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UNITED STATES
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 December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from: to
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Commission File No. 0-21341
OCWEN FINANCIAL CORPORATION
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(Exact name of Registrant as specified in its charter)
FLORIDA 65-0039856
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
THE FORUM, SUITE 1000
1675 PALM BEACH LAKES BOULEVARD
WEST PALM BEACH, FLORIDA 33401
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(Address of principal executive office) (Zip Code)
(561) 681-8000
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: Not applicable.
Securities registered pursuant to Section 12 (g) of the Act:
COMMON STOCK, $.01 PAR VALUE NEW YORK STOCK EXCHANGE (NYSE)
(Title of each class) (Name of each exchange on which registered)
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. [ ]
Aggregate market value of the Common Stock, $.01 par value, held by
nonaffiliates of the registrant, computed by reference to the closing price as
reported on the NYSE as of the close of business on February 27, 1998:
$902,378,460 (for purposes of this calculation affiliates include only directors
and executive officers of the Company).
Number of shares of Common Stock, $.01 par value, outstanding as of February 27,
1998: 60,708,520 shares
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the definitive Proxy Statement
for the Annual Meeting of Shareholders to be held on May 13, 1998 are
incorporated by reference into Part III, Items 10-13. Portions of the Annual
Report to Shareholders are incorporated by reference into Part II, Items 5-8.
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1
OCWEN FINANCIAL CORPORATION
1997 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
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PAGE
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PART I
Item 1. Business................................................................................ 4
General............................................................................... 4
Recent Transactions................................................................... 5
Discount Loan Acquisition and Resolution Activities................................... 6
Investment in Joint Ventures.......................................................... 11
Lending Activities ................................................................... 11
Loan Servicing Activities............................................................. 18
Asset Quality......................................................................... 18
Investment Activities................................................................. 24
Sources of Funds...................................................................... 30
Computer Systems and Use of Technology................................................ 33
Economic Conditions................................................................... 34
Competition........................................................................... 35
Subsidiaries.......................................................................... 35
Employees............................................................................. 36
Regulation............................................................................ 36
The Company........................................................................... 36
The Bank.............................................................................. 37
Federal Taxation...................................................................... 41
State Taxation........................................................................ 43
Item 2. Properties.............................................................................. 43
Offices............................................................................... 43
Item 3. Legal Proceedings....................................................................... 43
Item 4. Submission of Matters to a Vote of Security Holders..................................... 43
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters............... 43
Item 6. Selected Consolidated Financial Data.................................................... 43
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations... 44
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.............................. 44
Item 8. Financial Statements.................................................................... 44
2
OCWEN FINANCIAL CORPORATION
1997 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
(CONTINUED)
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PAGE
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Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure............................................................... 44
PART III
Item 10. Directors and Executive Officers of Registrant.......................................... 44
Item 11. Executive Compensation.................................................................. 44
Item 12. Security Ownership of Certain Beneficial Owners and Management.......................... 44
Item 13. Certain Relationships and Related Transactions.......................................... 44
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K........................ 45
Signatures.............................................................................. 47
FORWARD-LOOKING STATEMENTS
CERTAIN STATEMENTS CONTAINED HEREIN ARE NOT, AND CERTAIN STATEMENTS
CONTAINED IN FUTURE FILINGS BY THE COMPANY WITH THE SECURITIES AND EXCHANGE
COMMISSION, IN THE COMPANY'S PRESS RELEASES OR IN THE COMPANY'S OTHER PUBLIC OR
SHAREHOLDER COMMUNICATIONS, MAY NOT BE BASED ON HISTORICAL FACTS AND ARE
"FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES
ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934,
AS AMENDED. FORWARD-LOOKING STATEMENTS WHICH ARE BASED ON VARIOUS ASSUMPTIONS
(SOME OF WHICH ARE BEYOND THE COMPANY'S CONTROL), MAY BE IDENTIFIED BY REFERENCE
TO A FUTURE PERIOD OR PERIODS, OR BY THE USE OF FORWARD-LOOKING TERMINOLOGY,
SUCH AS "MAY," "WILL," "COULD," "BELIEVE," "EXPECT," "ANTICIPATE," "CONTINUE,"
"INTENDS," "PLANS," "PRESENTS," OR SIMILAR TERMS OR VARIATION ON THOSE TERMS, OR
BY THE USE OF THE NEGATIVE OF SUCH TERMINOLOGY. ACTUAL RESULTS COULD DIFFER
MATERIALLY FROM THOSE SET FORTH IN FORWARD-LOOKING STATEMENTS DUE TO A VARIETY
OF FACTORS, INCLUDING, BUT NOT LIMITED TO, THOSE RELATED TO THE ECONOMIC
ENVIRONMENT, PARTICULARLY IN THE MARKET AREAS IN WHICH THE COMPANY OPERATES,
COMPETITIVE PRODUCTS AND PRICING, THE GROWTH OR DECLINE OF, AND THE AVAILABILITY
OF PRODUCT TO PURCHASE IN, THE DISCOUNT LOAN INDUSTRY FISCAL AND MONETARY
POLICIES OF THE U.S. OR U.K. GOVERNMENTS, CHANGES IN GOVERNMENT REGULATIONS
AFFECTING FINANCIAL INSTITUTIONS AND REAL ESTATE INVESTMENT TRUSTS, INCLUDING
REGULATORY FEES, CAPITAL REQUIREMENTS AND TAXATION, CHANGES IN PREVAILING
INTEREST AND CURRENCY EXCHANGE RATES, ACQUISITIONS AND THE INTEGRATION OF
ACQUIRED BUSINESSES, SOFTWARE INTEGRATION, DEVELOPMENT AND LICENSING, CREDIT
INTEREST RATE AND OPERATIONAL RISK MANAGEMENT, ASSET/LIABILITY MANAGEMENT, THE
FINANCIAL AND SECURITIES MARKETS AND THE AVAILABILITY OF AND COSTS ASSOCIATED
WITH SOURCES OF LIQUIDITY. THE COMPANY DOES NOT UNDERTAKE, AND SPECIFICALLY
DISCLAIMS ANY OBLIGATION, TO PUBLICLY RELEASE THE RESULTS OF ANY REVISIONS WHICH
MAY BE MADE TO ANY FORWARD-LOOKING STATEMENTS TO REFLECT THE OCCURRENCE OF
ANTICIPATED OR UNANTICIPATED EVENTS OR CIRCUMSTANCES AFTER THE DATE OF SUCH
STATEMENTS.
3
PART I
ITEM 1. BUSINESS
GENERAL
Ocwen Financial Corporation (the "Company") is a specialty financial
services company which conducts business primarily through Ocwen Federal Bank
FSB (the "Bank"), a federally-chartered savings bank and a wholly-owned
subsidiary of the Company, and, to a lesser extent, through Ocwen Financial
Services, Inc. ("OFS"), 93.7% owned subsidiary of the Company which acquired
both the subprime single family residential lending operations previously
conducted by the Bank and substantially all of the assets of Admiral Home Loan
("Admiral"), the Company's primary correspondent mortgage banking firm for
subprime single family residential loans, in a transaction which closed on May
1, 1997. The Company, directly and through its non-bank subsidiaries, also
conducts certain lending and investment activities.
The Company considers itself to be involved in the single business
segment of providing financial services and conducts a variety of business
activities within this segment. The Company's primary business activities
currently consist of its subprime single family, small commercial and large
commercial discount loan acquisition and resolution activities, commercial real
estate lending activities, single family residential lending activities,
mortgage loans for others, investments in a wide variety of mortgage-related
securities and investments in low-income housing tax credit interests. In
addition, the Company previously operated an automated banking division, the
operations of which were discontinued in September 1995. The following table
presents the contribution by business activity to the Company's net income for
the years indicated.
Year Ended December 31,
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1997 1996 1995
--------------------- --------------------- ---------------------
(Dollars in Thousands)
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Amount % Amount % Amount %
-------- -------- -------- -------- -------- --------
Discount Loans:
Single family residential loans ........ $ 22,384 28% $ 12,580 25% $ 4,778 19%
Large commercial real estate loans ..... 23,476 30 16,179 32 9,824 39
Small commercial real estate loans ..... 5,194 7 3,687 7 4,395 17
Investment in low-income housing tax
credits ................................ 9,353 12 7,269 14 3,538 14
Commercial real estate lending ........... 11,802 15 3,785 8 3,041 12
Subprime single family residential
lending ................................. (1,526) (2) 4,115 8 364 1
Mortgage loan servicing .................. 3,780 5 2,559 5 175 1
Investment securities .................... 5,615 7 2,226 4 2,454 10
Other .................................... (1,146) (2) (2,258) (3) (3,102) (13)
-------- ----- -------- ----- -------- -----
$ 78,932 100% $ 50,142 100% $ 25,467 100%
======== ===== ======== ===== ======== =====
The Company's strategy focuses on what it believes to be the current
trend toward the growth in the sale or outsourcing of servicing of nonperforming
and underperforming loans by financial institutions and government agencies,
particularly in the event that credit quality for some product lines (such as
subprime mortgage loans) deteriorates. The Company's strategy also focuses on
leveraging its technology infrastructure and core expertise to expand its
activities into related business lines both for itself and on a fee basis for
others. For example, the Company has acquired two software companies and formed
a new corporation, Ocwen Asset Investment Corp. ("OAIC"), a Virginia corporation
which elected to be taxed as a real estate investment trust ("REIT") for federal
income tax purposes and which is managed by Ocwen Capital Corporation ("OCC"), a
newly-formed, wholly-owned subsidiary of the Company.
In May 1997, OAIC successfully completed an initial public offering of
its common stock, which resulted in net proceeds of $283.8 million for its
shares, inclusive of the amount contributed by Investors Mortgage Insurance
Holding Company ("IMI"), a wholly-owned subsidiary of the Company. At December
31, 1997, IMI owned approximately 9.0% of the outstanding common stock of OAIC
and had options to purchase an additional 10% of OAIC's common stock (one
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quarter of which vest annually over the next four years beginning in May 1998.
Also at December 31, 1997, IMI owned 160,000 or 0.837% of the outstanding
limited partnership units of Ocwen Partnership, L.P. ("OPLP"), the operating
partnership formed to undertake the business of OAIC.
On November 6, 1997, the Company acquired Amos, Inc. ("Amos"), a
Connecticut based company engaged primarily in the development of mortgage loan
servicing software. Amos' products are Microsoft(R) Windows based, client/server
architecture and feature real-time processing, year 2000 compliance, a scaleable
database platform and strong workflow capabilities. The aggregate purchase price
was $9.7 million, including $4.9 million which is contingent on Amos meeting
certain software development performance criteria.
On January 20, 1998, the Company acquired DTS Communications, Inc.
("DTS"), a real estate technology company located in San Diego, California, for
a purchase price of $13.0 million in cash, common stock of the Company and
repayment of certain indebtedness. DTS has developed technology tools to
automate real estate transactions over the Internet. DTS has been recognized by
Microsoft Corporation for the Microsoft(R) component-based architecture to
facilitate electronic data interchange. The common stock of the Company issued
in the acquisition was acquired from affiliates of the Company at the same price
per share as was used to calculate the number of shares issued in the
acquisition. DTS was recently honored as the recipient of this year's Inman
Innovator Award for "Software Applications that help the Real Estate Industry be
more efficient and speed up the Real Estate Transaction Process."
The Company plans to enhance both the Amos and DTS products by
combining features from its proprietary software systems for loan default
management and loss mitigation. Eventually, it is the Company's intention to
make its advanced loan resolution technology available to third parties in the
mortgage industry through the marketing of software licenses.
The Company is a registered savings and loan holding company subject to
regulation by the Office of Thrift Supervision (the "OTS"). The Bank is subject
to regulation by the OTS, as its chartering authority, and by the Federal
Deposit Insurance Corporation ("FDIC"), as a result of its membership in the
Savings Association Insurance Fund ("SAIF") which insures the Company's deposits
up to the maximum extent permitted by law. The Bank is also subject to certain
regulation by the Board of Governors of the Federal Reserve System ("Federal
Reserve Board") and currently is a member of the Federal Home Loan Bank ("FHLB")
of New York, one of the 12 regional banks which comprise the FHLB System.
RECENT TRANSACTIONS
On January 20, 1998, the Company acquired DTS (as discussed above).
On March 6, 1998, the Company acquired an approximately 35% interest in
Norland Capital Group PLC, which trades as Kensington Mortgage Company
("Kensington"), for (POUND STERLING) 27.5 million, or approximately US$45.4
million. Kensington Mortgage is a leading originator of non-conforming
residential mortgages in the UK, with over (POUND STERLING) 400 million of total
loans outstanding to over 8,000 borrowers as of December 1997. Founded in
October of 1995, Kensington has become a major provider of residential home
loans to UK borrowers who are unable to qualify for loans from traditional
sources, such as building societies and banks. Kensington has the distinction of
being the only non-conforming originator on the UK Council of Mortgage Lenders,
the trade association for the UK mortgage lending industry, whose 122 members
collectively account for 98% of the residential mortgage lending in the UK. This
council represents the UK's mortgage lenders, including banks, building
societies and other residential mortgage lenders, to the government, Parliament,
the media and other audiences.
On January 28, 1998, the Company, OAIC and Aames Financial Corporation
("Aames") announced that they had entered into a nonbinding letter of intent
pursuant to which they are negotiating for OAIC to acquire subordinated residual
interests with respect to mortgage loans originated or acquired by Aames through
the first quarter of 1998 and for the Company to assume responsibility for the
special servicing of nonperforming loans underlying such residuals. As the
result of these negotiations, on March 19, 1998, OAIC announced that it had
executed a definitive agreement with a Wall Street firm concerning the
acquisition of a subordinate interest-only security for approximately $14.3
million plus closing costs. Pursuant to related agreements, the Bank will be the
special servicer with respect to the underlying loans.
On February 17, 1998, OAIC repurchased from IMI 175,000 shares of
OAIC's common stock for an aggregate of approximately $3.1 million, reducing
IMI's ownership in OAIC to 8.12%. These shares were immediately resold to
5
certain officers and directors of the Company and OAIC. As part of this
transaction, IMI acquired 175,000 units from OPLP for approximately $3.1
million, increasing IMI's ownership in OPLP to 1.736%.
On March 31, 1998, the Company announced that it had entered into
definitive agreements for the acquisition of substantially all of the assets,
and certain liabilities, of the United Kingdom operations of Cityscape Financial
Corp. (Nasdaq SmallCap Market: CTYSC). The acquisition includes the purchase of
Cityscape's UK whole loan portfolio, securitized loan residuals, and loan
origination and servicing businesses for a price of approximately (POUND
STERLING) 285 million, subject to adjustment as of closing based on an agreed
upon formula (currently estimated to result in an upward or downward adjustment
of approximately (POUND STERLING) 5 million). Closing, which is anticipated to
occur in April, 1998, is subject to satisfaction of a number of conditions,
including obtaining rating agency consents and various substitutions in
connection with the transfer of the securitized residuals and related servicing
rights (which will require the consents of the trustees of the several
securitizations). As a result, there can be no assurance that the transaction
will be consummated.
DISCOUNT LOAN ACQUISITION AND RESOLUTION ACTIVITIES
The Company believes that, under appropriate circumstances, the
acquisition of nonperforming and underperforming mortgage loans at discounts
offers significant opportunities to the Company. Discount loans generally have
collateral coverage which is sufficiently in excess of the purchase price of the
loan, such that successful resolutions can produce total returns which are in
excess of an equivalent investment in performing mortgage loans.
The Company began its discount loan operations in 1991 and initially
focused on the acquisition of single family residential loans. In 1994 the
Company expanded this business to include the acquisition and resolution of
discount multi-family residential and commercial real estate loans (together,
unless the context otherwise requires, "commercial real estate loans"). Prior to
entering the discount loan business, management of the Company had substantial
loan resolution experience through former subsidiaries of the Company which had
been engaged in the business of providing private mortgage insurance for
residential loans. This experience assisted the Company in developing the
procedures, facilities and systems which are necessary to appropriately evaluate
and acquire discount loans and to resolve such loans in a timely and profitable
manner. Management of the Company believes that the resources utilized by the
Company in connection with the acquisition, servicing and resolution of discount
real estate loans, which include proprietary technology and software, allow the
Company to effectively manage an extremely data-intensive business and that, as
discussed below, these resources have applications in other areas.
COMPOSITION OF THE DISCOUNT LOAN PORTFOLIO. At December 31, 1997, the
Company's net discount loan portfolio amounted to $1.43 billion or 47% of the
Company's total assets. Substantially all of the Company's discount loan
portfolio is secured by first mortgage liens on real estate.
The following table sets forth the composition of the Company's
discount loan portfolio by type of loan at the dates indicated:
December 31,
-----------------------------------------------------------------------------
1997 1996 1995 1994 1993
----------- ----------- ----------- ----------- -----------
(Dollars in Thousands)
Single family residential
loans ..................... $ 900,817 $ 504,049 $ 376,501 $ 382,165 $ 430,355
Multi-family residential
loans ..................... 191,302 341,796 176,259 300,220 --
Commercial real estate loans 701,035 (1) 465,801 (1) 388,566 102,138 1,845
Other loans ................ 1,865 2,753 2,203 911 1,316
----------- ----------- ----------- ----------- -----------
Total discount loans ..... 1,795,019 1,314,399 943,529 785,434 433,516
Unaccreted discount ........ (337,350)(2) (241,908)(2) (273,758) (255,974) (129,882)
Allowance for loan losses .. (23,493) (11,538) -- -- --
----------- ----------- ----------- ----------- -----------
Discount loans, net ........ $ 1,434,176 $ 1,060,953 $ 669,771 $ 529,460 $ 303,634
=========== =========== =========== =========== ===========
- -------------------
(1) The balance at December 31, 1997 consisted of $363.7 million of loans
secured by office buildings, $98.9 million of loans secured by hotels,
$106.8 million of loans secured by retail properties or shopping centers
and $131.6 million of loans secured by other properties. The balance at
December 31, 1996 consisted of $202.1 million of loans secured by office
buildings, $46.0 million of loans secured by hotels, $138.6 million of
loans secured by retail properties or shopping centers and $79.1 million
of loans secured by other properties.
(2) The balance at December 31, 1997 consisted of $170.7 million on single
family residential loans, $46.0 million on multi-family residential loans,
$120.5 million on commercial real estate loans and $0.2 million on other
loans, respectively. The balance at December 31, 1996 consisted of $92.2
million on single family residential loans, $71.8 million on multi-family
residential loans, $77.6 million on commercial real estate loans and $0.3
million on other loans, respectively.
The properties which secure the Company's discount loans are located
throughout the United States. At December 31, 1997, the five states with the
greatest concentration of properties securing the Company's discount loans were
California, New Jersey, New York, Connecticut and Pennsylvania, which had $311.1
million, $220.9 million, $201.5 million, $103.7 million and $95.5 million
principal amount of discount loans (before unaccreted discount), respectively.
6
The Company believes that the relatively geographic distribution of its discount
loan portfolio can reduce the risks associated with concentrating such loans in
very limited more geographic areas, and that, due to its expertise, technology
and software, and procedures, the geographic distribution of its discount loan
portfolio does not place significantly greater burdens on the Company's ability
to resolve such loans.
Discount loans may have net book values up to the Bank's loan-to-one
borrower limitation. See "Business Regulation-The Bank-Loan-to-One Borrower."
ACQUISITION OF DISCOUNT LOANS. In the early years of the program, the
Company acquired discount loans from the FDIC and the Resolution Trust
Corporation ("RTC") primarily in auctions of pools of loans acquired by them
from the large number of financial institutions which failed during the late
1980s and early 1990s. Although the RTC no longer is in existence and the
banking and thrift industries have recovered from the problems experienced in
the late 1980s and early 1990s, governmental agencies, particularly the
Department of Housing and Urban Development ("HUD"), continue to be potential
sources of discount loans. The Company obtains a substantial amount of discount
loans from various private sector sellers, such as banks, savings institutions,
mortgage companies, subprime lenders and insurance companies. At December 31,
1997, approximately 58% of the loans in the Company's discount loan portfolio
had been acquired from the private sector.
The percentage of discount loans in the Company's discount loan
portfolio acquired from private sector sellers has decreased in recent periods
as a result of the Company's acquisition of a substantial amount of discount
loans from HUD. During the year ended December 31, 1997, the Company and a
co-investor were the successful bidder to purchase from HUD 24,773 single family
residential loans with an aggregate unpaid principal balance of $1.55 billion
and a purchase price of $1.34 billion. The Company acquired $771.6 million of
these loans and the right to service all of such loans. In 1996, the Company and
a co-investor were the successful bidder to purchase from HUD 4,591 single
family residential loans with an aggregate unpaid principal balance of $258.1
million and a purchase price of $204.0 million. The Company acquired $112.2
million of these loans and the right to service all of such loans. In 1996, the
Company also acquired from HUD discount multi-family residential loans with an
unpaid principal balance of $225 million. The foregoing acquisitions were in
addition to the acquisition of $741.2 million gross principal amount of single
family residential loans from HUD by BCBF, LLC (the "LLC"), a limited liability
company formed in March 1996 between the Bank and BlackRock Capital Finance L.P.
("BlackRock"). See "Business-Investment in Joint Ventures."
Primarily as a result of acquisitions from HUD, during 1996 and 1997
the Company (including its pro rata interest in the LLC) was the second largest
acquiror in the United States (behind Goldman Sachs' Whitehall Street Real
Estate Fund) of distressed real estate assets worldwide and the largest acquiror
in the U.S. of portfolios of such assets, according to statistics published by
REAL ESTATE ALERT.
HUD loans are acquired by HUD pursuant to various assignment programs
of the Federal Housing Administration ("FHA"). Under programs of the FHA, a
lending institution may assign an FHA-insured loan to HUD because of an economic
hardship on the part of the borrower which precludes the borrower from making
the scheduled principal and interest payment on the loan. FHA-insured loans also
are automatically assigned to HUD upon the 20th anniversary of the mortgage
loan. In most cases, loans assigned to HUD after this 20-year period are
performing under the original terms of the loan. Once a loan is assigned to HUD,
the FHA insurance has been paid and the loan is no longer insured. As a result,
none of the HUD loans are insured by the FHA.
A majority of the $771.6 million of loans acquired from HUD during the
year ended December 31, 1997 are subject to forbearance agreements after the
servicing transfer date. During the forbearance period, borrowers are required
to make a monthly payment which is based on their ability to pay and which may
be less than the contractual monthly payment. Once the forbearance period is
over, the borrower is required to make at least the contractual payment
regardless of ability to pay. Virtually all of the foregoing loans acquired from
HUD will reach the end of the forbearance period by the end of 1998. Prior
purchases of loans from HUD by the Company (and the LLC) primarily included
loans that were beyond the forbearance period.
Discount real estate loans generally are acquired in pools, although
discount commercial real estate loans may be acquired individually. These pools
generally are acquired in auctions or competitive bid circumstances in which the
Company faces substantial competition. Although many of the Company's
competitors have access to greater capital and have other advantages, the
Company believes that it has a competitive advantage relative to many of its
competitors as a result of its experience in managing and resolving discount
loans, its large investment in the computer systems, technology
7
and other resources which are necessary to conduct this business, its national
reputation and the strategic relationships and contacts which it has developed
in connection with these activities.
The Company generally acquires discount loans solely for its own
portfolio. From time to time, however, the Company and one or more co-investors
may submit a joint bid to acquire a pool of discount loans in order to enhance
the prospects of submitting a successful bid. If successful, the Company and the
co-investors generally allocate ownership of the acquired loans in an agreed
upon manner, although in certain instances the Company and the co-investor may
continue to have a joint interest in the acquired loans. In addition, from time
to time the Company and a co-investor may acquire discount loans through a joint
venture. See "Business-Investment in Joint Ventures."
Prior to making an offer to purchase a portfolio of discount loans, the
Company conducts an extensive investigation and evaluation of the loans in the
portfolio. Evaluations of potential discount loans are conducted primarily by
the Company's employees who specialize in the analysis of nonperforming loans,
often with further specialization based on geographic or collateral specific
factors. The Company's employees regularly use third parties, such as brokers,
who are familiar with a property's type and location, to assist them in
conducting an evaluation of the value of a collateral property, and depending on
the circumstances, particularly in the case of commercial real estate loans, may
use subcontractors, such as local counsel and engineering and environmental
experts, to assist in the evaluation and verification of information and the
gathering of other information not previously made available by a potential
seller.
The Company determines the amount to be offered by it to acquire
potential discount loans by using a proprietary modeling system and loan
information database which focuses on the anticipated recovery amount and the
timing and cost of the resolution of the loans. The amount offered by the
Company generally is at a discount from both the stated value of the loan and
the value of the underlying collateral which the Company estimates is sufficient
to generate an acceptable return on its investment.
RESOLUTION OF DISCOUNT LOANS. After a discount loan is acquired, the
Company utilizes its computer software systems to resolve the loan as
expeditiously as possible in accordance with specified procedures. The various
resolution alternatives generally include the following: (i) the borrower brings
the loan current in accordance with original or modified terms, (ii) the
borrower repays the loan or a negotiated amount of the loan, (iii) the borrower
agrees to deed the property to the Company in lieu of foreclosure, in which case
it is classified as real estate owned and held for sale by the Company, or (iv)
the Company forecloses on the loan and the property is acquired at the
foreclosure sale either by a third party or by the Company, in which case it is
classified as real estate owned and held for sale by the Company. In addition,
in the case of single family residential loans, assistance is provided to
borrowers in the form of forbearance agreements under which the borrower either
makes a monthly payment less than or equal to the original monthly payment or
makes a monthly payment more than the contractual monthly payment to make up for
arrearages.
In appropriate cases, the Company works with borrowers to resolve the
loan in advance of foreclosure. One method is through forbearance agreements,
which generally allow the borrower to pay the contractual monthly payment plus a
portion of the arrearage each month, and other means. Although this strategy may
result in an initial reduction in the yield on a discounted loan, the Company
believes that it is advantageous because it (i) generally results in a higher
resolution value than foreclosure; (ii) reduces the amount of real estate owned
acquired by foreclosure or by deed-in-lieu thereof and related costs and
expenses; (iii) enhances the ability of the Company to sell the loan in the
secondary market, either on a whole loan basis or through securitizations (in
which case the Company may continue to earn fee income from servicing such
loans); and (iv) permits the borrower to retain ownership of the home and, thus,
enhances relations between the Company and the borrower. As a result of the
Company's current loan resolution strategy of emphasizing forbearance agreements
and other resolutions in advance of foreclosure, the Company has been able to
resolve 71% of its discount loans before foreclosure.
The general goal of the Company's asset resolution process is to
maximize, in a timely manner, cash recovery on each loan in the discount loan
portfolio. The Company generally anticipates a longer period (approximately 12
to 30 months) to resolve discount commercial real estate loans than discount
single family residential loans because of their complexity and the wide variety
of issues that may occur in connection with the resolution of such loans.
The Credit Committee of the Board of Directors of the Bank actively
monitors the asset resolution process to identify discount loans which have
exceeded their expected foreclosure period and real estate owned which has been
held longer than anticipated. Plans of action are developed for each of these
assets to remedy the cause for delay and are reviewed by the Credit Committee.
8
SALE OF DISCOUNT LOANS. From time to time the Company sells performing
discount loans either on a whole loan basis or indirectly through the
securitization of such loans and sale of the mortgage-related securities backed
by them. During the years ended December 31, 1997, 1996 and 1995, respectively,
the Company sold $518.9 million, $230.2 million and $51.6 million of discount
loans, respectively, which resulted in gains of $60.4 million, $15.3 million and
$6.0 million, respectively, including net securitization gains of $53.1 million,
$7.9 million and $0, respectively. Also during 1997, the LLC, as part of larger
transactions involving the Company and an affiliate of Black Rock, completed the
securitizations of 1,730 discount single family residential loans acquired from
HUD in 1996 and 1995, with an unpaid principal balance of $78.4 million and past
due interest of $22.5 million, which resulted in the Company recognizing
indirect gains of $14.0 million as a result of the Company's pro rata interest
in the LLC. The Company continues to service the loans for a fee and has
retained interests in the related subordinate class of securities. For
information concerning the foregoing securitizations and retained securities,
see "Business-Investment Activities."
ACTIVITY IN THE DISCOUNT LOAN PORTFOLIO. The following table sets forth
the activity in the Company's gross discount loan portfolio during the periods
indicated:
Year Ended December 31,
------------------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993
------------------- ------------------- ------------------ ------------------ ------------------
No. of No. of No. of No. of No. of
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
---------- ------ ---------- ----- --------- ----- --------- ------ --------- ------
(Dollars in Thousands)
Balance at beginning
of period........... $1,314,399 5,460 $ 943,529 4,543 $ 785,434 3,894 $ 433,516 5,160 $ 310,464 5,358
Acquisitions(1)...... 1,776,773 17,703 1,110,887 4,812 791,195 2,972 826,391 2,781 294,359 2,412
Resolutions and
repayments(2)....... (484,869) (1,978) (371,228) (2,355) (300,161) (960) (265,292) (2,153) (116,890) (1,430)
Loans transferred to
real estate owned... (292,412) (1,596) (138,543) (860) (281,344) (984) (171,300) (1,477) (26,887) (602)
Sales................ (518,872) (6,609) (230,246) (680) (51,595) (379) (37,881) (417) (27,530) (578)
---------- ------ ---------- ----- --------- ----- --------- ------ --------- ------
Balance at end of
period.............. $1,795,019 12,980 $1,314,399 5,460 $ 943,529 4,543 $ 785,434 3,894 $ 433,516 5,160
========== ====== ========== ===== ========= ===== ========= ====== ========= ======
- ---------------------
(1) In 1997, acquisitions consisted of $1.06 billion of single family
residential loans, $57.7 million of multi-family residential loans and
$657.0 million of commercial real estate loans. In 1996, acquisitions
consisted of $365.4 million of single family residential loans, $310.4
million of multi-family residential loans, $433.5 million of commercial
real estate loans and $1.5 million of other loans. The 1996 data does not
include the Company's pro rata share of the $741.2 million of discount
loans acquired by the LLC (see Business Investment in Joint Ventures). In
1995, acquisitions consisted of $272.8 million of single family residential
loans, $141.2 million of multi-family residential loans, $374.9 million of
commercial real estate loans and $2.3 million of other loans. In 1994,
acquisitions consisted of $395.8 million of single family residential
loans, $315.5 million of multi-family residential loans and $115.1 million
of commercial real estate loans. In 1993, substantially all of the
acquisitions were of single family residential loans.
(2) Resolutions and repayments consists of loans which were resolved in a
manner which resulted in partial or full repayment of the loan to the
Company, as well as principal payments on loans which have been brought
current in accordance with their original or modified terms (whether
pursuant to forbearance agreements or otherwise) or on other loans which
have not been resolved.
For information relating to the activity in the Company's real estate
owned which is attributable to the Company's discount loan acquisitions, see
"Business-Asset Quality - Real Estate Owned."
9
PAYMENT STATUS OF DISCOUNT LOANS. The following table sets forth
certain information relating to the payment status of loans in the Company's
discount loan portfolio at the dates indicated.
December 31,
-----------------------------------------------------------------------
1997 1996 1995 1994 1993
----------- ----------- ---------- ---------- ----------
(Dollars in Thousands)
Loan status:
Current....................... $ 673,256 $ 579,597 $ 351,630 $ 113,794 $ 23,629
Past due 31 days to 89 days... 22,786 22,161 86,838 57,023 15,175
Past due 90 days or more (1).. 1,070,924 563,077 385,112 413,506 254,413
Acquired and servicing not
yet transferred.............. 28,053 149,564 119,949 201,111 140,299
----------- ----------- ---------- ---------- ----------
1,795,019 1,314,399 943,529 785,434 433,516
Unaccreted discount........... (337,350) (241,908) (273,758) (255,974) (129,882)
Allowance for loan losses..... (23,493) (11,538) -- -- --
----------- ----------- ---------- ---------- ----------
$ 1,434,176 $ 1,060,953 $ 669,771 $ 529,460 $ 303,634
=========== =========== ========== ========== ==========
- ----------------
(1) Includes $432.6 million and $57.0 million of loans with forbearance
agreements at December 31, 1997 and 1996, respectively, and $638.3 million
and $506.1 million of loans without forbearance agreements at December 31,
1997 and 1996, respectively. Of the $432.6 million of loans with
forbearance agreements past due 90 days or more in accordance with
original terms, $184.5 million were current and $131.8 million were past
due 31 to 89 days under the terms of the forbearance agreements.
ACCOUNTING FOR DISCOUNT LOANS. The acquisition cost for a pool of
discount loans is allocated to each individual loan within the pool based upon
the Company's pricing methodology. Prior to January 1, 1997, the discount
associated with all single family residential loans was recognized as a yield
adjustment and was accreted into interest income using the interest method
applied on a loan-by-loan basis once foreclosure proceedings were initiated, to
the extent the timing and amount of cash flows could be reasonably determined.
Effective January 1, 1997, the Company ceased accretion of discount on its
nonperforming single family residential loans. The discount which is associated
with a single family residential loan and certain multi-family residential and
commercial real estate loans which are current or subsequently brought current
by the borrower in accordance with the loan terms is accreted into the Company's
interest income as a yield adjustment using the interest method over the
contractual maturity of the loan. For all other loans interest is earned as cash
is received.
Gains on the repayment and discharge of loans are recorded in interest
income on discount loans. Upon receipt of title to property securing a discount
loan, the loans are transferred to real estate owned.
Beginning in 1996, adjustments to reduce the carrying value of discount
loans to the fair value of the property securing the loan are charged against
the allowance for loan losses on the discount loan portfolio. Prior to 1996,
such adjustments were charged against interest income on discount loans.
OTHER DISCOUNT LOAN ACTIVITIES. The Company believes that the
procedures, facilities and systems which it has developed in connection with the
acquisition and resolution of discount loans may be applied in other businesses.
The Company commenced a program in 1995 to utilize this experience by financing
the acquisition of discount loans by other institutions. During 1997 and 1996,
the Company originated $0 million and $25.8 million, respectively, of portfolio
finance loans, which had an aggregate balance of $17.7 million at December 31,
1997. Portfolio finance loans generally have two-year terms, floating interest
rates which adjust in accordance with a designated reference rate and a
loan-to-value ratio which does not exceed the lesser of 90% of the purchase
price or the estimated value of the collateral as determined by the Company, and
may include terms which provide the Company with a participation interest in the
profits from the resolution of the discount loan collateral. Portfolio finance
loans are included in the Company's non-discount loan portfolio under the
category of loan which is represented by the properties which secure the
discount loans that collateralize the Company's portfolio finance loans. See
"Business - Lending Activities."
The Company's discount loan acquisitions and resolution activities and
related securitization activities also have contributed significantly to
increases in the Company's loan servicing activities. See "Business-Loan
Servicing Activities."
10
INVESTMENT IN JOINT VENTURES
At December 31, 1997, the Company's investment in joint ventures
consisted solely of its investment in BCFL, L.L.C. ("BCFL"), a limited liability
company formed in January 1997 between the Company and BlackRock to acquire
multi-family loans. At December 31, 1996, the Company's investment in joint
ventures consisted of its 50% investment in the LLC. On December 12, 1997, the
LLC distributed all of its assets to the Company and its other 50% investor,
BlackRock. Simultaneous to the distribution, the Company acquired BlackRock's
portion of the distributed assets.
ACQUISITION OF HUD LOANS BY THE LLC. In April 1996, the LLC purchased
16,196 single family residential loans offered by HUD at an auction. Many of the
loans, which had an aggregate unpaid principal balance of $741.2 million at the
date of acquisition, were not performing in accordance with their original terms
or an applicable forbearance agreement. The aggregate purchase price paid to HUD
amounted to $626.4 million. All of the HUD loans acquired by the LLC were
secured by first mortgage liens on single family residences.
In connection with the acquisition, the Company entered into an
agreement with the LLC to service the HUD loans in accordance with its loan
servicing and loan default resolution procedures. In return for such servicing,
the Company received specific fees which were payable on a monthly basis. The
Company did not pay any additional amount to acquire these servicing rights and,
as a result, the acquisition of the right to service the HUD loans held by the
LLC did not result in the Company's recording capitalized mortgage servicing
rights for financial reporting purposes.
SECURITIZATION OF THE HUD LOANS. During 1997, the LLC, as part of
larger transactions involving the Company and an affiliate of BlackRock,
completed securitizations of 1,730 HUD loans held by it with an unpaid principal
balance of $78.4 million, past due interest of $22.5 million and a net book
value of $60.6 million; and during 1996, the LLC completed a securitization of
9,825 HUD loans with an aggregate unpaid principal balance of $419.4 million,
past due interest of $86.1 million and a net book value of $394.2 million. The
LLC recognized gains of $14.0 million and $69.8 million (including a gain of
$12.9 million on the sale in 1996 of $79.4 million of securities to the Company)
from the sale of the senior classes in the REMICs formed for purposes of these
transactions in the years ended December 31, 1997 and 1996, respectively, of
which $7.0 million and $34.9 million, respectively, were allocable to the
Company as a result of its pro rata interest in the LLC and included in equity
in earnings of joint venture.
ACCOUNTING FOR INVESTMENT IN JOINT VENTURES. The Company's investment
in the LLC was accounted for under the equity method of accounting. Under the
equity method of accounting, an investment in the shares or other interests of
an investee is initially recorded at the cost of the shares or interests
acquired and thereafter is periodically increased (decreased) by the investor's
proportionate share of the earnings (losses) of the investee and decreased by
all dividends received by the investor from the investee. The Company's
investment in the LLC amounted to $0 and $67.9 million at December 31, 1997 and
1996, respectively. Because the LLC was a pass-through entity for federal income
tax purposes, provisions for income taxes were established by each of the
Company and its co-investor, and not the LLC. The Company recognized $23.7
million and $38.3 million of pre-tax income from its investment in the LLC for
the years ended December 31, 1997 and 1996, respectively.
LENDING ACTIVITIES
COMPOSITION OF LOAN PORTFOLIO. At December 31, 1997, the Company's net
loan portfolio amounted to $266.3 million or 9% of the Company's total assets.
Loans held for investment in the Company's loan portfolio are carried at
amortized cost, less an allowance for loan losses, because the Company has the
ability and presently intends to hold them to maturity.
11
The following table sets forth the composition of the Company's loan
portfolio by type of loan at the dates indicated.
December 31,
----------------------------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------
(Dollars in Thousands)
Single family residential loans.. $ 46,226 $ 73,186 $ 75,928 $ 31,926 $ 30,385
Multi-family residential loans... 71,382(1) 67,842(1) 49,047(1) 1,800 39,352
Commercial real estate and land
loans:
Hotels (3) .................... 89,362(2) 200,311(2) 125,791 19,659 14,237
Office buildings (3) .......... 68,759 128,782 61,262 -- --
Land .......................... 2,858 2,332 24,904 1,315 4,448
Other ......................... 16,094 25,623 2,494 4,936 4,059
--------- --------- --------- --------- ---------
Total ....................... 177,073 357,048 214,451 25,910 22,744
Commercial non-mortgage ......... -- 2,614 -- -- --
Consumer ........................ 244 424 3,223 1,558 3,639
--------- --------- --------- --------- ---------
Total loans ................. 294,925 501,114 342,649 61,194 96,120
Undisbursed loan proceeds ....... (22,210) (89,840) (39,721) -- --
Unaccreted discount ............. (2,721) (5,169) (5,376) (3,078) (6,948)
Allowance for loan losses ....... (3,695) (3,523) (1,947) (1,071) (884)
--------- --------- --------- --------- ---------
Loans, net ................ $ 266,299 $ 402,582 $ 295,605 $ 57,045 $ 88,288
========= ========= ========= ========= =========
- ------------------
(1) At December 31, 1997, 1996 and 1995, multi-family residential loans
included $33.3 million, $36.6 million, and $7.7 million of construction
loans, respectively.
(2) At December 31, 1997 and 1996, hotel loans included $25.3 million and
$26.4 million of construction loans, respectively.
(3) During 1997, payoffs of commercial real estate loans secured by hotels and
office buildings totaled $80.5 million and $107.3 million, respectively.
The Company's lending activities are conducted on a nationwide basis
and, as a result, the properties which secure its loan portfolio are located
throughout the United States. At December 31, 1997, the five states in which the
largest amount of properties securing loans in the Company's loan portfolio were
New York, New Jersey, California, Maryland and Illinois, which had $58.8
million, $35.4 million, $27.7 million, $26.1 million and $21.2 million of
principal amount of loans, respectively. As noted above, the Company believes
that the relatively geographic distribution of its loan portfolio can reduce the
risks associated with concentrating such loans in more limited geographic areas.
12
CONTRACTUAL PRINCIPAL REPAYMENTS. The following table sets forth
certain information at December 31, 1997 regarding the dollar amount of loans
maturing in the Company's loan portfolio based on scheduled contractual
amortization, as well as the dollar amount of loans which have fixed or
adjustable interest rates. Demand loans, loans having no stated schedule of
repayments and no stated maturity and overdrafts are reported as due in one year
or less. Loan balances have not been reduced for (i) undisbursed loan proceeds,
unearned discounts and the allowance for loan losses or (ii) nonperforming
loans.
Maturing in
----------------------------------------------------------------------
After One Year After Five Years
One Through Five Through After Ten
Year or Less Years Ten Years Years
------------ ------------ ------------ ------------
(Dollars in Thousands)
Single family residential loans....... $ 4,999 $ 1,789 $ 8,094 $ 31,344
Multi-family residential loans........ 24,454 29,227 3,979 13,722
Commercial real estate and land loans. 18,646 150,108 4,233 4,085
Consumer and other loans.............. 21 224 -- --
------------ ------------ ------------ ------------
Total.............................. $ 48,120 $ 181,348 $ 16,306 $ 49,151
============ ============ ============ ============
Interest rate terms on amounts due:
Fixed.............................. $ 10,974 $ 166,001 $ 16,132 $ 27,951
Adjustable......................... 37,146 15,347 174 21,200
------------ ------------ ------------ ------------
$ 48,120 $ 181,348 $ 16,306 $ 49,151
============ ============ ============ ============
Scheduled contractual principal repayments may not reflect the actual
maturities of loans because of prepayments and, in the case of conventional
mortgage loans, due-on-sale clauses. The average life of mortgage loans,
particularly fixed-rate loans, tends to increase when current mortgage loan
rates are substantially higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgages are substantially higher
than current mortgage loan rates.
ACTIVITY IN THE LOAN PORTFOLIO. The following table sets forth the
activity in the Company's loan portfolio during the periods indicated.
Year Ended December 31,
----------------------------------------------
1997 1996 1995
----------- ----------- -----------
(Dollars in Thousands)
Balance at beginning of period....................... $ 501,114 $ 342,649 $ 61,194
Originations:
Single family residential loans................... 1,987 10,681 14,776
Multi-family residential loans.................... 16,799 68,076 48,664
Commercial real estate loans...................... 69,948 199,017 212,630
Commercial non-mortgage and consumer loans........ 1,140 3,366 207
----------- ----------- -----------
Total loans originated......................... 89,874 281,140 276,277
----------- ----------- -----------
Purchases:
Single family residential loans................... 78 305 29,833
Commercial real estate loans...................... -- -- 2,245
Consumer loans.................................... -- -- 1,966
----------- ----------- -----------
Total loans purchased.......................... 78 305 34,044
----------- ----------- -----------
Sales ............................................... (2,346) -- --
Loans transferred from available for sale............ 13,782 45 4,353
Principal repayments................................. (306,916) (121,818) (33,168)
Transfer to real estate owned........................ (661) (1,207) (51)
----------- ----------- -----------
Net increase (decrease) in net loans................. (206,189) 158,465 281,455
----------- ----------- -----------
Balance at end of period............................. $ 294,925 $ 501,114 $ 342,649
=========== =========== ===========
13
LOANS AVAILABLE FOR SALE. In addition to loans acquired for investment,
the Company also originates and purchases loans which it presently does not
intend to hold to maturity. Such loans are designated as loans available for
sale upon origination or purchase and generally are carried at the lower of cost
or aggregate market value. At December 31, 1997, loans available for sale
amounted to $177.0 million or 6% of the Company's total assets.
The following table sets forth the composition of the Company's loans
available for sale by type of loan at the dates indicated.
December 31
--------------------------------------------------------------------------
1997 1996 1995 1994 1993
----------- ----------- ----------- ----------- -----------
(Dollars in thousands)
Single family residential loans...... $ 176,554 $ 111,980 $ 221,927 $ 16,825 $ 30,217
Multi-family residential loans....... -- 13,657 28,694 83,845 44,919
Consumer loans....................... 487 729 1,169 1,623 25,930
----------- ----------- ----------- ----------- -----------
177,041 $ 126,366 $ 251,790 $ 102,293 $ 101,066
=========== =========== =========== =========== ===========
Although the Company's loans available for sale are secured by
properties located nationwide, currently a substantial majority of such loans
are subprime single family residential loans originated primarily in the western
states, particularly California, primarily as the result of Admiral having been
located there prior to the acquisition of substantially all of its assets by
OFS. As a result, $35.2 million or 20% of the Company's loans available for sale
at December 31, 1997 were secured by properties located in California, primarily
as the result of Admiral having been located there prior to the acquisition of
substantially all of its assets by OFS.
SINGLE FAMILY RESIDENTIAL LOANS. Since late 1994, the Company's lending
activities have included the origination and purchase of single family
residential loans to borrowers who because of prior credit problems, the absence
of a credit history or other factors are unable or unwilling to qualify as
borrowers for a single family residential loan under guidelines of the Federal
National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage
Corporation ("FHLMC") ("conforming loans") and who have substantial equity in
the properties which secure the loans. Loans to non-conforming borrowers are
perceived by the Company as being advantageous because they generally have
higher interest rates and origination and servicing fees and generally lower
loan-to-value ratios than conforming loans and because the Company's expertise
in the servicing and resolution of nonperforming loans can be utilized in
underwriting such loans, as well as to address loans acquired pursuant to this
program which become nonperforming after acquisition.
Through 1996, the Company acquired subprime single family residential
loans primarily through a correspondent relationship with Admiral and, to a
lesser extent, correspondent relationships with three other financial services
companies. Correspondent institutions originate loans based on guidelines
provided by the Company and promptly sell the loans to the Company on a
servicing-released basis.
In order to solidify and expand its sources of subprime single family
residential loans, the Company, through OFS, acquired substantially all of the
assets of Admiral in a transaction which closed on May 1, 1997. See
"Business-Subsidiaries." At the time of acquisition, Admiral engaged in subprime
lending on a retail and wholesale basis through eleven loan production offices
located in California and independent mortgage brokers and correspondent lending
institutions located in California and eleven other states. In connection with
the Company's acquisition of assets from Admiral, the Bank transferred its
retail and wholesale subprime single family residential lending operations to
OFS, which included, among other things, transferring its rights under contracts
with brokers and correspondent lending institutions and its rights and
obligations under leases to six loan production offices recently opened by it,
which are located in California, Illinois, Massachusetts, Oregon and Utah. OFS
currently conducts its business on a retail and wholesale basis through 27 loan
production offices located in seven states and plans to open an additional five
such offices in 1998.
OFS' principal sources of funds consist of (i) four lines of credit
with unaffiliated parties which aggregate $650 million and are secured by the
mortgage loans acquired with such lines and (ii) a $30 million unsecured,
subordinated credit facility provided by the Company to OFS at the time of the
acquisition of substantially all of the assets of Admiral. The Company has
adopted policies that set forth the specific lending requirements of the Company
as they relate to the processing, underwriting, property appraisal, closing,
funding and delivery of subprime loans. These policies include program
descriptions which set forth four classes of loans, designated A, B, C and D.
Class A loans generally relate to borrowers who have no or limited adverse
incidents in their credit histories, whereas Class B, C and D loans relate to
14
increasing degrees of adverse incidents in the borrower's credit histories.
Factors which are considered in evaluating a borrower in this regard are the
presence or absence of a credit history, prior delinquencies in the payment of
mortgage and consumer credit and personal bankruptcies.
The terms of the loan products offered by the Company directly or
through its correspondents emphasize real estate loans which generally are
underwritten with significant reliance on a borrower's level of equity in the
property securing the loan, which may be an owner-occupied or, depending on the
class of loan and its terms, a non-owner occupied property. Although the
Company's guidelines require information in order to enable the Company to
evaluate a borrower's ability to repay a loan by relating the borrower's income,
assets and liabilities to the proposed indebtedness, because of the significant
reliance on the ratio of the principal amount of the loan to the appraised value
of the security property, each of the four principal classes of loans identified
by the Company include products which permit reduced documentation for verifying
a borrower's income and employment. Loans which permit reduced documentation
generally require documentation of employment and income for the most recent
six-month period, as opposed to the two-year period required in the case of full
documentation loans. Although the Company reserves the right to verify a
borrower's income, assets and liabilities and employment history, other than as
set forth above, it generally does not verify such information through other
sources.
The Company's strategy is to offer a broad range of products to its
borrowers and its origination sources. Loans may have principal amounts which
conform to the guidelines set by FHLMC or FNMA for conforming loans or principal
amounts which significantly exceed these amounts (so called "jumbo loans").
Loans may have fixed or adjustable interest rates and terms ranging up to 30
years.
The following table sets forth the activity in the Company's net loans
available for sale during the periods indicated:
Year Ended December 31,
------------------------------------------------------
1997 1996 1995
------------ -------------- --------------
(Dollars in Thousands)
Balance at beginning of period................. $ 126,366 $ 251,790 $ 102,293
Purchases:
Single family residential.................... 278,081 284,598 230,077
Multi-family residential..................... -- 10,456 10,056
------------ -------------- --------------
278,081 295,054 240,133
------------ -------------- --------------
Originations:
Single family residential.................... 316,101 9,447 360
Multi-family residential..................... -- -- 24,810
------------ -------------- --------------
316,101 9,447 25,170
------------ -------------- --------------
Sales.......................................... (501,079) (395,999) (100,104)
Increase in lower of cost or market reserve.... (1,034) (2,455) (118)
Loans transferred (to)/from loan portfolio..... (13,674) 45 (4,353)
Principal repayments, net of capitalized
interest..................................... (22,151) (27,845) (11,231)
Transfer to real estate owned.................. (5,569) (3,671) --
------------ -------------- --------------
Net increase (decrease) in loans............. 50,675 (125,424) 149,497
------------ -------------- --------------
Balance at end of period....................... $ 177,041 $ 126,366 $ 251,790
============ ============== ==============
The Company purchased and originated a total of $588.3 million of
single family residential loans to non-conforming borrowers during 1997 and
$294.0 million of such loans during 1996. At December 31, 1997, the Company had
$167.0 million of subprime single family residential loans, which had a weighted
average yield of 10.41%.
The Company generally intends to sell or securitize its subprime single
family residential loans, and as a result, all of such loans were classified as
available for sale at December 31, 1997. During 1997, the Company sold $82.6
million of subprime single family residential loans for gains of $3.3 million;
during 1996 the Company sold $161.5 million of such
15
loans for gains of $571,000; and during 1995 the Company sold $25.3 million of
subprime single family residential loans for gains of $188,000. An additional
$415.8 million and $211.2 million of loans were securitized and sold in public
offerings underwritten by unaffiliated investment banking firms during 1997 and
1996, respectively, generating gains of $18.8 million and $7.2 million,
respectively, upon the sale of the securities. The Company retained subordinate
and REMIC residual securities in connection with these transactions. Such
securities had an aggregate carrying value of $41.8 million at December 31,
1997. See "Business-Investment Activities."
Although subprime loans generally have higher levels of default than
conforming loans, the Company believes that the borrower's equity in the
security property and its expertise in the area of resolution of nonperforming
loans will continue to make its subprime borrower loan program a successful one
notwithstanding such defaults and any resulting losses. There can be no
assurance that this will be the case, however.
In addition to the Company's subprime single family residential loan
programs, from time to time the Company purchases pools of single family
residential loans for investment purposes. During 1995, the Company purchased
$29.8 million of loans which were primarily secured by properties located in the
area surrounding the Bank's physical facility in northern New Jersey.
MULTI-FAMILY RESIDENTIAL AND COMMERCIAL REAL ESTATE LOANS. The
Company's lending activities include the acquisition of loans secured by
commercial real estate, particularly loans secured by hotels and office
buildings, which the Company began originating in late 1994 and late 1995,
respectively. Commercial real estate loans currently are made to finance the
purchase and refinance of commercial properties, the refurbishment of distressed
properties and, recently, the construction of hotels. At December 31, 1997, the
Company's loans secured by commercial real estate (and land) amounted to $177.1
million and consisted primarily of $89.4 million and $68.8 million of loans
secured by hotels and office buildings, respectively.
From time to time, the Company originates loans for the construction of
multi-family residences, as well as bridge loans to finance the acquisition and
rehabilitation of distressed multi-family residential properties. At December
31, 1997, the Company's multi-family residential loan portfolio included $33.3
million of multi-family residential construction loans, of which $21.1 million
had been funded, and $38.1 million of acquisition and rehabilitation loans, of
which $34.8 million had been funded.
From time to time the Company also originates loans secured by existing
multi-family residences. Although the Company has deemphasized this type of
lending in recent periods, it previously was active in the origination and
securitization of such loans. During 1995, 1994 and 1993, the Company
securitized multi-family residential loans acquired by it with an aggregate
principal amount of $83.9 million, $346.6 million and $67.1 million,
respectively. The Company subsequently sold all of the securities backed by
these loans.
The multi-family residential and commercial real estate loans acquired
by the Company in recent periods generally have principal amounts between $3.0
million and the Bank's loan-to-one-borrower limitation (see "Regulation-The
Bank-Loans-to-One-Borrower") and are secured by properties which in management's
view have good prospects for appreciation in value during the loan term. In
addition, the Company currently is implementing a program to originate
multi-family residential and commercial real estate loans with smaller principal
amounts (generally up to $3.0 million) and which may be secured by a wide
variety of such properties.
The Company's large multi-family residential and commercial real estate
loans generally have fixed interest rates, terms of two to five years and
payment schedules which are based on amortization over 15 to 25 year periods.
The maximum loan-to-value ratio generally does not exceed 80% of the stabilized
value of the property and 88% of the total costs of the property in the case of
construction, refurbishment or rehabilitation loans.
Multi-family residential and commercial real estate loans are secured
by a first priority lien on the real property, all improvements thereon and, in
the case of hotel loans, all fixtures and equipment used in connection
therewith, as well as a first priority assignment of all revenue and gross
receipts generated in connection with the property. The liability of a borrower
on multi-family residential and commercial real estate loans generally is
limited to the borrower's interest in the property, except with respect to
certain specified circumstances.
In addition to stated interest, the large multi-family residential and
commercial real estate loans originated by the Company commonly include
provisions pursuant to which the borrower agrees to pay the Company as
additional interest
16
on the loan an amount based on specified percentages (generally between 10-38%)
of the net cash flow from the property during the term of the loan and/or the
net proceeds from the sale or refinancing of the property upon maturity of the
loan. Participating interests also may be obtained in the form of additional
fees which must be paid by the borrower in connection with a prepayment of the
loan, generally after an initial lock-out period during which prepayments are
prohibited. The fees which could be payable by a borrower during specified
periods of the loan consist either of fixed exit fees or yield maintenance
payments, which are required to be paid over a specified number of years after
the prepayment and are intended to increase the yield to the Company on the
proceeds from the loan payoff to a level which is comparable to the yield on the
prepaid loan. At December 31, 1997, the Company's loan portfolio included $101.1
million of funded and unfunded loans in which the Company participates in the
residual profits of the underlying real estate, of which $89.0 million had been
funded. The Company generally accounts for loans in which it participates in
residual profits as loans and not as investments in real estate; however,
because of concerns raised by the staff of the OTS in this regard, in December
1996 and during 1997 the Bank sold to the Company subordinated, participating
interests in a total of eleven acquisition, development and construction loans,
which interests had an aggregate principal balance of $18.0 million. On a
consolidated basis, eight of these loans, which amounted to $64.3 million at
December 31, 1997, were carried by the Company as investments in real estate.
The Bank (but not the Company) has agreed with the OTS to cease origination of
mortgage loans with profit participation features in the underlying real estate,
with the exception of existing commitments.
Construction loans generally have terms of three to four years and
interest rates which float on a monthly basis in accordance with designated
reference rates. Payments during the term of the loan may be made to the Company
monthly on an interest-only basis. The loan amount may include an interest
reserve which is maintained by the Company and utilized to pay interest on the
loan during a portion of its term.
Construction loans are secured by a first priority lien on the real
property, all improvements thereon and all fixtures and equipment used in
connection therewith, as well as a first priority assignment of all revenues and
gross receipts generated in connection with the property. Construction loans are
made without pre-leasing requirements or any requirement of a commitment by
another lender to "take-out" the construction loan by making a permanent loan
secured by the property upon completion of construction. Disbursements on a
construction loan are subject to a retainage percentage of 10% and are made only
after evidence that available funds have been utilized by the borrower and are
sufficient to pay for all construction costs through the date of the
construction advance and funds remain in the construction budget and from
sources other than the loan to complete construction of the project.
The Company generally requires the general contractor selected by the
borrower, which along with the general construction contract is subject to the
Company's review and approval, to provide payment and performance bonds issued
by a surety approved by the Company in an amount at least equal to the costs
which are estimated to be necessary to complete construction of the project in
accordance with the construction contract. Moreover, the Company generally
conducts site inspections of projects under construction at least bi-monthly and
of completed projects at least semi-annually.
Multi-family residential, commercial real estate and construction
lending generally are considered to involve a higher degree of risk than single
family residential lending because such loans involve larger loan balances to a
single borrower or group of related borrowers. In addition, the payment
experience on multi-family residential and commercial real estate loans
typically is dependent on the successful operation of the project, and thus such
loans may be adversely affected to a greater extent by adverse conditions in the
real estate markets or in the economy generally. Risk of loss on a construction
loan is dependent largely upon the accuracy of the initial estimate of the
property's value at completion of construction or development and the estimated
cost (including interest) of construction, as well as the availability of
permanent take-out financing. During the construction phase, a number of factors
could result in delays and cost overruns. If the estimate of value proves to be
inaccurate, the Company may be confronted, at or prior to the maturity of the
loan, with a project which, when completed, has a value which is insufficient to
ensure full repayment. In addition to the foregoing, multi-family residential
and commercial real estate loans which are not fully amortizing over their
maturity and which have a balloon payment due at their stated maturity, as is
generally the case with the Company's multi-family residential and commercial
real estate loans, involve a greater degree of risk than fully amortizing loans
because the ability of a borrower to make a balloon payment typically will
depend on its ability either to timely refinance the loan or to timely sell the
security property. The ability of a borrower to accomplish these results will be
affected by a number of factors, including the level of available mortgage rates
at the time of sale or refinancing, the financial condition and operating
history of the borrower and the property which secures the loan, tax laws,
prevailing economic conditions and the availability of financing for
multi-family residential and commercial real estate generally.
17
LOAN SERVICING ACTIVITIES
During 1996, the Company developed a program to provide loan servicing
and various other asset management and resolution services to third party owners
of nonperforming assets, underperforming assets and subprime assets such as
Class B, C and D single family residential mortgage loans. Servicing contracts
entered into by the Company provide for the payment to the Company of specified
fees and in some cases may include terms which allow the Company to participate
in the profits resulting from the successful resolution of the assets being
serviced.
The Bank has been approved as a loan servicer by HUD, FHLMC and FNMA.
The Bank is rated a Tier 1 servicer and as a preferred servicer for high-risk
mortgages by FHLMC, the highest rating categories, and also is rated as a
"strong" special servicer for commercial mortgage loans by Standard & Poor's,
which also is the highest rating category. In addition, the Bank is the only
servicer rated as a special servicer for residential mortgage loans.
The following tables set forth the number and amount of loans serviced
by the Company for others at the dates indicated:
December 31, 1997
-----------------------------------------------------------------------------------------------------
Discount Loans Subprime Loans Other Loans Total
----------------------- ----------------------- ----------------------- -----------------------
No. of No. of No. of No. of
Amount Loans Amount Loans Amount Loans Amount Loans
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Loans securitized and sold
with recourse ............ $ 624,591 11,148 $ 555,914 4,976 $ -- -- $1,180,505 16,124
Loans serviced for third
parties .................. 1,682,764 23,181 2,352,352 29,911 294,198 1,092 4,329,314 54,184
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
$2,307,355 34,329 $2,908,266 34,887 $ 294,198 1,092 $5,509,819 70,308
========== ========== ========== ========== ========== ========== ========== ==========
December 31, 1996
-----------------------------------------------------------------------------------------------------
Discount Loans Subprime Loans Other Loans Total
----------------------- ----------------------- ----------------------- -----------------------
No. of No. of No. of No. of
Amount Loans Amount Loans Amount Loans Amount Loans
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Loans securitized and sold
with recourse ............ $ 204,586 4,796 $ 202,766 1,879 $ -- -- $ 407,352 6,675
Loans serviced for third
parties .................. 1,209,535 22,511 6,784 60 294,427 917 1,510,746 23,488
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
$1,414,121 27,307 $ 209,550 1,939 $ 294,427 917 $1,918,098 30,163
========== ========== ========== ========== ========== ========== ========== ==========
The increases in the number and amount of loans serviced by the Company
for others in recent periods were primarily attributable to the Company's
acquisition of rights to service discount loans acquired from HUD by BlackRock,
directly and indirectly through the LLC, and servicing rights resulting from the
securitization of both loans acquired from HUD by the Company and BlackRock,
directly and indirectly through the LLC, and subprime single family residential
loans held by the Company.
The Company generally does not purchase rights to service loans for
others and, as a result, capitalized mortgage servicing rights amount to only
$5.7 million and $2.4 million at December 31, 1997 and 1996, respectively. In
accordance with Statement of Financial Accounting Standards ("SFAS") No. 122
"Accounting for Mortgage Servicing Rights," the Company amortizes mortgage
servicing rights over the estimated weighted average life of the loans and
periodically evaluates its mortgage servicing rights for impairment based on the
fair value of those rights, which is recognized through a valuation allowance.
ASSET QUALITY
The Company, like all financial institutions, is exposed to certain
credit risks related to the value of the collateral that secures its loans and
the ability of borrowers to repay their loans. Management of the Company closely
monitors the Company's loan and investment portfolios and the Company's real
estate owned for potential problems and reports to the Board of Directors at
regularly scheduled meetings.
NONPERFORMING LOANS. It is the Company's policy to establish an
allowance for uncollectible interest on loans in its loan portfolio and loans
available for sale which are past due 90 days or more and to place such loans on
non-accrual
18
status. As a result, the Company currently does not have any loans which are
accruing interest but are past due 90 days or more. Loans also may be placed on
non-accrual status when, in the judgment of management, the probability of
collection of interest is deemed to be insufficient to warrant further accrual.
When a loan is placed on non-accrual status, previously accrued but unpaid
interest is reversed by a charge to interest income.
The following table sets forth certain information relating to the
Company's nonperforming loans in its loan portfolio at the dates indicated:
December 31,
--------------------------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------
(Dollars in Thousands)
Nonperforming loans (1):
Single family residential loans......... $ 1,575 $ 2,123 $ 2,923 $ 2,478 $ 2,347
Multi-family residential loans.......... 7,583(2) 106 731 152 664
Consumer and other loans................ -- 55 202 29 556
--------- --------- --------- --------- ---------
Total................................. $ 9,158 $ 2,284 $ 3,856 $ 2,659 $ 3,567
========= ========= ========= ========= =========
Nonperforming loans as a percentage of:
Total loans (3)......................... 3.36% 0.56% 1.27% 4.35% 3.71%
Total assets............................ 0.30% 0.09% 0.20% 0.21% 0.27%
Allowance for loan losses as
a percentage of:
Total loans(3)........................ 1.37% 0.87% 0.65%(4) 1.84% 0.99%
Nonperforming loans................... 40.35% 154.24% 50.49% 40.28% 24.78%
- -------------------
(1) The Company did not have any nonperforming loans in its loan portfolio
which were deemed troubled debt restructurings at the dates indicated.
(2) The increase in nonperforming multi-family residential loans during 1997
was primarily attributable to a $7.4 million loan secured by a 127-unit
condominium building located in New York, New York, which management
believes is well collateralized.
(3) Total loans is net of undisbursed loan proceeds.
(4) The decrease in the allowance for loan losses as a percentage of total
loans from 1994 was due to the significant increase in the loan portfolio
in 1995 as a result of the purchase of single family residential loans and
the origination of multi-family residential and commercial real estate
loans.
The following table presents a summary of the Company's nonperforming
loans in the loans available for sale portfolio at the dates indicated:
December 31,
1997 1996 1995 1994 1993
---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Nonperforming loans:
Single family loans.................. $ 13,509 $ 14,409 $ 7,833 $ -- $ --
Consumer loans....................... 25 36 100 120 884
---------- ---------- ---------- ---------- ----------
$ 13,534 $ 14,445 7,933 $ 120 $ 884
========== ========== ========== ========== ==========
Nonperforming loans a percentage of:
Total loans available for sale 7.64% 11.43% 3.2% .12% .87%
Total assets .44% .58% .58% .01% .06%
19
For information relating to the payment status of loans in the
Company's discount loan portfolio, see "Business-Discount Loan Acquisition and
Resolution Activities."
REAL ESTATE OWNED. Properties acquired through foreclosure or by
deed-in-lieu thereof are valued at the lower of amortized cost or fair value.
Properties included in the Company's real estate owned portfolio are
periodically re-evaluated to determine that they are being carried at the lower
of cost or fair value less estimated costs to sell. Holding and maintenance
costs related to properties are recorded as expenses in the period incurred.
Deficiencies resulting from valuation adjustments to real estate owned
subsequent to acquisition are recognized as a valuation allowance. Subsequent
increases related to the valuation of real estate owned are reflected as a
reduction in the valuation allowance, but not below zero. Increases and
decreases in the valuation allowance are charged or credited to income,
respectively. Accumulated valuation allowances amounted to $12.3 million at
December 31, 1997 as compared to $11.5 million at December 31, 1996.
The following table sets forth certain information relating to the
Company's real estate owned at the dates indicated.
December 31,
----------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
(Dollars in Thousands)
Discount loan portfolio:
Single family residential......................... $ 76,409 $ 49,728 $ 75,144 $ 86,426 $ 33,369
Multi-family residential ......................... 16,741 14,046 59,932 -- --
Commercial real estate ........................... 71,339 36,264 31,218 8,801 --
-------- -------- -------- -------- --------
Total ....................................... 164,489 100,038 166,294 95,227 33,369
Loan portfolio ...................................... 357 592 262 1,440 128
Loans available for sale............................. 2,419 3,074 -- -- --
-------- -------- -------- -------- --------
Total ....................................... $167,265 $103,704 $166,556 $ 96,667 $ 33,497
======== ======== ======== ======== ========
The following table sets forth certain geographical information by type
of property at December 31, 1997 related to the Company's real estate owned.
Multi-family Residential
Single Family Residential and Commercial Total
------------------------- ------------------------- ------------------------
No. of No. of No. of
Amount Properties Amount Properties Amount Properties
-------- ---------- -------- ---------- --------- ----------
(Dollars in Thousands)
California............... $ 24,717 314 $ 28,703 41 $ 53,420 355
Florida.................. 3,080 53 14,181 20 17,261 73
Connecticut.............. 3,945 63 13,075 11 17,020 74
New York................. 11,099 216 2,101 13 13,201 229
New Jersey............... 7,536 105 3,555 12 11,091 117
Other.................... 28,451(1) 604 26,822(2) 53 55,272 657
-------- -------- -------- -------- --------- --------
Total................... $ 78,828 1,355 $ 88,437 150 $ 167,265 1,505
======== ======== ======== ======== ========= ========
- -------------------
(1) Consists of properties located in 40 other states, none of which
aggregated over $5.6 million in any one state.
(2) Consists of properties located in 20 other states, none of which
aggregated over $7.5 million in any one state.
20
The following table sets forth the activity in the real estate owned
during the periods indicated.
Year Ended December 31,
---------------------------------------------------------------------------
1997 1996 1995
------------------------ ------------------------- -----------------------
No. of No. of No of
Amount Properties Amount Properties Amount Properties
--------- ---------- --------- ---------- --------- ----------
(Dollars in Thousands)
Balance at beginning of period.... $ 103,704 825 $ 166,556 1,070 $ 96,667 1,018
Properties acquired through
foreclosure or deed-in-lieu
thereof ........................ 205,621 1,656 102,098 918 185,174 970
Acquired in connection with
acquisitions of discount loans.. 38,486 545 2,529 12 24,617 311
Sales ............................ (179,693) (1,521) (160,592) (1,175) (139,233) (1,229)
Change in allowance .............. (853) -- (6,887) -- (669) --
--------- --------- --------- --------- --------- ---------
Balance at end of period ......... $ 167,265 1,505 $ 103,704 825 $ 166,556 1,070
========= ========= ========= ========= ========= =========
The following table sets forth the amount of time that the Company had
held its real estate owned at the dates indicated.
December 31,
----------------------------------------------------
1997 1996 1995
------------ ------------ ------------
(Dollars in Thousands)
One to two months................................. $ 83,144 $ 17,695 $ 25,398
Three to four months.............................. 28,912 15,291 22,672
Five to six months................................ 20,929 14,348 25,742
Seven to 12 months................................ 23,621 13,004 76,782
Over 12 months.................................... 10,659 43,366 15,962
------------ ------------ ------------
$ 167,265 $ 103,704 $ 166,556
============ ============ ============
The average period during which the Company held the $179.7 million,
$160.6 million and $139.2 million of real estate owned which was sold during the
years ended December 31, 1997, 1996 and 1995, respectively, was 9 months, 11
months and 8 months, respectively.
Although the Company evaluates the potential for significant
environmental problems prior to acquiring or originating a loan, there is a risk
for any mortgage loan, particularly a multi-family residential and commercial
real estate loan, that hazardous substances or other environmentally restricted
substances could be discovered on the related real estate. In such event, the
Company might be required to remove such substances from the affected properties
or to engage in abatement procedures at its sole cost and expense. There can be
no assurance that the cost of such removal or abatement will not substantially
exceed the value of the affected properties or the loans secured by such
properties, that the Company would have adequate remedies against the prior
owners or other responsible parties or that the Company would be able to resell
the affected properties either prior to or following completion of any such
removal or abatement procedures. If such environmental problems are discovered
prior to foreclosure, the Company generally will not foreclose on the related
loan; however, the value of such property as collateral will generally be
substantially reduced, and as a result, the Company may suffer a loss upon
collection of the loan.
From time to time, the Company makes loans to finance the sale of real
estate owned. At December 31, 1997, such loans amounted to $8.4 million and
consisted of $4.4 million of single family residential loans, $3.7 million of
multi-family residential loans and $339,000 of commercial loans. All of the
Company's loans to finance the sale of real estate owned were performing in
accordance with their terms at December 31, 1997.
CLASSIFIED ASSETS. OTS regulations require that each insured savings
association classify its assets on a regular basis. In addition, in connection
with examinations of insured associations, OTS examiners have authority to
identify problem assets and, if appropriate, require them to be classified.
There are three classifications for problem assets: "substandard," "doubtful"
and "loss." Substandard assets have one or more defined weaknesses and are
characterized by the distinct possibility that the insured institution will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full on the basis of currently
existing facts, conditions and values questionable, and there is a high
possibility
21
of loss. An asset classified as a loss is considered uncollectible and of such
little value that continuance as an asset of the institution is not warranted.
Another category designated "special mention" also must be established and
maintained for assets which do not currently expose an insured institution to a
sufficient degree of risk to warrant classification as substandard, doubtful or
loss but do possess credit deficiencies or potential weaknesses deserving
management's close attention. Assets classified as substandard or doubtful
require the institution to establish general allowances for loan losses. If an
asset or portion thereof is classified as a loss, the insured institution must
either establish specific allowances for loan losses in the amount of 100% of
the portion of the asset classified as a loss or charge off such amount. In this
regard, the Company establishes required reserves and charges off loss assets as
soon as administratively practicable. General loss allowances established to
cover possible losses related to assets classified substandard or doubtful may
be included in determining an institution's regulatory capital, while specific
valuation allowances for loan losses do not qualify as regulatory capital.
In 1996, based upon discussions with the OTS and as a result of an OTS
bulletin issued on December 13, 1996 entitled "Guidance on the Classification
and Regulatory Reporting of Certain Delinquent Loans and Other Credit Impaired
Assets," the Company has classified all discount loans that are 90 or more days
contractually past due, not otherwise classified, as special mention and all
real estate owned, not otherwise classified, as special mention. The Company
also modified its policy for classifying nonperforming discount loans and real
estate owned related to its discount loan portfolio ("nonperforming discount
assets") to take into account both the holding period of such assets from the
date of acquisition and the ratio of book value to market value of such assets.
All nonperforming discount assets which are held 15 months or more after the
date of acquisition are classified substandard; nonperforming discount assets
held 12 months to less than 15 months from the date of acquisition are
classified as substandard if a ratio of book value to market value is 80% or
more; and nonperforming discount assets held less than 12 months from the date
of acquisition are classified as substandard if they have a ratio of book value
to market value of more than 85%. In addition, nonperforming discount assets
which are performing for a period of time subsequent to acquisition by the
Company are classified as substandard at the time such loans become
nonperforming. The Company also modified its classified assets policy to
classify all real estate owned which is not cash flowing and which has been held
for more than 15 months and three years as substandard and doubtful,
respectively. The Company's past experience indicates that classified discount
assets do not necessarily correlate to probability or severity of loss.
Excluding assets which have been classified loss and fully reserved by
the Company, the Company's classified assets at December 31, 1997 under the
above policy consisted of $404.1 million of assets classified as substandard and
$577,000 of assets classified as doubtful. In addition, at the same date, $616.1
million of assets were designated as special mention.
Substandard assets at December 31, 1997 under the above policy
consisted primarily of $242.4 million of loans and real estate owned related to
the Company's discount single family residential loan program, $150.5 million of
loans and real estate owned related to the Company's discount commercial real
estate loan program and $9.7 million of subprime single family residential
loans. Special mention assets at December 31, 1997 under the policy consisted
primarily of $559.3 million and $56.8 million of loans and real estate owned
related to the Company's discount single family residential and discount
commercial real estate loan programs, respectively.
ALLOWANCES FOR LOSSES. The Company maintains an allowance for loan
losses for each of its loan and discount loan portfolios at a level which
management considers adequate to provide for potential losses in each portfolio
based upon an evaluation of known and inherent risks in such portfolios.
22
The following table sets forth the breakdown of the allowance for loan
losses on the Company's loan portfolio and discount loan portfolio by loan
category and the percentage of loans in each category to total loans in the
respective portfolios at the dates indicated:
December 31,
--------------------------------------------------------------------------------------
1997 1996 1995 1994 1993
--------------- --------------- --------------- -------------- ---------------
Amount % Amount % Amount % Amount % Amount %
------- ------ ------- ----- ------ ------ ------ ----- ------ -----
(Dollars in Thousands)
Loan portfolio:
Single family residential
loans..................... $ 512 15.7% $ 520 14.6% $ 346 22.2% $ 615 52.2% $ 174 31.6%
Multi-family residential
loans..................... 2,163 24.2 673 13.5 683 14.3 -- 2.9 333 40.9
Commercial real estate
loans..................... 1,009 60.0 2,299 71.3 875 62.6 218 42.3 218 23.7
Commercial non-mortgage
loans..................... -- -- 11 0.5 -- -- -- -- -- --
Consumer loans.............. 11 0.1 20 0.1 43 0.9 238 2.6 159 3.8
------- ------ ------- ----- ------ ------ ------ ----- ------ -----
Total..................... $ 3,695 100.0% $ 3,523 100.0% $1,947 100.0% $1,071 100.0% $ 884 100.0%
======= ====== ======= ===== ====== ====== ====== ===== ====== =====
Discount loan
portfolio(1):
Single family residential
loans..................... $15,017 50.2% $ 3,528 38.4% $ -- --% $ -- --% $ -- --%
Multi-family residential
loans..................... 2,616 10.7 3,124 26.0 -- -- -- -- -- --
Commercial real estate
loans..................... 5,860 39.0 4,886 35.4 -- -- -- -- -- --
Other loans................. -- 0.1 -- 0.2 -- -- -- -- -- --
------- ------ ------- ----- ------ ------ ------ ----- ------ -----
Total................... $23,493 100.0% $11,538 100.0% $ -- --% $ -- --% $ -- --%
======= ====== ======= ===== ====== ====== ====== ===== ====== =====
- -------------------
(1) The Company did not maintain an allowance for loan losses on its discount
loan portfolio prior to 1996.
The allocation of the allowance to each category is not necessarily
indicative of future losses and does not restrict the use of the allowance to
absorb losses in any other category.
The following table sets forth an analysis of activity in the allowance
for loan losses relating to the Company's loan portfolio during the periods
indicated:
Year Ended December 31,
--------------------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
(Dollars in Thousands)
Balance at beginning of period.... $ 3,523 $ 1,947 $ 1,071 $ 884 $ 752
Provision for loan losses......... 325 1,872 1,121 -- --
Charge-offs:
Single family residential loans (100) (261) (131) (302) (150)
Multi-family residential loans.. -- (7) -- -- (170)
Commercial real estate loans.... -- -- (40) -- --
Consumer loans.................. (53) (28) (92) (170) (16)
-------- -------- -------- -------- --------
Total charge-offs.............. (153) (296) (263) (472) (336)
Recoveries:
Single family residential loans -- -- 3 410 346
Multi-family residential loans.. -- -- -- -- --
Commercial real estate loans.... -- -- 15 -- --
Consumer loans.................. -- -- -- 249 122
-------- -------- -------- -------- --------
Total recoveries............... -- -- 18 659 468
-------- -------- -------- -------- --------
Net (charge-offs) recoveries... (153) (296) (245) 187 132
-------- -------- -------- -------- --------
Balance at end of period.......... $ 3,695 $ 3,523 $ 1,947 $ 1,071 $ 884
======== ======== ======== ======== ========
Net charge-offs (recoveries) as a
percentage of average loan
portfolio, net.................. 0.04% 0.09% 0.19% (0.28)% (0.10)%
23
The following table sets forth an analysis of activity in the allowance
for loan losses relating to the Company's discount loan portfolio during the
periods indicated:
Year Ended December 31,
-----------------------
1997 1996
-------- ----------
(Dollars in Thousands)
Balance at beginning of period .................... $ 11,538 $ --
Provision for loan losses ......................... 31,894 20,578
Charge-offs:
Single family residential loans ................. (13,281) (7,009)
Multi-family residential loans .................. (2,056) (704)
Commercial real estate loans .................... (5,012) (1,503)
Other loans ..................................... -- --
-------- ----------
Total charge-offs ............................ (20,349) (9,216)
-------- ----------
Recoveries:
Single family residential loans ................. 410 176
Multi-family residential loans .................. -- --
Commercial real estate loans .................... -- --
Consumer loans .................................. -- --
-------- ----------
Total recoveries ............................. 410 176
-------- ----------
Net (charge-offs) ............................ (19,939) (9,040)
-------- ----------
Balance at end of period .......................... $ 23,493 $ 11,538
======== ==========
Net charge-offs as a percentage of average
discount loan portfolio ........................ 1.55% 1.34%
INVESTMENT ACTIVITIES
GENERAL. The investment activities of the Company currently include
investments in mortgage-related securities, investment securities and low-income
housing tax credit interests. The investment policy of the Company, which is
established by the Investment Committee and approved by the Board of Directors,
is designed primarily to provide a portfolio of diversified instruments while
seeking to optimize net interest income within acceptable limits of interest
rate risk, credit risk and liquidity.
MORTGAGE-BACKED AND RELATED SECURITIES. From time to time, the Company
invests in mortgage-backed and mortgage-related securities. Although
mortgage-backed and mortgage-related securities generally yield less than the
loans that back such securities because of costs associated with their payment
guarantees or credit enhancements, such securities are more liquid than
individual loans and may be used to collateralize borrowings of the Company.
Other mortgage-backed and mortgage-related securities indirectly bear the risks
of the underlying loans, such as prepayment risk (interest-only securities) and
credit risk (subordinated interests), and are generally less liquid than
individual loans.
Mortgage-related securities include senior and subordinate regular
interests and residual interests in collateralized mortgage obligations
("CMOs"), including CMOs which have qualified as REMICs. The regular interests
in some CMOs are like traditional debt instruments because they have stated
principal amounts and traditionally defined interest-rate terms. Purchasers of
certain other interests in REMICs are entitled to the excess, if any, of the
issuer's cash inflows, including reinvestment earnings, over the cash outflows
for debt service and administrative expenses. These interests may include
instruments designated as residual interests, which represent an equity
ownership interest in the underlying collateral, subject to the first lien of
the investors in the other classes of the REMIC.
A senior-subordinated structure often is used with CMOs to provide
credit enhancement for securities which are backed by collateral which is not
guaranteed by FNMA, FHLMC or the Government National Mortgage Association
("GNMA"). These structures divide mortgage pools into two risk classes: a senior
class and one or more subordinated classes. The subordinated classes provide
protection to the senior class. When cash flow is impaired, debt service goes
first to the holders of senior classes. In addition, incoming cash flows also
may be held in a reserve fund to meet any future shortfalls of cash flow to
holders of senior classes. The holders of subordinated classes may not receive
any principal repayments until the holders of senior classes have been paid and,
when appropriate, until a specified level of funds has been contributed to the
reserve fund.
24
Interest-only and principal-only securities are so-called stripped
mortgage-related securities, in which interest coupons may be stripped from a
mortgage-related security to create an interest-only ("IO") strip, where the
investor receives all of the interest cash flows and none of the principal, and
a principal-only ("PO") strip, where the investor receives all of the principal
cash flows and none of the interest. Inverse floating rate interest-only
("Inverse IO") securities also have coupons which are stripped from a
mortgage-related security. However, Inverse IOs have coupons whose interest
rates change inversely with, and often as a multiple of, a specialized index
such as the one-month London Interbank Offered Rate ("LIBOR").
The following table sets forth the fair value of the Company's
mortgage-backed and related securities available for sale at the dates
indicated.
December 31,
---------------------------------------------
1997 1996 1995
---------- ---------- ----------
(Dollars in Thousands)
Mortgage-related securities:
Single family residential:
CMOs (AAA-rated)............................ $ 160,451 $ 73,935 $ 138,831
Interest only:
AAA-rated................................. 13,863 1,173 --
FHLMC..................................... 64,745 47,571 2,182
FNMA...................................... 59,715 49,380 9,592
GNMA...................................... 29,766 -- --
Principal only.............................. -- -- 8,218
Subordinates................................ 67,830 19,164 27,310
PAC securities ............................. -- -- 574
REMIC residuals............................. 15,693 20,560 472
Futures contracts and swaps................. (94) (1,921) (1,598)
---------- ---------- ----------
Total..................................... 411,969 209,862 185,581
---------- ---------- ----------
Multi-family residential and commercial:
Interest only:
AAA-rated................................. 1,030 83,590 103,932
FNMA...................................... -- -- 5,261
Non-investment grade...................... 3,477 3,799 --
Subordinates................................ 14,048 57,534 42,954
Futures contracts........................... -- (780) (248)
---------- ---------- ----------
Total..................................... 18,555 144,143 151,899
---------- ---------- ----------
Total.................................. $ 430,524 $ 354,005 $ 337,480
========== ========== ==========
At December 31, 1997, the carrying value of the Company's investment in
IO strips amounted to $172.6 million. The Company invests in IO strips and PO
strips from time to time based on its capital position, interest rate risk
profile and the market for such securities. IO strips and PO strips exhibit
considerably more price volatility than mortgages or ordinary mortgage
pass-through securities, due in part to the uncertain cash flows that result
from changes in the prepayment rates of the underlying mortgages. In the case of
IO strips in particular, increased prepayments of the underlying mortgages as a
result of a decrease in market interest rates or other factors can result in a
loss of all or part of the purchase price of such security, although IO strips
relating to mortgage-related securities backed by multi-family residential and
commercial real estate loans (which amounted to $4.5 million of the $172.6
million of IO strips owned by the Company at December 31, 1997) generally have
provisions which prohibit and/or provide economic disincentives to prepayments
for specified periods. The Company generally attempts to offset the interest
rate risk associated with a particular IO strip or PO strip by purchasing other
securities. At December 31, 1997, all of the Company's IO strips were either
issued by FHLMC, FNMA or GNMA or rated AAA by national rating agencies, with the
exception of IO securities with an aggregate carrying value of $3.5 million,
which were rated investment grade below this level.
The Company generally retains subordinate securities, subordinate IOs
and REMIC residual securities, which are certificated, related to its
securitization of loans. Subordinate securities, subordinate IOs and REMIC
residual
25
securities retained represent the present value of the right to the excess cash
flows generated by the securitized loans that represent the difference between
(a) principal and interest at the stated rate paid by borrowers and (b) the sum
of (i) principal and pass-through interest paid to third-party investors, (ii)
trustee fees, (iii) third-party credit enhancement fees (if applicable), (iv)
stipulated servicing fees and (v) estimated loan portfolio losses. The Company's
right to receive this excess cash flow may begin after certain reserve
requirements have been met, which are specific to each securitization and may be
used as a means of credit enhancement. The Company determines the present value
of anticipated cash flows at the time each securitization transaction closes,
utilizing valuation assumptions appropriate for each particular transaction.
The significant valuation assumptions are related to the anticipated
average lives of the loans sold, the anticipated prepayment speeds and the
anticipated credit losses related thereto. In order to determine the present
value of this excess cash flow, the Company currently applies a discount rate of
between 18% and 28% to the projected cash flows.
The annual prepayment rate of the securitized loans is a function of
full and partial prepayments and defaults. The Company makes assumptions as to
the prepayment rates of the underlying loans, which the Company believes are
reasonable, in estimating fair values of the subordinate securities, subordinate
IOs and REMIC residual securities retained. During fiscal 1997, the Company
utilized proprietary prepayment curves generated by the Company (reaching an
approximate maximum annual rate of 28%).
In its estimates of annual loss rates, the Company utilizes assumptions
that it believes are reasonable. The Company estimates annual losses of between
0.25% and 1.20% of the underlying loans.
The Company classifies its subordinate securities, subordinate IOs and
REMIC residual securities retained as available for sale securities in
accordance with SFAS No. 115. Securities available for sale are carried at fair
value with the net unrealized gains or losses reported as a separate component
of stockholders' equity, net of tax. The determination of fair value is based on
the previously mentioned valuation basis and on broker valuation estimates. The
subordinate securities, subordinate IOs and REMIC residual securities retained
are amortized based on the interest method.
The Company retains the right to service loans it originates or
purchases and then subsequently securitizes. Fees for servicing loans are based
on a stipulated percentage which is equal to between 0.50% and 0.60% of the
unpaid principal balance of the underlying loans. The Company recognizes a
servicing asset as part of its gain on securitized loan sales.
The Company periodically assesses the carrying value of its subordinate
securities, subordinate IOs and REMIC residual securities retained as well as
the servicing assets for impairment. There can be no assurance that the
Company's estimates used to determine the gain on securitized loan sales,
subordinate securities, subordinate IOs and REMIC residual securities retained
and servicing assets valuations will remain appropriate for the life of each
securitization. If actual loan prepayments or defaults exceed the Company's
estimates, the carrying value of the Company's subordinate securities,
subordinate IOs and REMIC residual securities retained and/or servicing assets
may be decreased or the Company may increase its allowance for possible credit
losses on loans sold through a charge against earnings during the period
management recognizes the disparity. Other factors may also result in a
writedown of the Company's subordinate securities, subordinate IOs and REMIC
residual securities retained in subsequent periods. As of December 31, 1997 the
Company determined that no such impairment existed.
At December 31, 1997, the carrying value of the Company's investment in
subordinate classes of mortgage-related securities amounted to $81.9 million,
and included $62.8 million of subordinated classes of mortgage-related
securities acquired in connection with the securitization activities of the
Company and $19.1 million acquired from the LLC in 1996 in connection with its
securitization of HUD loans. During 1997, the Company acquired $50.1 million of
subordinate classes of mortgage-related securities, all of which were acquired
in connection with the Company's securitizations of loans. For additional
information see "Business - Discount Loan Acquisition and Resolution Activities
- - Activity in the Discount Loan Portfolio" and "Business - Lending
Activities-Single Family Residential Loans." At December 31, 1997, the Company's
subordinate securities supported senior classes of securities having an
outstanding principal balance of $1.77 billion. Because of their subordinate
position, subordinate classes of mortgage-related securities involve more risk
than the other classes.
26
During 1996, the Company retained residual securities in REMICs which
were formed in connection with the securitization and sale of $211.2 million of
subprime single family residential loans in two underwritten public offerings as
partial payment for the loans sold by it. These REMIC residual securities had a
carrying value of $15.7 million at December 31, 1997 and supported senior
classes of securities having an outstanding principal balance of $135.6 million,
which provide credit support similar to the senior-subordinated structure. Cash
flows supporting the REMIC residuals are generated by the amount by which the
interest collected on the underlying mortgage loans exceeds the interest due on
the senior securities. See "Business - Lending Activities - Single family
Residential Loans."
The Company generally does not intend to purchase subordinate classes
of mortgage-related securities created by unaffiliated parties. The Company may
retain subordinated classes resulting from the securitization of assets held by
it directly or indirectly through the Bank and investments in joint ventures,
although it is intended that any such securities held by the Bank will be
distributed to the Company as a dividend subject to its ability to declare such
dividends under applicable limitations.
Under a regulatory bulletin issued by the OTS, a federally-chartered
savings institution such as the Bank generally may invest in "high risk"
mortgage securities only to reduce its overall interest rate risk and after it
has adopted various policies and procedures, although under specified
circumstances such securities also may be acquired for trading purposes. A "high
risk" mortgage security for this purpose generally is any mortgage-related
security which meets one of three tests which are intended to measure the
average life or price volatility of the security in relation to a benchmark
fixed rate, 30-year mortgage-backed pass-through security. At December 31, 1997,
the Bank held mortgage-related securities with a carrying value of $141.1
million (amortized cost of $137.0 million) which were classified as "high-risk"
mortgage securities by the OTS.
The expected actual maturity of a mortgage-backed and related security
is shorter than its stated maturity due to prepayments of the underlying
mortgages. Prepayments that are faster than anticipated may shorten the life of
the security and adversely affect its yield to maturity. The yield is based upon
the interest income and the amortization of any premium or accretion of any
discount related to the mortgage-backed and related security. Prepayments on
mortgage-backed and related securities have the effect of accelerating the
amortization of premiums and accretion of discounts, which decrease and increase
interest income, respectively. Although prepayments of underlying mortgages
depend on many factors, including the type of mortgages, the coupon rate, the
age of mortgages, the geographical location of the underlying real estate
collateralizing the mortgages and general levels of market interest rates, the
difference between the interest rates on the underlying mortgages and the
prevailing mortgage interest rates generally is the most significant determinant
of the rate of prepayments. During periods of falling mortgage interest rates,
if the coupon rate of the underlying mortgages exceeds the prevailing market
interest rates offered for mortgage loans, refinancing generally increases and
accelerates the prepayment of the underlying mortgages and the related security.
Similarly, during periods of increasing interest rates, refinancing generally
decreases, thus lengthening the estimated maturity of mortgage loans.
INVESTMENT SECURITIES. At December 31, 1997, investment securities
consisted primarily of the Company's investment in OAIC and a required
investment in FHLB stock and investments in other common stocks. Non-marketable
equity securities held for investment are stated at cost because the Company has
the ability and the intent to hold them to maturity. Marketable equity
securities are designated as available for sale and are carried at market value
based on quoted market prices. Net unrealized gains or losses are reported as a
separate component of stockholders' equity. Unrealized losses on securities that
reflect a decline in value which is other than temporary, if any, are charged to
earnings.
27
The following table sets forth the Company's investment securities at
the dates indicated.
December 31,
---------------------------------------------------
1997 1996 1995
------------ ------------ ------------
(Dollars in Thousands)
Marketable equity securities:
Other common stocks (1)............... $ 46,272 $ -- $ --
Non-marketable equity securities:
U.S. Government securities............ -- -- 10,036
FHLB stock(2)......................... 10,825 8,798 8,520
Limited partnership interests (3)..... 2,470 103 109
------------ ------------ ------------
Total............................... $ 59,567 $ 8,901 $ 18,665
============ ============ ============
- -------------------
(1) Balance at December 31, 1997 consisted primarily of 1,715,000 shares of
stock of OAIC.
(2) As a member of the FHLB of New York, the Bank is required to purchase and
maintain stock in the FHLB of New York in an amount equal to at least 1%
of its aggregate unpaid residential mortgage loans, home purchase
contracts and similar obligations at the beginning of each year or 5% of
borrowings, whichever is greater.
(3) Balance at December 31, 1997 consisted primarily of 160,000 limited
partnership units of OPLP.
TRADING SECURITIES. When securities are purchased with the intent to
resell in the near term, they are classified as trading securities and reported
on the Company's consolidated statement of financial condition as a separately
identified trading account. Securities in this account are carried at current
market value. All trading securities are marked-to-market, and any increase or
decrease in unrealized appreciation or depreciation is included in the Company's
consolidated statements of operations.
Under guidelines approved by the Board of Directors of the Company, the
Company is authorized to hold a wide variety of securities as trading
securities, including U.S. Government and agency securities and mortgage-backed
and mortgage-related securities. The Company also is authorized by such
guidelines to use various hedging techniques in connection with its trading
activities, as well as to effect short sales of securities, pursuant to which
the Company sells securities which are to be acquired by it at a future date.
Under current guidelines, the amount of securities held by the Company in a
trading account may not exceed on a gross basis the greater of $200 million or
15% of the Company's total assets, and the total net amount of securities
(taking into account any related hedge or buy/sell agreement relating to similar
securities) may not exceed the greater of $150 million or 10% of total assets.
The Company's securities held for trading at December 31, 1996 amounted
to $75.6 million and represented one AAA-rated CMO which was sold in January
1997. The Company held no securities for trading at December 31, 1997.
INVESTMENTS IN LOW-INCOME HOUSING TAX CREDIT INTERESTS. The Company
invests in low-income housing tax credit interests primarily through limited
partnerships for the purpose of obtaining Federal income tax credits pursuant to
Section 42 of the Code, which provides a tax credit to investors in qualified
low-income rental housing that is constructed, rehabilitated or acquired after
December 31, 1986. To be eligible for housing tax credits, a property generally
must first be allocated an amount of tax credits by the tax credit allocating
agency, which in most cases also serves as the housing finance agency, of the
state in which the property is located. If the property is to be constructed or
rehabilitated, it must be completed and placed in service within a specified
time, generally within two years after the year in which the tax credit
allocation is received. A specified portion of the apartment units in a
qualifying project may be rented only to qualified tenants for a period of 15
years, or a portion of any previously claimed tax credits will be subject to
recapture, as discussed below.
At December 31, 1997, the Company's investment in low-income housing
tax credit interests amounted to $128.6 million or 4% of total assets, as
compared to $93.3 million or 4% of total assets at December 31, 1996. The
Company's
28
investments in low-income housing tax credit interests are made by the Company
indirectly through subsidiaries of the Company, which may be a general partner
and/or a limited partner in the partnership.
In accordance with a 1995 pronouncement of the Emerging Issues Task
Force, the Company's accounting for investments in low-income housing tax credit
partnerships in which it acts solely as a limited partner, which amounted to
$78.6 million in the aggregate at December 31, 1997, depends on whether the
investment was made on or after May 18, 1995.
Low-income housing tax credit partnerships in which the Company,
through a subsidiary, acts as a general partner, are presented on a consolidated
basis. At December 31, 1997, the Company's investment in low-income housing tax
credit interests included $50.0 million of assets related to low-income housing
tax credit partnerships in which a subsidiary of the Company acts as a general
partner. At December 31, 1997, the Company had commitments to make $2.1 million
of additional investments in such partnerships.
The Company also makes loans to low-income housing tax credit
partnerships in which it has invested to construct the affordable housing
project owned by the partnerships. At December 31, 1997, the Company had $37.6
million of construction loans outstanding to low-income housing tax credit
partnerships and commitments to fund an additional $9.9 million of such loans.
Approximately $7.3 million of such funded construction loans at December 31,
1997 were made to partnerships in which subsidiaries of the Company acted as the
general partner and thus were consolidated with the Company for financial
reporting purposes. The risks associated with these construction loans generally
are the same as those made by the Company to unaffiliated third parties. See
"Business-Lending Activities".
The affordable housing projects owned by the low-income housing tax
credit partnerships in which the Company had invested at December 31, 1997 are
geographically located throughout the United States. At December 31, 1997, the
Company's largest funded investment in a low-income housing tax credit interest
was a $9.7 million investment in a partnership which owned a 170-unit qualifying
project located in Racine, Wisconsin, and the Company's largest unfunded
investment in such a partnership was a $9.0 million commitment to fund equity
and debt investments in a partnership which will construct a 96-unit qualifying
project in Knoxville, Tennessee, of which $1.3 million of equity and $849,000 of
debt was funded as of such date.
At December 31, 1997, the Company had invested in or had commitments to
invest in 43 low-income housing tax credit partnerships, of which 31 had been
allocated tax credits. The Company estimates that the investment in low-income
housing tax credit interests in which it had invested at December 31, 1997 will
provide approximately $217.3 million of tax credits.
During 1997, the Company sold an investment in a low-income housing tax
credit interest which had a carrying value of $15.7 million for a gain of $6.3
million. During 1996, the Company sold $19.8 million of its investments in
low-income housing tax credit interests for a gain of $4.9 million. Depending on
available prices, its ability to utilize tax credits and other factors, the
Company may seek to sell other of its low-income housing tax credit interests in
the future.
The ownership of low-income housing tax credit interests produces two
types of tax benefits. The primary tax benefit flows from the low-income housing
tax credits under the Code which are generated by the ownership and operation of
the real property in the manner required to obtain such tax credits. These
credits may be used to offset Federal income tax on a dollar for dollar basis
but may not offset the alternative minimum tax; tax credits thus may reduce the
overall Federal income tax to an effective rate of 20%. In addition, the
operation of the rental properties produces losses for financial statement and
tax purposes in the early years and sometimes throughout the anticipated
ownership period. These tax losses may be used to offset taxable income from
other operations and thereby reduce income tax which would otherwise be paid on
such taxable income.
Tax credits may be claimed over a ten-year period on a straight-line
basis once the underlying multi-family residential properties are placed in
service. Tax credits claimed reduce the tax payments computed based upon taxable
income to not less than the alternative minimum tax computed for that year or
any year not more than three years before or 15 years after the year the tax
credit is earned. The taxpayer Relief Act of 1997 changed the tax credit
carryback period from 3 years to 1 year and the carry forward period from 15
years to 20 years for credits that become available for use in years beginning
after December 31, 1997. Tax credits are realized even if units in the project
do not continue to be occupied once the units in the project have been initially
rented to a qualifying tenant, and tax credits are not dependent on a project's
operating income or appreciation. Tax credits can be claimed over a ten-year
period and generally can be lost or
29
recaptured only if non-qualifying tenants are placed in units, ownership of the
project is transferred or the project is destroyed and not rebuilt during a
15-year compliance period for the project. The Company has established specific
investment criteria for investment in multi-family residential projects which
have been allocated tax credits, which require, among other things, a third
party developer of the project and/or the seller of the interest therein to
provide a guarantee against loss or recapture of tax credits and to maintain
appropriate insurance to fund rebuilding in case of destruction of the project.
Notwithstanding the Company's efforts, there can be no assurance that the
multi-family residential projects owned by the low-income housing tax credit
partnerships in which it has invested will satisfy applicable criteria during
the 15-year compliance period and that there will not be loss or recapture of
the tax credits associated therewith.
Investments made pursuant to the affordable housing tax credit program
of the Code are subject to numerous risks resulting from changes in the Code.
For example, the Balanced Budget Act of 1995, which was vetoed by the President
of the United States in December 1995 for reasons which were unrelated to the
tax credit program, generally would have established a sunset date for the
affordable housing tax credit program of the Code for housing placed in service
after December 31, 1997 and would have required a favorable vote by Congress to
extend the credit program. Although this change would not have impacted the
Company's existing investments, other potential changes in the Code, which have
been discussed from time to time, could reduce the benefits associated with the
Company's existing investments in low-income housing tax credit interests,
including the replacement of the current graduated income taxation provisions in
the Code with a "flat tax" based system and increases in the alternative minimum
tax, which cannot be reduced by tax credits. Management of the Company is unable
to predict whether any of the foregoing or other changes to the Code will be
subject to future legislation and, if so, what the contents of such legislation
will be and its effects, if any, on the Company.
SOURCES OF FUNDS
GENERAL. Deposits, FHLB advances, reverse repurchase agreements,
securities financings, maturities, resolutions and principal repayments on
securities and loans and proceeds from the sale of securities, loans and real
estate owned held for sale currently are the principal sources of funds for use
in the Company's investment and lending activities and for other general
business purposes. Management of the Company closely monitors rates and terms of
competing sources of funds on a regular basis and generally utilizes the sources
which are the most cost effective.
DEPOSITS. The primary source of deposits for the Company currently is
brokered certificates of deposit obtained primarily through national investment
banking firms which, pursuant to agreements with the Company, solicit funds from
their customers for deposit with the Company ("brokered deposits"). Such
deposits obtained through national investment banking firms amounted to $1.34
billion or 68% of the Company's total deposits at December 31, 1997. In
addition, during 1995, the Company commenced a program to obtain certificates of
deposit from customers of regional and local investment banking firms which are
made aware of the Company's products by the Company's direct solicitation and
marketing efforts. At December 31, 1997, $251.9 million or 13% of the Company's
deposits were obtained in this manner through over 140 regional and local
investment banking firms. The Company also solicits certificates of deposit from
institutional investors and high net worth individuals identified by the
Company. At December 31, 1997, $177.9 million or 9% of the Company's total
deposits consisted of deposits obtained by the Company from such efforts.
The Company's brokered deposits at December 31, 1997 were net of $11.7
million of unamortized deferred fees. The amortization of deferred fees is
computed using the interest method and is included in interest expense on
certificates of deposit.
The Company believes that the effective cost of brokered and other
wholesale deposits is more attractive to the Company than deposits obtained on a
retail basis from branch offices after the general and administrative expense
associated with the maintenance of branch offices is taken into account.
Moreover, brokered and other wholesale deposits generally give the Company more
flexibility than retail sources of funds in structuring the maturities of its
deposits and in matching liabilities with comparably maturing assets. At
December 31, 1997, $840.5 million or 46% of the Company's certificates of
deposits were scheduled to mature within one year.
Although management of the Company believes that brokered and other
wholesale deposits are advantageous in certain respects, such funding sources,
when compared to retail deposits attracted through a branch network, are
generally more sensitive to changes in interest rates and volatility in the
capital markets and are more likely to be compared by the investor to competing
investments. In addition, such funding sources may be more sensitive to
significant changes in the financial condition of the Company. There are also
various regulatory limitations on the ability of all but well-capitalized
insured financial institutions to obtain brokered deposits. See "Regulation The
Bank - Brokered Deposits." These
30
limitations currently are not applicable to the Company because the Bank is a
well-capitalized financial institution under applicable laws and regulations.
See "Regulation - The Bank -Regulatory Capital Requirements." There can be no
assurances, however, that the Company will not become subject to such
limitations in the future.
As a result of the Company's reliance on brokered and other wholesale
deposits, significant changes in the prevailing interest rate environment, in
the availability of alternative investments for individual and institutional
investors or in the Company's financial condition, among other factors, could
affect the Company's liquidity and results of operations much more significantly
than might be the case with an institution that obtained a greater portion of
its funds from retail or core deposits attracted through a branch network.
In addition to brokered and other wholesale deposits, the Company
obtains deposits from its office located in Bergen County, New Jersey. These
deposits include non-interest bearing checking accounts, NOW and money market
checking accounts, savings accounts and certificates of deposit and are obtained
through advertising, walk-ins and other traditional means. At December 31, 1997,
the deposits which were allocated to this office amounted to $60.7 million or 3%
of the Company's deposits.
The following table sets forth information related to the Company's
deposits at the dates indicated.
December 31,
-------------------------------------------------------------------------------
1997 1996 1995
----------------------- ------------------------ ------------------------
Amount Avg. Rate Amount Avg. Rate Amount Avg. Rate
---------- --------- ---------- --------- ---------- ----------
(Dollars in Thousands)
Non-interest bearing
checking accounts.......... $ 130,372 --% $ 96,563 --% $ 48,482 --%
NOW and money market
checking accounts.......... 27,624 4.73 22,208 2.99 17,147 3.37
Savings accounts.............. 1,664 2.30 2,761 2.30 3,471 2.30
---------- ---------- ----------
159,660 121,532 69,100
---------- ---------- ----------
Certificates of deposit(1).... 1,834,899 1,809,098 1,440,240
Unamortized deferred fees..... (11,737) (10,888) (7,694)
---------- ---------- ----------
Total certificates of deposit. 1,823,162 6.00 1,798,210 5.80 1,432,546 5.68
---------- ---------- ----------
Total deposits........... $1,982,822 5.95 $1,919,742 5.47 $1,501,646 5.46
========== ========== ==========
- -------------------
(1) At December 31, 1997, 1996 and 1995, certificates of deposit issued on an
uninsured basis amounted to $133.7 million, $147.5 million and $80.0
million, respectively. Of the $133.7 million of uninsured deposits at
December 31, 1997, $98.1 million were from political subdivisions in New
Jersey and secured or collateralized as required under state law.
The following table sets forth, by various interest rate categories,
the certificates of deposit in the Company at the dates indicated.
December 31,
--------------------------------------------------
1997 1996 1995
----------- ----------- -----------
(Dollars in Thousands)
2.99% or less.............................. $ 841 $ 1,442 $ 222
3.00-3.50%................................. -- 4 39
3.51-4.50.................................. 41 1,149 42,751
4.51-5.50.................................. 292,192 595,730 454,653
5.51-6.50.................................. 1,300,463 990,621 660,745
6.51-7.50.................................. 229,134 208,774 273,655
7.51-8.50.................................. 491 490 481
----------- ----------- -----------
$ 1,823,162 $ 1,798,210 $ 1,432,546
=========== =========== ===========
31
The following table sets forth the amount and maturities of the
certificates of deposit in the Company at December 31, 1997.
Over Six
Months and One Year
Six Months Less than Through Two Over Two
and Less One Year Years Years Total
------------ ------------ ------------ ------------ ------------
(Dollars in Thousands)
2.99% or less............. $ 813 $ -- $ 28 $ -- $ 841
3.00-3.50%................ -- -- -- -- --
3.51-4.50................. 24 -- 11 6 41
4.51-5.50................. 172,733 32,710 42,758 43,991 292,192
5.51-6.50................. 288,206 287,208 260,386 464,663 1,300,463
6.51-7.50................. 28,568 30,201 73,151 97,214 229,134
7.51-8.50................. -- -- 295 196 491
------------ ------------ ------------ ------------ ------------
$ 490,344 $ 350,119 $ 376,629 $ 606,070 $ 1,823,162
============ ============ ============ ============ ============
At December 31, 1997, the Company had $194.5 million of certificates of
deposit in amounts of $100,000 or more outstanding maturing as follows: $97.7
million within three months; $28.4 million over three months through six months;
$19.4 million over six months through 12 months; and $49.0 million thereafter.
For additional information related to the Company's deposits, see Note
15 to the Consolidated Financial Statements included in Item 8 hereof.
BORROWINGS. Through the Bank, the Company obtains advances from the
FHLB of New York upon the security of certain of its residential first mortgage
loans, mortgage-backed and mortgage-related securities and other assets,
including FHLB stock, provided certain standards related to the creditworthiness
of the Bank have been met. FHLB advances are available to member financial
institutions such as the Bank for investment and lending activities and other
general business purposes. FHLB advances are made pursuant to several different
credit programs, each of which has its own interest rate, which may be fixed or
adjustable, and range of maturities.
The Company also obtains funds pursuant to securities sold under
reverse repurchase agreements. Under these agreements, the Company sells
securities (generally mortgage-backed and mortgage-related securities) under an
agreement to repurchase such securities at a specified price at a later date.
Reverse repurchase agreements have short-term maturities (typically 90 days or
less) and are deemed to be financing transactions. All securities underlying
reverse repurchase agreements are reflected as assets in the Company's
consolidated financial statements and are held in safekeeping by broker-dealers.
Beginning in 1997, borrowings of the Company include lines of credit
obtained by OFS, as follows: (i) a $200.0 million secured line of credit from
Morgan Stanley Mortgage Capital Inc., (ii) a $50.0 million secured line of
credit from Texas Commerce Bank National Association, (iii) a $200.0 million
secured line of credit from Merrill Lynch and (iv) a $200.0 million secured line
of credit from Lehman Commercial Paper, Inc. An aggregate of $118.3 million was
outstanding to OFS under these lines of credit at December 31, 1997, which have
interest rates which float in accordance with a designated prime rate.
The Company's borrowings also include notes, subordinated debentures
and other interest-bearing obligations. At December 31, 1997, this category of
borrowings consisted primarily of $100.0 million of 12% Subordinated Debentures
issued by the Bank in June 1995 and due 2005 (the "Debentures") and $125.0
million of 11.875% Notes due 2003 (the "Notes") issued by the Company through a
public offering on September 25, 1996 and due 2003. Historically, from time to
time, the Company privately has raised funds by issuing short-term notes to
certain executives and stockholders of the Company. Such notes were repaid
during 1996 and amounted to $8.6 million at December 31, 1995.
32
The following table sets forth information relating to the Company's
borrowings and other interest-bearing obligations at the dates indicated.
December 31,
------------------------------
1997 1996 1995
-------- -------- --------
(Dollars in Thousands)
FHLB advances ............................... $ -- $ 399 $ 70,399
Reverse repurchase agreements ............... 108,250 74,546 84,761
Obligations outstanding under lines of
credit ..................................... 118,304 -- --
Notes, debentures and other interest
bearing obligations:
Notes .................................... 125,000 125,000 --
Debentures ............................... 100,000 100,000 100,000
Hotel mortgages payable .................. -- 573 8,427
Short-term notes ......................... 1,975 -- 8,627
-------- -------- --------
226,975 225,573 117,054
-------- -------- --------
$453,529 $300,518 $272,214
======== ======== ========
The following table sets forth certain information relating to the
Company's short term borrowings having average balances during any of the
reported periods of greater than 30% of stockholders' equity at the end of the
reported period.
At or for the Year Ended December 31,
-----------------------------------------------
1997 1996 1995
---------- --------- ----------
(Dollars in Thousands)
FHLB ADVANCES:
Average amount outstanding during the period.... $ 9,482 $ 71,221 $ 14,866
Maximum month-end balance outstanding
during the period.............................. $ 399 $ 81,399 $ 100,399
Weighted average rate:
During the period.............................. 5.46% 5.69% 7.57%
At end of period............................... --% 7.02% 5.84%
OBLIGATIONS OUTSTANDING UNDER LINES OF CREDIT:
Average amount outstanding during the period.... $ 84,272 $ -- $ --
Maximum month-end balance outstanding
during the period.............................. $ 267,095 $ -- $ --
Weighted average rate:
During the period.............................. 6.62% --% --%
At end of period............................... 6.32% --% --%
COMPUTER SYSTEMS AND USE OF TECHNOLOGY
The Company believes that its use of information technology has been a
key factor in achieving success in the acquisition, management and resolution of
discount loans and believes that this technology also has applicability to other
aspects of its business which involve servicing intensive assets, including
subprime residential mortgage lending, servicing of nonperforming or
underperforming loans for third parties and asset management services.
In addition to its standard industry software applications which have
been customized to meet the Company's requirements, the Company has internally
developed fully integrated proprietary applications designed to provide decision
support, automation of decision execution, tracking and exception reporting
associated with the management of nonperforming and underperforming loans. The
Company also has deployed: a predictive dialing solution which permits the
Company to direct the calls made by its collectors and increases the
productivity of the department; an interactive voice response system which
provides automated account information to customers; a document imaging system
which permits immediate access to pertinent loan documents; and a data warehouse
which permits corporate data to be shared on a centralized basis for decision
support. The Company is also implementing electronic commerce which further
automates the Company's communications with its third party service providers.
33
The Company's proprietary systems result in a number of benefits
including consistency of service to customers, reduced training periods for
employees, resolution decisions which evaluate on an automated basis the optimal
means to maximize the net resolution proceeds (which may include a variety of
resolution alternatives including placing the borrowers on forbearance plans,
pursuing a pre-approved sale of the property, or completing foreclosure
proceedings), the ability to effect foreclosure as quickly as possible within
state-specific foreclosure timelines and the management of third party service
providers to ensure quality of service. The federal mortgage agencies and
credit-rating agencies have established a variety of measurements for approved
servicers, against which the Company compares favorably. See "Business-Loan
Servicing Activities."
Through its document imaging system, the Company is able to produce
complete foreclosure packages within minutes. The Company believes that the
industry standard generally is to prepare a complete foreclosure package within
sixty days. Delays in the time to resolution result in increased third party
costs, opportunity costs and direct servicing expenses. As a result, the Company
has designed its systems and procedures to move a loan through the foreclosure
process in a timely manner.
The Company has invested in a sophisticated computer infrastructure to
support its software applications. The Company uses an IBM RISC AS400 and
NetFrame and COMPAQ Proliant file servers as its primary hardware platform. The
Company uses CISCO Routers, Cabletron Hubs and chassis with fiber optic cabling
throughout and between buildings so as to achieve the highest performance. The
Company also has deployed a DAVOX predicative dialer which currently has
capacity for 120 seats. The Company's document imaging system currently stores 6
million images. The Company's systems have significant capacity for expansion
and upgrade.
The Company protects its proprietary information by developing,
maintaining and enforcing a comprehensive set of information security policies;
by having each employee execute an intellectual property agreement with the
Company, which among other things, prohibits disclosure of confidential
information and provides for the assignment of developments; by affixing a
copyright symbol to copies of any of the Company's proprietary information to
which a third party has access; by emblazoning the start-up screen of any of the
Company's proprietary software with the Company's logo and a copyright symbol;
by having third-party contract employees and consultants execute a contract with
the Company which contains, among other things, confidentiality and assignment
provisions; and by otherwise limiting third-party access to the Company's
proprietary information.
ECONOMIC CONDITIONS
GENERAL. The success of the Company is dependent to a certain extent
upon the general economic conditions in the geographic areas in which it
conducts substantial business activities. Adverse changes in national economic
conditions or in the economic conditions of regions in which the Company
conducts substantial business likely would impair the ability of the Company to
collect on outstanding loans or dispose of real estate owned and would otherwise
have an adverse effect on its business, including the demand for new loans, the
ability of customers to repay loans and the value of both the collateral pledged
to the Company to secure its loans and its real estate owned. Moreover,
earthquakes and other natural disasters could have similar effects. Although
such disasters have not significantly adversely affected the Company to date,
the availability of insurance for such disasters in California, in which the
Company conducts substantial business activities, is severely limited. At
December 31, 1997, the Company had loans with an unpaid balance aggregating
$375.1 million (including loans available for sale) secured by properties
located in California and $48.3 million of the Company's real estate owned was
located in California, which collectively represent 13.8% of the Company's total
assets at such date.
EFFECTS OF CHANGES IN INTEREST RATES. The Company's operating results
depend to a large extent on its net interest income, which is the difference
between the interest income earned on interest-earning assets and the interest
expense incurred in connection with its interest-bearing liabilities. Changes in
the general level of interest rates can affect the Company's net interest income
by affecting the spread between the Company's interest-earning assets and
interest-bearing liabilities, as well as, among other things, the ability of the
Company to originate loans; the value of the Company's interest-earning assets
and its ability to realize gains from the sale of such assets; the average life
of the Company's interest-earning assets; the value of the Company's mortgage
servicing rights; and the Company's ability to obtain deposits in competition
with other available investment alternatives. Interest rates are highly
sensitive to many factors, including governmental monetary policies, domestic
and international economic and political conditions and other factors beyond the
control of the Company. The Company actively monitors its assets and liabilities
and employs a hedging strategy which seeks to limit the effects of changes in
interest rates on its operations. Although management believes that the
maturities of the Company's assets currently are well balanced in relation to
its liabilities (based on various estimates as to how changes
34
in the general level of interest rates will impact its assets and liabilities),
there can be no assurance that the profitability of the Company would not be
adversely affected during any period of changes in interest rates.
COMPETITION
The businesses in which the Company is engaged generally are highly
competitive. The acquisition of discount loans is particularly competitive, as
acquisitions of such loans are often based on competitive bidding. The Company
also encounters significant competition in connection with its other lending
activities, its investment and in its deposit-gathering activities. Many of the
Company's competitors are significantly larger than the Company and have access
to greater capital and other resources. In addition, many of the Company's
competitors are not subject to the same extensive federal regulations that
govern federally-insured institutions such as the Bank and their holding
companies. As a result, many of the Company's competitors have advantages over
the Company in conducting certain businesses and providing certain services.
SUBSIDIARIES
Set forth below is a brief description of the operations of the
Company's significant non-banking subsidiaries.
IMI. Through subsidiaries, IMI owns an interest in the Westin Hotel in
Columbus, Ohio, residential units in cooperative buildings which are acquired in
connection with the foreclosure on loans held by the Bank or by deed-in-lieu
thereof, as well as other real estate related ventures. During 1997, IMI sold a
69% partnership interest in the Westin Hotel for a small gain. At December 31,
1997, IMI also owned 9% of the outstanding common stock of OAIC.
OFS. OFS was formed by the Company under Florida law in October 1996
for the purposes of purchasing substantially all of the assets of Admiral, the
Company's primary correspondent mortgage banking firm for subprime single family
residential loans, and assuming all of the Bank's subprime single family
residential lending operations. Under the terms of the acquisition, a
transaction which closed on May 1, 1997, the Company agreed to pay Admiral $6.8
million and to transfer to Admiral 20% of the voting stock of OFS. In addition,
OFS assumed specified liabilities of Admiral in connection with this
transaction, including a $3.0 million unsecured loan which was made by the Bank
to Admiral at the time OFS entered into the asset acquisition agreement with
Admiral, which loan was repaid with the proceeds from a $30.0 million unsecured,
subordinated credit facility provided by the Company to OFS at the time of the
closing of such acquisition. On December 3, 1997, Ocwen purchased 2,705
additional shares of common stock of OFS for $15.0 million, increasing its
ownership percentage from 80% to 93.7%.
See "Business- Lending Activities-Single Family Residential Loans."
OCC. OCC is a wholly-owned subsidiary of the Company which was formed
under Florida law to manage the day-to-day operations of OAIC, subject to
supervision by OAIC's Board of Directors. The directors and executive officers
of OCC consist solely of William C. Erbey, Chairman, President and Chief
Executive Officer, and other executive officers of the Company. OAIC is a
Virginia corporation which elected to be taxed as a REIT under the Code. In May
1997, OAIC conducted an initial public offering of 17,250,000 shares of its
common stock, which resulted in net proceeds of $238.8 million, inclusive of the
$27.9 million contributed by the Company for an additional 1,875,000 shares, or
9.8% of the outstanding shares of OAIC common stock. The OAIC common stock is
traded on the Nasdaq National Market under the symbol "OAIC."
Pursuant to a management agreement between OCC and OAIC, and subject to
supervision by OAIC's Board of Directors, OCC formulates operating strategies
for OAIC, arranges for the acquisition of assets by OAIC, arranges for various
types of financing for OAIC, monitors the performance of OAIC's assets and
provides certain administrative and managerial services in connection with the
operation of OAIC. For performing these services, OCC receives (i) a base
management fee in an amount equal to 1% of total assets per annum, calculated
and paid quarterly based upon the average invested assets, as defined, by OAIC,
which is intended to cover OCC's cost of providing management services to the
Company, and (ii) a quarterly incentive fee in an amount equal to the product of
(A) 25% of the dollar amount by which (1)(a) funds from operations, as defined,
per share of OAIC common stock plus (b) gains (or minus losses) from debt
restructuring and sales of property per share of OAIC common stock, exceeds (2)
an amount equal to (a) the weighted average of the initial public offering price
per share of the OAIC common stock and the prices per share of any secondary
offerings of OAIC common stock by OAIC multiplied by (b) the ten-year U.S.
Treasury rate plus 5% per annum, multiplied by (B) the weighted average number
of shares of OAIC common stock outstanding. The Board of Directors of OAIC may
adjust the base management fee in the future if necessary to align the fee more
closely with the actual costs of
35
such services. OCC also may be reimbursed for the costs of certain due diligence
tasks performed by it on behalf of OAIC and will be reimbursed for the
out-of-pocket expenses incurred by it on behalf of OAIC.
Recently, the Company transferred the lending operations associated
with its large multi-family residential and commercial real estate loans to OCC.
To date, OCC has emphasized originating loans for OAIC (in order to enable OAIC
to invest the proceeds from the initial public offering of OAIC's common stock)
and not the Company.
EMPLOYEES
At December 31, 1997 the Company had 990 full time employees. The
employees are not represented by a collective bargaining agreement. Management
considers the Company's employee relations to be satisfactory.
REGULATION
Financial institutions and their holding companies are extensively
regulated under federal and state laws. As a result, the business, financial
condition and prospects of the Company can be materially affected not only by
management decisions and general economic conditions, but also by applicable
statutes and regulations and other regulatory pronouncements and policies
promulgated by regulatory agencies with jurisdiction over the Company and the
Bank, such as the OTS and the FDIC. The effect of such statutes, regulations and
other pronouncements and policies can be significant, cannot be predicted with a
high degree of certainty and can change over time. Moreover, such statutes,
regulations and other pronouncements and policies are intended to protect
depositors and the insurance funds administered by the FDIC and not stockholders
or holders of indebtedness which are not insured by the FDIC.
The enforcement powers available to Federal banking regulators are
substantial and include, among other things, the ability to assess civil
monetary penalties, to issue cease-and-desist or removal orders and to initiate
injunctive actions against banking organizations and institution-affiliated
parties, as defined. In general, these enforcement actions must be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with regulatory authorities.
The following discussion and other references to and descriptions of the
regulation of financial institutions contained herein constitute brief summaries
thereof as currently in effect. This discussion is not intended to constitute,
and does not purport to be, a complete statement of all legal restrictions and
requirements applicable to the Company and the Bank and all such descriptions
are qualified in their entirety by reference to applicable statutes, regulations
and other regulatory pronouncements.
THE COMPANY
GENERAL. The Company is a registered savings and loan holding company
under the Home Owner's Loan Act (the "HOLA"). As such, the Company is subject to
regulation, supervision and examination by the OTS.
ACTIVITIES RESTRICTION. There are generally no restrictions on the
activities of a savings and loan holding company, such as the Company, which
holds only one subsidiary savings institution. However, if the Director of the
OTS determines that there is reasonable cause to believe that the continuation
by a savings and loan holding company of an activity constitutes a serious risk
to the financial safety, soundness or stability of its subsidiary savings
institution, the Director may impose such restrictions as are deemed necessary
to address such risk, including limiting: (i) payment of dividends by the
savings institution; (ii) transactions between the savings institution and its
affiliates; and (iii) any activities of the savings institution that might
create a serious risk that the liabilities of the holding company and its
affiliates may be imposed on the savings institution. Notwithstanding the above
rules as to permissible business activities of unitary savings and loan holding
companies, if the savings institution subsidiary of such a holding company fails
to meet the qualified thrift lender ("QTL") test set forth in OTS regulations,
then such unitary holding company shall become subject to the activities and
restrictions applicable to multiple savings and loan holding companies and,
unless the savings institution requalifies as a QTL within one year thereafter,
shall register as, and become subject to the restriction applicable to, a bank
holding company. See "The Bank-Qualified Thrift Lender Test."
If the Company were to acquire control of another savings institution
other than through merger or other business combination with the Bank, the
Company would thereupon become a multiple savings and loan holding company.
Except where such acquisition is pursuant to the authority to approve emergency
thrift acquisition and where each subsidiary
36
savings institution meets the QTL test, as set forth below, the activities of
the Company and any of its subsidiaries (other than the Bank or other subsidiary
savings institutions) would thereafter be subject to further restrictions. Among
other things, no multiple savings and loan holding company or subsidiary thereof
which is not a savings institution generally shall commence or continue for a
limited period of time after becoming a multiple savings and loan holding
company or subsidiary thereof any business activity, other than: (i) furnishing
or performing management services for a subsidiary savings institution; (ii)
conducting an insurance agency or escrow business; (iii) holding, managing, or
liquidating assets owned by or acquired from a subsidiary savings institution;
(iv) holding or managing properties used or occupied by a subsidiary savings
institution; (v) acting as trustee under deeds of trust; (vi) those activities
authorized by regulation as of March 5, 1987 to be engaged in by multiple
savings and loan holding companies; or (vii) unless the Director of the OTS by
regulation prohibits or limits such activities for savings and loan holding
companies, those activities authorized by the Federal Reserve Board as
permissible for bank holding companies. Those activities described in clause
(vii) above also must be approved by the Director of the OTS prior to being
engaged in by a multiple savings and loan holding company.
RESTRICTIONS ON ACQUISITIONS. Except under limited circumstances,
savings and loan holding companies are prohibited from acquiring, without prior
approval of the Director of the OTS: (i) control of any other savings
institution or savings and loan holding company or substantially of the assets
thereof; or (ii) more than 5% of the voting shares of a savings institution or
holding company thereof which is not a subsidiary. Except with the prior
approval of the Director of the OTS, no director or officer of a savings and
loan holding company, or person owning or controlling by proxy or otherwise more
than 25% of such company's stock, may acquire control of any savings
institution, other than a subsidiary savings institution, or of any other
savings and loan holding company.
The Director of the OTS may approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls savings
institutions in more than one state only if: (i) the multiple savings and loan
holding company involved controls a savings institution which operated a home or
branch office located in the state of the institution to be acquired as of March
5, 1987; (ii) the acquiror is authorized to acquire control of the savings
institution pursuant to the emergency acquisition provisions of the Federal
Deposit Insurance Act ("FDIA"); or (iii) the statutes of the state in which the
institution to be acquired is located specifically permit institutions to be
acquired by state-chartered savings institutions located in the state where the
acquiring entity is located (or by a holding company that controls such
state-chartered savings institutions).
RESTRICTIONS ON TRANSACTIONS WITH AFFILIATES. Transactions between the
Company or any of its non-bank subsidiaries and the Bank are subject to various
restrictions, which are described below under "The Bank-Affiliate Transactions."
THE BANK
GENERAL. The Bank is a federally-chartered savings bank organized under
the HOLA. As such, the Bank is subject to regulation, supervision and
examination by the OTS. The deposit accounts of the Bank are insured up to
applicable limits by the SAIF administered by the FDIC and, as a result, the
Bank also is subject to regulation, supervision and examination by the FDIC.
The business and affairs of the Bank are regulated in a variety of
ways. Regulations apply to, among other things, insurance of deposit accounts,
capital ratios, payment of dividends, liquidity requirements, the nature and
amount of the investments that the Bank may make, transactions with affiliates,
community and consumer lending laws, internal policies and controls, reporting
by and examination of the Bank and changes in control of the Bank.
INSURANCE OF ACCOUNTS. Pursuant to legislation enacted in September
1996, a fee was required to be paid by all SAIF-insured institutions at the rate
of $0.657 per $100 of deposits held by such institutions at March 31, 1995. The
money collected recapitalized the SAIF reserve to the level of 1.25% of insured
deposits as required by law. In September 1996, the Bank recorded a pre-tax
accrual of $7.1 million for this assessment, which was subsequently paid in
November 1996. The recapitalization of the SAIF has resulted in lower deposit
insurance premiums for most SAIF-insured financial institutions, including the
Bank.
Insured institutions also are required to share in the payment of
interest on the bonds issued by a specially created government entity ("FICO"),
the proceeds of which were applied toward resolution of the thrift industry
crisis in the 1980s. Beginning on January 1, 1997, in addition to the insurance
premiums paid by SAIF-insured institutions to maintain the SAIF reserve at its
required level pursuant to the current risk classification system, SAIF-insured
institutions pay deposit
37
insurance premiums at the annual rate of 6.4 basis points of their insured
deposits and BIF-insured institutions will pay deposit insurance premiums at the
annual rate of 1.3 basis points of their insured deposits towards the payment of
interest on the FICO bonds.
Under the current risk classification system, institutions are assigned
to one of three capital groups which are based solely on the level of an
institution's capital--"well capitalized," "adequately capitalized" and
"undercapitalized"--which are defined in the same manner as the regulations
establishing the prompt corrective action system under Section 38 of the FDIA,
as discussed below. These three groups are then divided into three subgroups,
which are based on supervisory evaluations by the institution's primary federal
regulator, resulting in nine assessment classifications. Assessment rates
currently range from 0 basis points for well capitalized, healthy institutions
to 27 basis points for undercapitalized institutions with substantial
supervisory concerns.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices, is in an
unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances which would result in
termination of the Bank's deposit insurance.
REGULATORY CAPITAL REQUIREMENTS. Federally-insured savings associations
are subject to three capital requirements of general applicability: a tangible
capital requirement, a core or leverage capital requirement and a risk-based
capital requirement. All savings associations currently are required to maintain
tangible capital of at least 1.5% of adjusted total assets (as defined in the
regulations), core capital equal to 3% of adjusted total assets and total
capital (a combination of core and supplementary capital) equal to 8% of
risk-weighted assets (as defined in the regulations). For purposes of the
regulation, tangible capital is core capital less all intangibles other than
qualifying purchased mortgage servicing rights, of which the Bank had $4.9
million at December 31, 1997. Core capital includes common stockholders' equity,
non-cumulative perpetual preferred stock and related surplus, minority interests
in the equity accounts of fully consolidated subsidiaries and certain
nonwithdrawable accounts and pledged deposits. Core capital generally is reduced
by the amount of a savings association's intangible assets, other than
qualifying mortgage servicing rights.
A savings association is allowed to include both core capital and
supplementary capital in the calculation of its total capital for purposes of
the risk-based capital requirements, provided that the amount of supplementary
capital included does not exceed the savings association's core capital.
Supplementary capital consists of certain capital instruments that do not
qualify as core capital, including subordinated debt (such as the Bank's
Debentures) which meets specified requirements, and general valuation loan and
lease loss allowances up to a maximum of 1.25% of risk-weighted assets. In
determining the required amount of risk-based capital, total assets, including
certain off-balance sheet items, are multiplied by a risk weight based on the
risks inherent in the type of assets. The risk weights assigned by the OTS for
principal categories of assets currently range from 0% to 100%, depending on the
type of asset.
OTS policy imposes a limitation on the amount of net deferred tax
assets under SFAS No. 109 that may be included in regulatory capital. (Net
deferred tax assets represent deferred tax assets, reduced by any valuation
allowances, in excess of deferred tax liabilities.) Application of the limit
depends on the possible sources of taxable income available to an institution to
realize deferred tax assets. Deferred tax assets that can be realized from the
following generally are not limited: taxes paid in prior carryback years and
future reversals of existing taxable temporary differences. To the extent that
the realization of deferred tax assets depends on an institution's future
taxable income (exclusive of reversing temporary differences and carryforwards),
or its tax-planning strategies, such deferred tax assets are limited for
regulatory capital purposes to the lesser of the amount that can be realized
within one year of the quarter-end report date or 10% of core capital. The
Bank's regulatory capital at December 31, 1997, has been reduced by $536,000 of
disallowed deferred tax assets in excess of the OTS limit.
In August 1993, the OTS adopted a final rule incorporating an
interest-rate risk component into the risk-based capital regulation. Under the
rule, an institution with a greater than "normal" level of interest rate risk
will be subject to a deduction of its interest rate risk component from total
capital for purposes of determining whether it has met the risk-based capital
requirement. As a result, such an institution will be required to maintain
additional capital in order to comply with the risk-based capital requirement.
Although the final rule was originally scheduled to be effective as of January
1994, the
38
OTS has indicated that it will delay invoking its interest rate risk rule until
appeal procedures are implemented and evaluated. The OTS has not yet established
an effective date for the capital deduction. Management of the Company does not
believe that the adoption of an interest rate risk component to the risk-based
capital requirement will adversely affect the Bank if it becomes effective in
its current form.
In April 1991, the OTS proposed to modify the 3% of adjusted total
assets core capital requirement in the same manner as was done by the
Comptroller of the Currency for national banks. Under the OTS proposal, only
savings associations rated composite 1 under the CAMEL rating system will be
permitted to operate at the regulatory minimum core capital ratio of 3%. For all
other savings associations, the minimum core capital ratio will be 3% plus at
least an additional 100 to 200 basis points, which will increase the core
capital ratio requirement from 4% to 5% of adjusted total assets or more. In
determining the amount of additional capital, the OTS will assess both the
quality of risk management systems and the level of overall risk in each
individual savings association through the supervisory process on a case-by-case
basis.
PROMPT CORRECTIVE ACTION. Federal law provides the Federal banking
regulators with broad power to take "prompt corrective action" to resolve the
problems of undercapitalized institutions. The extent of the regulators' powers
depends on whether the institution in question is "well capitalized,"
"adequately capitalized," "undercapitalized," "significantly undercapitalized"
or "critically undercapitalized." Under regulations adopted by the Federal
banking regulators, an institution shall be deemed to be: (i) "well capitalized"
if it has a total risk-based capital ratio of 10.0% or more, has a Tier I
risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of
5.0% or more and is not subject to specified requirements to meet and maintain a
specific capital level for any capital measure; (ii) "adequately capitalized" if
it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based
capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or
more (3.0% under certain circumstances) and does not meet the definition of
"well capitalized," (iii) "undercapitalized" if it has a total risk-based
capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is
less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0%
under certain circumstances), (iv) "significantly undercapitalized" if it has a
total risk-based capital ratio that is less than 6.0%, a Tier I risk-based
capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is
less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of
tangible equity to adjusted total assets that is equal to or less than 2.0%. The
regulations also permit the appropriate Federal banking regulator to downgrade
an institution to the next lower category (provided that a significantly
undercapitalized institution may not be downgraded to critically
undercapitalized) if the regulator; determines: (i) after notice and opportunity
for hearing or response, that the institution is in an unsafe or unsound
condition or (ii) that the institution has received (and not corrected) a
less-than-satisfactory rating for any of the categories of asset quality,
management, earnings or liquidity in its most recent exam. At December 31, 1997,
the Bank was a "well capitalized" institution under the prompt corrective action
regulations of the OTS.
Depending upon the capital category to which an institution is
assigned, the regulators' corrective powers, many of which are mandatory in
certain circumstances, include: prohibition on capital distributions;
prohibition on payment of management fees to controlling persons; requiring the
submission of a capital restoration plan; placing limits on asset growth;
limiting acquisitions, branching or new lines of business; requiring the
institution to issue additional capital stock (including additional voting
stock) or to be acquired; restricting transactions with affiliates; restricting
the interest rates that the institution may pay on deposits; ordering a new
election of directors of the institution; requiring that senior executive
officers or directors be dismissed; prohibiting the institution from accepting
deposits from correspondent banks; requiring the institution to divest certain
subsidiaries; prohibiting the payment of principal or interest on subordinated
debt; and, ultimately, appointing a receiver for the institution.
QUALIFIED THRIFT LENDER TEST. All savings associations are required to
meet the QTL test set forth in the HOLA and regulations of the OTS thereunder to
avoid certain restrictions on their operations. A savings association that does
not meet the QTL test set forth in the HOLA and implementing regulations must
either convert to a bank charter or comply with the following restrictions on
its operations: (i) the association may not engage in any new activity or make
any new investment, directly or indirectly, unless such activity or investment
is permissible for a national bank; (ii) the branching powers of the association
shall be restricted to those of a national bank; (iii) the association shall not
be eligible to obtain any advances from its FHLB; and (iv) payment of dividends
by the association shall be subject to the rules regarding payment of dividends
by a national bank. Upon the expiration of three years from the date the
association ceases to be a QTL, it must cease any activity and not retain any
investment not permissible for a national bank and immediately repay any
outstanding FHLB advances (subject to safety and soundness considerations). The
Bank met the QTL test throughout 1997.
39
RESTRICTIONS ON CAPITAL DISTRIBUTIONS. The OTS has promulgated a
regulation governing capital distributions by savings associations, which
include cash dividends, stock redemptions or repurchases, cash-out mergers,
interest payments on certain convertible debt and other transactions charged to
the capital account of a savings association as a capital distribution.
Generally, the regulation creates three tiers of associations based on
regulatory capital, with the top two tiers providing a safe harbor for specified
levels of capital distributions from associations so long as such associations
notify the OTS and receive no objection to the distribution from the OTS.
Associations that do not qualify for the safe harbor provided for the top two
tiers of associations are required to obtain prior OTS approval before making
any capital distributions.
Tier I associations may make the highest amount of capital
distributions, and are defined as savings associations that, before and after
the proposed distribution, meet or exceed their fully phased-in regulatory
capital requirements. Tier I associations may make capital distributions during
any calendar year equal to the greater of: (i) 100% of net income for the
calendar year-to-date plus 50% of its "surplus capital ratio" at the beginning
of the calendar year; and (ii) 75% of its net income over the most recent
four-quarter period. The "surplus capital ratio" is defined to mean the
percentage by which the association's ratio of total capital to assets exceeds
the ratio of its fully phased-in capital requirement to assets, and "fully
phased-in capital requirement" is defined to mean an association's capital
requirement under the statutory and regulatory standards applicable on December
31, 1994, as modified to reflect any applicable individual minimum capital
requirement imposed upon the association. At December 31, 1997, the Bank was a
Tier I association under the OTS capital distribution regulation.
In December 1994, the OTS published a notice of proposed rulemaking to
amend its capital distribution regulation. Under the proposal, the three tiered
approach contained in existing regulations would be replaced and institutions
would be permitted to make capital distributions that would not result in their
capital being reduced below the level required to remain "adequately
capitalized," as defined above under "Prompt Corrective Action."
LOAN-TO-ONE BORROWER. Under applicable laws and regulations, the amount
of loans and extensions of credit which may be extended by a savings institution
such as the Bank to any one borrower, including related entities, generally may
not exceed the greater of $500,000 or 15% of the unimpaired capital and
unimpaired surplus of the institution. Loans in an amount equal to an additional
10% of unimpaired capital and unimpaired surplus also may be made to a borrower
if the loans are fully secured by readily marketable securities. An
institution's "unimpaired capital and unimpaired surplus" includes, among other
things, the amount of its core capital and supplementary capital included in its
total capital under OTS regulations.
At December 31, 1997, the Bank's unimpaired capital and surplus
amounted to $405.1 million, resulting in a general loans-to-one borrower
limitation of $60.8 million under applicable laws and regulations. See
"Business-Discount Loan Acquisition and Resolution Activities-Composition of the
Discount Loan Portfolio" and "Lending Activities-Composition of Loan Portfolio."
BROKERED DEPOSITS. Under applicable laws and regulations, an insured
depository institution may be restricted in obtaining, directly or indirectly,
funds by or through any "deposit broker," as defined, for deposit into one or
more deposit accounts at the institution. The term "deposit broker" generally
includes any person engaged in the business of placing deposits, or facilitating
the placement of deposits, of third parties with insured depository institutions
or the business of placing deposits with insured depository institutions for the
purpose of selling interests in those deposits to third parties. In addition,
the term "deposit broker" includes any insured depository institution, and any
employee of any insured depository institution, which engages, directly or
indirectly, in the solicitation of deposits by offering rates of interest (with
respect to such deposits) which are significantly higher than the prevailing
rates of interest on deposits offered by other insured depository institutions
having the same type of charter in such depository institution's normal market
area. As a result of the definition of "deposit broker," all of the Bank's
brokered deposits, as well as possibly its deposits obtained through customers
of regional and local investment banking firms and the deposits obtained from
the Bank's direct solicitation efforts of institutional investors and high net
worth individuals, are potentially subject to the restrictions described below.
Under FDIC regulations, well-capitalized institutions are subject to the
no-brokered deposit limitations, while adequately- capitalized institutions are
able to accept, renew or roll over brokered deposits only: (i) with a waiver
from the FDIC; and (ii) subject to the limitation that they do not pay an
effective yield on any such deposit which exceeds by more than (a) 75 basis
points, the effective yield paid on deposits of comparable size and maturity in
such institution's normal market area for deposits accepted in its normal market
area or (b) by 120% for retail deposits and 130% for wholesale deposits,
respectively, of the current yield on comparable maturity U.S. Treasury
obligations for deposits accepted outside the institution's normal market area.
Undercapitalized institutions are not permitted to accept brokered deposits and
may not
40
solicit deposits by offering an effective yield that exceeds by more than 75
basis points, the prevailing effective yields on insured deposits of comparable
maturity in the institution's normal market area or in the market area in which
such deposits are being solicited. At December 31, 1997, the Bank was a
well-capitalized institution which was not subject to restrictions on brokered
deposits. See "Business - Sources of Funds - Deposits."
LIQUIDITY REQUIREMENTS. All savings associations are required to
maintain an average daily balance of liquid assets, which include specified
short-term assets and certain long-term assets, equal to a certain percentage of
the sum of its average daily balance of net withdrawable deposit accounts and
borrowings payable in one year or less. The liquidity requirement may vary from
time to time (between 4% and 10%) depending upon economic conditions and savings
flows of all savings associations. In November 1997, the OTS amended its
liquidity regulations to, among other things, provide that a savings association
shall maintain liquid assets of not less than 4% of the amount of its liquidity
base at the end of the preceding calendar quarter as well as to provide that
each savings association must maintain sufficient liquidity to ensure its safe
and sound operation. Prior to November 1997, the required liquid asset ratio was
5%. Historically, the Bank has operated in compliance with these requirements.
AFFILIATE TRANSACTIONS. Under federal law and regulation, transactions
between a savings association and its affiliates are subject to quantitative and
qualitative restrictions. Affiliates of a savings association include, among
other entities, companies that control, are controlled by or are under common
control with the savings association. As a result, the Company, OAIC and the
Company's non-bank subsidiaries are affiliates of the Bank.
Savings associations are restricted in their ability to engage in
"covered transactions" with their affiliates. In addition, covered transactions
between a savings association and an affiliate, as well as certain other
transactions with or benefiting an affiliate, must be on terms and conditions at
least as favorable to the savings association as those prevailing at the time
for comparable transactions with non-affiliated companies. Savings associations
are required to make and retain detailed records of transactions with
affiliates.
Notwithstanding the foregoing, a savings association is not permitted
to make a loan or extension of credit to any affiliate unless the affiliate is
engaged only in activities the Federal Reserve Board has determined to be
permissible for bank holding companies. Savings associations also are prohibited
from purchasing or investing in securities issued by an affiliate, other than
shares of a subsidiary.
Savings associations are also subject to various limitations and
reporting requirements on loans to insiders. These limitations require, among
other things, that all loans or extensions of credit to insiders (generally
executive officers, directors or 10% stockholders of the institution) or their
"related interests" be made on substantially the same terms (including interest
rates and collateral) as, and follow credit underwriting procedures that are not
less stringent than, those prevailing for comparable transactions with the
general public and not involve more than the normal risk of repayment or present
other unfavorable features.
COMMUNITY INVESTMENT AND CONSUMER PROTECTION LAWS. In connection with
its lending activities, the Bank is subject to a variety of federal laws
designed to protect borrowers and promote lending to various sectors of the
economy and population. Included among these are the Federal Home Mortgage
Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending Act,
Equal Credit Opportunity Act, Fair Credit Reporting Act and the Community
Reinvestment Act.
SAFETY AND SOUNDNESS. Other regulations include: (i) real estate
lending standards for insured institutions, which provide guidelines concerning
loan-to-value ratios for various types of real estate loans; (ii) risk-based
capital rules to account for interest rate risk, concentration of credit risk
and the risks posed by "non-traditional activities;" (iii) rules requiring
depository institutions to develop and implement internal procedures to evaluate
and control credit and settlement exposure to their correspondent banks; and
(iv) rules addressing various "safety and soundness" issues, including
operations and managerial standards, standards for asset quality, earnings and
stock valuations, and compensation standards for the officers, directors,
employees and principal stockholders of the insured institution.
FEDERAL TAXATION
GENERAL. The Company and all of its subsidiaries currently file, and
expect to continue to file, a consolidated Federal income tax return based on a
calendar year. Prior to October 1, 1996, IMI and its subsidiaries filed a
separate
41
Federal consolidated tax return. Consolidated returns have the effect of
eliminating inter-company transactions, including dividends, from the
computation of taxable income.
For taxable years beginning prior to January 1, 1996, a savings
institution, such as the Bank, that met certain definitional tests relating to
the composition of its assets and the sources of its income (a "qualifying
savings institution") was permitted to establish reserves for bad debts and to
claim annual tax deductions for additions to such reserves. A qualifying savings
institution was permitted to make annual additions to such reserves based on the
institution's loss experience. Alternatively, a qualifying savings institution
could elect, on an annual basis, to use the "percentage of taxable income"
method to compute its addition to its bad debt reserve on qualifying real
property loans (generally, loans secured by an interest in improved real
estate). The percentage of taxable income method permitted the institution to
deduct a specified percentage of its taxable income before such deduction,
regardless of the institution's actual bad debt experience, subject to certain
limitations. From 1988 to 1995, the Bank has claimed bad debt deductions under
the percentage of taxable income method because that method produced a greater
deduction than did the experience method.
On August 20, 1996, President Clinton signed the Small Business Job
Protection Act ("the Act") into law. One provision of the Act repealed the
reserve method of accounting for bad debts for savings institutions effective
for taxable years beginning after 1995 and provided for recapture of a portion
of the reserves existing at the close of the last taxable year beginning before
January 1, 1996. For its tax years beginning on or after January 1, 1996, the
Bank is required to account for its bad debts under the specific charge-off
method. Under this method, deductions may be claimed only as and to the extent
that loans become wholly or partially worthless.
ALTERNATIVE MINIMUM TAX. In addition to the regular corporate income
tax, corporations, including qualifying savings institutions, are subject to an
alternative minimum tax. The 20% tax is computed on Alternative Minimum Taxable
Income ("AMTI") and applies if it exceeds the regular tax liability. AMTI is
equal to regular taxable income with certain adjustments. For taxable years
beginning after 1989, AMTI includes an adjustment for 75% of the excess of
"adjusted current earnings" over regular taxable income. Net operating loss
carrybacks and carryforwards are permitted to offset only 90% of AMTI.
Alternative minimum tax paid can be credited against regular tax due in later
years.
TAX RESIDUALS. From time to time, the Company acquires REMIC residuals
or retains residual securities in REMICs which were formed by the Company in
connection with the securitization and sale of loans. Although a tax residual
may have little or no future economic cash flows from the REMIC from which it
has been issued, the tax residual does bear the income tax liability or benefit
resulting from the difference between the interest rate paid on the securities
by the REMIC and the interest rate received on the mortgage loans held by the
REMIC. This generally results in taxable income for the Company in the first
several years of the REMIC and equal amounts of tax deductions thereafter. The
Company receives cash payments in connection with the acquisition of tax
residuals to compensate the Company for the time value of money associated with
the tax payments related to these securities and the costs of modeling,
recording, monitoring and reporting the securities. The Company defers all fees
received and recognizes such fees in interest income on a level yield basis over
the expected life of the deferred tax asset related to tax residuals. The
Company also adjusts the recognition in interest income of fees deferred based
upon the changes in the actual prepayment rates of the underlying mortgages held
by the REMIC and periodic reassessments of the expected life of the deferred tax
asset related to tax residuals. At December 31, 1997, the Company's gross
deferred tax assets included $3.5 million which was attributable to the
Company's tax residuals and related deferred income.
INVESTMENTS IN LOW-INCOME HOUSING TAX CREDIT INTERESTS. For a
discussion of the tax effects of investments in low-income housing tax credit
interests, see "Business-Investment Activities-Investment in Low-Income Housing
Tax Credit Interests."
EXAMINATIONS. The most recent examination by the IRS of the Company's
Federal income tax return was of the tax return filed for 1993. The statute of
limitations has run out with respect to 1993 and all prior tax years. Thus, the
Federal income tax returns for the years 1994 through 1997 are open for
examination. The Internal Revenue Service currently is completing an examination
of the Company's Federal income tax return for 1994; management of the Company
does not anticipate any material adjustments as a result of this examination,
although there can be no assurances in this regard. No state return of the
Company has been examined, and no notification has been received by the Company
that any state intends to examine any of the Company's tax returns.
42
STATE TAXATION
The Company's income is subject to tax by the States of Florida and
California, which have statutory tax rates of 5.5% and 11.3%, respectively, and
is determined based on certain apportionment factors. The Company is taxed in
New Jersey on income, net of expenses, earned in New Jersey at a statutory rate
of 3.0%.
ITEM 2. PROPERTIES
At December 31, 1997, the Company conducted business from its executive
and administrative offices located in West Palm Beach, Florida and a
full-service banking office located in northern New Jersey.
The following table sets forth information relating to the Company's
executive and main offices at December 31, 1997.
Net Book Value of Property or
Leasehold
Location Owned/Leased Improvements
(Dollars in Thousands)
- ------------------------------------------------- ---------------------- -----------------------------------
Executive Offices:
1675 Palm Beach Lakes Blvd.
West Palm Beach, FL....................... Leased $ 6,021
Main Office:
2400 Lemoine Ave
Fort Lee, NJ.............................. Leased $ --
In addition to the above offices, OFS maintains 27 loan production
offices in 7 states, including 18 offices in California. These offices are
operated pursuant to leases with up to three-year terms, each of which can be
readily replaced on commercially reasonable terms.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Information required by this Item appears under the caption
"Shareholder Information" on page 71 of the Annual Report to Stockholders and is
incorporated herein by reference.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL INFORMATION
Information required by this Item appears under the caption "Selected
Consolidated Financial Information" on pages 1 to 2 of the Annual Report to
Stockholders and is incorporated herein by reference.
43
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Information required by this Item appears under the caption
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" on pages 4 to 20 of the Annual Report to Stockholders and is
incorporated herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information required by this Item appears under the caption "Asset and
Liability Management" on pages 15 to 17 of the Annual Report to Stockholders and
is incorporated herein by reference.
ITEM 8. FINANCIAL STATEMENTS
Information required by this Item appears on pages 22 to 70 in the
Annual Report to Stockholders and is incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information contained in the Company's 1998 Proxy Statement under
the captions "Election of Directors -- Nominees for Director," "Executive
Officers Who Are Not Directors," and "Security Ownership of Certain Beneficial
Owners -- Section 16(a) Beneficial Ownership Reporting Compliance" is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information contained in the Company's 1998 Proxy Statement under
the captions "Executive Compensation," other than under the sub-caption "Report
of the Nominating and Compensation Committee," and "Board of Directors
Compensation" is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information contained in the Company's 1998 Proxy Statement under
the caption "Security Ownership of Certain Beneficial Owners -- Beneficial
Ownership of Common Stock" is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information contained in the Company's 1998 Proxy Statement under
the caption "Certain Relationships and Related Transactions" is incorporated
herein by reference.
44
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
EXHIBITS
3.1 Amended and Restated Articles of Incorporation (1)
3.2 Bylaws (1)
4.0 Form of Certificate of Common Stock (1)
4.1 Form of Indenture between the Company and Bank One, Columbus,
NA as Trustee (1)
4.2 Form of Note due 2003 (included in Exhibit 4.1) (1)
4.3 Certificate of Trust of Ocwen Capital Trust I (3)
4.4 Amended and Restated Declaration of Trust of Ocwen Capital
Trust I (3)
4.5 Form of Capital Security of Ocwen Capital Trust I (4)
4.6 Form of Indenture relating to 10 7/8% Junior Subordinated
Debentures due 2027 of the Company (3)
4.7 Form of 10 7/8% Junior Subordinated Debentures due 2027 of the
Company (4)
4.8 Form of Guarantee of the Company relating to the Capital
Securities of Ocwen Capital Trust I (3)
4.9 Form of Indenture between the Company and The Bank of New York
as Trustee
4.10 Form of Subordinated Debentures due 2005 (included in Exhibit
4.2) (5)
10.1 Ocwen Financial Corporation 1991 Non-Qualified Stock Option
Plan, as amended (1)
10.2 Annual Incentive Plan (1)
10.3 Ocwen Financial Corporation 1996 Stock Plan for Directors, as
amended (2)
10.4 Ocwen Financial Corporation 1998 Annual Incentive Plan (6)
10.5 Ocwen Financial Corporation Long-Term Incentive Plan (6)
11.1 Computation of earnings per share (7)
13.1 Annual Report to Stockholders for the year ended December 31,
1997
21.0 Subsidiaries (see "Business-General")
23.0 Consent of Price Waterhouse LLP
27.1 Financial Data Schedule - For the year ended December 31, 1997
27.2 Amended Financial Data Schedule - For the year ended December
31, 1996
27.3 Amended Financial Data Schedule - For the period ended
September 30, 1996
27.4 Amended Financial Data Schedule - For the period ended March
31, 1997
27.5 Amended Financial Data Schedule - For the period ended June
30, 1997
27.6 Amended Financial Data Schedule - For the period ended
September 30, 1997
99.0 BCBF, L.L.C. December 31, 1997 audited financial statements
- -------------------
(1) Incorporated by reference to the similarly described exhibit filed in
connection with the Registrant's Registration Statement on Form S-1, File
No. 333-5153, declared effective by the commission on September 25, 1996.
(2) Incorporated by reference to the similarly described exhibit included with
the Registrants Quarterly Report on Form 10-Q for the quarter ended
September 30, 1996.
(3) Incorporated by reference to the similarly identified exhibit filed in
connection with the Company's Registration Statement on Form S-1 (File No.
333-28889), as amended, declared effective by the Commission on August 6,
1997.
(4) Incorporated by reference to similarly described exhibit included with
Registrant's Quarterly Report on Form 10-Q for the quarter ended September
30, 1997.
(5) Incorporated by reference to the similarly described exhibit filed in
connection with Amendment No. 2 to Offering Circular on Form OC (on Form
S-1) filed on June 7, 1995.
(6) Incorporated by reference to the similarly described exhibit to the
Company's Definitive Proxy Statement with respect to the Company's 1998
Annual Meeting as filed with the Commission on March 31, 1998.
(7) Computation of earnings per share appears on page 55 in the Annual Report
to Stockholders and is incorporated herein by reference.
The Company's management contracts or compensatory plans or arrangements
consist of Exhibits No. 10.1, 10.2, 10.3, 10.4 and 10.5.
45
FINANCIAL STATEMENTS AND SCHEDULES. The following Consolidated
Financial Statements of Ocwen Financial Corporation and Report of Price
Waterhouse LLP, Independent Certified Public Accountants are incorporated by
reference to pages 22 to 70 of the Company's Annual Report to Stockholders:
Report of Independent Certified Public Accountants
Consolidated Statements of Financial Condition at December 31,
1997 and 1996
Consolidated Statements of Operations for each of the three years
in the period ended December 31, 1997
Consolidated Statements of Changes in Stockholders' Equity for
each of the three years in the period ended December 31, 1997
Consolidated Statements of Cash Flows for each of the three years
in the period ended December 31, 1997
Notes to Consolidated Financial Statements
Financial statement schedules have been omitted because they are not
applicable or the required information is shown in the Consolidated Financial
Statements or notes thereto.
REPORTS ON FORM 8-K FILED DURING THE QUARTER ENDED DECEMBER 31, 1997.
(1) A Form 8-K was filed by the Company on October 30, 1997 which contained
a news release announcing the Company's financial results for the three
and nine months ended September 30, 1997.
(2) A Form 8-K/A was filed by the Company on November 21, 1997 which
contained the news release announcing the Company's financial results
for the three and nine months ended September 30, 1997 dated October
27, 1997 and originally filed on October 30, 1997, amended for changes
to reflect the final financial information as determined in connection
with the filing by the Company of its Form 10-Q for the quarter ended
September 30, 1997, including the retroactive adjustment for the
2-for-1 stock split approved by the Board of Directors on October 29,
1997.
46
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
OCWEN FINANCIAL CORPORATION
By: /s/ William C. Erbey
------------------------------------------------
William C. Erbey
Chairman of the Board, President and
Chief Executive Officer
(duly authorized representative)
Date: March 31, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
this Report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated:
/s/ William C. Erbey Date: March 31, 1998
- ------------------------------------------------------
William C. Erbey, Chairman of the Board,
Chief Executive Officer and President
(principal executive officer)
/s/ Barry N. Wish Date: March 31, 1998
- -------------------------------------------------------
Barry N. Wish, Director
/s/ W.C. Martin Date: March 31, 1998
- -------------------------------------------------------
W.C. Martin, Director
/s/ Howard H. Simon Date: March 31, 1998
- -------------------------------------------------------
Howard H. Simon, Director
/s/ Hon. Thomas F. Lewis Date: March 31, 1998
- -------------------------------------------------------
Hon. Thomas F. Lewis, Director
/s/ Mark S. Zeidman Date: March 31, 1998
- -------------------------------------------------------
Mark S. Zeidman, Chief Financial Officer
(principal financial and accounting officer)
47