cash provided by financing activities ....................... 480,637,000 40,244,000 291,898,000
--------------- -------------- --------------
Net increase (decrease) in cash and cash equivalents ............ 8,442,000 (14,580,000) 2,961,000
Cash and cash equivalents at beginning of period ................ 12,322,000 26,902,000 23,941,000
--------------- -------------- --------------
Cash and cash equivalents at end of period ...................... $ 20,764,000 12,322,000 26,902,000
=============== ============== ==============
Supplemental disclosures:
Interest paid ................................................. $ 41,769,000 44,501,000 30,207,000
Income taxes paid (refunded) .................................. $ (4,470,000) 16,125,000 (1,197,000)
See accompanying notes to consolidated financial statements.
F-6
65
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
Aames Financial Corporation (the "Company" or "Aames") operates in a single
industry segment as 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, 1999,
Aames operated 101 retail loan offices serving 37 states. At June 30, 1999, 18
of the 101 branches were located in California. Its wholly-owned subsidiary, One
Stop Mortgage, Inc. ("One Stop"), operated 35 additional offices located in 28
states. At June 30, 1999, 2 of the 35 branches were located in California. The
Company originates and purchases loans on a nationwide basis through three
production channels -- retail, broker and correspondent. During the years ended
June 30, 1999 and 1998, the Company originated and purchased $2.19 billion and
$2.38 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 extended on the basis of the equity in the
borrower's property and the creditworthiness of the borrower. The aggregate
outstanding balance of loans serviced by the Company was $3.84 billion and $4.15
billion at June 30, 1999 and June 30, 1998, respectively (which includes $413
million and $206 million of loans at June 30, 1999 and June 30, 1998,
respectively, serviced for the Company by unaffiliated subservicers under
subservicing agreements).
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 AND CASH EQUIVALENTS
The Company considers all highly liquid debt instruments with an original
maturity of no more than three months to be cash equivalents.
LOANS HELD FOR SALE
Loans held for sale are loans the Company plans to securitize or sell as
whole loans and 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 interest advances and other
servicing related advances to securitization trusts, and accrued interest
receivable on loans held for sale. At June 30, 1999, accounts receivable also
included a capital contribution receivable.
F-7
66
EQUIPMENT AND IMPROVEMENTS, NET
Equipment and improvements, net, 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 and fixtures............................ Five to seven years
Data processing software.......................... Three years
Leasehold improvements............................ Lower of life of lease or asset
LOAN SALES
The Company depends on its ability to sell loans originated and purchased
by it in the secondary market, as market conditions allow, to generate cash
proceeds to pay down its warehouse and repurchase facilities and fund new
originations and purchases. 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.
REVENUE RECOGNITION
The Company adopted Financial Accounting Standards Board ("FASB") Statement
of Financial Accounting Standards ("SFAS") 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125")
effective January 1, 1997. As a result of the adoption of SFAS 125, the Company
records amounts previously categorized as excess servicing gains in the
consolidated statement of operations 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 asset called interest-only strips.
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
non-cash 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 represents the
difference between the proceeds (including premiums) from the sale, net of
related transaction costs, and the allocated carrying amount of the loans sold.
The allocated carrying amount is determined by allocating the original amount of
the loan (including premiums paid on loans purchased) between the portion sold
and any retained interests (interest-only strip), based on their relative fair
values at the date of transfer. The interest-only strip 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 .50%), a back-up
servicing fee, if any, and a monoline insurance fee, if any, and an estimate for
loan losses. Unrealized gains or losses include the recognition of an unrealized
gain or loss which represents the initial difference between the allocated
carrying amount and the fair market value of the interest-only strip at the date
of sale. 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 interest-only strips are recorded at estimated
fair value and are marked to market through a charge (or credit) to earnings.
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: (i) a future rate of
prepayment; (ii) a discount rate used to calculate present value; and (iii) a
prospective cumulative loan loss estimate on loans sold. The future cash flows
represent management's best estimate. Management monitors performance of the
loans and changes in the estimates are reflected in earnings. 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 Company used a discount rate of 15%.
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 rights 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, 1999 and 1998, there were no valuation allowances on mortgage
servicing rights.
F-8
67
ADVERTISING EXPENSE
The Company's policy is to charge advertising costs to expense when
incurred. The Company charged to expense $29 million, $23 million and $18
million in fiscal years ended June 30, 1999, 1998 and 1997, respectively.
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.
EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share of common stock is computed using the
weighted average number of shares of common stock outstanding during each
period. Diluted earnings (loss) per share includes the effects of the conversion
of shares related to the Company's 5.5% Convertible Subordinated Debentures due
2006 as well as the average number of stock options outstanding, except when
their effect is antidilutive.
All references in the accompanying consolidated balance sheet, consolidated
statement of operations 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 split in the form of stock dividends effected on February
21, 1997, and the Company's presentation of basic earnings per share ("EPS")
under the adoption of SFAS 128 during the year ended June 30, 1998.
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 is currently re-evaluating its hedging policy and
no hedge transactions were in place at June 30, 1999.
In the past, the Company has hedged its fixed rate pipeline and some
LIBOR-based tranches in its fixed rate securitizations. The Company has utilized
fixed rate hedge products which were swap agreements with third parties that
sell United States Treasury securities not yet purchased and the purchase of
Treasury put options. The Company has utilized LIBOR rate caps as hedge
instruments on certain LIBOR-based tranches secured by fixed rate mortgages. The
use, amount and timing of hedging transactions are determined by members of the
Company's senior management.
RECLASSIFICATIONS
Certain amounts related to 1998 and 1997 have been reclassified to conform
to the 1999 presentation.
ADOPTION OF RECENT ACCOUNTING STANDARDS
In June 1998, the FASB issued SFAS 133, "Accounting for Derivative
Instruments and Hedging Activities." In July 1999, the FASB issued SFAS 137
which deferred the effective date of SFAS 133 to fiscal years beginning after
June 15, 2000. SFAS 133 requires companies to record derivatives on the balance
sheet as assets and liabilities, measured at fair value. Gains and losses
resulting from changes in the values of those derivatives would be accounted for
in earnings. Depending on the use of the derivative and the satisfaction of
other requirements, special hedge accounting may apply. The Company has not
determined the impact that adoption of this standard will have on its future
consolidated financial statements.
NOTE 2. RESTATEMENT
Restatement of Prior Period Results. In December 1998, the FASB issued, in
question and answer format, "A Guide to Implementation of Statement 125 on
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities, Questions and Answers, Second Edition" (the "Special Report").
The Special Report indicates that two methods have arisen in practice for
accounting for credit enhancements relating to securitization. These methods are
the cash-in method and the cash-out method. The cash-in method treats credit
enhancements (pledged loans or cash) as belonging to the Company. As such, these
assets are recorded at their face value as of the time they are received by the
trust. The cash-out method treats credit enhancements as assets owned by the
related securitization trust. As such, these assets are treated as part of the
interest-only strips and are recorded at a discounted value for the period
between when collected
F-9
68
by the trust and the projected receipt to the Company. The Special Report
indicates that if no true market exists for credit enhancement assets, the
cash-out method should be used to measure the fair value of credit enhancements.
The Company had historically used the cash-in method to account for its
interest-only strips. However, during the three months ended December 31, 1998,
the Company retroactively changed its practice of measuring and accounting for
its interest-only strips to the cash-out method in response to the FASB's
Special Report and to public comments from the Securities and Exchange
Commission released on December 8, 1998.
Under the cash-in method previously used by the Company, the assumed
discount period for measuring the present value of the interest-only strips
ended when the cash flows were received by the securitization trust; and, the
initial deposits to overcollateralization accounts were recorded at face value.
Under the cash-out method as specified in the Special Report by the FASB and
comments made by the Securities and Exchange Commission, the assumed discount
period for measuring the present value of the interest-only strips ends when
cash, including the return of any initial deposits, is distributed to the
Company on an unrestricted basis.
The change to the cash-out method results only in a difference in the
timing of revenue recognition from a securitization and has no effect on the
total cash flows of securitization transactions. While the total amount of
revenue recognized over the term of a securitization is the same under either
method, the cash-out method results in lower initial gains on the sale of loans
due to the longer discount period, and higher subsequent loan service revenue
resulting from the impact of discounting cash flows.
As a result, the Company's consolidated results of operations for periods
subsequent to June 30, 1994 have been restated. The restatement resulted in the
following changes to the financial statements presented (dollars in thousands,
except per share amounts):
Year Ended June 30,
--------------------
1998 1997
-------- --------
Revenue:
Previous ................................................. $286,110 238,578
As restated .............................................. 266,489 214,531
Net income:
Previous ................................................. 40,317 17,109
As restated .............................................. 27,563 1,478
Earnings per share:
Basic:
Previous .............................................. 1.41 0.65
As restated ........................................... 0.97 0.06
Diluted:
Previous .............................................. 1.23 0.60
As restated ........................................... 0.87 0.05
Interest-only strips:
(end of period)
Previous ................................................. 554,161 383,249
As restated .............................................. 490,542 339,251
Stockholders' equity:
(end of period)
Previous ................................................. 345,403 268,354
As restated .............................................. $304,051 239,755
NOTE 3. NONRECURRING CHARGES
During the fiscal year ended June 30, 1999, the Company recorded a $37
million one-time charge related to advances which are recorded as accounts
receivable on the Company's balance sheet. The one-time charge relates to
payments made by the Company to the securitization trusts for which it acts as
servicer. As servicer of the loans it securitizes, the Company is obligated to
advance, or "loan," to the trusts delinquent interest. In addition, as servicer,
the Company advances to the trusts foreclosure-related expenses and certain tax
and insurance remittances relating to loans in securitized pools. The Company,
as servicer, is then entitled to recover these advances from regular monthly
cash flows into the trust, including monthly payments, pay-offs and liquidation
proceeds on the related loan. Until recovered, the Company records the
F-10
69
cumulative advances in accounts receivable on the balance sheet. In addition,
the Company, as servicer, is obligated to make additional payments into the
trusts which are not recoverable from monthly cash flows. These payments, for
example, relate to compensating interest payments for loans that pay-off other
than at a month's end. As servicer, the Company is required to pay into the
trust that portion of a monthly interest payment that is not included in the
pay-off amount. However, payments into a trust that are not recovered from
monthly cash flows may be recoverable from the trust's distributions to the
Company, as residual certificate holder.
In early 1999, the Company began to explore ways to reduce the cash burden
of its servicing advance obligations through various financing techniques. At
the same time, the Company determined that certain amounts recorded as accounts
receivable associated with the Company's securitization trusts were not
recoverable from the trusts' monthly cash flows. As a result, accounts
receivable were written-down by $37 million.
In fiscal 1997, the Company incurred $32 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 relocating corporate headquarters recorded in the first fiscal
quarter and to severance and other strategic decisions made in the fourth fiscal
quarter.
NOTE 4. CASH AND CASH EQUIVALENTS AND CASH HELD IN TRUST
At June 30, 1999, the Company had corporate cash and cash equivalents
available of $21 million, none of which was restricted. Cash equivalents include
$15 million of overnight Eurodollar deposits at June 30, 1999.
The Company services loans on behalf of customers. In such capacity,
certain funds are collected and placed in segregated trust accounts which
totaled $93 million and $58 million at June 30, 1999 and June 30, 1998,
respectively. These accounts and corresponding liabilities are not included in
the accompanying consolidated balance sheet.
NOTE 5. LOANS HELD FOR SALE
The following is a summary of the composition of the Company's loans held
for sale by interest rate type at June 30, 1999 and 1998:
JUNE 30,
---------------------------
1999 1998
------------ -----------
Fixed rate mortgages $335,921,000 140,525,000
Adjustable rate mortgages 223,948,000 57,677,000
------------ -----------
$559,869,000 198,202,000
============ ===========
Subsequent to June 30, 1999, the Company sold approximately $400 million of
loans held for sale in the form of a securitization and recorded a gain on sale.
NOTE 6. ACCOUNTS RECEIVABLE
At June 30, 1999 and 1998, accounts receivable was comprised of the
following:
1999 1998
------------ -----------
Interest advances $ 7,585,000 10,335,000
Servicing advances 14,240,000 16,088,000
Capital proceeds receivable 24,750,000 --
Other receivables 10,389,000 24,649,000
------------ -----------
$ 56,964,000 51,072,000
============ ===========
F-11
70
During the year ended June 30, 1999, the Company reduced its servicing
advance obligations by engaging a loan servicing company to subservice two of
the Company's securitization pools. The subservicer assumed the obligation to
make all future advances on those two pools. At the same time, the Company also
sold to the subservicer the outstanding servicing advances on the two pools for
approximately $13 million.
Also during the year ended June 30, 1999, the Company entered into an
arrangement with an investment bank pursuant to which the investment bank
purchased certain cumulative advances and undertook the obligation to make a
substantial portion of the Company's advance obligations on its pre-1999 pools.
As a result of this arrangement, the Company received approximately $50 million
in cash for certain servicing advances carried in accounts receivable.
At June 30, 1999, accounts receivable included $25 million of capital
proceeds receivable which were received in cash on August 3, 1999.
NOTE 7. INTEREST-ONLY STRIPS
The activity in the interest-only strips during the years ended June 30,
1999 and 1998 is summarized as follows:
JUNE 30,
------------------------------
1999 1998
------------- ------------
Balance, beginning of year ......................... $ 490,542,000 339,251,000
Gain on sale of loans .............................. 35,716,000 121,098,000
Accretion .......................................... 34,671,000 41,008,000
Cash received from trusts .......................... (39,976,000) (30,310,000)
Valuation (write-down) of interest-only strips ..... (188,626,000) 19,495,000
------------- ------------
Balance, end of year ............................... $ 332,327,000 490,542,000
============= ============
During the quarter ended June 30, 1999, the Company considered the
historical performance of its securitized pools, recent prepayment experience of
those pools, the credit performance of previously securitized loans and other
industry data in connection with the performance of its interest-only strips.
Key assumptions and estimates used by the Company in its June 30, 1999
review of the interest-only strips were the following:
Peak rates of prepayment:
Fixed rate loans 29.0%
Adjustable rate loans 42.0% to 57.0%
Weighted average life 2.9 years
Discount rate 15.0%
Prospective cumulative loss estimate 2.7%
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. Included in interest-only strips at June 30, 1999 and 1998, were amounts
held in trust of approximately $259 million and $195 million, respectively,
which were available for 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.
During the quarter ended December 31, 1998, as part of its ongoing
monitoring process, management adjusted each of its assumptions (rate of
prepayment, discount rate and credit loss) to reflect current market conditions.
This change in estimate resulted in a valuation adjustment of the Company's
interest-only strips of approximately $194 million (the "Write-Down"), gross of
a positive valuation adjustment of $5.2 recorded in the quarter ended September
30, 1998, in connection with the Company's securitization. The components of the
valuation adjustment were as follows:
F-12
71
Rate of Prepayment. In its valuation analysis of prepayment speeds, the
Company considered the relationship between the rate paid on the certificates or
bonds issued in the securitizations and the weighted average coupons on the
mortgages outstanding in each securitization pool from time to time.
Additionally, for the quarters up to and including September 30, 1998,
prepayment rates used by the Company were held constant, e.g. flat, over the
life of the pool. The estimates used by the Company for the quarters up to and
including September 30, 1998 were flat prepayment rates ranging from 26% for
fixed to 30.5% for adjustable and hybrid loan products. These rates represented
a weighted average loan life of approximately 2.6 to 3.8 years. During the
quarter ended December 31, 1998, the Company finalized the development of an
enhanced analytical model that more precisely reflected the performance of the
securitized loans. This analytical model enabled the Company to refine its
estimate of the prepayment rates associated with the performance of its
securitized loans. Additionally, data and information received from market
participants (credit and capital providers) assisted the Company in its
assessment of current market conditions resulting in the Company applying a more
precise valuation estimate to its prepayment assumptions. The Company
incorporated this new information in developing its improved judgment as to
prepayment speeds and changed its estimate of prepayment rates from a flat
constant prepayment rate to a vectored rate, which more closely approximates the
performance of the securitized loans. These revised prepayment rates resulted in
a weighted average life of 2.86 years. The impact of the change in prepayment
speeds amounted to approximately $62 million, which was included in the
Write-Down.
Discount Rate. For the quarters up to and including September 30, 1998,
the Company used the weighted average interest rates of the loans included in
the pool as the best estimate available as an appropriate discount rate to
determine fair value. As the market deteriorated in the quarter ended December
31, 1998, it became apparent that an increase in discount rate would be required
in order for the estimate of fair value to be consistent with market conditions.
To determine the appropriate discount rate, the Company reviewed general market
conditions as reflected by market sales of senior tranche asset-backed
securities. Management believed that the pass-through rate on senior tranche
securities should be lower than the discount rate applied to the subordinate,
and higher risk, interest-only strips. However, the adversity of the market
during the quarter ended December 31, 1998 was so severe that, in some
instances, transactions of senior tranche asset-backed securities could not even
be completed. Accordingly, the Company incorporated this current market
information in developing its judgment as to the appropriate risk adjusted rate
of return in establishing its change in estimate of the discount rate to be used
in estimating the fair value of the interest-only strips. For the quarter ended
December 31, 1998, the Company increased its discount rate to 15% to reflect
current market conditions. The impact of this change in discount rate amounted
to approximately $65 million, which was included in the Write-Down.
Credit Losses. For the quarter up to and including September 30, 1998, the
Company used a prospective cumulative loan loss estimate of 1.4% of the balance
of the loans in the securitization pools as an appropriate estimate to determine
fair value. This estimate was developed through a review of the credit
performance of securitized loans in the aggregate. In conjunction with its
previous quarterly review of loss estimates, the Company considered the level of
delinquency of securitized loans and the percentage of annualized losses to
securitized loans in the aggregate. As market conditions deteriorated in the
quarter ended December 31, 1998, the Company refined its estimate of credit
losses by expanding the factors it considered in developing its credit loss
estimates to include loss and delinquency information by channel, credit grade
and product, and information available from other market participants such as
investment bankers, credit providers and credit agencies. Management believes
the increase in losses in the December 1998 quarter reflected general market
conditions rather than the continuing effects of the transfer of servicing
in-house. Publicly available information from investment banking firms and
credit agencies began to indicate a market expectation that credit losses within
the sub-prime home equity sector would rise. Those indications, in part, arise
from the impact of the adverse market conditions on severely delinquent
borrowers who, in a more favorable market, would avoid default by refinancing
with other lenders. In the current market, with competition lessening and
underwriting guidelines tightening, these borrowers are much more likely to
default. Accordingly, the Company increased its prospective cumulative loan loss
estimate to 2.7% (discounted back at 15%) of the balance of the loans in the
securitization pools at December 31, 1998. This change in credit loss estimate
resulted in a valuation adjustment of $67 million, which was included in the
Write-Down.
NOTE 8. MORTGAGE SERVICING RIGHTS, NET
The activity in mortgage servicing rights during the years ended June 30,
1999 and 1998 is summarized as follows:
F-13
72
JUNE 30,
------------------------------
1999 1998
------------ ------------
Balance, beginning of year ........................................................... $ 32,090,000 21,641,000
Mortgage servicing rights originated ................................................. 6,194,000 19,513,000
Mortgage servicing rights amortized .................................................. (11,431,000) (9,064,000)
Mortgage servicing rights charged-off ................................................ (5,925,000) --
------------ -----------
Balance, end of year ................................................................. $ 20,928,000 32,090,000
============ ===========
The mortgage servicing rights are amortized over the estimated lives of
the loans to which they relate.
During the year ended June 30, 1999, in connection with the transfer of
servicing of two pools and a special servicing arrangement for two additional
pools with a subservicer, the Company charged off the carrying value of the
mortgage servicing rights associated with those pools.
NOTE 9. EQUIPMENT AND IMPROVEMENTS, NET
Equipment and improvements, net consisted of the following at June 30,
1999 and 1998:
JUNE 30,
-----------------------------
1999 1998
------------ ------------
Data processing equipment ............................................................. $ 11,496,000 10,421,000
Furniture and fixtures ................................................................ 8,623,000 8,353,000
Data processing software .............................................................. 6,340,000 3,213,000
Leasehold improvements ................................................................ 2,575,000 2,032,000
------------ ------------
Total ....................................................................... 29,034,000 24,019,000
Accumulated depreciation and amortization ............................................. (15,539,000) (10,080,000)
------------ ------------
Equipment and improvements, net ....................................................... $ 13,495,000 13,939,000
============ ============
NOTE 10. BORROWINGS
Borrowings consisted of the following at June 30, 1999 and 1998:
JUNE 30,
----------------------------
1999 1998
------------ ------------
9.125% Senior Notes due 2003, guaranteed by each
of the restricted subsidiaries (as defined in the indenture) of the Company ......... $150,000,000 150,000,000
5.5% Convertible Subordinated Debentures due 2006, convertible to 6.1 million
shares of common stock at $18.67 per share. The Convertible
Subordinated Debentures are subordinated to all existing and future senior
indebtedness of the Company (as defined in the Indenture) ........................... 113,970,000 113,990,000
10.5% Senior Notes due 2002,
Principal payments of $5,750,000 required in each of calendar
years 1999 through 2002 ............................................................. 17,250,000 23,000,000
------------ ------------
Borrowings .................................................................. $281,220,000 286,990,000
============ ============
Maturities on borrowings are as follows:
Fiscal Years Ended June 30,
2000.................................................................................... $ 5,750,000
2001.................................................................................... 5,750,000
2002.................................................................................... 5,750,000
2003.................................................................................... --
2004.................................................................................... 150,000,000
Thereafter.............................................................................. 113,970,000
------------
Total borrowings.............................................................. $281,220,000
============
F-14
73
In October 1996, the Company completed an offering of its 9.125% Senior
Notes due 2003 which are guaranteed by all but one 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 income and net equity of such subsidiaries are substantially
equivalent to the total assets, net income and net equity of the Company on a
consolidated basis.
At June 30, 1999 and 1998, the Company had unamortized debt issuance costs
of $6 million and $7 million, respectively, related to the issuance of the $23
million of 10.5% Senior Notes due 2002, the issuance of the $115 million of 5.5%
Convertible Subordinated Debentures due 2006 and the issuance of the $150
million of 9.125% Senior Notes due 2003. This balance is included in prepaid and
other assets on the consolidated balance sheet and is amortized to expense over
the terms of the related debt issuances.
NOTE 11. REVOLVING WAREHOUSE AND REPURCHASE FACILITIES
The Company utilizes revolving warehouse and repurchase facilities to
finance the holding of mortgage loans prior to sale or securitization. As of
June 30, 1999 and 1998, the Company had total revolving warehouse and repurchase
facilities available in the amount of $590 million and $950 million,
respectively. Warehouse and repurchase facilities typically have a term of one
year or less and are designated to fund mortgage loans originated within
specified underwriting guidelines. The majority of the mortgage loans remain in
the facilities for a period generally of up to 90 days at which point they are
securitized or sold to institutional investors.
Amounts outstanding under revolving warehouse and repurchase facilities
consisted of the following at June 30, 1999 and 1998:
JUNE 30,
----------------------------
1999 1998
------------ ------------
Warehouse facility of $90 million from an investment bank, collateralized by
loans held for sale; expires on February 9, 2000; bears interest at 1.5% over
one month LIBOR .......................................................................... $ 47,018,000 --
Repurchase facility of $300 million from an investment bank; collateralized by
loans held for sale; expires on March 31, 2000; bears interest from 1.50% to
2.00%, depending on document status, over one month LIBOR ................................ 293,037,000 --
Repurchase facility of $200 million from a commercial bank; collateralized by
loans held for sale; expires on April 7, 2000; bears interest from 1.25% to
1.50%, depending on document status, over one month LIBOR ................................ 195,942,000 --
Warehouse facility of $400 million from a syndicate of ten commercial banks;
collateralized by loans held for sale and certain servicing receivables; expired
April 9, 1999; bore interest at the Company's option of either 1.05% over the
Fed Funds Rate, or .80% over one month LIBOR ............................................. -- 135,500,000
Warehouse facility of $300 million from an investment bank; collateralized by
loans held for sale; expired on September 11, 1999; bore interest at .65% over
one month LIBOR .......................................................................... -- 5,512,000
------------ ------------
Amounts outstanding under warehouse and repurchase facilities .................. $535,997,000 141,012,000
============ ============
At June 30, 1999, the one month LIBOR rate was 5.20%. The one month LIBOR
and Federal Funds rates were 5.7% and 7.1%, respectively, at June 30, 1998.
Commencing July 1, 1999 and to maturity, the Company's $300 million
repurchase facility bears interest from 1.50% to 2.00%, depending on document
status, over one month LIBOR, and the term of this facility was extended to
March 31, 2000. Also, effective July 1, 1999, the Company began using a $100
million uncommitted repurchase facility from an investment bank to fund loan
originations. In August, 1999, the Company closed a $400 million loan
securitization. Amounts outstanding under revolving warehouse and repurchase
facilities were reduced by approximately $392 million, including all borrowings
under the $100 million uncommitted repurchase facility.
F-15
74
The weighted-average interest rate on borrowings outstanding under
revolving warehouse and repurchase facilities at June 30, 1999 and 1998 were
approximately 6.39% and 6.69%, respectively. During the year ended June 30,
1999, the average amount of borrowings under revolving warehouse and repurchase
facilities was $349 million and the maximum outstanding under such lines at any
one time during the year ended June 30, 1999, was $796 million.
At June 30, 1999, included in prepaid and other assets in the accompanying
consolidated balance sheet was approximately $1.8 million of deferred commitment
fees relating to the Company's revolving warehouse and repurchase facilities
remaining to be amortized to expense over their remaining terms.
NOTE 12. INCOME TAXES
The provision (benefit) for income taxes consisted of the following for
the years ended June 30, 1999, 1998 and 1997:
JUNE 30,
-----------------------------------------
1999 1998 1997
------------ ---------- ----------
Current:
Federal ......................... $ 1,200,000 10,060,000 203,000
State ........................... 400,000 3,249,000 262,000
------------ ---------- ----------
1,600,000 13,309,000 465,000
------------ ---------- ----------
Deferred:
Federal ......................... (24,155,000) 6,814,000 4,665,000
State ........................... (7,627,000) 5,120,000 2,852,000
------------ ---------- ----------
(31,782,000) 11,934,000 7,517,000
------------ ---------- ----------
Total ................... $(30,182,000) 25,243,000 7,982,000
============ ========== ==========
Current and deferred taxes payable were comprised of the following at
June 30, 1999 and 1998:
JUNE 30,
-----------------------------
1999 1998
------------ ------------
Current taxes payable (receivable):
Federal .................................... $ -- 3,190,000
State ...................................... (1,737,000) (967,000)
------------ ------------
(1,737,000) 2,223,000
Deferred taxes payable:
Federal .................................... 7,819,000 26,442,000
State ...................................... -- 4,505,000
------------ ------------
7,819,000 30,947,000
------------ ------------
Total .............................. $ 6,082,000 33,170,000
============ ============
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities consisted of the
following at June 30, 1999 and 1998:
F-16
75
JUNE 30,
---------------------------
1999 1998
------------ ------------
Deferred tax liabilities:
Interest-only strips ......................... $ -- 27,754,000
Mark-to-market ............................... 5,960,000 5,960,000
Mortgage servicing rights .................... 8,416,000 13,317,000
Other, net ................................... -- 1,351,000
------------ ------------
Total gross deferred tax liabilities ..... 14,376,000 48,382,000
------------ ------------
Deferred tax assets:
Interest-only strips ......................... (53,367,000) --
State taxes .................................. (5,033,000) (5,033,000)
Allowance for doubtful accounts .............. (10,073,000) (3,195,000)
Net operating loss carry forward ............. (19,272,000) (4,969,000)
Other ........................................ (5,986,000) (4,238,000)
------------ ------------
Total gross deferred tax assets .......... (93,731,000) (17,435,000)
Tax valuation allowance ........................ 87,174,000 --
------------ ------------
Net deferred tax liabilities ................... $ 7,819,000 30,947,000
============ ============
The estimated effective tax rates for the years ended June 30, 1999, 1998
and 1997 were as follows:
1999
-------------------------------------------------
TAX AFFECTED EFFECTIVE
PERMANENT PERMANENT TAX RATE
DIFFERENCES DIFFERENCES CALCULATION
-------------- ------------- --------------
Tax benefit ................ $ (30,182,000)
Loss before income taxes ... (278,149,000)
Effective tax rate ......... (10.9)%
=============
Federal statutory rate ..... (35.0)%
State pre-tax after
permanent difference...... $ -- (21,142,000) (7.6)
Disallowed compensation .... 3,000,000 1,050,000 .4
Tax valuation allowance .... -- 87,174,000 31.3
Other, net ................. 253,000 89,000 --
-------------
(10.9)%
=============
1998
------------------------------------------------
TAX AFFECTED EFFECTIVE
PERMANENT PERMANENT TAX RATE
DIFFERENCES DIFFERENCES CALCULATION
----------- ------------ -----------
Tax provision............... $25,243,000
Income before income taxes.. 52,806,000
Effective tax rate.......... 47.8%
===========
Federal statutory rate...... 35.0%
State pre-tax after
permanent difference...... $8,369,000 5,439,000 10.3
Disallowed compensation .... 3,398,000 1,189,300 2.3
Other, net ................. 253,940 132,250 0.2
-----------
47.8%
===========
F-17
76
1997
--------------------------------------------------
TAX AFFECTED EFFECTIVE
PERMANENT PERMANENT TAX RATE
DIFFERENCES DIFFERENCES CALCULATION
----------- ------------ -----------
Tax benefit ................................................ $7,982,000
Income before income taxes ................................. 9,460,000
Effective tax rate ......................................... 84.4%
==========
Federal statutory rate ..................................... 35.0%
State pre-tax after permanent difference ................... 36,558,000 2,654,000 28.1
Pooling of interests ....................................... 5,156,000 1,805,000 19.1
Stock options .............................................. (2,227,000) (779,000) (8.4)
Other, net ................................................. 2,872,000 1,005,000 10.6
----------
84.4%
==========
The income tax refund receivable of $1.7 million was received subsequent
to June 30, 1999.
The investment in the Company by Capital Z Financial Services Fund, II,
L.P., a Bermuda limited partnership ("Capital Z"), results in a change of
control for income tax purposes thereby potentially limiting the Company's
ability to utilize net operating loss carryforwards and certain other future
deductions.
The Company's residual interest in real estate mortgage investment
conduits ("REMIC") creates excess inclusion income for tax purposes which may
give rise to a current income tax payable. Available loss carry-forwards and
operating losses may not reduce taxable income below excess inclusion income
earned from the REMIC.
NOTE 13. 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 $11 million, $9.1 million and
$5.3 million, for the years ended June 30, 1999, 1998 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).
At June 30, 1999, future minimum rental payments required under
non-cancelable operating leases that have initial or remaining terms in excess
of one year are as follows:
2000......................................... $ 9,445,000
2001......................................... 7,963,000
2002......................................... 6,724,000
2003......................................... 5,996,000
2004 4,489,000
Thereafter................................... 30,869,000
-----------
$65,486,000
===========
During the fourth fiscal quarter of 1999, the Company entered into a new
mandatory forward commitment to sell loans. Terms of the new forward commitment,
which expires on May 16, 2000, include provisions for the Company to sell a
minimum of $500 million and a maximum of $1.50 billion of loans to the purchaser
on a servicing released basis. At June 30, 1999, the Company had fulfilled
approximately $80 million of loans held for sale under this commitment.
LITIGATION
In the ordinary course of its business, the Company is subject to various
claims made against it by borrowers, private investors and others arising from,
among other things, losses that are claimed to have been incurred as a result of
alleged
F-18
77
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
consolidated financial position or results of operations; however, any claims
asserted in the future may result in expenses which could have a material
adverse effect on the Company's consolidated financial position and results of
operations.
EMPLOYMENT AND SEVERANCE AGREEMENTS
On May 13, 1999, the Company's chief executive officer resigned. At June
30, 1999, the Company had agreed in principle to the terms of a severance and
consulting arrangement pursuant to which the former officer will receive
$600,000, a corporate owned automobile and be granted 774,049 shares under the
Aames Financial Corporation 2000 Stock Option Plan, which remains subject to the
approval by the Company's stockholders.
At June 30, 1999, the president of the Company had an employment agreement
with the Company expiring in February, 2004, which provides for a $600,000
annual base salary and (i) a calendar 1999 guaranteed cash bonus to be paid in
the amount of $540,000 in the form of a recourse loan which shall be forgiven
and deemed paid in full so long as the president remains employed by the Company
through the first anniversary date of the agreement (ii) supplemental cash
bonuses subject to Board of Directors' determination of the Company's
satisfactory completion of a program of cost reductions (iii) cash bonuses after
the 1999 calendar year of up to $600,000; or in excess of 100% of annual base
salary for extraordinary performance subject to Board of Directors' approval and
the achievement of nonfinancial goals as established by the Board of Directors
(iv) a loan in the amount of $1.7 million to be used to purchase shares of
Series C Convertible Preferred Stock which shall be deemed nonrecourse provided
that the president remains employed by the Company through the first anniversary
date of the agreement. In addition to benefits provided to other employees, the
agreement provides the president with excess standard life insurance, medical
and dental benefits for himself and his family and long-term disability
benefits. Further under the agreement, the Company will grant an option to the
president to purchase 3,214,642 shares of the Company's common stock pursuant to
the Aames Financial Corporation Stock Option Plan, which remains subject to the
approval of the Company's stockholders. In the event of termination (as defined
in the agreement), the Company will be obligated to pay severance in a declining
amount over the anniversary dates of the agreement, subject to offset for
amounts owed to the Company by the president and for any salary earned by the
president from other employers. The agreement also limits the amount of Company
stock that the president may sell, assign or otherwise transfer while employed
by the Company.
During the year ended June 30, 1999 and as a means to induce the president
to enter into the agreement outlined in general terms above, the Company paid
the president a bonus of approximately $1.5 million, the receipt of which the
president had deferred since June, 1998.
Certain other members of management had employment or severance agreements
which provided for enhanced severance and other benefits upon a change in
control, as defined in the agreements.
NOTE 14. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosures of the estimated fair value of financial
instruments as of June 30, 1999 and 1998 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.
F-19
78
JUNE 30, 1999 JUNE 30, 1998
----------------------------- --------------------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
------------ ------------ ------------ ------------
BALANCE SHEET:
Cash and cash equivalents .................................. $ 20,764,000 20,764,000 12,322,000 12,322,000
Loans held for sale ........................................ 559,869,000 576,178,000 198,202,000 208,112,000
Accounts receivable ........................................ 56,964,000 56,964,000 51,072,000 51,072,000
Interest-only strips, at estimated fair market value ....... 332,327,000 332,327,000 490,542,000 490,542,000
Mortgage servicing rights, net ............................. 20,928,000 20,928,000 32,090,000 32,090,000
Borrowings ................................................. 281,220,000 171,888,000 286,990,000 246,938,000
Revolving warehouse and repurchase facilities .............. 535,997,000 535,997,000 141,012,000 141,012,000
OFF BALANCE SHEET:
Hedge position notional amount outstanding ................. -- -- 250,000,000 248,455,000
The fair value estimates as of June 30, 1999 and 1998 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 consolidated 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.
- Loans held for sale are based on current investor yield
requirements.
- Accounts receivable are short term in nature, therefore the carrying
value approximates fair value.
- Interest-only strips and mortgage servicing rights are based on the
present value of expected future cash flows using assumptions based
on Company-specific and industry information as well as the
Company's historical experience.
- 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.
- Amounts outstanding under revolving warehouse and repurchase
facilities are short term in nature and generally bear market rates
of interest and therefore, are based on the carrying amount which is
a reasonable estimate of fair value.
- Hedge positions are based on quoted market prices.
NOTE 15. 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. There was no contribution to the Plan by the Company during the
year ended June 30, 1999. During the years ended June 30, 1998 and 1997, the
Company's contributions to the plan aggregated $549,000 and $432,000,
respectively.
DEFERRED COMPENSATION PLAN
During the year ended June 30, 1999, the Company terminated the Deferred
Compensation Plan which had been implemented in April 1997. During the year
ended June 30, 1998, the Company made $203,700 of discretionary contributions to
the plan.
F-20
79
STOCK BASED COMPENSATION
The Company's Board of Directors adopted the Aames Financial Corporation
Stock Option Plan (the "1999 Plan") as of February 10, 1999, as amended. The
1999 Plan remains subject to the approval of the stockholders. If approved, the
1999 Plan will supercede the Company's 1991 Stock Incentive Plan, 1995 Stock
Incentive Plan, 1996 Stock Incentive Plan, 1997 Stock Option Plan and 1997
Non-Qualified Stock Option Plan. The 1999 Plan provides for the issuance of
options to purchase shares of the Company's common stock to officers, key
executives and consultants of the Company. Subject to adjustment for stock
splits, stock dividends and other similar events, shares reserved for issuance
under the 1999 Plan shall be 14,612,000 shares.
At June 30, 1999, the Company has reserved 5,450,000 shares of the common
stock for issuance under its 1991 Stock Incentive Plan, 1995 Stock Incentive
Plan, 1996 Stock Incentive Plan, 1997 Stock Option Plan and 1997 NonQualified
Stock Option 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 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, 1999, 1998 and 1997 and changes
during the years then ended are as follows:
OPTION OPTION
SHARES PRICE RANGE
--------- ------------
1999
Outstanding at beginning of year..................... 4,570,669 $ 0.19-29.70
Granted.............................................. 911,680 13.38
Exercised............................................ (53,266) 3.89-7.94
Forfeited............................................ (403,585) 3.04-29.67
--------- ------------
Outstanding at end of year........................... 5,025,498 $ 0.19-29.60
========= ============
1998
Outstanding at beginning of year..................... 4,182,491 $ 0.19-29.70
Granted.............................................. 1,084,091 11.81-19.94
Exercised............................................ (419,414) 3.33-13.63
Forfeited............................................ (276,499) 0.20-28.92
--------- ------------
Outstanding at end of year........................... 4,570,669 $ 0.19-29.70
========= ============
1997
Outstanding at beginning of year .................... 2,940,722 $ 0.19-18.61
Granted ............................................. 1,647,733 12.00-29.70
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
========= ============
The number of options exercisable at June 30, 1999 and 1998, was 2,997,329
and 2,324,755, respectively. The weighted-average fair value of options granted
during 1999 and 1998 was $7.99 and $6.30, respectively.
F-21
80
The Company applies Accounting Principles Board Opinion 25 and related
interpretations in accounting for its stock-based compensation plans and
arrangements. No compensation cost has been recognized for its stock option
plan. If compensation cost for the stock option plan 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
(loss) and earnings (loss) per share would have been reflected to the pro forma
amounts indicated below:
JUNE 30,
------------------------------------------------
1999 1998 1997
------------- ------------- -------------
Net income (loss):
As reported .............................. $(247,967,000) 27,563,000 1,478,000
Pro forma ................................ (249,552,000) 26,511,000 (2,437,000)
Basic earnings (loss) per share:
As reported .............................. (8.00) 0.97 0.06
Pro forma ................................ (8.05) 0.93 (0.09)
Diluted earnings (loss) per share:
As reported .............................. (8.00) 0.87 0.05
Pro forma ................................ (8.05) 0.84 (0.09)
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,
----------------------
1999 1998
--------- -------
Dividend yield............................... 0.00% 1.20%
Expected volatility.......................... 70.00 54.76
Risk-free interest rate...................... 5.47 5.78
Expected life of option...................... 4.5 years 5 years
NOTE 16. STOCKHOLDERS' EQUITY
During the year ended June 30, 1999, the Company received $76.5 million in
new capital from Capital Z (through a partnership majority-owned by Capital Z),
certain designees of Capital Z and Cary H. Thompson pursuant to his Management
Investment Agreement with the Company. The investment was made on February 10,
1999 (the "Initial Closing") at which time the Company issued 26,704 shares of
Series B Convertible Preferred Stock and 50,046 shares of Series C Convertible
Preferred Stock for $1,000 per share. Net proceeds to the Company, after
issuance expenses, were $67.4 million.
On August 3, 1999, the Company received $25 million in additional capital
from Capital Z, through a partnership majority-owned by Capital Z, (the
"Additional Investment") at which time the Company issued 25,000 additional
shares of Series C Convertible Preferred Stock for $1,000 per share. Net
proceeds to the Company, after issuance expenses, were $24.8 million. The
Additional Investment is reflected in accounts receivable and stockholders'
equity in the accompanying consolidated balance sheet at June 30, 1999, pursuant
to the FASB's Emerging Issues Task Force ("EITF") Issue No. 85-1. EITF 85-1
provides guidance on recording capital proceeds as an asset if a binding
agreement exists at the balance sheet date requiring that the capital be
infused; and, if such capital is realized in cash prior to the issuance of the
financial statements.
The Company's Series B Convertible Preferred Stock and the Series C
Convertible Preferred Stock rank senior in right to dividends and liquidation to
all classes of the Company's common and preferred stock. The Series C
Convertible Preferred Stock does not have the right to vote for directors.
The Series B Convertible Preferred Stock and the Series C Convertible
Preferred Stock accrue and accumulate dividends at a rate of 6.5%. The Company
has the option to accrue but not pay the dividends for the first two years after
their issuance. If the Company's stockholders do not adopt certain amendments to
the Company's Certificate of Incorporation before the earlier of September 30,
1999 or September 13, 1999, the date of the scheduled stockholders' meeting (if,
in the latter case, any of the proposed amendments to the Certificate of
Incorporation is defeated at the meeting), the dividend rate on the Series B and
Series C Convertible Preferred Stock held by Capital Z will increase from 6.5%
to 15% per annum and Capital Z will be able to exercise a warrant to purchase up
to 3,000,000 additional shares of common stock at an exercise price of $1.00 per
share. Commencing on the earlier of (i) the 10th anniversary of the date on
which the Series B Convertible Preferred Stock and the Series C Convertible
Preferred Stock were first issued and (ii) the date on which fewer than 25% of
the Series B Convertible Preferred Stock and the Series C Convertible Preferred
Stock issued on the first date of issuance remain outstanding, the Company may,
at its option, redeem all outstanding shares of the Series B Convertible
Preferred Stock and the Series C Convertible Preferred Stock. Borrowing
agreements and revolving warehouse and repurchase agreements generally limit the
Company's ability
F-22
81
to pay dividends if such payment would result in an event of default. In
addition, the Company's indentures relating to its 10.5% 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. Under the most
restrictive of these limitations, the Company will be prohibited from paying
cash dividends on its capital stock for the foreseeable future.
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 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.
On April 27, 1998, the Company issued 2.78 million shares of its common
stock, or 9.9% of the Company's outstanding shares, to private entities
controlled by Ronald Perelman and Gerald Ford, at a purchase price of $13.7625
per share, or approximately $38 million. As part of the agreement, the Company
also issued warrants to these entities to purchase an aggregate additional 9.9%
of the Company's stock at an exercise price of $7.67 (as adjusted), subject to
customary anti-dilution provisions. The warrants are exercisable only upon a
change in control of the Company and expire in April 2001.
The following table reconciles basic earnings (loss) per share to diluted
(loss) earnings per share for the years ended June 30, 1999, 1998 and 1997
(dollars and share data in thousands, except earnings per share):
YEAR ENDED JUNE 30,
-----------------------------------
1999 1998 1997
---------- -------- --------
Basic weighted average number of shares ............. 31,000 28,548 26,400
Add: options ........................................ -- 1,094 1,971
Add: convertible shares ............................. -- 6,107 --
---------- -------- --------
Diluted shares ...................................... 31,000 35,749 28,371
========== ======== ========
Basic net income (loss) ............................. $ (247,967) 27,563 1,478
Interest on convertible subordinated debentures ..... -- 3,645 --
---------- -------- --------
Diluted net income (loss) ........................... $ (247,967) $ 31,208 $ 1,478
========== ======== ========
Earnings (loss) per share:
Basic ............................................... $ (8.00) 0.97 0.06
Diluted ............................................. $ (8.00) 0.87 0.05
NOTE 17. TRANSACTIONS INVOLVING DIRECTORS, OFFICERS AND AFFILIATES
On January 26, 1998, the Board of Directors approved the Executive and
Director Loan Program under which directors and executive officers of the
Company were entitled to obtain a mortgage loan from the Company at the
Company's cost
F-23
82
of funds (plus 25 basis points) as determined by an approved, independent
investment banking firm. The Executive and Director Loan Program was terminated
in June 1999. All loans made under the Executive and Director Loan Program were
fixed rate, fully amortized, 15- or 30-year loans with no prepayment penalties
and were underwritten to the Company's underwriting guidelines in effect at the
time of the loan. Participants in this program were not charged any loan fees
except for those fees or costs charged by third parties. During the years ended
June 30, 1999 and 1998, the Company originated $7.5 million and $8.3 million of
loans to directors, officers and persons related to affiliates, respectively.
Included in loans held for sale at June 30, 1999 and 1998 in the accompanying
consolidated balance sheet are loans to directors, officers and affiliates of
$1.6 million and $7.8 million, respectively. All loans originated under the
Executive and Director Loan Program are intended for sale.
During the year ended June 30, 1999, the Company incurred management fees
and out-of-pocket expenses in the amount of $1.2 million relating to advisory
services rendered by Equifin Capital Partners, LLC ("Equifin"), an affiliate of
Capital Z.
In connection with the Initial Closing, the Company paid a transaction
fee and a commitment fee of $1.0 million and $2.0 million, respectively, to
Capital Z, and paid a $250,000 transaction fee to Equifin. The transaction fees
were deducted from capital proceeds received. The Company also reimbursed
Capital Z $262,000 for out-of-pocket expenses.
From time to time certain officers, directors and employees of the
Company, as well as members of their immediate families, acted as private
investors in loan transactions originated by the Company. All such loans were
originated on terms and conditions which were no more favorable than loans
originated by the Company for other nonaffiliated private investors except that
such persons received 75% of any prepayment fees collected by the Company on
such loans. The Company discontinued its private investor program in August
1997.
NOTE 18. QUARTERLY FINANCIAL DATA (UNAUDITED)
A summary of unaudited quarterly operating results for the years ended
June 30, 1999 and 1998 follows (in thousands, except per share amounts):
THREE MONTHS ENDED,
-----------------------------------------------------
SEPT. 30 DEC. 31 MAR. 31 JUNE 30
-------- -------- -------- --------
1999
Revenue ................................... $ 57,761 (154,423) 36,814 43,695
Income (loss) before income taxes ......... (3,233) (208,076) (52,153) (14,687)
Net income (loss) ......................... (2,156) (195,745) (35,979) (14,087)
Earnings (loss) per share - diluted ....... (0.07) (6.31) (1.16) (0.46)
1998
Revenue ................................... $ 64,499 70,341 59,538 72,111
Income before income taxes ................ 18,760 17,840 3,937 12,269
Net income ................................ 9,933 9,170 2,018 6,442
Earnings per share -- diluted ............. 0.31 0.29 0.07 0.20
NOTE 19. FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET ACTIVITIES
SECURITIZATIONS -- HEDGING INTEREST RATE RISK
The most significant variable in the determination of gain on sale in a
securitization is the spread between the weighted average coupon on the
securitized loans and the pass-through interest rate. In the interim period
between loan origination or purchase and securitization of such loans, the
Company is exposed to interest rate risk. The majority of loans are securitized
within 90 days of origination or purchase. However, a portion of the loans are
held for sale or securitization for as long as twelve months (or longer, in very
limited circumstances) prior to securitization. If interest rates rise during
the period that the mortgage loans are held, the spread between the weighted
average interest rate on the loans to be securitized
F-24
83
and the pass-through interest rates on the securities to be sold (the latter
having increased as a result of market interest rate movements) would narrow.
Upon securitization, this would result in a reduction of the Company's related
gain on sale. Historically, the Company mitigated this exposure through swap
agreements with third parties that sell United States Treasury securities not
yet purchased and the purchase of Treasury Put Options. Hedge gains or losses
are initially deferred and subsequently included in gain on sale upon completion
of the securitization. With respect to the Company's securitizations, gain on
sale included hedge losses of $13.5 million, $1.3 million and $3.0 million in
fiscal 1999, 1998 and 1997, respectively. These hedging activities help mitigate
the risk of absolute movements in interest rates but they do not mitigate the
risk of a widening in the spreads between pass-through certificates and U.S.
Treasury securities with comparable maturities.
At June 30, 1999, the Company did not have any hedge transactions in place
and no gains or losses were deferred.
CREDIT RISK
The Company is exposed to on-balance sheet credit risk related to its
receivables and interest-only strips. The Company is exposed to off-balance
sheet credit risk related to loans which the Company has committed to originate
or purchase.
The Company is a party to financial instruments with off-balance sheet
credit risk in the normal course of business. These financial instruments
include commitments to extend credit to borrowers and commitments to purchase
loans from correspondents. The Company has a first or second lien position on
all of its loans, and the combined loan-to-value ratio ("CLTV") permitted by the
Company's mortgage underwriting guidelines generally may not exceed 90%. The
CLTV represents the combined first and second mortgage balances as a percentage
of the appraised value of the mortgaged property, with the appraised value
determined by an appraiser with appropriate professional designations. A title
insurance policy is required for all loans.
F-25
84
EXHIBIT INDEX
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(13)
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(14)
4.2(a) Rights Agreement, dated as of June 21, 1996 between
Registrant and Wells Fargo Bank, as rights agent(4)
4.2(b) Amendment to Rights Agreement, dated as of April 27, 1998(17)
4.2(c) Amendment to Rights Agreement, dated as of December 23,
1998(22)
4.3 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)
4.4(a) 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)
4.4(b) Second Supplemental Indenture, dated as of February 10, 1999,
between Registrant, The Chase Manhattan Bank and certain
wholly owned subsidiaries of Registrant, relating to
Registrant's 9.125% Senior Notes due 2003(21)
10.1 Form of Director and Officer Indemnification Agreement(14)
10.2(a) Second Amended and Restated Employment, dated as of May 8,
1997, between Registrant and Cary H. Thompson(14)
10.2(b) Stock Option Agreement between Registrant and Cary H.
Thompson(10)
10.2(c) Amendment No. 1, dated as of August 26, 1998, to Exhibit
10.2(a)(19)
10.3(a) Employment Agreement, dated as of August 28, 1996, between
Registrant and Neil Kornswiet(14)
10.3(b) Amendment No. 1, dated as of June 1, 1997, to Exhibit
10.3(a)(14)
10.3(c) Amended and Restated Employment Agreement, dated as of August
26, 1998, between Registrant and Neil B. Kornswiet(19)
10.4 Employment Agreement, dated as of May 12, 1997, between the
Registrant and David A. Sklar
10.5 Second Amended and Restated Employment Agreement, dated as of
June 1, 1997, between Registrant and Barbara Polsky(14)
10.6(a) Employment Agreement, dated as of June 1, 1997, between
Registrant and Mark Costello(14)
10.6(b) Performance Bonus Plan for Mark Costello(20)
10.7 1991 Stock Incentive Plan, as amended(2)
10.8 1995 Stock Incentive Plan(10)
10.9(a) 1996 Stock Incentive Plan(12)
10.9(b) Amendment No. 1 to Exhibit 10.9(a)(14)
10.10 1997 Stock Option Plan(15)
10.11 1997 Non-Qualified Stock Option Plan (amended and restated
effective May 22, 1998)(15)
10.12 Office Lease, dated as of September 15, 1998, between
Colonnade Wilshire Corp. and the Registrant, for the premises
located at 3731 Wilshire Boulevard, Los Angeles, California.
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(14)
10.13(b) First Amendment, dated as of August 15, 1997, to Exhibit
10.13(a)(14)
85
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 Reserved
10.16 Reserved
10.17 Reserved
10.18(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)
10.18(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)
10.19 Management Voting Agreement between Registrant, Cary H.
Thompson and Neil B. Kornswiet, dated as of February 10,
1999(21)
10.20 Variable Deferred Compensation Plan(14)
10.21(a) Employment Agreement between Registrant and Cary H.
Thompson(21)
10.21(b) Amendment No. 1, dated as of December 23, 1998, to Exhibit
10.21(a)(21)
10.22 Management Investment Agreement, dated as of February 10,
1999, between Registrant and Cary H. Thompson(21)
10.23 Employment Agreement between Registrant and Neil B.
Kornswiet(21)
10.24 Management Investment Agreement, dated as of February 10,
1999, between Registrant and Neil B Kornswiet(21)
10.25(a) Preferred Stock Purchase Agreement, dated as of December 23,
1998, between Registrant and Capital Z Financial Services
Fund II, L.P.(22)
10.25(b) Amendment No. 1 to Exhibit 10.25(a)(21)
10.25(c) Amendment No. 2 to Exhibit 10.25(a)
10.25(d) Amendment No. 3 to Exhibit 10.25(a)
10.25(e) Amendment No. 4 to Exhibit 10.25(a)
10.26(a) Amended and Restated Master Repurchase Agreement Governing
Purchase and Sales of Mortgage Loans, dated as of February
10, 1999, between Aames Capital Corporation, Registrant's
wholly owned subsidiary ("ACC") and Lehman Commercial Paper,
Inc.(25)
10.26(b) Amendment, dated as of June 30, 1999, to Exhibit 10.26(a)
10.26(c) Second Amendment, dated as of June 30, 1999, to Exhibit
10.26(a)
10.26(d) Guaranty, dated as of March 8, 1996, between Registrant and
Lehman Commercial Paper, Inc., with respect to Exhibit
10.26(a)(25)
10.27(a) Master Loan and Security Agreement, dated as of February 10,
1999, between ACC and Greenwich Capital Financial Products,
Inc.(25)
10.27(b) Amendment No. 1, dated as of June 10, 1999, to Exhibit 10.27
10.27(c) Amendment No. 2, dated as of June 30, 1999, to Exhibit
10.28(a)
10.27(d) Guaranty, dated as of February 10, 1999, between Registrant
and Greenwich Capital Financial Products, Inc., with respect
to Exhibit 10.28(a)(25)
10.27(e) Amendment No. 1, dated as of June 30, 1999, to Exhibit
10.28(d)
10.28(a) Master Repurchase Agreement, dated as of April 8, 1999,
between ACC and NationsBank, N.A.(25)
10.28(b) Guaranty, dated as of April 8, 1999, between Registrant and
NationsBank, N.A., with respect to Exhibit 10.28(a)(25)
10.28(c) First Amendment, dated as of June 30, 1999, to Exhibit
10.28(a) and Exhibit 10.28(b)
10.29 Agreement for Management Advisory Services, dated as of
February 10, 1999 between Registrant and Equifin Capital
Management, LLC(25)
10.30 Historical Advance Purchase Agreement, dated as of June 10,
1999, between ACC and Steamboat Financial Partnership I, L.P.
86
10.31 Historical Advance Purchase Agreement, dated as of June 17,
1999, between ACC and Steamboat Financial Partnership I, L.P.
10.32 Limited Partnership Agreement of Steamboat Financial
Partnership I, L.P., dated as of June 10, 1999, between
Random Properties Acquisition Corp. IV, ACC and Greenwich
Capital Derivatives, Inc.
10.33 Reserved
10.34 Delinquency Advance Purchase Agreement, dated as of May 13,
1999, between ACC and Fairbanks Capital Corp.
10.35 Sub-Servicing Agreement 1997-1, dated as of April 21, 1999,
between ACC and Fairbanks Capital Corp.
10.36 Sub-Servicing Agreement 1996-D, dated as of April 21, 1999,
between ACC and Fairbanks Capital Corp.
11 Computation of Per Share Earnings (Loss)
21 Subsidiaries of the Registrant
23.1 Consent of Ernst & Young LLP
23.2 Consent of PricewaterhouseCoopers 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 Current Report on Form 8-K
dated September 11, 1996.
(14) Incorporated by reference from Registrant's Annual Report on Form 10-K for
the year ended June 30, 1997.
(15) Incorporated by reference from Registrant's Registration Statement on Form
S-8 dated July 24, 1998.
(16) Incorporated by reference from Registrant's Current Report on Form 8-K
dated April 27, 1998.
(17) Incorporated by reference from Registrant's Registration Statement on Form
8-A/A dated April 27, 1998.
(18) Incorporated by reference from Registrant's Current Report on Form 8-K
dated March 25, 1998.
(19) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1998.
(20) Incorporated by reference from Registrant's Annual Report on Form 10-K for
the year ended June 30, 1998.
(21) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended December 31, 1998.
(22) Incorporated by reference from Registrant's Current Report on Form 8-K
dated December 31, 1998.
(23) Incorporated herein by reference to the Form of Warrant to Purchase Common
Stock of the Registrant, filed as Exhibit C to Exhibit 10.1 of the
Registrant's Current Report on Form 8-K, filed with the Commission on
December 31, 1998.
(24) Incorporated herein by reference to the Form of Contingent Warrant to
Purchase Common Stock of the Registrant, filed as Exhibit E to Exhibit
10.1 of the Registrant's Current Report on Form 8-K, filed with the
Commission on December 31, 1998.
87
(25) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1999.