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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____________ to _____________
Commission File Number: 1-12109
DELTA FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 11-3336165
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1000 WOODBURY ROAD, SUITE 200, WOODBURY, NEW YORK 11797
---------------------------------------------------------
(Address of registrant's principal executive offices including ZIP Code)
(516)364-8500
-------------
(Registrant's telephone number, including area code)
NO CHANGE
---------
(Former name, former address and former fiscal year, if changed
since last report)
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 [ ]
As of June 30, 2002, 15,904,049 shares of the Registrant's common stock,
par value $0.01 per share, were outstanding.
INDEX TO FORM 10-Q
Page No.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Consolidated Balance Sheets as of June 30, 2002 and
December 31, 2001.................................................. 1
Consolidated Statements of Operations for the three and six
months ended June 30, 2002 and June 30, 2001....................... 2
Consolidated Statements of Cash Flows for the six months ended
June 30, 2002 and June 30, 2001.................................... 3
Notes to Consolidated Financial Statements......................... 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.............................................. 9
PART II- OTHER INFORMATION
Item 1. Legal Proceedings..................................................33
Item 2. Changes in Securities and Use of Proceeds..........................36
Item 3. Defaults Upon Senior Securities....................................36
Item 4. Submission of Matters to a Vote of Security Holders................36
Item 5. Other Information..................................................36
Item 6. Exhibits and Current Reports on Form 8-K.......................... 36
Signatures..................................................................37
Certification of President and Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002...............................38
Certification of Executive Vice President and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002...................39
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS (UNAUDITED)
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
JUNE 30, DECEMBER 31,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2002 2001
---------- -----------
ASSETS
Cash and interest-bearing deposits $ 2,908 6,410
Accounts receivable 4,578 4,062
Loans held for sale, net 34,022 94,407
Accrued interest receivable 69 812
Excess cash flow certificates, net 20,765 16,765
Equipment, net 3,372 4,998
Prepaid and other assets 859 752
Deferred tax asset, net 5,600 5,600
-------- --------
Total assets $ 72,173 $ 133,806
======== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Bank payable $ 810 1,267
Warehouse financing and other borrowings 23,389 89,628
Senior Notes 10,844 10,844
Accounts payable and accrued expenses 19,054 20,217
-------- --------
Total liabilities 54,097 121,956
-------- --------
Stockholders' Equity:
Preferred stock, Series A, $.01 par value.
Authorized 150,000 Shares, 139,156 shares
outstanding at June 30, 2002 and
December 31, 2001 13,916 13,916
Common stock, $.01 par value. Authorized
49,000,000 shares; 16,020,849 shares issued
and 15,904,049 shares outstanding at June 30,
2002 and 16,000,542 shares issued and 15,883,749
shares outstanding at December 31, 2001 160 160
Additional paid-in capital 99,481 99,472
Retained deficit (94,163) (100,380)
Treasury stock, at cost (116,800 shares) (1,318) (1,318)
-------- --------
Total stockholders' equity 18,076 11,850
-------- --------
Total liabilities and stockholders' equity $ 72,173 133,806
========= ========
See accompanying notes to consolidated financial statements.
1
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2002 2001 2002 2001
------ ------ ------ ------
REVENUES
Net gain on sale of mortgage loans $ 14,725 15,160 27,063 21,203
Interest 3,225 5,243 7,127 (9,546)
Servicing fees -- 770 -- 2,983
Net origination fees and other income 3,569 3,892 6,918 7,388
------- ------- -------- ---------
Total revenues 21,519 25,065 41,108 22,028
------- ------- -------- ---------
EXPENSES
Payroll and related costs 10,099 11,959 19,776 23,283
Interest expense 1,469 5,992 3,016 11,821
General and administrative 5,847 23,562 11,847 35,393
Restructuring and other special charges -- (13) -- 1,246
------- ------- --------- --------
Total expenses 17,415 41,500 34,639 71,743
-------- ------- -------- --------
Income (loss) before income
tax expense 4,104 (16,435) 6,469 (49,715)
Provision for income tax expense 132 93 252 565
-------- -------- -------- ---------
Net income (loss) $ 3,972 (16,528) 6,217 (50,280)
========== ========= ======== =========
PER SHARE DATA:
Basic - net income (loss) per share $ 0.25 (1.04) 0.39 (3.17)
========== ========= ======== =========
Diluted - net income (loss) per share $ 0.23 (1.04) 0.37 (3.17)
========== ========= ======== =========
Basic -weighted average number of
shares outstanding 15,888,014 15,883,749 15,885,893 15,883,749
========== ========== ========== ==========
Diluted -weighted average number of
shares outstanding 16,941,584 15,883,749 16,855,349 15,883,749
========== ========== ========== ==========
See accompanying notes to consolidated financial statements.
2
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
(DOLLARS IN THOUSANDS) 2002 2001
------- ------
Cash flows from operating activities:
Net income (loss) $ 6,217 (50,280)
Adjustments to reconcile net income (loss) to net cash used in
operating activities:
Provision for loan and recourse losses 441 2,293
Depreciation and amortization 1,810 6,007
Deferred origination costs 529 (84)
Excess cash flow certificates received in
securitization transactions, net (4,000) 30,432
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable (516) 16,012
Decrease in loans held for sale, net 59,460 1,596
Decrease accrued interest receivable 743 9,891
(Increase) decrease in prepaid and other assets (107) 32,451
Decrease in accounts payable and accrued expenses (1,208) (2,050)
Decrease in investor payable -- (69,489)
Decrease in advance payments by borrowers for
taxes and insurance -- (12,940)
--------- --------
Net cash provided by (used in) operating activities 63,369 (36,161)
--------- --------
Cash flows from investing activities:
(Purchase) disposition of equipment (184) 1,483
---------- ----------
Net cash (used in) provided by investing activities (184) 1,483
---------- ----------
Cash flows from financing activities:
Repayments from warehouse financing and other borrowings (66,239) (23,422)
(Decrease) increase in bank payable, net (457) 60
Proceeds from exercise of stock options 9 --
---------- ----------
Net cash used in financing activities (66,687) (23,362)
---------- ----------
Net decrease in cash and interest-bearing deposits (3,502) (58,040)
Cash and interest-bearing deposits at beginning of period 6,410 62,270
---------- --------
Cash and interest-bearing deposits at end of period $ 2,908 4,230
========== ========
Supplemental Information:
Cash paid during the period for:
Interest $ 2,916 11,551
========== ========
Income taxes $ 121 80
========== ========
See accompanying notes to consolidated financial statements.
3
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
Delta Financial Corporation (together with its subsidiaries "Delta" or "we"
or "the Company") is a Delaware corporation, which was organized in August 1996.
The accompanying unaudited consolidated financial statements include the
accounts of Delta and its wholly owned subsidiaries. In consolidation, we have
eliminated all significant inter-company accounts and transactions.
We have prepared the accompanying unaudited consolidated financial statements
in accordance with accounting principles generally accepted in the United States
of America (GAAP) for interim financial information and the instructions to Form
10-Q. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with GAAP have been condensed or
omitted pursuant to the rules and regulations of the Securities and Exchange
Commission. You should read the accompanying unaudited consolidated financial
statements and the information included under the heading "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
conjunction with our audited consolidated financial statements and related notes
for the year ended December 31, 2001. The results of operations for the three-
and six-month periods ended June 30, 2002 is not necessarily indicative of the
results that will be expected for the entire year.
We have made all adjustments that are, in the opinion of management,
considered necessary for a fair presentation of the financial position and
results of operations for the interim periods presented. We have reclassified
certain prior period amounts in the financial statements to conform to the
current year presentation.
(2) SUMMARY OF REGULATORY SETTLEMENTS
In September 1999, we settled allegations by the New York State Banking
Department (the "NYSBD") and a lawsuit by the New York State Office of the
Attorney General (the "NYOAG") alleging that we had violated various state and
federal lending laws. The global settlement was evidenced by (a) a Remediation
Agreement by and between Delta Funding and the NYSBD, dated as of September 17,
1999 and (b) a Stipulated Order on Consent by and among Delta Funding, Delta
Financial and the NYOAG, dated as of September 17, 1999. As part of the
Settlement, we, among other things, implemented agreed upon changes to our
lending practices; are providing reduced loan payments aggregating $7.25 million
to certain borrowers identified by the NYSBD; and have created a fund managed by
the NYSBD and financed by the grant of 525,000 shares of Delta Financial's
common stock, with an agreed upon fixed value of $9.10 per share which
approximates the stock's book value at the time of the settlement.
Each month, on behalf of borrowers designated by the NYSBD, we make
subsidy payments to the related securitization trusts. These subsidy payments
fund the differential between the original loan payments and the reduced loan
payments. As part of the second exchange offer we completed in August 2001 (see
Note No. 3 "-Corporate Restructuring, Debt Modification, and Debt
Restructuring"), Delta Funding Residual Exchange Company, LLC (the "LLC") (an
unaffiliated entity to us) - a newly-formed entity, the voting membership
interests of which are
4
owned by the former holders of our senior secured notes and senior notes due
2004 (the "Notes") who tendered their Notes for such membership interests and
other securities - is obligated to satisfy these payment subsidies out of the
cash flows generated by the mortgage related securities (primarily from the
excess cashflow certificates) it owns. Management believes the LLC will have
sufficient cash flows from its assets to satisfy these payment subsidies.
However, if the LLC's cash flows are insufficient to pay this obligation, we
remain responsible to satisfy our obligations under the Remediation Agreement.
The proceeds of the stock fund will be used to pay borrowers and to
finance a variety of consumer educational and counseling programs. We do not
manage the fund created for this purpose. The number of shares of common stock
deposited in the fund does not adjust to account for fluctuations in the market
price of our common stock. Changes to the market price of these shares of common
stock deposited in the fund do not have any impact on our financial statements.
We did not make any additional financial commitments between the settlement date
and March 2000.
In March 2000, we finalized an agreement with the U.S. Department of
Justice, the Federal Trade Commission and the Department of Housing and Urban
Development, to complete the global settlement we had reached with the NYSBD and
NYOAG. The federal agreement mandates some additional compliance efforts for us,
but it does not require any additional financial commitment by us.
(3) CORPORATE RESTRUCTURING, DEBT MODIFICATION, AND DEBT RESTRUCTURING
In 2000, we began a corporate restructuring - by reducing our workforce and
modifying the terms of the indenture governing our senior notes due 2004 (the
"senior notes") - as part of our continuing efforts to improve operating
efficiencies and to address our negative cash flow from operations. Entering
2001, management still had several concerns, which we believed needed to be
addressed for us to remain a viable company. Our principal concerns were:
o the cash drain created by our ongoing monthly delinquency and servicing
advance requirements as servicer for securitization trusts (known as
"securitization advances");
o the high cost of servicing a seasoned loan portfolio, including the
capital charges associated with making securitization advances;
o our ability to make timely interest payments on our senior notes and
senior secured notes due 2004 (the "senior secured notes"); and
o our ability to effectuate a successful business model given the overhang
of corporate ratings of "Caa2" by Moody's and "CC" by Fitch.
Therefore in the first quarter of 2001, we embarked upon a business plan
aimed at alleviating some of these concerns and issues.
CORPORATE RESTRUCTURING
In January 2001, we entered into an agreement with Ocwen Financial
Corporation ("Ocwen") to transfer our servicing portfolio to Ocwen. In May 2001,
we physically transferred our entire servicing portfolio to Ocwen, and laid-off
the majority of our servicing staff - a total of 128 employees. We recorded a
$0.5 million pre-tax charge relating to this restructuring which is included in
the line item called "restructuring and other special charges" on our
consolidated
5
statements of operations. This charge relates to employee severance associated
with closing our servicing operations. We no longer service loans nor do we have
a servicing operation.
We have accrued restructuring charges related to the write down of lease
obligations of $0.3 million and $0.6 million at June 30, 2002 and December 31,
2001, respectively. There was no additional accruals recorded during the six
months ended June 30, 2002.
DEBT MODIFICATION AND DEBT RESTRUCTURING
In August 2000, we announced an agreement to modify the terms of the
indenture governing our senior notes (the "Debt Modification"). With the consent
of the holders of greater than fifty percent of our senior notes, we modified a
negative pledge covenant in the senior notes indenture, which had previously
prevented us from selling or otherwise obtaining financing by using our excess
cashflow certificates as collateral. In consideration for the senior
noteholders' consent, we agreed, in an exchange offer (the "First Exchange
Offer"), to offer then current holders the opportunity to exchange their then
existing senior notes for (a) new senior secured notes and (b) ten-year warrants
to buy approximately 1.6 million shares of common stock, at an initial exercise
price of $9.10 per share, subject to upward or downward adjustment in certain
circumstances. The senior secured notes have the same coupon, face amount and
maturity date as the senior notes and up until the Second Debt Restructuring
(see below) were secured by at least $165 million of our excess cashflow
certificates. The First Exchange Offer was consummated in December 2000, with
holders of greater than $148 million (of $150 million) of senior notes tendering
in the exchange.
In February 2001, we entered into a letter of intent with the beneficial
holders of over fifty percent of our senior secured notes to restructure, and
ultimately extinguish, the senior secured notes (the "Second Debt
Restructuring"). In March 2001, we obtained the formal consent of these
beneficial holders of the senior secured notes through a consent solicitation
that modified certain provisions of the senior secured notes indenture to, among
other things, allow for the release of two excess cashflow certificates then
securing the senior secured notes. We were able to first finance and ultimately
sell the excess cashflow certificates underlying five securitizations (including
two excess cashflow certificates that were released as part of the Second Debt
Restructuring) for a $15 million cash purchase price to provide working capital.
In consideration for their consent, we agreed to offer the holders of the
senior secured notes (and the senior notes), an opportunity to exchange their
Notes for new securities described immediately below (the "Second Exchange
Offer"). The Second Exchange Offer was consummated on August 29, 2001, pursuant
to which holders of approximately $138.1 million (of $148.2 million) in
principal amount of our senior secured notes and $1.1 million (of $1.8 million)
in principal amount of our senior notes, exchanged their Notes for commensurate
interests in:
o voting membership interests in Delta Funding Residual Exchange Company
LLC, a newly-formed limited liability company (unaffiliated with us), to
which we transferred all of the mortgage-related securities previously
securing the senior secured notes (primarily comprised of excess cashflow
certificates);
o shares of common stock of a newly-formed management corporation that
will manage the LLC's assets; and
6
o shares of our newly-issued Series A preferred stock having an aggregate
preference amount of $13.9 million.
The LLC is controlled by the former noteholders that now hold all the voting
membership interests in the LLC. As part of the transaction, we obtained a
non-voting membership interest in the LLC, which entitles us to receive 15% of
the net cash flows from the LLC for the first three years (through June 2004)
and, thereafter, 10% of the net cash flows from the LLC. The net cash flows from
the LLC are equal to the total cash flows generated by the assets held by the
LLC for a particular period, less (a) all expenses of the LLC, (b) certain
related income tax payments, and (c) the NYSBD subsidy payments. We began
receiving distributions from the LLC in the first quarter of 2002 from a fourth
quarter 2001 distribution.
As part of the Second Exchange Offer, all tendering noteholders waived their
right to receive any future interest coupon payments on the tendered notes
beginning with the August 2001 interest coupon payment. With the closing of the
Second Exchange Offer, we paid the August 2001 interest coupon payment on the
approximately $10.8 million of notes that did not tender in the Second Exchange
Offer. By extinguishing substantially all of our long-term debt, the rating
agencies that previously rated us and our long-term debt have withdrawn their
corporate ratings.
(4) EARNINGS PER SHARE
The following is a reconciliation of the denominators used in the
computations of basic and diluted Earnings Per Share ("EPS"). The numerator for
calculating both basic and diluted EPS is net income (loss) from continuing
operations.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- --------------------
(DOLLARS IN THOUSANDS, EXCEPT EPS DATA) 2002 2001 2002 2001
- -------------------------------------------------------------------------------------------------------
Net income (loss) $3,972 $(16,528) $6,217 $(50,280)
Basic - weighted-average shares 15,888,014 15,883,749 15,885,893 15,883,749
Basic EPS $0.25 $(1.04) $0.39 $(3.17)
Basic - weighted-average shares 15,888,014 15,883,749 15,885,893 15,883,749
Incremental shares-options 1,053,570 -- 969,456 --
- -------------------------------------------------------------------------------------------------------
Diluted - weighted-average shares 16,941,584 15,883,749 16,855,349 15,883,749
Diluted EPS $0.23 $(1.04) $0.37 $(3.17)
(5) IMPACT OF NEW ACCOUNTING STANDARDS
In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets," which requires that goodwill and intangible assets
with indefinite useful lives no longer be amortized, but instead be tested for
impairment at least annually in accordance with the provision of SFAS No. 142.
SFAS No. 142 also requires that intangible assets with estimable useful lives be
amortized over their respective estimated useful lives to their estimated
residual values. The amortizing intangible assets will also be reviewed for
impairment at least annually. SFAS No. 142 is applicable to fiscal years
beginning after December 15, 2001 and is required to be applied
7
at the beginning of the entity's fiscal year. There was no impact on our
financial condition or results of operations upon adoption of SFAS No. 142 on
January 1, 2002.
In June 2001, FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations," which requires that the fair value of a liability for an asset
retirement obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The associated asset retirement
costs are to be capitalized as part of the carrying amount of the long-lived
asset and depreciated over the life of the asset. The liability is accreted at
the end of each period through charges to operating expense. If the obligation
is settled for other than the carrying amount of the liability, the Company will
recognize a gain or loss on settlement. The provisions of SFAS No. 143 are
effective for fiscal years beginning after June 15, 2002. Management does not
expect the adoption of SFAS No. 143 to have an impact on the financial position,
results of operations, or cash flows of the Company.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment
of Disposal of Long-Lived Assets," which replaces SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of." The provisions of SFAS No. 144 are effective for financial statements
issued for fiscal years beginning after December 15, 2001 and, generally, are to
be applied prospectively. There was no impact on our financial condition or
results of operations upon adoption of SFAS No. 144 on January 1, 2002.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." The Statement updates, clarifies and simplifies existing
accounting pronouncements. SFAS No. 145 rescinds SFAS No. 4, "Reporting Gains
and Losses from Extinguishment of Debt," which required all gains and losses
from extinguishment of debt to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. As a result, the criteria
in Accounting Principles Board Opinion (APB) No. 30, "Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions," will now be used to classify those gains and
losses. SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements," amended SFAS No. 4, and is no longer necessary because SFAS No. 4
has been rescinded. SFAS No. 145 amends SFAS No. 13, "Accounting for Leases," to
require that certain lease modifications that have economic effects similar to
sale-leaseback transactions be accounted for in the same manner as
sale-leaseback transactions. This amendment is consistent with the FASB's goal
of requiring similar accounting treatment for transactions that have similar
economic effects. SFAS No. 145 also makes technical corrections to existing
pronouncements. While those corrections are not substantive in nature, in some
instances, they may change accounting practice. The provisions of SFAS No. 145
are effective for fiscal years beginning after May 15, 2002. Early application
of SFAS No. 145 is encouraged. There will be no material impact on our financial
condition or results of operations upon adoption of SFAS No. 145.
8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATED
FINANCIAL STATEMENTS AND NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SET FORTH
THEREIN.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
SECURITIZATION AND SALE OF MORTGAGE LOANS
Securitizations effectively provide us with a source of long-term financing.
In conjunction with securitization transactions, trusts are created in the form
of off-balance sheet qualified special purpose entities, or QSPEs. Typically
each quarter, we pool together loans, and sell these loans to these
securitization trusts. We carry no contractual obligation related to these
trusts or the loans sold to them, nor do we have any direct or contingent
liability related to the trusts, except for the standard representations and
warranties made in conjunction with each securitization trust. Furthermore, we
provide no guarantees to investors with respect to cash flow or performance for
these trusts. These entities represent qualified special purpose entities and
are therefore not consolidated for financial reporting purposes in accordance
with SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities".
EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold. At the time each
securitization transaction closes, we determine the present value of the related
excess cashflow certificates using certain assumptions we make regarding the
underlying mortgage loans. The excess cashflow certificate is then recorded on
our consolidated financial statements at an estimated fair value. Our estimates
primarily include the following:
o future rate of prepayment of the mortgage loans;
o credit losses on the mortgage loans;
o the London Inter-Bank Offered Rate ("LIBOR") forward curve (using
current LIBOR as the floor rate); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the present value of
the cash flows we expect to receive in the future from such certificate based
upon our best estimate. We monitor the performance of the loans underlying each
excess cashflow certificate, and any changes in our estimates (and consequent
changes in value of the excess cashflow certificates) is reflected in the line
item called "interest income" in the quarter in which we make any such change in
our estimate. Although we believe that the assumptions we use are reasonable,
there can be no assurance as to the accuracy of the assumptions or estimates.
9
GENERAL
Delta Financial Corporation (together with its subsidiaries, "Delta" or
"we"), is a specialty consumer finance company that originates, securitizes, and
sells (and, prior to May 2001, serviced) non-conforming mortgage loans, which
are primarily secured by first mortgages on one- to four-family residential
properties. Throughout our 20 years of operating history, we have focused on
lending to individuals who generally do not satisfy the credit, documentation or
other underwriting standards set by more traditional sources of mortgage credit,
including those entities that make loans in compliance with conventional
mortgage lending guidelines established by Fannie Mae and Freddie Mac. We make
loans to these borrowers for such purposes as debt consolidation, refinancing,
education and home improvements.
Our mortgage business has two principal components. First, we make mortgage
loans, which is a cash and expense outlay for us, because our cost to originate
a loan exceeds the fees we collect at the time we originate that loan. At the
time we originate a loan, and prior to the time we sell that loan, we finance
that loan by borrowing under warehouse lines of credit. Second, we sell loans,
either through securitization or on a whole loan basis, to generate cash and
non-cash revenues. We use the proceeds from these sales to repay our warehouse
lines of credit and for working capital, recording the premiums received from
the loan sales and securitizations as revenue.
ORIGINATION OF MORTGAGE LOANS. We make mortgage loans through two
distribution channels - wholesale (or broker) and retail. We receive loan
applications both directly from borrowers and from licensed independent third
party mortgage brokers who submit applications on a borrower's behalf. We
process and underwrite the submission and, if the loan comports with our
underwriting criteria, approve the loan and lend the money to the borrower.
While we generally collect points and fees from the borrower when a loan closes,
our cost to originate a loan typically far outweighs any fees we may collect
from the borrower.
Through our wholesale distribution channel, we originate mortgage loans
indirectly through licensed mortgage brokers and other real estate professionals
who submit loan applications on behalf of borrowers ("brokered loans"). We
currently originate the majority of our brokered loans in 20 states, through our
network of approximately 1,500 brokers.
Through our retail distribution channel, we develop retail loan leads
("retail loans") primarily through our telemarketing system and our network of
11 retail offices located in seven states. In 2001, we closed four
under-performing retail offices - two in Florida, one in Ohio and one in Indiana
- - and opened our second retail call center in Pittsburgh, Pennsylvania.
For the three months ended June 30, 2002, we originated $210.1 million of
loans, an increase of 27% over the $165.1 million of loans originated in the
comparable period in 2001. Of these amounts, approximately $141.0 million were
brokered loans and $69.1 million were retail loans during the three months ended
June 30, 2002, compared to $82.6 million and $82.5 million, respectively, during
the three months ended June 30, 2001. Loan production in the second quarter of
2002 increased 11% from $190.0 million in the first quarter of 2002. The first
quarter production was comprised of $122.8 million of brokered loans and $67.2
million of retail loans.
POOLING OF LOANS PRIOR TO SALE. After we close or fund a loan, we typically
pledge the loan as collateral under a warehouse line of credit to obtain
financing against that loan. By doing so,
10
we replenish our capital so we can make new loans. Typically, loans are financed
on warehouse lines of credit for only a limited time - generally, not more than
three months - until such time as we can pool enough loans and sell the pool of
loans either through securitization or on a whole loan basis. During this time,
we earn interest paid by the borrower as income, but this income is offset in
part by the interest we pay to the warehouse creditors for providing us with
financing.
SALE OF LOANS. We derive the majority of our revenues and cash flows from
selling mortgage loans (and related interests including securitization servicing
rights on newly-originated pools of mortgage loans) through securitization or on
a whole loan basis. In the second quarter of 2002, we securitized $200.0 million
and sold $35.4 million of mortgage loans, on a whole loan servicing released
basis. During the six months ended June 30, 2002, we securitized $375.0 million
and sold $74.1 million of mortgage loans, on a whole loan servicing released
basis. We plan to continue to utilize a combination of securitization and whole
loan sales for the foreseeable future.
SECURITIZATION. As described above, we typically complete securitizations on
a quarterly basis. The securitization trust raises money to purchase the
mortgage loans from us by selling securities to the public - known as
asset-backed pass-through securities that are secured by the pool of mortgage
loans held by the securitization trust. These asset-backed securities or senior
certificates, which are usually purchased by insurance companies, mutual funds
and/or other institutional investors, represent senior interests in the cash
flows from the mortgage loans in the trust. Following the securitization,
holders of these senior certificates receive the principal collected, including
prepayments of principal, on the mortgage loans in the trust. In addition,
holders receive a portion of the interest on the loans in the trust equal to the
pass-through interest rate on the remaining principal balance. These securities
are typically sold for a par purchase price, or a slight discount to par - with
par representing the aggregate principal balance of the mortgage loans backing
the asset-backed securities. For example, if a securitization trust contains
collateral of $100 million of mortgage loans, we typically receive close to $100
million in proceeds from the sales of these securities, depending upon the
structure we utilize for the securitization.
The securitization trust also issues a certificate (referred to as an excess
cashflow certificate), which entitles the holder to receive the difference
between the interest payments due on the mortgage loans sold to the
securitization trust and the interest payments due, at the pass-through rates,
to the holders of the pass-through securities, less the contractual servicing
fee and other costs and expenses of administering the securitization trust. For
any monthly distribution, the holder of an excess cashflow certificate receives
payments only after payments have been made on all the other securities issued
by the securitization trust. In addition, before the holder of the excess cash
flow certificate receives payments, cash flows from such excess cashflow
certificates are applied as follows:
o first, to cover any losses on the mortgage loans in the related mortgage
pool, because the excess cashflow certificates are subordinate in right of
payment to all other securities issued by the securitization trust;
o second, to reimburse the bond insurer, if any, of the related series of
pass-through certificates for amounts paid by or otherwise owing to that
insurer;
o third, to build or maintain the overcollateralization (described in more
detail immediately below) for that securitization trust at the required
level by being applied as an accelerated
11
payment of principal to the holders of the pass-through certificates of
the related series;
o fourth, to reimburse holders of the subordinated certificates of the
related series of pass-through certificates for unpaid interest and for
any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates which was
not paid because of the imposition of a cap on their pass-through rates -
these payments being called basis risk shortfall amounts.
Overcollateralization occurs when additional payments of principal are made
to the holders of the pass-through certificates in order to establish a spread
between the principal amount of the trust's outstanding loans and the amount of
outstanding pass-through certificates. Pooling and Servicing Agreements, which
govern our securitizations, require overcollateralization and the "waterfall"
described above to provide credit enhancement (I.E., a source of funds to absorb
losses) for the senior securities issued by the securitization trust and for the
bond insurer, if any.
Our securitizations typically require overcollateralization of between 1.5%
and 3.0% of the initial securitization principal amount securitized (known as
the "overcollateralization limit"). Historically, our securitizations provided
for the overcollateralization limits to be funded by the cash flows generated by
the excess cashflow certificates. Once the overcollateralization limit is
reached - which typically occurs between 18-24 months after the completion of a
securitization, with the specific timing depending upon the structure and
performance of the securitization - these cash flows are then distributed to us
as the holder of the excess cashflow certificates. Cash flows from our excess
cashflow certificates are subject to certain delinquency or loss tests, as
defined by the rating agencies and or the bond insurer insuring the
securitization. Over time, we receive distributions from the
overcollateralization account subject to the performance of the mortgage loans
in each securitization.
In each of our more recent securitizations prior to our 2002 transactions -
in which the overcollateralization limits were funded by the cash flows
generated by the excess cashflow certificates over the first several months of a
securitization - we derived the following economic interests:
o we received a cash purchase price from the sale of an interest-only
certificate sold in connection with a securitization. This certificate
entitles the holder to a recurring interest payment over a guaranteed
period of 36 months, and reduces the cash flows we would otherwise receive
as owner of the excess cashflow certificates;
o we received a cash premium from selling the right to service the loans
being securitized. This right entitles the contractual servicer to service
the loans on behalf of the securitization trust, and earn a contractual
servicing fee, and ancillary servicing fees in such capacity; and
o we retained an excess cashflow certificate. Although the cash flows
generated by excess cashflow certificates are received over time, under
existing accounting rules, we must report as income at the time of the
securitization the present value of all projected cash flows we expect to
receive in the future from these excess cashflow certificates based upon
an assumed discount rate. Our valuation of these excess cashflow
certificates is primarily based on (1) our estimate of the amount of
expected losses or defaults that will take place on the underlying
mortgage loans over the life of the mortgage loans, and (2) the expected
amount of prepayments on the mortgage loans due to the underlying
12
borrowers of the mortgage loans paying off their mortgage loan prior to
the loan's stated maturity.
We utilized a new securitization structure in the first and second quarters
of 2002. In lieu of selling an interest-only certificate, we sold a net interest
margin certificate or NIM. The NIM is generally structured where we sell the
excess cashflow certificate to a qualified special purpose entity or owner trust
(the NIM trust) and the NIM trust in turn issues (1) interest-bearing NIM
note(s) (backed by the excess cashflow certificate), and (2) NIM owner trust
certificate evidencing ownership in the NIM trust. We sell this excess cashflow
certificate without recourse except that we provide normal representations and
warranties to the NIM trust. One or more investors purchase the NIM note(s) and
the proceeds from the sale of the note(s), along with a owner trust certificate
that is subordinate to the note(s), represent the consideration to us for the
sale of the excess cashflow certificate.
The NIM note(s) entitles the holder to be paid a specified interest rate, and
further provides for all cash flows generated by the excess cashflow
certificates to be used to pay all principal and interest on the NIM note(s)
until paid in full. As part of the NIM transaction, we received the cash
proceeds from the sale of the NIM note(s) and a subordinate interest in the
owner trust, represented by the owner trust certificate. This owner trust
certificate entitles us to all cash flows generated by the excess cashflow
certificates after the holder of the NIM note(s) has been paid in full. As such,
we classify the NIM owner trust certificate on our balance sheet as an excess
cashflow certificate and value the NIM owner trust certificate using the same
assumptions that we utilize in valuing excess cashflow certificates.
As part of the NIM transaction, we were required to fully fund the
overcollateralization amount at closing - as opposed to having it build up over
time as we had in past securitizations. We used a portion of the cash proceeds
from the NIM note(s) to do so.
In the securitization that we issued in the first and second quarters of
2002, we derived the following economic interests:
o we received a cash purchase price from the sale of the NIM note(s) issued
by a NIM trust, to which we sold the excess cashflow certificate;
o we received a cash premium from selling the right to service the loans
being securitized; and
o we retained a NIM owner trust certificate, which entitles us to receive
cash flows generated by the excess cashflow certificates issued in
connection with the securitization after the holder of the NIM note(s) has
been paid in full.
At the time we completed the first and second quarter 2002 securitizations,
we recognized as revenue each of the three economic interests described above,
which was recorded as net gain on sale of mortgage loans on our consolidated
statement of operations.
13
A summary of the gain on sale and cash flow from our second quarter 2002
securitization is presented below:
GAIN ON SALE SUMMARY
Loans Sold (thousands) $ 200,000
NIM Proceeds, net of Overcollateralization Account 5.15%
Excess Cashflow Certificate (owner trust certificate) 1.29%
Mortgage Servicing Rights 0.89%
Less: Transaction Costs (0.78%)
---------
Net gain on sale recorded 6.55%
=========
CASH FLOW SUMMARY
NIM Proceeds, net of Overcollateralization Account 5.15%
Mortgage Servicing Rights 0.89%
Less: Transaction Costs (0.78%)
---------
Net Cash Flow at Closing 5.26%
=========
Our net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate the loans,
adjusted for the following:
o any direct loan origination costs incurred (an increase in the investment)
and loan origination fees received (a decrease in the investment) in
connection with the loans, which are treated as a component of the initial
investment in loans;
o the principal payments received, and the amortization of the net loan fees
or costs, during the period we held the loans prior to their
securitization; and
o any gains (a decrease in the investment) or losses (an increase in the
investment) we incur on any hedging instruments that we may have utilized
to hedge against the effects of changes in interest rates during the
period we hold the loans prior to their securitization. (See "-Hedging,"
beginning on page 30).
We allocate our basis in the mortgage loans and excess cashflow certificates
between the portion of the mortgage loans and excess cashflow certificates sold
through securitization and the portion retained (the NIM owner trust
certificate, in 2002) based on the relative fair values of those portions on the
date of sale. We may recognize gains or losses attributable to the changes in
fair value of the excess cashflow certificates, which are recorded at estimated
fair value and accounted for as "trading" securities. Since there is no active
market for such excess cashflow certificates, we determine the estimated fair
value of the excess cashflow certificates by discounting the future expected
cash flows.
WHOLE LOAN SALES. We also sell loans, without retaining the right to service
the loans, in exchange for a cash premium. This is recorded as income under net
gain on sale of mortgage loans at the time of sale. In the second quarter of
2002, we sold $35.4 million loans on a whole loan basis for an average premium
(net of reserve) of 4.60% of the principal amount of mortgage loans sold.
OTHER. In addition to the income and cash flows we earn from securitizations
and whole loan sales, we also earn income and generate cash flows from:
14
o the net interest spread earned on mortgage loans while we hold the
mortgage loans for sale (the difference between the interest rate on the
mortgage loan paid by the underlying borrower less the financing costs we
pay to our warehouse lenders to fund our loans);
o net loan origination fees on brokered loans and retail loans; and
o retained excess cashflow certificates and distributions from Delta Funding
Residual Exchange Company, LLC (described above in "-Debt Modification and
Debt Restructuring").
CORPORATE RESTRUCTURING, DEBT MODIFICATION AND DEBT RESTRUCTURING. As
discussed in more detail in "Corporate Restructuring, Debt Modification and Debt
Restructuring" beginning on page 5, we engaged in a series of transactions
beginning in 2000, and concluding in the third quarter of 2001, aimed at
improving operating efficiencies and reducing our negative cash flow. We spent
much of 2001 working on two transactions in particular, which we believe were of
tantamount importance in this regard - selling our servicing portfolio and
extinguishing most of our long term debt.
o In May 2001, we completed the transfer of our servicing portfolio to
Ocwen, which freed us from the significant cash drain associated with
making securitization advances (and the capital costs associated with
making such advances), and of servicing a highly seasoned portfolio
following three successive quarters of selling the securitization
servicing rights for newly originated mortgage loans;
o In August 2001, we completed our Second Exchange Offer, which extinguished
substantially all of our long-term debt, leaving approximately $10.8
million out of $150 million of our Notes still outstanding. This debt
extinguishment helped us threefold. First, it eliminated nearly $140
million of principal which we otherwise would have had to repay in 2004.
Second, it eliminated more than $13 million of yearly interest expense
that we would have had to pay to the former noteholders had they still
held their Notes. Third, the ratings agencies that previously rated us and
our Notes have withdrawn their corporate ratings.
We believe that our transfer of servicing to Ocwen and the Second Exchange
Offer were essential steps in our continuing effort to restructure our
operations and reduce our negative cash flow previously associated with our
servicing operations and the Notes. There can be no assurances, however, that
these or other factors described herein will not have a material adverse effect
on our results of operations and financial condition. (See "-Forward Looking
Statements and Risk Factors," beginning on page 31).
EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the present
value of the
15
related excess cashflow certificates using certain assumptions we make regarding
the underlying mortgage loans. The excess cashflow certificate is then recorded
on our consolidated financial statements at an estimated fair value. Our
estimates primarily include the following:
o future rate of prepayment of the mortgage loans;
o credit losses on the mortgage loans;
o the London Inter-Bank Offered Rate ("LIBOR") forward curve (using
current LIBOR as the floor rate); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the cash flow we
expect to receive in the future from such certificate based upon our best
estimate. We monitor the performance of the loans underlying each excess
cashflow certificate, and any changes in our estimates (and consequent changes
in value of the excess cashflow certificates) is reflected in the line item
called "interest income" in the quarter in which we make any such change in our
estimate. Although we believe that the assumptions we use are reasonable, there
can be no assurance as to the accuracy of the assumptions or estimates.
In determining the fair value of each of the excess cashflow certificates, we
make the following underlying assumptions regarding mortgage loan prepayments,
mortgage loan default rates, the LIBOR forward curve and discount rates:
(A) PREPAYMENTS. We base our prepayment rate assumptions upon our on-going
analysis of the performance of mortgage pools we previously securitized,
and the performance of similar pools of mortgage loans securitized by
others in the industry. We apply different prepayment speed assumptions to
different loan product types because it has been our experience that
different loan product types exhibit different prepayment patterns.
Generally, our loans can be grouped into two loan products - fixed rate
loans and adjustable rate loans. With fixed rate loans, an underlying
borrower's interest rate remains fixed throughout the life of the loan.
Our adjustable rate loans are really a "hybrid" between fixed and
adjustable rate loans, in that the rate generally remains fixed typically
for the first three years of the loan, and then adjusts typically every
six months thereafter. Within each product type, other factors can affect
prepayment rate assumptions. Some of these factors, for instance, include:
o whether or not a loan contains a prepayment penalty - an amount that
a borrower must pay to a lender if the borrower prepays the loan
within a certain time after the loan was originated. Loans
containing a prepayment penalty typically do not prepay as quickly
as those without such a penalty;
o as is customary with adjustable rate mortgage loans, the
introductory interest rate charged to the borrower is artificially
lower, between one and two full percentage points, than the rate for
which the borrower would have otherwise qualified. Generally, once
the adjustable rate mortgage begins adjusting on the first
adjustment date, the interest rate payable on that loan increases,
at times fairly substantially. This interest rate increase can be
exacerbated if there is an absolute increase in interest rates. As a
result of these increases and the potential for future
16
increases, adjustable rate mortgage loans typically are more
susceptible to early prepayments.
There are several reasons why a loan will prepay prior to its maturity,
including (but not limited to):
o a decrease in interest rates;
o improvement in the borrower's credit profile, which may allow them
to qualify for a lower interest rate loan;
o competition in the mortgage market, which may result in lower
interest rates being offered;
o the borrower's sale of his or her home; and
o a default by the borrower, resulting in foreclosure by the lender.
It is unusual for a borrower to prepay a mortgage loan during the first
few months because of the following:
o it typically takes at least several months after the mortgage loans
are originated for any of the above events to occur;
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our most recent changes to the month one and
peak speed components of our prepayment assumptions - in the third quarter
of 2001 and, prior to that, in the third quarter 2000:
LOAN TYPE SEPTEMBER 30, 2001 SEPTEMBER 30, 2000
----------------------------------------------------------
Fixed Rate:
At Month One 4.00% 4.00%
Peak Speed 30.00% 23.00%
Adjustable Rate:
At Month One 4.00% 4.00%
Peak Speed 75.00% 50.00%
(B) DEFAULT RATE. A default reserve for both fixed- and adjustable-rate loans
sold to the securitization trusts of 5.00% of the amount initially
securitized at June 30, 2002 compared to 3.50% at June 30, 2001.
Our loan loss assumption reflects our belief that:
o prepayment speeds generally will be slower in the future than in the
past;
o the rise in home values will be flat or slightly moderate as
compared to the past few years; and
o borrowers will therefore be less able to refinance their mortgages to
avoid default which may have an adverse effect on the non-
performing loans in the securitizations trusts underlying our excess
excess cashflow certificates.
17
(C) LIBOR FORWARD CURVE. The London Interbank Offer Rate, or LIBOR, forward
curve is used to project future interest rates, which affects our cash
flow projections for each security. The projected cash flows are then
discounted at 15% (see "-Discount Rate" below) to establish the fair
market value of our excess cashflow certificates.
(D) DISCOUNT RATE. We use a discount rate that we believe reflects the risks
associated with our excess cashflow certificates. While quoted market
prices on comparable excess cashflow certificates are not available, we
compare our valuation assumptions and performance experience to our
competitors' in the non-conforming mortgage industry. Our discount rate
takes into account the asset quality and the performance of our
securitized mortgage loans compared to that of the industry and other
characteristics of our securitized loans. We quantify the risks associated
with our excess cashflow certificates by comparing the asset quality and
payment and loss performance experience of the underlying securitized
mortgage pools to comparable industry performance. We believe that the
practice of many companies in the non-conventional mortgage industry has
been to add a spread for risk to the all-in cost of securitizations to
determine their discount rate. From these comparisons, we have identified
a spread that we add to the all-in cost of our mortgage loan
securitization trusts' investor certificates. The discount rate we use to
determine the present value of cash flows from excess cashflow
certificates reflects increased uncertainty surrounding current and future
market conditions, including without limitation, uncertainty concerning
inflation, recession, home prices, interest rates and equity markets.
We utilized a discount rate of 15% at June 30, 2002 compared to 13% at
June 30, 2001 on all excess cashflow certificates, except those that at
June 30, 2001 were subject to a NIM transaction we consummated in November
2000, for which we used an 18% discount rate. We increased the discount
rate on these excess cashflow certificates during the period that the
senior NIM securities remained outstanding, to account for the potentially
higher risk associated with the residual cash flows expected to be
received by the holder of the certificated interest in the NIM trust,
which was subordinated to the multiple senior securities sold in the NIM
transaction. As part of the Second Exchange Offer, all of the excess
cashflow certificates that were subject to the November 2000 NIM
transaction were transferred to the LLC. We did not increase the discount
rate on the excess cashflow certificates from our latest two
securitizations despite issuing NIM securities because the NIM securities
in the most recent transactions were:
o issued from a single securitization as compared to the November 2000
NIM transaction, which was backed by a combination of six
securitizations issued between September 1997 and March 1999 resulting
in more volatility or variability in determining the timing of cash
flows to be received by the NIM; and
o issued from a new securitization as compared to the November 2000 NIM
transaction, which was backed by several seasoned securitization
trusts. The predictability in determining the timing of cash flows for
the first two years on a newly issued securitization is typically
higher than securitizations that have been outstanding for a greater
period of time because defaults or losses to the trust within the first
few years of issuance are typically lower and more predictable compared
to a securitization that has been outstanding for a longer period of
time (a more seasoned
18
transaction). Therefore, there is a higher probability in determining
the timing of cash flows to the NIM investor on a new issuance
securitization as compared to a seasoned transaction.
At March 31, 2002, we recorded a charge to interest income to reflect a fair
value adjustment to our excess cashflow certificates, totaling $2.1 million,
relating to the timing of excess cashflows that are to be received by the excess
cashflow certificate after the release or "stepdown" of the
overcollateralization account.
The following table summarizes the excess cashflow activity for the six months
ended June 30, 2002 and 2001 (dollars in thousands):
June 30, June 30,
2002 2001
-------- --------
Balance, beginning of period $16,765 216,907
New excess cashflow certificates 6,059 7,031
Cash received from excess cashflow certificates (729) (7,333)
Net accretion excess cashflow certificates 755 10,933
Fair Value Adjustment (2,085) (661)
Sales -- 40,402
------- --------
Balance, end of period 20,765 186,475
Our valuation of retained excess cashflow certificates is highly dependent
upon the reasonableness of our assumptions and the predictiveness of the
relationships that drive the results of our valuation model. The assumptions we
utilize, described above, are complex, as we must make judgment calls about the
effect of matters that are inherently uncertain. As the number of variables and
assumptions affecting the possible future resolution of the uncertainties
increase, those judgments become even more complex.
In volatile markets, like those we have experienced in 2001 and in 2002,
there is increased risk that our actual results may vary significantly from our
assumed results. And the greater the time period over which the uncertainty will
exist, the greater the potential volatility for our valuation assumptions.
For example, assumptions regarding prepayment speeds, defaults, and LIBOR
rates are used in estimating fair values of our excess cashflow certificates. If
loans prepay faster than estimated, or loan loss levels are higher than
anticipated, or LIBOR is higher than anticipated, we may be required to write
down the value of such certificates. While we believe that our assumptions are
reasonable estimates using our historical loan performance and the performance
of similar mortgage pools from other lenders - in addition to accessing other
public information about market factors such as interest rates, inflation,
recession, unemployment and real estate market values, among other things -
these are just estimates and it is virtually impossible to predict the actual
level of prepayments and losses, which are also driven by consumer behavior.
DEFERRED TAX ASSET
As of June 30, 2002, we carried a deferred tax asset, net of $5.6 million on
our consolidated financial statements - comprised primarily of federal and state
net operating losses or "NOLs" less the tax impact and a valuation allowance.
19
As of June 30, 2002, we have a gross deferred tax asset of $50.0 million and
a valuation allowance of $44.4 million. Following two successive years of
posting significant losses, and the modest amount of earnings we have earned
over the past few quarters and project to earn over the next several quarters,
we believe it was appropriate to establish this valuation allowance under GAAP.
If we are able to continue to record earnings in upcoming years, we expect to:
o utilize a larger amount of the gross deferred tax asset to offset the
majority of such earnings; and
o potentially decrease the amount of, and/or eliminate, the valuation
allowance in accordance with GAAP.
As of June 30, 2002, federal and state NOLs carryforwards totaled $98.7
million, with $13.7 million expiring in 2019, $12.4 million expiring in 2020,
and $72.6 million expiring in 2021.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THE THREE MONTHS ENDED JUNE 30,
2001
GENERAL
Our net income for the three months ended June 30, 2002 was $4.0 million, or
$0.25 per share, basic and $0.23 per share, diluted, compared to a net loss of
$16.5 million, or $1.04 per share, basic and diluted, for the three months ended
June 30, 2001. Comments regarding the components of net income are detailed in
the following paragraphs.
REVENUES
Total revenues decreased $3.6 million, or 14% to $21.5 million for the three
months ended June 30, 2002, from $25.1 million for the comparable period in
2001. The decrease in revenue was primarily attributable to lower interest
income from our excess cashflow certificates as we transferred the majority of
these certificates as part of our Second Exchange Offer in 2001. In addition, we
did not receive any servicing fees due to the transfer of our servicing
portfolio to Ocwen in May of 2001. (See "-Corporate Restructuring, Debt
Modification and Debt Restructuring").
We originated $210.1 million of mortgage loans for the three months ended
June 30, 2002, representing a 27% increase from $165.1 million of mortgage loans
originated for the comparable period in 2001. We securitized $200.0 million and
sold $35.4 million of loans, on a servicing-released basis during the three
months ended June 30, 2002, compared to $165.0 million and $20.7, respectively,
during the same period in 2001.
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans
represents (1) the sum of (a) the fair value of the non-cash excess cashflow
certificates retained by us in a securitization for each period, (b) the cash
premium purchase price we receive in connection with selling an interest-only
certificate in a securitization for each period, (c) the cash purchase price we
receive in connection with selling a NIM note, net of overcollateralization
amount and interest rate cap, (d) the cash premium received from selling
mortgage servicing rights in connection with each securitization, and/or the
fair value of the non-cash capitalized mortgage servicing rights associated with
loans securitized in each period, and (e) the cash premiums earned from selling
whole loans on a servicing-released basis, (2) less the (i) costs associated
20
with securitizations, (ii) any hedge loss (gain) associated with a particular
securitization, and (iii) any loss associated with loans sold at a discount.
Net gain on sale of mortgage loans decreased $0.5 million, or 3%, to $14.7
million for the three months ended June 30, 2002, from $15.2 million for the
comparable period in 2001. This decrease was primarily due to lower gain on sale
percentage recognized on the fair value of our non cash excess cashflow
certificates during the second quarter in 2002 compared to the same period in
2001. This was due to change in assumptions used to value the certificate (See
"-Excess Cashflow Certificates, net"). This decrease was partially offset by
higher cash proceeds recognized on securitization, net of related expenses
compared to same period in 2001. In addition, the Company recorded higher cash
premiums earned on whole loan sales for the three months ended June 30, 2002.
For the three months ended June 30, 2002, 83% of the net gain on sale of
mortgage loans represented cash proceeds as compared to 54% of the net gain on
sale of mortgage loans in the same period in 2001.
INTEREST INCOME. Interest income primarily represents the sum of (1) the
gross cash interest we earn on loans held for sale, (2) the cash we receive from
our excess cashflow certificates, (3) the non-cash mark-to-market or non-cash
valuation adjustments to our excess cashflow certificates to reflect changes in
fair value, and (4) the cash interest earned on bank accounts.
Interest income decreased $2.0 million, or 38%, to $3.2 million for the three
months ended June 30, 2002, from $5.2 million for the comparable period in 2001.
The decrease in interest income was primarily due to lower revenues from our
retained excess cashflow certificates, as we transferred the majority of these
certificates as part of our Second Exchange Offer in 2001 (See "-Corporate
Restructuring, Debt Modification and Debt Restructuring").
SERVICING FEES. Servicing fees represent all contractual and ancillary
servicing revenue we receive, less the offsetting amortization of the
capitalized mortgage servicing rights, and any adjustments recorded to reflect
valuation allowances for the impairment in mortgage servicing rights.
We did not receive any servicing fees during the three months ended June 30,
2002, as a result of us transferring our entire servicing portfolio to Ocwen in
May of 2001. For the three months ended June 30, 2001, servicing fees totaled
$0.8 million.
NET ORIGINATION FEES AND OTHER INCOME. Net origination fees and other income
represent (1) fees earned on broker and retail originated loans, (2) premiums
paid to originate mortgage loans and (3) other miscellaneous income, if any.
Net origination fees and other income decreased $0.3 million, or 8%, to $3.6
million for the three months ended June 30, 2002, from $3.9 million for the
comparable period in 2001. During the three months ended June 30, 2002 our
production mix represented 62% of broker loans and 38% of retail loans, compared
to 50% and 50%, respectively, in the same period in 2001. The production mix
resulted in a decrease in origination fees since the increase in broker loans
generated higher broker premium fees and the decrease in the retail loans
created lower origination fees.
21
EXPENSES
Total expenses decreased by $24.1 million, or 58%, to $17.4 million for the
three months ended June 30, 2002, from $41.5 million for the comparable period
in 2001. The Company recorded several charges in the second quarter of 2001
relating to, among other things, its corporate and debt restructuring,
including: (1) the Company's disposition and transfer of its servicing portfolio
to Ocwen in May 2001, (2) capital charges associated with repurchasing our
interest and servicing advance securitizations prior to the transfer of the
servicing portfolio, (3) a change in accounting estimates regarding the life
expectancy of the Company's computer-related equipment, and (4) a charge for
reserves primarily against a pool of non-performing loans, which the Company
ultimately sold in July 2001. In addition, expenses were lower in the second
quarter of 2002 due to significantly lower interest expense resulting from our
extinguishing approximately $139.2 million of Notes in the Second Exchange Offer
(See "-Corporate Restructuring, Debt Modification and Debt Restructuring").
Lastly, the Company recorded lower warehouse financing costs due to lower
borrowing costs during 2002.
PAYROLL AND RELATED COSTS. Payroll and related costs include salaries,
benefits and payroll taxes for all employees.
Payroll and related costs decreased by $1.9 million, or 16%, to $10.1 million
for the three months ended June 30, 2002, from $12.0 million for the comparable
period in 2001. The decrease was primarily the result of a downsizing we
effectuated, as part of our overall corporate restructuring, related to our
transfer of servicing operation in May 2001.
INTEREST EXPENSE. Interest expense includes the borrowing costs under our
warehouse credit facilities to finance loan originations, equipment financing
and the Notes.
Interest expense decreased by $4.5 million, or 75%, to $1.5 million for the
three months ended June 30, 2002 from $6.0 million for the comparable period in
2001. The decrease was primarily due to (i) our extinguishing $139.2 million of
Notes, and the corresponding interest expense related thereto, and (ii) lower
warehouse financing costs due to lower borrowing costs. The average one-month
LIBOR rate, which is the benchmark index used to determine our cost of borrowed
funds, decreased on average to 1.8% for the three months ended June 30, 2002,
compared to an average of 4.3% for the same period in 2001.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
consist primarily of office rent, insurance, telephone, depreciation, legal
reserves and fees, license fees, accounting fees, travel and entertainment
expenses, advertising and promotional expenses and the provision for loan losses
on the inventory of loans held for sale and recourse loans.
General and administrative expenses decreased $17.8 million, or 75%, to $5.8
million for the three months ended June 30, 2002, from $23.6 million for the
comparable period in 2001. The second quarter of 2001 included expenses
primarily associated from the (1) Company's disposition and transfer of our
servicing portfolio in May 2001 to Ocwen (2) capital charges previously
associated with our interest and servicing advance securitizations prior to the
transfer of the servicing portfolio, (3) a change in accounting estimates
regarding the life expectancy of the Company's computer-related equipment, (4) a
charge for reserves primarily against a pool of non-performing loans, which the
Company ultimately sold in July 2001 and (5) debt restructuring cost associated
with the Company's Second Exchange Offer.
22
INCOME TAXES. Deferred tax assets and liabilities are recognized based upon
the income reported in the financial statements regardless of when such taxes
are paid. These deferred taxes are measured by applying current enacted tax
rates. We recorded a tax provision of $0.1 million primarily related to excess
inclusion income generated by our excess cashflow certificates, for the period
ended June 30, 2002 and 2001, respectively. Excess inclusion income cannot be
offset by our NOL's under the REMIC tax laws. It is primarily caused by the
REMIC securitization trust utilizing cash, that otherwise would have been paid
to us as holder of the excess cashflow certificate, to make payments to other
security holders, to create and/or maintain overcollateralization by
artificially paying down the principal balance of the asset-backed securities.
Going forward, we expect to continue to incur a modest amount of excess
inclusion income, which we will be unable to offset with our NOL's.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2001
GENERAL
The Company's net income for the six months ended June 30, 2002 was $6.2
million, or $0.39 per share, basic and $0.37 diluted, compared to net loss of
$50.3 million, or $3.17 per share, basic and diluted, for the six months ended
June 30, 2001. Comments regarding the components of net loss are detailed in the
following paragraphs.
REVENUES
Total revenues increased $19.1 million, or 87%, to $41.1 million for the six
months ended June 30, 2002, from $22.0 million for the comparable period in
2001. The increase in revenue was primarily attributable to our $25.4 million
write down of five excess cashflow certificates sold in 2001 for a cash purchase
price significantly below our carrying value of such excess cashflow
certificates. In addition, the increase was also attributable to a higher net
gain on sale in 2002 when we completed securitizations totaling $375.0 million,
compared to 2001, when we completed securitizations totaling $165.0 million.
These increases in revenue were partially offset by a decrease in interest
income from our retained excess cashflow certificates, as we transferred the
majority of these certificates as part of our Second Exchange Offer in 2001 and
by us not receiving any servicing fees following the transfer of our servicing
portfolio to Ocwen in May 2001. (See "-Corporate Restructuring, Debt
Modification and Debt Restructuring").
The Company originated $400.1 million of mortgage loans for the six months
ended June 30, 2002, representing a 19% increase from $335.8 million of mortgage
loans originated for the comparable period in 2001. The Company securitized and
sold $449.1 million in loans during the six months ended June 30, 2002,
representing a 36% increase from $330.0 million securitized or sold in the
comparable period in 2001.
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans
increased $5.9 million, or 28%, to $27.1 million for the six months ended June
30, 2002, from $21.2 million for the comparable period in 2001. This increase
was primarily due to (i) an increase in the amount of loans securitized and sold
compared to 2001 and (ii) our selling a higher percentage of whole loan sales,
instead of securitizing (which typically results in a higher net gain on sale
percentage than whole loan sales), during 2001. We securitized $375.0 million
and sold $74.1 million of mortgage loans on a servicing-released basis in 2002,
compared to $165.0 million of loans
23
securitized and $165.0 million of mortgage loans sold during the same period in
2001.
INTEREST INCOME. Interest income increased $16.6 million, or 175%, to $7.1
million for the six months ended June 30, 2002, from $(9.5) million for the
comparable period in 2001. The increase in interest income was primarily due to
a $25.4 million write down of excess cashflow certificates in 2001 in connection
with the sale of such certificates for a cash purchase price of $15.0 million.
The increase was also attributed to a higher average loan balance (and,
consequently, more interest earned on loans held for sale) in 2002 compared to
the same period in 2001. The increase was partially offset by a decrease in
revenues from our excess cashflow certificates, as we transferred the majority
of these certificates as part of our Second Exchange Offer in 2001 (See
"-Corporate Restructuring, Debt Modification and Debt Restructuring").
SERVICING FEES. We did not receive any servicing fees during the six
months ended June 30, 2002, as a result of us transferring our entire servicing
portfolio to Ocwen in May of 2001. For the six months ended June 30, 2001,
servicing fees totaled $3.0 million.
NET ORIGINATION FEES AND OTHER INCOME. Origination fees decreased $0.5
million, or 7%, to $6.9 million for the six months ended June 30, 2002, from
$7.4 million for the comparable period in 2001. During the six months ended June
30, 2002, we had a production mix of 66% broker loans and 34% retail loans,
compared to 56% and 44%, respectively, in the same period in 2001. The
production mix resulted in a decrease in origination fees since the increase in
broker loans generated higher broker premium fees and the decrease in the retail
loans created lower origination fees.
EXPENSES
Total expenses decreased by $37.1 million, or 52%, to $34.6 million for
the six months ended June 30, 2002, from $71.7 million for the comparable period
in 2001. The first half of 2001 included expenses associated primarily with: (1)
the Company's disposition and transfer of its servicing portfolio to Ocwen in
May 2001, (2) capital charges associated with repurchasing our interest and
servicing advance securitizations prior to the sale of the servicing portfolio,
(3) a change in accounting estimates regarding the life expectancy of the
Company's computer-related equipment in 2001, and (4) a charge for reserves
primarily against a pool of non-performing loans, which the Company ultimately
sold in July 2001. In addition, in 2002, we had a significantly lower interest
expense resulting from our extinguishing approximately $139.2 million of Notes
in the Second Exchange Offer (see "-Corporate Restructuring, Debt Modification
and Debt Restructuring"). Lastly, we recorded lower warehouse financing costs
due to lower borrowing costs during 2002.
PAYROLL AND RELATED COSTS. Payroll and related costs decreased by $3.5
million, or 15%, to $19.8 million for the six months ended June 30, 2002, from
$23.3 million for the comparable period in 2001. The decrease was primarily the
result of a downsizing effectuated, as part of our overall corporate
restructuring, related to our transfer of our servicing operations in May 2001.
INTEREST EXPENSE. Interest expense decreased by $8.8 million, or 75%, to $3.0
million for the six months ended June 30, 2002 from $11.8 million for the
comparable period in 2001. The decrease was primarily due to (i) our
extinguishing $139.2 million of Notes, and the corresponding interest expense
related thereto, and (ii) lower warehouse financing costs due to lower borrowing
costs. The average one-month LIBOR rate, which is the benchmark index used
24
to determine our cost of borrowed funds, decreased on average to 1.8% for the
six months ended June 30, 2002, compared to an average of 4.9% for the same
period in 2001.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased $23.6 million, or 67%, to $11.8 million for the six months ended June
30, 2002, from $35.4 million for the comparable period in 2001. The first half
of 2001 included expenses primarily associated with (1) the Company's
disposition and transfer of its servicing portfolio in May 2001 to Ocwen (2)
capital charges previously associated with our interest and servicing advance
securitizations prior to the sale of the servicing portfolio, (3) a change in
accounting estimates regarding the life expectancy of the Company's
computer-related equipment, (4) a charge for reserves primarily against a pool
of non-performing loans, which the Company ultimately sold in July 2001 and (5)
debt restructuring cost associated with the Company's Debt Exchange Offer.
INCOME TAXES. We recorded a tax provision of $0.3 million and $0.6
million, primarily related to excess inclusion income generated by our excess
cashflow certificates, for the period ended June 30, 2002 and 2001,
respectively.
FINANCIAL CONDITION
JUNE 30, 2002 COMPARED TO DECEMBER 31, 2001
CASH AND INTEREST-BEARING DEPOSITS. Cash and interest-bearing deposits
decreased $3.5 million, or 55%, to $2.9 million at June 30, 2002, from $6.4
million at December 31, 2001. The decrease is primarily due to us utilizing
operating cash to fund our production of mortgage loans.
LOANS HELD FOR SALE, NET. Loans held for sale, net decreased $60.4 million,
or 64%, to $34.0 million at June 30, 2002, from $94.4 million at December 31,
2001. This decrease was primarily due to the net difference between loan
originations and loans securitized or sold during the six months ended June 30,
2002.
ACCRUED INTEREST RECEIVABLE. Accrued interest receivable decreased $0.7
million, or 92%, to $0.1 million at June 30, 2002, from $0.8 million at December
31, 2001. This decrease was primarily due to a lower amount of loans held for
sale at June 30, 2002 compared to December 31, 2001.
EXCESS CASHFLOW CERTIFICATES, NET. Excess cashflow certificates, net
increased $4.0 million, or 24%, to $20.8 million at June 30, 2002, from $16.8
million at December 31, 2001. This increase was primarily due to us recording
new excess cashflow certificates, totaling $6.1 million from loans securitized
in the first two quarters of 2002. This increase was partially offset by a fair
value mark-to-market adjustment of our excess cashflow certificates, reflecting
the change in fair value of such excess cashflow certificates.
EQUIPMENT, NET. Equipment, net, decreased $1.6 million, or 32%, to $3.4
million at June 30, 2002, from $5.0 million at December 31, 2001. This decrease
primarily reflects the periodic depreciation of our fixed assets.
WAREHOUSE FINANCING AND OTHER BORROWINGS. Warehouse financing and other
borrowings decreased $66.2 million, or 74%, to $23.4 million at June 30, 2002,
from $89.6 million at December 31, 2001. This decrease was primarily
attributable to a lower amount of monies borrowed under our warehouse credit
facilities, which are used to fund our loans held for sale.
25
SENIOR NOTES. Senior notes totaled $10.8 million at June 30, 2002 and
December 31, 2001. The senior notes accrue interest at a rate of 9.5% per annum,
payable semi-annually on February 1 and August 1.
ACCOUNTS PAYABLE AND ACCRUED EXPENSE. Accounts payable and accrued expense
decreased $1.1 million, or 5%, to $19.1 million at June 30, 2002 from $20.2
million at December 31, 2001. This decrease was primarily the result of timing
of various operating accruals and payables.
LIQUIDITY AND CAPITAL RESOURCES
We require substantial amounts of cash to fund our loan originations,
securitization activities and operations. The Company has historically operated
on a negative cash flow basis due primarily to increase in the volume of loan
originations and the growth of its securitization program. During the second
quarter of 2002, the Company reduced its negative cash flow and achieved a
positive cash flow from operations. Embedded in our current cost structure are
many fixed costs, which are not likely to be significantly affected by a
relatively substantial increase in loan originations. If we continue to increase
our loan production to generate sufficient additional revenues from our
securitizations and loan sales to offset our current cost structure and negative
cash flow, we believe we can generate positive cash flow within the foreseeable
future, as we did this quarter. There can be no assurance, however, that we will
be continue generating positive cash flow within the foreseeable future or at
all.
Currently, our primary sources of cash - the vast majority of which we
typically generate towards the end of the quarter when we securitize and/or sell
our mortgage loans on whole loan basis - include:
o the premiums we receive from selling NIM and/or interest-only
certificates and mortgage servicing rights in connection with our
securitizations;
o the premiums we receive from selling whole loans, servicing released;
o origination fees on newly closed loans;
o cash flows from excess cashflow certificates we retain in connection
with our securitizations; and
o distributions from the LLC (an unaffiliated entity to us).
Currently, our primary uses of cash, which are generally incurred
continuously throughout the quarter, include the funding of:
o loan originations pending their pooling and sale, net of warehouse
financing;
o interest expense on warehouse lines of credit, the remaining notes and
other financing;
o fees, expenses, and tax payments on excess inclusion income incurred in
connection with our securitization program; and
o general ongoing administrative and operating expenses.
Because of the timing of our cash inflows and cash uses, we typically expend
cash throughout the quarter and replenish it towards the end of the quarter.
Historically, we have financed our operations utilizing various secured
credit financing facilities, issuance of corporate debt (I.E., senior notes),
issuance of equity, and the sale of interest-
26
only certificates (sold in conjunction with each of our securizations) to offset
our negative operating cash flow and support our originations, securitizations,
servicing (prior to May 2001) and general operating expenses. Over the past few
years, we have engaged in a series of transactions to further address our
negative cash flow, including the following:
o in 2000, completing three securitizations of interest (delinquency) and
servicing advances, in which we sold our rights to be reimbursed for our
outstanding delinquency and servicing advances that we made as servicer
for a cash purchase price. We used the proceeds from these
securitizations to (1) repay a $25 million working capital sub-line of
our former bank syndicate warehouse facility that expired in June 2000,
which was secured by our delinquency and servicing advance receivables,
and (2) for working capital to finance our operations, including the
funding of new delinquency and servicing advances. We ultimately
repurchased these securitizations in 2001, in connection with the sale
of servicing to Ocwen, using the proceeds we received from selling the
underlying delinquency and servicing advance receivables to Ocwen;
o modifying our senior notes in 2000 as part of the Debt Modification (see
"-Corporate Restructuring, Debt Modification and Debt Restructuring"),
which enabled us to monetize a portion of our excess cashflow
certificates, first by obtaining $17 million in residual financing in
August 2000, secured by some of our excess cashflow certificates.
Shortly thereafter, in November 2000, we sold six excess cashflow
certificates through a private placement NIM transaction to an owner
trust that issued senior certificates to institutional investors for a
cash purchase. The net proceeds of the NIM transaction, after expenses,
was used entirely to repay the $17 million of residual financing we
borrowed in August 2000 and to create a $7.125 million cash escrow
account to be used to pay the semi-annual interest payment due on the
notes in February 2001;
o as part of our Second Debt Restructuring, at the time of the signing of
the Letter of Intent in February 2001, we obtained approximately $2.5
million of residual financing secured by several of our excess cashflow
certificates. We received approximately $7.1 million of additional
residual financing secured primarily by additional excess cashflow
certificates following the consummation of the consent solicitation and
the execution of the third supplemental indenture in March 2001. Also in
March 2001, we entered into a sale agreement to sell five excess
cashflow certificates for a $15.0 million cash purchase price. As
customary with sales of similar assets, the cash settlement did not
occur until the pools of mortgage loans underlying the six excess
cashflow certificates were transferred to an agreed upon servicer to
service the pool of mortgage loans for the benefit of the purchaser. The
purchaser of these five excess cashflow certificates provided bridge
financing, in the form of residual financing described above, until the
transfer of servicing in May 2001. We used these proceeds to repay the
residual financing and have been using the balance of the proceeds,
together with the initial residual financing, for working capital.
Because these excess cashflow certificates were sold at a significant
discount to our book value for such excess cashflow certificates, we
recorded $25.4 million pre-tax non-cash charge in the first quarter of
2001.
Currently, our primary sources of liquidity continue to be, subject to market
conditions:
o on-balance sheet warehouse financing and other secured financing
facilities (e.g., capital leasing);
27
o securitizations of mortgage loans and our corresponding sale of NIM
and/or interest-only certificates (depending upon the securitization
structure) and mortgage servicing rights;
o sales of whole loans;
o cash flows from retained excess cashflow certificates;
o distributions from the LLC (an unaffiliated entity to us) (see
"-Corporate Restructuring, Debt Modification and Debt
Restructuring"); and
o utilizing NIM securitizations and/or selling or financing our
retained excess cashflow certificates.
If we are not able to obtain financing, we will not be able to originate new
loans and our business and results of operations will be materially and
adversely affected.
To accumulate loans for securitization or sale, we borrow money on a
short-term basis through warehouse lines of credit. We have relied upon a few
lenders to provide the primary credit facilities for our loan originations. At
June 30, 2002 we had two $200 million committed credit line warehouse facilities
each with a variable interest rate and a maturity date of May 2003. There can be
no assurance that we will be able to renew these warehouse facilities at their
maturity, or obtain new ones, at terms satisfactory to us or at all.
We are required to comply with various operating and financial covenants as
provided in our warehouse agreements, which are customary for agreements of
their type. The continued availability of funds provided to us under these
agreements is subject to, among other conditions, our continued compliance with
these covenants. Additionally, we are required to comply with restrictive
covenants in connection with our Series A preferred stock and our warrants. We
believe we are in compliance with such covenants as of June 30, 2002.
We have repurchase agreements with certain of the institutions that have
purchased mortgages. Currently, some of the agreements provide for the
repurchase by us of any of the mortgage loans that go to foreclosure sale. At
the foreclosure sale, we will repurchase the mortgage, if necessary, and make
the institution whole. The dollar amount of loans, which were sold with
recourse, is $3.1 million at June 30, 2002 and $4.8 million at June 30, 2001. We
have an allowance for recourse losses of $1.3 million at June 30, 2002 and $1.7
million at June 30, 2001, respectively.
We may, from time to time, if opportunities arise that we deem to be
appropriate, repurchase in the open market some of our outstanding preferred
stock and/or senior notes. The funds for any such repurchases would be expected
to come from our existing cash. There is no assurance that we will effectuate
any such repurchases or the terms thereof.
Subject to our ability to execute our business strategy and the various
uncertainties described above (and described in more detail in "-Forward Looking
Statements and Risk Factors" below), we anticipate that we will have sufficient
cash flows, short-term funding and capital resources to meet our liquidity
obligations for the foreseeable future.
INTEREST RATE RISK
Our primary market risk exposure is interest rate risk. Profitability may be
directly affected
28
by the level of, and fluctuation in, interest rates, which affect our ability to
earn a spread between interest received on our loans and the costs of our
borrowings, which are tied to various interest rate swap maturities, commercial
paper rates and LIBOR. Our profitability is likely to be adversely affected
during any period of unexpected or rapid changes in interest rates. A
substantial and sustained increase in interest rates could adversely affect our
ability to originate loans. A significant decline in interest rates could
increase the level of loan prepayments thereby decreasing the size of the loan
servicing portfolio underlying our securitizations. To the extent excess
cashflow certificates have been capitalized on our financial statements, higher
than anticipated rates of loan prepayments or losses could require us to write
down the value of such excess cashflow certificates, adversely impacting our
earnings. In an effort to mitigate the effect of interest rate risk, we
periodically review our various mortgage products and identify and modify those
that have proven historically more susceptible to prepayments. However, there
can be no assurance that these modifications to our product line will mitigate
effectively interest rate risk in the future.
Periods of unexpected or rapid changes in interest rates, and/or other
volatility or uncertainty regarding interest rates, also can adversely affect us
by increasing the likelihood that asset-backed investors will demand higher
spreads than normal to offset the volatility and/or uncertainty, which decreases
the value of the excess cashflow certificates we receive in connection with a
securitization.
Fluctuating interest rates also may affect the net interest income we earn,
resulting from the difference between the yield we receive on loans held pending
sales and the interest paid by us for funds borrowed under our warehouse
facility. We do, however, undertake to hedge our exposure to this risk by using
various hedging strategies, including Fannie Mae mortgage securities, treasury
rate lock contracts and/or interest rate swaps. (See "--Hedging"). Fluctuating
interest rates also may affect net interest income as certain of our
asset-backed securities are priced based on one-month LIBOR, but the collateral
underlying such securities are comprised of mortgage loans with either fixed
interest rates or "hybrid" interest rates - fixed for the initial two or three
years of the mortgage loan, and adjusting thereafter every six months - which
creates basis risk.
HEDGING
We adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as of January 1, 2001. The Standard requires that all derivative
instruments be recorded in the balance sheet at fair value. However, the
accounting for changes in fair value of the derivative instrument depends on
whether the derivative instrument qualifies as a hedge. If the derivative
instrument does not qualify as a hedge, changes in fair value are reported in
earnings when they occur. If the derivative instrument qualifies as a hedge, the
accounting treatment varies based on the type of risk being hedged. There was no
impact on our financial condition or results of operations upon the adoption of
SFAS No. 133, as amended.
We originate mortgage loans and then sell them through a combination of whole
loan sales and securitizations. Between the time we originate the mortgage and
sell it in the secondary market, we may hedge the risk of fluctuations in
interest rates. Our risk begins subsequent to originating mortgage loans and
prior to selling or securitizing such mortgage loans. Since we have a closed
(and funded) mortgage loan at a specified interest rate with an expected gain at
29
time of sale, our exposure is to a higher interest rate environment due to
market conditions. A higher interest rate market implies that we will have a
higher cost of funds, which decreases the net spread we would earn between the
mortgage interest rate on each mortgage loan less the cost of funds. As a
result, we may experience a lower gain on sale.
The cost of funds is generally composed of two components, the interest rate
swap with a similar duration and average life and the swaps spread or profit
margin required by the investors. We had previously used a "Treasury Rate Lock"
and 15-year Fannie Mae mortgage securities ("FNMA Securities") to hedge our cost
of funds exposure. However recently, the securitizations are priced to the
investor using the interest rate swaps curve. As such, our cost of funds is more
closely tied to interest rate swaps and we will likely use interest rate swaps
to hedge our mortgage loans in inventory pending securitization pricing. While
none of the above are perfect hedges, we believe interest rate swaps will
demonstrate the highest correlation to our cost of funds on a go-forward basis.
We determine the nature and quantity of hedging transactions based upon various
factors including, without limitation, market conditions and the expected volume
of mortgage originations. We will enter into these hedging strategies through
one of our warehouse lenders and/or one of the investment bankers that
underwrite our securitizations. These strategies are designated as hedges on our
financial statements and are closed out when we sell the associated loans.
If the value of the hedges decrease, offsetting an increase in the value of
the loans, upon settlement with our hedge counterparty, we will pay the hedge
loss in cash and then realize the corresponding increase in the value of the
loans as part of our net gain on sale of mortgage loans through either the
excess cashflow certificates we retain from securitization or from whole loan
sale premiums. Conversely, if the value of the hedges increase, offsetting a
decrease in the value of the loans, upon settlement with our hedge counterparty,
we will receive the hedge gain in cash and realize the corresponding decrease in
the value of the loans through a reduction in either the value of the
corresponding excess cashflow certificates or whole loan sale premiums.
We believe our hedging strategy has largely been an effective tool to manage
our interest rate risk on loans prior to securitization, by providing us with a
cash gain (or loss) to largely offset the reduced (increased) excess spread (and
resultant lower (or higher) net gain on sale) from an increase (decrease) in
interest rates. A hedge may not, however, perform its intended purpose of
offsetting changes in net gain on sale.
We make decisions concerning the nature of our hedging transactions based
upon various factors including, without limitation, market conditions and the
expected volume of mortgage originations. We may enter into these hedging
strategies through one of our warehouse lenders and/or an investment bank that
underwrites our securitizations. We will review continually the frequency and
effectiveness of our hedging strategy to mitigate risk pending a securitization
or loan sale.
If a hedging transaction is deemed to be appropriate, and can be properly
documented and mathematically shown to meet the appropriate effectiveness
criteria, we will account for these hedges as fair value hedges in accordance
with SFAS No. 133, as amended.
We will continue to review our hedging strategy to best mitigate risk pending
securitization or loan sales.
We did not hedge during the quarters ended June 30, 2002 and 2001.
30
INFLATION
Inflation most significantly affects our loan originations and values of our
excess cashflow certificates, because of the substantial effect inflation can
have on interest rates. Interest rates normally increase during periods of high
inflation and decrease during periods of low inflation. (See "--Interest Rate
Risk").
IMPACT OF NEW ACCOUNTING STANDARDS
For discussion regarding the impact of new accounting standards, refer to
Note 5 of Notes to the Consolidated Financial Statements.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
Except for historical information contained herein, certain matters discussed
in this Form 10-Q are "forward-looking statements" as defined in the Private
Securities Litigation Reform Act ("PSLRA") of 1995, which involve risk and
uncertainties that exist in our operations and business environment, and are
subject to change on various important factors. We wish to take advantage of the
"safe harbor" provisions of the PSLRA by cautioning readers that numerous
important factors discussed below, among others, in some cases have caused, and
in the future could cause our actual results to differ materially from those
expressed in any forward-looking statements made by us, or on our behalf. The
following include some, but not all, of the factors or uncertainties that could
cause actual results to differ from projections:
o Our ability or inability to increase our loan originations to specified
levels (and subsequent sale or securitization of such loans) to offset
our current cost structure and negative cash flow;
o Our ability or inability to continue to access lines of credit at
favorable terms and conditions, including without limitation, warehouse
and other credit facilities used to finance newly-originated mortgage
loans held for sale;
o Our ability or inability to continue our practice of securitizing
mortgage loans held for sale, as well as our ability to utilize optimal
securitization structures (including the sale of NIM or interest-only
certificates, and the sale of servicing rights, at the time of
securitization) at terms favorable to us;
o Our ability or inability to continue monetizing our excess cashflow
certificates, including without limitation, selling, financing or
securitizing (through NIM transactions) such assets;
o Costs associated with litigation, compliance with the NYSBD Remediation
Agreement and NYOAG Stipulated Order on Consent, and rapid or unforeseen
escalation of the cost of regulatory compliance, generally including but
not limited to, adoption of new, or changes in federal, state or local
lending laws and regulations and the application of such laws and
regulations, licenses, environmental compliance, adoption of new, or
changes in accounting policies and practices and the application of such
polices and practices. Failure to comply with various federal, state and
local regulations, accounting policies, environmental compliance, and
compliance with the Remediation Agreement and Stipulated Order on
Consent can lead to loss of approved status, certain rights of
31
rescission for mortgage loans, class action lawsuits and administrative
enforcement action against us;
o A general economic slowdown. Periods of economic slowdown or recession
may be accompanied by decreased demand for consumer credit and declining
real estate values. Because of our focus on credit-impaired borrowers,
the actual rate of delinquencies, foreclosures and losses on loans
affected by the borrowers reduced ability to use home equity to support
borrowings could be higher than those generally experienced in the
mortgage lending industry. Any sustained period of increased
delinquencies, foreclosure, losses or increased costs could adversely
affect our ability to securitize or sell loans in the secondary market;
o The effects of interest rate fluctuations and our ability or inability
to hedge effectively against such fluctuations in interest rates, the
effect of changes in monetary and fiscal policies, laws and regulations,
other activities of governments, agencies, and similar organizations,
social and economic conditions, unforeseen inflationary pressures and
monetary fluctuation;
o Increased competition within our markets has taken on many forms, such
as convenience in obtaining a loan, customer service, marketing and
distribution channels, loan origination fees and interest rates. We are
currently competing with large finance companies and conforming mortgage
originators many of whom have greater financial, technological and
marketing resources;
o Unpredictable delays or difficulties in development of new product
programs; and
o The unanticipated expenses of assimilating newly-acquired businesses
into our structure, as well as the impact of unusual expenses from
ongoing evaluations of business strategies, asset valuations,
acquisitions, divestitures and organizational structures.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Because the nature of our business involves the collection of numerous
accounts, the validity of liens and compliance with various state and federal
lending laws, we are subject, in the normal course of business, to numerous
claims and legal proceedings. Our lending practices have been the subject of
several lawsuits styled as class actions and of investigations by various
regulatory agencies including the NYSBD, the NYOAG and the United States
Department of Justice (the "DOJ"). The current status of these actions is
summarized below.
o In or about November 1998, we received notice that we had been named in
a lawsuit filed in the United States District Court for the Eastern
District of New York. In December 1998, plaintiffs filed an amended
complaint alleging that we had violated the Home Ownership and Equity
Protection Act ("HOEPA"), the Truth in Lending Act ("TILA") and New York
State General Business Lawss. 349. The complaint seeks (a) certification
of a class of plaintiffs, (b) declaratory judgment permitting
rescission, (c) unspecified actual, statutory, treble and punitive
damages (including attorneys' fees), (d) certain injunctive relief, and
(e) declaratory judgment declaring the loan transactions as void and
unconscionable. On December 7, 1998, plaintiff filed a motion seeking a
temporary
32
restraining order and preliminary injunction, enjoining us
from conducting foreclosure sales on 11 properties. The District Court
Judge ruled that in order to consider such a motion, plaintiff must move
to intervene on behalf of these 11 borrowers. Thereafter, plaintiff
moved to intervene on behalf of 3 of these 11 borrowers and sought
injunctive relief on their behalf. We opposed the motions. On December
14, 1998, the District Court Judge granted the motion to intervene and
on December 23, 1998, the District Court Judge issued a preliminary
injunction that enjoined us from proceeding with the foreclosure sales
of the three intervenors' properties. We filed a motion for
reconsideration of the December 23, 1998 order. In January 1999, we
filed an answer to plaintiffs' first amended complaint. In July 1999,
plaintiffs were granted leave, on consent, to file a second amended
complaint. In August 1999, plaintiffs filed a second amended complaint
that, among other things, added additional parties but contained the
same causes of action alleged in the first amended complaint. In
September 1999, we filed a motion to dismiss the complaint, which was
opposed by plaintiffs and, in June 2000, was denied in part and granted
in part by the Court. In or about October 1999, plaintiffs filed a
motion seeking an order preventing us, our attorneys and/or the NYSBD
from issuing notices to certain of our borrowers, in accordance with a
settlement agreement entered into by and between Delta and the NYSBD. In
or about October 1999 and November 1999, respectively, we and the NYSBD
submitted opposition to plaintiffs' motion. In March 2000, the Court
issued an order that permitted us to issue an approved form of the
notice. In September 1999, plaintiffs filed a motion for class
certification, which we opposed in February 2000, and was ultimately
withdrawn without prejudice by plaintiffs in January 2001. In February
2002, we executed a settlement agreement with plaintiffs, pursuant to
which we denied all wrongdoing, but agreed to resolve the litigation on
a class-wide basis. A fairness hearing was held in May 2002 and we are
awaiting a decision from the Court. We believe that the Court will
approve the settlement, but if it does not, we believe that we have
meritorious defenses and intend to defend this suit, but cannot estimate
with any certainty our ultimate legal or financial liability, if any,
with respect to the alleged claims.
o In or about March 1999, we received notice that we had been named in a
lawsuit filed in the Supreme Court of the State of New York, New York
County, alleging that we had improperly charged certain borrowers
processing fees. The complaint seeks (a) certification of a class of
plaintiffs, (b) an accounting, and (c) unspecified compensatory and
punitive damages (including attorneys' fees), based upon alleged (i)
unjust enrichment, (ii) fraud, and (iii) deceptive trade practices. In
April 1999, we filed an answer to the complaint. In September 1999, we
filed a motion to dismiss the complaint, which was opposed by
plaintiffs, and in February 2000, the Court denied the motion to
dismiss. In April 1999, we filed a motion to change venue and plaintiffs
opposed the motion. In July 1999, the Court denied the motion to change
venue. We appealed and in March 2000, the Appellate Court granted our
appeal to change venue from New York County to Nassau County. In August
1999, plaintiffs filed a motion for class certification, which we
opposed in July 2000. In or about September 2000, the Court granted
plaintiffs' motion for class certification, from which we filed a Notice
of Appeal. In or about June 2001, we filed a motion for summary judgment
to dismiss the complaint, which was denied by the Court in October 2001.
We have appealed that decision as well,
33
and the trial court agreed to stay the action pending the result of that
appeal. We believe that we have meritorious defenses and intend to
defend this suit, but cannot estimate with any certainty our ultimate
legal or financial liability, if any, with respect to the alleged
claims.
o In or about July 1999, we received notice that we had been named in a
lawsuit filed in the United States District Court for the Western
District of New York, alleging that amounts collected and maintained by
us in certain borrowers' tax and insurance escrow accounts exceeded
certain statutory (RESPA) and/or contractual (the respective borrowers'
mortgage agreements) ceilings. The complaint seeks (a) certification of
a class of plaintiffs, (b) declaratory relief finding that our practices
violated applicable statutes and/or the mortgage agreements, (c)
injunctive relief, and (d) unspecified compensatory and punitive damages
(including attorneys' fees). In October 1999, we filed a motion to
dismiss the complaint. In or about November 1999, the case was
transferred to the United States District Court for the Northern
District of Illinois. In February 2000, the plaintiff opposed our motion
to dismiss. In March 2000, the Court granted our motion to dismiss in
part, and denied it in part. In February 2002, we executed a settlement
agreement with plaintiffs pursuant to which we denied all wrongdoing,
but agreed to resolve the litigation on a class-wide basis. A fairness
hearing was held June 2002, at which point the Court approved the
settlement. The Company and plaintiffs' counsel are in the process of
administering the settlement.
o In or about August 1999, the NYOAG filed a lawsuit against us alleging
violations of (a) RESPA (by paying yield spread premiums), (b) HOEPA and
TILA, (c) ECOA, (d) New York Executive Lawss.296-a, and (e) New York
Executive Lawss.63(12). In September 1999, we settled the lawsuit with
the NYOAG, as part of a global settlement by and among us, the NYOAG and
the NYSBD, evidenced by that certain (a) Remediation Agreement by and
between us and the NYSBD, dated as of September 17, 1999 and (b)
Stipulated Order on Consent by and among us and the NYOAG, dated as of
September 17, 1999. As part of the Settlement, we, among other things,
have implemented agreed upon changes to our lending practices; are
providing reduced loan payments aggregating $7.25 million to certain
borrowers identified by the NYSBD; and have created a fund financed by
the grant of 525,000 shares of our common stock, the proceeds of which
will be used, for among other things, to pay borrowers and for a variety
of consumer educational and counseling programs. As a result, the NYOAG
lawsuit has been dismissed as against us. The Remediation Agreement and
Stipulated Order on Consent supersede our previously announced
settlements with the NYSBD and the NYOAG. In March 2000, we finalized a
settlement agreement with the United States Department of Justice, the
Federal Trade Commission and the Department of Housing and Urban
Renewal, to complete the global settlement it had reached with the NYSBD
and NYOAG. The federal agreement mandates some additional compliance
efforts, but it does not require any additional financial commitment.
o In November 1999, we received notice that we had been named in a lawsuit
filed in the United States District Court for the Eastern District of
New York, seeking certification as a class action and alleging
violations of the federal securities laws in connection with our initial
public offering in 1996 and our reports subsequently filed with the
Securities and
34
Exchange Commission. The complaint alleges that the scope of the
violations alleged in the consumer lawsuits and regulatory
actions brought in or around 1999 indicate a pervasive pattern of action
and risk that should have been more thoroughly disclosed to investors in
our common stock. In May 2000, the Court consolidated this case and
several other lawsuits that purportedly contain the same or similar
allegations against us and in August 2000 plaintiffs filed their
Consolidated Amended Complaint. In October 2000, we filed a motion to
dismiss the Complaint in its entirety, which was opposed by plaintiffs
in November 2000, and denied by the Court in September 2001. We believe
that we have meritorious defenses and intend to defend this suit, but
cannot estimate with any certainty our ultimate legal or financial
liability, if any, with respect to the alleged claims.
o In or about April 2000, we received notice that we had been named in a
lawsuit filed in the Supreme Court of the State of New York, Nassau
County, alleging that we had improperly charged and collected from
borrowers certain fees when they paid off their mortgage loans with us.
The complaint seeks (a) certification of a class of plaintiffs, (b)
declaratory relief finding that the payoff statements used include
unauthorized charges and are deceptive and unfair, (c) injunctive
relief, and (d) unspecified compensatory, statutory and punitive damages
(including legal fees), based upon alleged violations of Real Property
Law 274-a, unfair and deceptive practices, money had and received and
unjust enrichment, and conversion. We answered the complaint in June
2000. In March 2001, we filed a motion for summary judgment, which was
opposed by plaintiffs in March 2001, and we filed reply papers in April
2001. In June 2001, our motion for summary judgment dismissing the
complaint was granted. In August 2001, plaintiffs appealed the decision.
In August 2002, we executed a settlement agreement with plaintiffs
pursuant to which we denied all wrongdoing, but agreed to resolve the
litigation on a class-wide basis. We anticipate that a fairness hearing
will be scheduled in the upcoming months, at which time we further
anticipate that the Court will approve the settlement. In the event the
settlement is not approved, we believe that we have meritorious defenses
and intend to defend this suit, but cannot estimate with any certainty
our ultimate legal or financial liability, if any, with respect to the
alleged claims.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None
ITEM 4. SUBMISSION TO A VOTE OF SECURITY HOLDERS.
The annual meeting of stockholders was held on May 7, 2002. At the meeting,
Hugh.Miller and Margaret A. Williams were elected as Class III Directors for a
term of three years. Sidney A. Miller, Martin D. Payson, Richard Blass and
Arnold B. Pollard continue to serve as members of the Board of Directors.
Votes cast in favor of Mr. Miller's selection totaled 14,459,420,
while 42,890 votes were withheld.
Votes cast in favor of Ms. Williams's selection totaled 14,223,120,
while 279,190 votes were withheld.
35
The stockholders also voted to ratify the appointment of KPMG LLP as the
Company's independent auditors for the fiscal year ending December 31, 2002.
Votes cast in favor of this ratification were 14,483,135, while votes cast
against were 18,875 and abstentions totaled 300.
ITEM 5. OTHER INFORMATION. None
ITEM 6. EXHIBITS AND CURRENT REPORTS ON FORM 8-K.
(a) Exhibits: None
(b) Reports on Form 8-K: None
36
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, as
amended, the Registrant has duly caused this Report on Form 10-Q to be signed on
its behalf by the undersigned, thereunto duly authorized.
DELTA FINANCIAL CORPORATION
(Registrant)
Dated: August 13, 2002
By: /S/ HUGH MILLER
-----------------------------
Hugh Miller
PRESIDENT & CHIEF
EXECUTIVE OFFICER
By: /S/ RICHARD BLASS
-----------------------------
Richard Blass
EXECUTIVE VICE PRESIDENT
AND
CHIEF FINANCIAL OFFICER
37
CERTIFICATION OF PRESIDENT AND CHIEF EXECUTIVE OFFICER
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
I, Hugh Miller, President and Chief Executive Officer of Delta Financial
Corporation (the "Company"), pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002, do hereby certify as follows:
1. The quarterly report on Form 10-Q of the Company for the period ended June
30, 2002 fully complies with the requirements of Section 13(a) or 15(d) of
the Securities Exchange Act of 1934; and
2. The information contained in such Form 10-Q fairly presents, in all material
respects, the financial condition and results of operations of the Company.
IN WITNESS WHEREOF, I have executed this Certification this 13 day of August,
2002.
/s/HUGH MILLER
-------------------------------------
Hugh Miller
PRESIDENT AND CHIEF EXECUTIVE
OFFICER
38
CERTIFICATION OF EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
I, Richard Blass, Executive Vice President and Chief Financial Officer of
Delta Financial Corporation (the "Company"), pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, do hereby certify as follows:
1. The quarterly report on Form 10-Q of the Company for the period ended June
30, 2002 fully complies with the requirements of Section 13(a) or 15(d) of
the Securities Exchange Act of 1934; and
2. The information contained in such Form 10-Q fairly presents, in all material
respects, the financial condition and results of operations of the Company.
IN WITNESS WHEREOF, I have executed this Certification this 13 day of August,
2002.
/s/RICHARD BLASS
-------------------------------------
Richard Blass
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
39