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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 March 31, 2003
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 March 31, 2003, 16,186,789 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 March 31, 2003 and
December 31, 2002.................................................. 1
Consolidated Statements of Operations for the three months ended
March 31, 2003 and March 31, 2002.................................. 2
Consolidated Statements of Cash Flows for the three months ended
March 31, 2003 and March 31, 2002.................................. 3
Notes to Consolidated Financial Statements......................... 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.............................................. 8
Item 3 Quantitative and Qualitative Disclosures About Market Risk........ 31
Item 4. Control and Procedures............................................ 32
PART II - OTHER INFORMATION
Item 1. Legal Proceedings..................................................33
Item 2. Changes in Securities and Use of Proceeds..........................35
Item 3. Defaults Upon Senior Securities....................................35
Item 4. Submission of Matters to a Vote of Security Holders................35
Item 5. Other Information..................................................35
Item 6. Exhibits and Current Reports on Form 8-K...........................35
Signatures....................................................................36
Certifications................................................................37
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS (UNAUDITED)
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
(DOLLARS IN THOUSANDS, EXCEPT FOR SHARE DATA) 2003 2002
---------- -----------
ASSETS (UNAUDITED) (AUDITED)
Cash and interest-bearing deposits $ 3,127 3,405
Accounts receivable 1,936 1,700
Loans held for sale, net 69,974 33,984
Excess cash flow certificates, net 25,976 24,565
Equipment, net 2,460 2,553
Prepaid and other assets 2,068 1,737
Deferred tax asset, net 5,600 5,600
--------- ---------
Total assets $ 111,141 73,544
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Bank payable $ 1,146 1,369
Warehouse financing and other borrowings 46,338 16,352
Senior notes 10,844 10,844
Accounts payable and accrued expenses 13,486 12,327
Income taxes payable 3,130 3,155
--------- ---------
Total liabilities 74,944 44,047
--------- ---------
STOCKHOLDERS' EQUITY:
Preferred stock, Series A, $.01 par value. Authorized 150,000
shares, 139,156 shares outstanding at March 31, 2003
and December 31, 2002 13,916 13,916
Common stock, $.01 par value. Authorized 49,000,000
shares; 16,303,589 and 16,022,349 shares issued and
16,186,789 and 15,905,549 shares outstanding at
March 31, 2003 and December 31, 2002, respectively 163 160
Additional paid-in capital 99,482 99,482
Accumulated deficit (76,046) (82,743)
Treasury stock, at cost (116,800 shares) (1,318) (1,318)
---------- ----------
Total stockholders' equity 36,197 29,497
---------- ----------
Total liabilities and stockholders' equity $ 111,141 73,544
========== ========+=
See accompanying notes to consolidated financial statements.
1
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2002
----------- -----------
REVENUES
Net gain on sale of mortgage loans $ 18,165 12,338
Interest 2,810 3,902
Net origination fees and other income 5,571 3,404
------- -------
Total revenues 26,546 19,644
------- -------
EXPENSES
Payroll and related costs 12,729 9,677
Interest expense 1,079 1,547
General and administrative 5,773 6,055
------- -------
Total expenses 19,581 17,279
------- -------
Income before income tax expense 6,965 2,365
Income tax expense 268 120
------- -------
Net income $ 6,697 2,245
======= =======
PER SHARE DATA:
Basic- net income per common share $ 0.42 0.14
======= =======
Diluted - net income per common share $ 0.36 0.14
======= =======
Weighted-average number of shares
outstanding - Basic 15,921,173 15,883,749
========== ==========
Weighted-average number of shares
outstanding - Diluted 18,489,825 16,406,317
========== ==========
See accompanying notes to consolidated financial statements.
2
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
(DOLLARS IN THOUSANDS) 2003 2002
------- -------
Cash flows from operating activities:
Net income $ 6,697 2,245
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Provision for loan and recourse losses 64 441
Depreciation and amortization 435 994
Deferred origination costs (275) 225
Excess cashflow certificates received in
securitization transactions, net (1,411) (1,657)
Changes in operating assets and liabilities:
Increase in accounts receivable (236) (145)
(Increase) decrease in loans held for sale, net (35,715) 28,987
(Increase) decrease in prepaid and other assets (331) 261
Increase (decrease) in warehouse lines of credit 30,535 (32,052)
Increase (decrease) in accounts payable and accrued expenses 1,095 (740)
(Decrease) increase in income taxes payable (25) 139
-------- -------
Net cash provided by (used in) operating activities 833 (1,302)
-------- -------
Cash flows from investing activities:
Purchase of equipment (342) (13)
-------- --------
Net cash used in investing activities (342) (13)
-------- --------
Cash flows from financing activities:
Decrease in bank payable (223) (162)
Repayments of other borrowings (549) (942)
Proceeds from exercise of warrants 3 -
-------- --------
Net cash used in financing activities (769) (1,104)
-------- --------
Net decrease in cash and interest-bearing deposits (278) (2,419)
Cash and interest-bearing deposits at beginning of period 3,405 6,410
-------- --------
Cash and interest-bearing deposits at end of period $ 3,127 3,991
======== ========
Supplemental Information:
Cash paid during the period for:
Interest $ 1,301 1,807
======== ========
Income taxes $ 293 7
======== ========
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, 2002, which were filed with the Securities and
Exchange Commission with our most recent annual report on Form 10-K. The results
of operations for the three-month period ended March 31, 2003 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) STOCK OPTION PLANS
We apply the intrinsic-value-based method of accounting prescribed by
Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES, and related interpretations, including Financial Accounting Standards
Board ("FASB") Interpretation No. 44, ACCOUNTING FOR CERTAIN TRANSACTIONS
INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB OPINION NO. 25, issued in
March 2000, to account for our fixed-plan stock options. Under this method,
compensation expense is recorded on the date of grant only if the current market
price of the underlying stock exceeded the exercise price. Statement of
Financial Accounting Standards ("SFAS") No. 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, established accounting and disclosure requirements using a
fair-value-based method of accounting for stock-based employee compensation
plans. As allowed by SFAS No. 123, we have elected to continue to apply the
intrinsic-value-based method of accounting described above, and have adopted
only the disclosure requirements of SFAS No. 123. In April 2003, the FASB
announced it will, in the future, require all companies to expense the value of
employee stock options but has not decided how to measure the fair value of the
options. As such, the financial statement impact of stock option expensing is
not known as this time. The following table illustrates the effect on net income
if the
4
fair-value-based method had been applied.
THREE MONTHS ENDED
(Dollars in thousands, MARCH MARCH
except share data) 31, 2003 31, 2002
--------- ---------
Net income, as reported $ 6,697 2,245
Deduct total stock-based
employee compensation
expense determined under
fair-value-based method
for all awards, net of tax (110) (117)
--------- ---------
Pro forma net income $ 6,587 2,128
========= =========
Earnings per share:
Basic - as reported $ 0.42 0.14
========= =========
Basic - pro forma $ 0.41 0.13
========= =========
Diluted -as reported $ 0.36 0.14
========= =========
Diluted - pro forma $ 0.36 .013
========= =========
(3) LOANS HELD FOR SALE, NET
Our inventory consists of first and second mortgages, which had a weighted
average interest rate of 8.52% at March 31, 2003 and 8.45% at December 31, 2002.
These mortgages are being held, at the lower of cost or estimated fair value,
for future sale. Certain of these mortgages are pledged as collateral for a
portion of the warehouse financing and other borrowings. Mortgages are payable
in monthly installments of principal and interest and have terms varying from
five to thirty years.
Loans Held for Sale, net, are summarized as follows:
(DOLLARS IN THOUSANDS) March 31, 2003 December 31, 2002
- ------------------------------------------------------------------------------
Loans held for sale $ 69,885 34,170
Net deferred origination cost 524 249
Valuation allowance (435) (435)
- ------------------------------------------------------------------------------
Loans held for sale, net $ 69,974 33,984
- ------------------------------------------------------------------------------
5
(4) EXCESS CASHFLOW CERTIFICATES, NET
The activity related to our excess cashflow certificates is as follows:
(DOLLARS IN THOUSANDS) March 31, 2003 December 31, 2002
- --------------------------------------------------------------------------------------
Balance, beginning of year $ 24,565 16,765
New excess cashflow certificates 2,611 10,499
Cash received from excess cashflow certificates (1,896) (2,588)
Net accretion of excess cashflow certificates 696 1,974
Fair value adjustments -- (2,085)
- --------------------------------------------------------------------------------------
Balance, end of year $ 25,976 24,565
- --------------------------------------------------------------------------------------
(5) WAREHOUSE FINANCING AND OTHER BORROWINGS
At March 31, 2003 and December 31, 2002, we had two warehouse credit
facilities for a combined amount of $400.0 million. The lines are collateralized
by specific mortgage receivables, which are equal to or greater than the
outstanding balances under the line at any point in time.
The following table summarizes certain information regarding warehouse
financing and other borrowings at the relevant times:
(DOLLARS IN MILLIONS)
BALANCE
Facility ------- Expiration
Facility Description Amount Rate 3/31/03 12/31/02 Date
- ---------------------------------------------------------------------------------------------------
Warehouse line of credit $200.0 LIBOR + 1.125% $ 30.9 -- May 2003
Warehouse line of credit $200.0 LIBOR + 1.125% 13.4 13.8 May 2003
Capital leases n/a 3.76% - 12.50% 2.0 2.6 Apr 2003 - Jun 2006
- ---------------------------------------------------------------------------------------------------
Total $400.0 $ 46.3 16.4
- ---------------------------------------------------------------------------------------------------
In May 2003, we extended one of our warehouse lines of credit and allowed the
second warehouse line of credit to expire, replacing it with a new $200 million
warehouse line of credit from a new creditor. Both warehouse lines of credit are
due to expire in May 2004, have interest rates of London Inter-Bank Offered Rate
("LIBOR") + 1.125%, and are collateralized by specific mortgage receivables,
which are equal to or greater than the outstanding balances under the line at
any point in time.
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. We believe we are in compliance with such covenants as of March
31, 2003.
(6) 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.
6
For the three months ended March 31:
(DOLLARS IN THOUSANDS, EXCEPT EPS DATA) 2003 2002
- ------------------------------------------------------------------------------
Net Income $ 6,697 2,245
Weighted-average shares 15,921,173 15,883,749
Basic EPS $ 0.42 0.14
Weighted-average shares 15,921,173 15,883,749
Incremental shares-options 2,568,652 522,568
- ------------------------------------------------------------------------------
18,489,825 16,406,317
Diluted EPS $ 0.36 0.14
- ------------------------------------------------------------------------------
(7) WARRANTS
In December 2000, as part of our first exchange offer, we issued ten-year
warrants to buy approximately 1.6 million shares of our common stock, at an
initial exercise price of $9.10 per share, subject to upward or downward
adjustment in certain circumstances. In December 2002, the exercise price for
the warrants was adjusted downward to $0.01 per share in accordance with Section
6 of the warrant agreement, dated December 21, 2000, by and between Mellon
Investor Services LLP, as warrant agent and us. During the three months ended
March 31, 2003, approximately 281,240 warrants were exercised.
(8) IMPACT OF NEW ACCOUNTING STANDARDS
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No.
133, "Accounting for Derivatives Instruments and Hedging Activities," for
certain decisions made by the Board as part of the Derivatives Implementation
Group process. This statement is effective for contracts entered into or
modified after June 30, 2003 and hedging relationships designated after June 30,
2003. Management does not expect that the provisions of SFAS No. 149 will impact
our results of operations or financial condition.
7
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
EXCESS CASHFLOW CERTIFICATES. Our excess cashflow certificates primarily
consist of the right to receive the future excess cash flows from a pool of
securitized mortgage loans. Our interest in these certificates generally
consists of the following:
o The interest spread between the coupon on the underlying mortgage loans
and the cost of financing (which, when we sell Net Interest Margin ("NIM")
notes, is only received after the NIM notes are paid in full);
o On our 2002 securitizations, prepayment penalties received from borrowers
who payoff their loans early in their life (which, when we sell NIM notes,
is only received after the NIM notes are paid in full ); and
o Overcollateralization, which is designed to protect the securities sold to
the securitization pass-through investors from credit loss on the
underlying mortgage loans (and which we describe in greater detail under
"Securitizations").
The excess cash flow we receive is highly dependent upon the interest rate
environment, to the extent that basis risk exists between the securitization
trust's assets and liabilities. For instance, in each of our securitizations
that we issued since 2002, the cost of financing for the securitized loans is
indexed against 1 month LIBOR, meaning that each month, the interest rate
received by the pass through certificate holders may adjust (upwards or
downwards) as 1 month LIBOR changes (liability), while the majority of the
underlying mortgage loans in the securitization trust have a fixed note rate for
at least 3 years (asset). As a result, as rates rise and fall, the amount of our
excess cash flows will fall and rise, which in turn will increase or decrease
the value of our excess cashflow certificates.
In each of our securitizations in which we sold NIM note(s), we purchased, on
behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM
noteholder(s), which helps mitigate the basis risk for the approximate time that
the NIM notes are outstanding.
We believe the accounting estimates related to the valuation of our excess
cashflow certificates is a "critical accounting estimate" because it can
materially affect net income and requires us to forecast interest rates,
mortgage principal payments, prepayments, and loan loss assumptions which are
highly uncertain and require a large degree of judgment. The rate used to
discount the projected cash flows is also critical in the valuation of our
excess cashflow certificates. Management uses internal, historical collateral
performance data and published forward LIBOR curves when modeling future
expected excess cashflows. We believe the value of our excess cashflows
certificates is fair, but can provide no assurance that future prepayment and
loss experience or changes in their required market discount rate will not
require write-downs of the excess cashflow certificate asset. Write-downs would
reduce income of future periods.
8
GENERAL
Delta Financial Corporation (together with its subsidiaries, "Delta" or "we"
or the "Company"), is a specialty consumer finance company that originates,
securitizes, and sells non-conforming mortgage loans, which are primarily
secured by first mortgages on one- to four-family residential properties.
Throughout our 21-year operating history, we have focused on lending to
individuals who generally do not satisfy the credit, documentation or other
underwriting standards set by more traditional sources of mortgage credit,
including those entities that make loans in compliance with conventional
mortgage lending guidelines established by Fannie Mae and Freddie Mac. We make
loans to these borrowers for such purposes as debt consolidation, refinancing,
education and home improvements. Our corporate offices are located at 1000
Woodbury Road, Woodbury, NY 11797 and we can be contacted at (516) 364-8500 or
through our internet web site at http://www.deltafinancial.com. (Information
contained on our website does not constitute part of this report.) Our Exchange
Act filings can be accessed on the Investor Relations page of our web site,
through a link to EDGAR.
Our mortgage business has two principal components. First, we make mortgage
loans to individual borrowers, which is a cash and expense outlay for us,
because our cost to originate a loan exceeds the fees we collect at the time we
originate 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 a warehouse line of
credit. Second, we sell loans, either through securitization or on a whole loan
basis, to generate cash and non-cash revenues, recording the premiums received
as revenues. We use the proceeds from these sales to repay our warehouse lines
of credit and for working capital.
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 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.
INDEPENDENT MORTGAGE BROKER (WHOLESALE) CHANNEL. Through our wholesale
distribution channel, we originate mortgage loans indirectly through independent
mortgage brokers and other real estate professionals who submit loan
applications on behalf of borrowers. We currently originate the majority of our
wholesale loans in 26 states, through our network of approximately 1,500
brokers. The broker's role is to source the business, identify the applicant,
assist in completing the loan application, gather necessary information and
documents and serve as the liaison between us and the borrower through the
entire origination process. We review, process and underwrite the applications
submitted by the broker, approve or deny the application, set the interest rate
and other terms of the loan and, upon acceptance by the borrower and
satisfaction of all conditions imposed by us as the lender, lend the money to
the borrower. Because brokers conduct their own marketing and employ their own
personnel to complete loan applications (and hence charge a broker fee that is
commensurate with their services) and maintain contact with borrowers,
originating loans through our broker network allows us to increase our loan
volume without incurring the higher marketing and employee costs associated with
increased retail originations.
9
RETAIL LOAN CHANNEL. Through our retail distribution channel, we develop
retail loan leads ("retail loans") primarily through our telemarketing system
and our network of 7 retail offices and 4 origination centers (which are
typically staffed with considerably more loan officers and cover a broader area
than retail offices) located in eight states. We continually monitor our retail
operations and evaluate current and potential retail offices on the basis of
selected demographic statistics, marketing analyses and other criteria developed
by us. Typically, contact with the customer is initially handled through our
telemarketing center. On the basis of an initial screening conducted at the time
of the call, our telemarketer makes a preliminary determination of whether the
customer and the property meet our lending criteria. If the customer does meet
our criteria, the telemarketer will forward the customer to one of our local
branches or origination centers. The mortgage analyst at the local branch or
origination center may complete the application over the telephone, or schedule
an appointment in the retail loan office most conveniently located to the
customer or in the customer's home, depending on the customer's needs. The
mortgage analyst assists the applicant in completing the loan application,
ensures that an appraisal has been ordered from an independent third party
appraisal company, orders a credit report from an independent, nationally
recognized credit reporting agency and performs various other tasks in
connection with the completion of the loan package. Our mortgage analysts are
trained to structure loans that meet the applicant's needs while satisfying our
lending guidelines. The loan package is underwritten for loan approval on a
centralized basis. If the loan package is approved, we will fund the loan.
For the three months ended March 31, 2003, we originated $323 million of
loans, an increase of 70% over the $190 million of loans originated in the
comparable period in 2002. Of these amounts, approximately $175 million were
brokered loans and $148 million were retail loans, compared to $123 million and
$67 million, respectively, during the three months ended March 31, 2002. In
addition, loan production in the first quarter of 2003 increased 25% from $258
million in the fourth quarter of 2002. The fourth quarter production was
comprised of $145 million of brokered loans and $113 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, we replenish our capital so we can
make new loans. Typically, loans are financed on a warehouse line 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 creditor for providing us with financing.
SALE OF LOANS. We derive the majority of our revenues and cash flows from
selling mortgage loans through one of two outlets: (i) securitization, which
involves the public offering by a securitization trust of asset-backed
pass-through securities (and related interests including securitization
servicing rights on newly-originated pools of mortgage loans); and (ii) whole
loan sales, which includes the sale of pools of individual loans to
institutional investors, banks, and consumer finance-related companies on a
servicing released basis. We select the outlet depending on market conditions,
relative profitability and cash flows. We generally realize higher gain on sale
when we securitize than we do when we sell whole loans. We apply the
10
proceeds from loan sales, whether through securitizations or whole loan basis,
to repay our warehouse lines of credit - in order to make available capacity
under these facilities for future funding of mortgage loans - and utilize any
additional funds for working capital.
Going forward, we expect to continue to use a combination of securitizations
and whole loan sales, with the amounts of each dependent upon conditions in the
marketplace and our goal of maximizing earnings and liquidity.
The following table sets forth certain information regarding loans sold
through the Company's securitizations and on a whole loan basis during the
quarter ended March 31, 2003, (dollars in thousands):
AMOUNT PERCENTAGE
______________________________________
Loan securitizations $ 261,000 96%
Whole loan sales 12,220 4%
----------------------------
Total securitizations and loans sold $ 273,220 100%
============================
SECURITIZATION. When we securitize loans, we create trusts in the form of
off-balance sheet qualified special purpose entities, or QSPEs. These trusts are
established for the limited purpose of buying and reselling mortgage loans.
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".
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 for cash by insurance companies, mutual funds and/or
other institutional investors, represent senior interests in the cash flows from
the mortgage loans in the trust.
The securitization trust issues senior certificates, which entitle the
holders of these senior certificates to receive the principal collected,
including prepayments of principal, on the mortgage loans in the trust. In
addition, holders receive a portion of the interest on the loans in the trust
equal to the pass-through interest rate on the remaining principal balance. The
securitization trust also issues a subordinate certificate or BIO certificate
(referred to as an excess cashflow certificate), and a P certificate
(representing the right to receive prepayment penalties from borrowers who
payoff their loans early in their life). Each month, the P certificate holder is
entitled to receive prepayment penalties received from borrowers who payoff
their loans early in their life.
For any monthly distribution, the holder of an excess cashflow certificate
receives payments only after all required payments have been made on all the
other securities issued by the securitization trust. In addition, before the
holder of the excess cash flow certificate receives payments, cash flows from
such excess cashflow certificates are applied in a "waterfall" manner as
follows:
11
o first, to cover any losses on the mortgage loans in the related mortgage
loan pool, because the excess cashflow certificates are subordinate in
right of payment to all other securities issued by the securitization
trust;
o second, to reimburse the bond insurer, if any, of the related series of
pass-through certificates for amounts paid by or otherwise owing to that
insurer;
o third, to build or maintain the overcollateralization provision (described
in more detail immediately below) for that securitization trust at the
required level by being applied as an accelerated payment of principal to
the holders of the pass-through certificates of the related series;
o fourth, to reimburse holders of the subordinated certificates of the
related series of pass-through certificates for unpaid interest and for
any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates which was
not paid because of the imposition of a cap on their pass-through rates -
these payments being called basis risk shortfall amounts.
The overcollateralization provision or "O/C" is a credit enhancement which is
designed to protect the securities sold to the securitization pass-through
investors from credit loss on the underlying mortgage loans. In short,
overcollateralization is when the amount of collateral (I.E., mortgage loans)
owned by a securitization trust exceeds the aggregate amount of senior
pass-through certificates. The O/C is created to absorb losses that the
securitization trust may suffer, as loans are liquidated at a loss.
Historically, we built up the O/C typically over the first 18-24 months of a
securitization (with the specific timing depending upon the structure, amount of
excess spread, and performance of the securitization), by utilizing the cash
flows from the excess cashflow certificates to make additional payments of
principal to the holders of the pass-through certificates until the required O/C
level was reached. Beginning in our 2002 securitizations, we created the O/C by
initially selling pass-through securities totaling approximately 98.5% of the
total amount of mortgage loans sold to the trust. In doing so, we create the
full amount of the O/C required by the trust up front, at the time we complete
the securitization, instead of over time. For example, if a securitization trust
contains collateral of $100 million of mortgage loans, we sell approximately
$98.5 million in senior pass-through certificates. Prior to our 2002
securitization transactions, we typically issued pass-through certificates for a
par purchase price, or a slight discount to par - with par representing the
aggregate principal balance of the mortgage loans backing the asset-backed
securities. For example, if a securitization trust contains collateral of $100
million of mortgage loans, we typically received close to $100 million in
proceeds from the sales of these certificates, depending upon the structure we
utilize for the securitization.
The O/C is generally expressed as a percentage of the initial mortgage loan
or collateral principal balance sold to the securitization trust. The required
O/C is initially determined by either the rating agencies and/or the bond
insurer, if any, using various factors including (1) characteristics of the
mortgage loans sold to the trust (I.E., credit scores and loan to value ratios);
(2) the amount of excess spread between the interest rate on the pool of
mortgage loans sold to the securitization trust and the interest paid to the
pass-through certificate holders, less the servicing fee, and other related
expenses such as trustee fees and bond insurer fee, if any; and (3) the
structure of the underlying securitization.
12
Our securitizations have typically required an O/C of between 1.25% and 3.0%
of the initial mortgage loans sold to the securitization trust. The required O/C
can increase or decrease throughout the life of the transaction depending upon
subordination levels, delinquency and/or loss tests and is subject to minimums
and maximums, as defined by the rating agencies and/or the bond insurer insuring
the securitization. On our securitizations prior to 2002, after the O/C
requirement is reached, the cash flows from the excess cashflow certificates are
then distributed to us as the holder of the excess cashflow certificates, in
accordance with the "waterfall" described above. Over time, if the cash
collected during the periods exceeds the amount necessary to maintain the
required O/C and all other required distributions have been met, and there is no
shortfall in the related required O/C, the excess is then released to us as
holder of the excess cashflow certificate.
We began utilizing a new securitization structure in 2002,pursuant to which
we sold a net interest margin certificate or NIM. The NIM is generally
structured where we sell the excess cashflow certificate and P certificate
(which entitles the holder to all prepayment penalties collected by the
securitization trust) to a QSPE 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 P certificate), and (2) a NIM owner trust certificate evidencing
ownership in the NIM trust. We sell the excess cashflow certificate and P
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 certificate
and P certificate to be used to pay all principal and interest on the NIM
note(s) until paid in full. This typically occurs approximately 22-25 months
from the date the NIM note(s) were issued. 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 NIM owner trust, represented by the owner trust certificate. The
owner trust certificate entitles us to all cash flows generated by the excess
cashflow certificate and P certificate after the holder of the NIM note(s) has
been paid in full. As such, 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 O/C at
closing - as opposed to having it build up over time as we had in past
securitizations - which is why we sold senior pass-through certificates totaling
approximately 1.5% less than the collateral in the securitization trust. We use
a portion of the proceeds we receive from selling NIM note(s) to make up for the
difference between (1) the value of the mortgage loans sold and (2) the proceeds
from selling the senior pass-through certificates.
In our 1st quarter 2003 securitization, 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 certificates;
o we received a cash purchase price from the sale of an interest-only
certificate, which
13
entitles the holder to receive payments of interest at a pre-determined
rate and over a fixed period of time - I.E., the first 30 months of the
securitization transaction in this case;
o we retained a NIM owner trust certificate, which entitles us to receive
cash flows generated by the excess cashflow certificates and the P
certificate issued in connection with the securitization after the holder
of the NIM note(s) has been paid in full. Although the cash flows
generated by excess cashflow certificates are received over time, under
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, (2) the expected
amount of prepayments on the mortgage loans due to the underlying
borrowers of the mortgage loans paying off their mortgage loan prior to
the loan's stated maturity, (3) the London Inter-Bank Offered Rate
("LIBOR") forward curve (using current LIBOR as the floor rate) and (4) a
discount rate; and
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 (which includes prepayment
penalties for certain securitization servicing rights we previously sold)
in such capacity.
At the time we completed the 1st quarter 2003 securitization, we recognized
as revenue each of the economic interests described above, which were recorded
as net gain on sale of mortgage loans on our consolidated statement of
operations.
A summary of the gain on sale and cash flow we received from our 1st quarter
2003 securitization is presented below. "Loans Sold" represents the amount of
loans actually transferred to the securitization trusts during the period.
GAIN ON SALE SUMMARY
Loans Sold (in thousands) $261,000
========
NIM Proceeds, Net of Up Front Overcollateralization 5.28%
Interest Only Certificate Proceeds 0.45 %
Excess Cashflow Certificate (owner trust certificate) 1.00 %
Mortgage Servicing Rights 0.65 %
Less: Transaction Costs (0.63)%
-------
Net Gain on Sale Recorded 6.75 %
=======
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CASH FLOW SUMMARY
NIM Proceeds, Net of Up Front Overcollateralization 5.28 %
Interest Only Certificate Proceeds 0.45 %
Mortgage Servicing Rights 0.65 %
Less: Transaction Costs (0.63)%
-------
Net Cash Flow at Closing 5.75 %
=======
Our net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate the loans,
adjusted for the following:
o any direct loan origination costs incurred (an increase in the investment)
and loan origination fees received (a decrease in the investment) in
connection with the loans, which are treated as a component of the initial
investment in loans;
o the principal payments received, and the amortization of the net loan fees
or costs, during the period we held the loans prior to their
securitization; and
o any gains (a decrease in the investment) or losses (an increase in the
investment) we incur on any hedging instruments that we may have utilized
to hedge against the effects of changes in interest rates during the
period we hold the loans prior to their securitization (See "-Hedging").
We allocate our basis in the mortgage loans and excess cashflow certificates
between the portion of the mortgage loans and excess cashflow certificates sold
through securitization and the portion retained (the NIM owner trust certificate
since 2002) based on the relative fair values of those portions on the date of
sale. We may recognize gains or losses attributable to the changes in fair value
of the excess cashflow certificates, which are recorded at estimated fair value
and accounted for as "trading" securities. Since there is no active market for
such excess cashflow certificates, we determine the estimated fair value of the
excess cashflow certificates by discounting the future expected cash flows.
Each securitization trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which insures the timely payment of interest and the
ultimate payment of principal of the credit-enhanced investor certificate, or
both (known as a "hybrid"). In "senior-subordinated" structures, the senior
certificate holders are protected from losses by subordinated certificates,
which absorb any such losses first. In addition to such credit enhancement, the
excess cash flows that would otherwise be paid to the holder of the excess
cashflow certificate is used when and if it subsequently becomes necessary to
obtain or maintain required overcollateralization limits. Overcollateralization
is used to absorb losses prior to making a claim on the financial guaranty
insurance policy or the subordinated certificates.
WHOLE LOAN SALES. We also sell loans, without retaining the right to service
the loans, in exchange for a cash premium. The premiums we receive from the loan
sales are recorded as revenue under net gain on sale of mortgage loans at the
time of sale. The cash premiums ranged between 2.6% to 5.8% of the principal
amount of mortgage loans sold in the first quarter of 2003.
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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:
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 lender to fund our loans);
o net loan origination fees on brokered loans and retail loans; and
o retained excess cashflow certificates; and
o distributions from the Delta Funding Residual Exchange Company LLC (the
"LLC"), a limited liability company (unaffiliated to us). We have a
non-voting membership interest in the LLC, which entitles us to receive
15% of the net cash flows from the LLC through June 2004 and, thereafter,
10% of the net cash flows from the LLC.
EXCESS CASHFLOW CERTIFICATES, NET
Our excess cashflow certificates primarily consist of the right to receive
the future excess cash flows from a pool of securitized mortgage loans. Our
interest in these certificates generally consists of the following:
o The interest spread between the coupon on the underlying mortgage loans
and the cost of financing (which, when we sell NIM notes, is only received
after the NIM Notes are paid in full);
o The prepayment penalties received from borrowers who payoff their loans
early in their life (which, when we sell NIM notes, is only received after
the NIM Notes are paid in full); and
o Overcollateralization, which is designed to protect the securities sold to
the securitization pass-through investors from credit loss on the
underlying mortgage loans (and which we describe in greater detail above
under "Securitization").
The excess cash flow we receive is highly dependent upon the interest rate
environment to the extent basis risk exists between the securitization trust's
assets and liabilities. For instance, in this quarter's securitization, the cost
of financing for the securitized loans is indexed against 1 month LIBOR meaning
that each month the interest rate received by the pass-through certificate
holders may adjust (upwards or downwards) as 1 month LIBOR changes (liability),
while a significant amount of the underlying mortgage loans in the
securitization trust have a fixed note rate for at least 3 years (asset). As a
result, as rates rise and fall, the amount of our excess cash flows will fall
and rise, which in turn will increase or decrease the value of our excess
cashflow certificates.
In each of our securitizations in which we sold NIM note(s), we purchased, on
behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM
noteholder(s), which helps mitigate the basis risk for the approximate time that
the NIM notes are outstanding.
We believe the accounting estimates related to the valuation of our excess
cashflow certificates is a "critical accounting estimate" because it can
materially affect net income and requires us to forecast interest rates,
mortgage principal payments, prepayments, and loan loss assumptions which are
highly uncertain and require a large degree of judgment. The rate used to
discount the projected cash flow is also critical in the valuation of our excess
cashflow
16
certificates. Management uses internal, historical collateral performance data
and published forward LIBOR curves when modeling future expected excess
cashflows. We believe the value of our excess cashflow certificates is fair, but
can provide no assurance that future prepayment and loss experience, changes in
the LIBOR rate, or changes in their required market discount rate will not
require write-downs of the excess cashflow certificate asset. Write-downs would
reduce income of future periods.
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the present
value of the related excess cashflow certificates (which, in the securitizations
we have issued since 2002 includes NIM owner trust certificates, and the
underlying BIO certificates and P certificates), using certain assumptions we
make regarding the underlying mortgage loans. The excess cashflow certificate is
then recorded on our consolidated financial statements at an estimated fair
value. Our estimates primarily include the following:
o future rate of prepayment of the mortgage loans - the expected amount
of prepayments on the mortgage loans due to the underlying borrowers of
the mortgage loans paying off their mortgage loan prior to the loan's
expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of
expected losses or defaults that will take place on the underlying
mortgage loans over the life of the mortgage loans because the excess
cashflow certificates are subordinate in right of payment to all other
securities issued by the securitization trust. Consequently, any losses
sustained on mortgage loans comprising a particular securitization trust
are first absorbed by the excess cashflow certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) - our
estimate of future interest rates which affects both the rate paid to
the floating rate pass-through security investors (primarily the 1 month
LIBOR index) and the adjustable rate mortgage loans sold to the
securitization trust (which provide for a fixed rate of interest for the
first 24 or 36 months and a 6 month variable rate of interest thereafter
using the 6 month LIBOR index); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the cash flow we
expect to receive in the future from such certificate based upon our best
estimate. We monitor the performance of the loans underlying each excess
cashflow certificate, and any changes in our estimates (and consequent changes
in value of the excess cashflow certificates) are reflected in the line item
called "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
17
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 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 the
borrower to qualify for a lower interest rate loan;
o competition in the mortgage market, which may result in lower interest
rates being offered;
o the borrower's sale of his or her home;
o the borrower's need for additional monies; 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;
18
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our current prepayment assumptions for the month
one and peak speed. The assumptions have not changed since September 2001:
LOAN TYPE MONTH ONE PEAK SPEED
--------- --------- ----------
Fixed Rate 4.00% 30.00%
Adjustable Rate 4.00% 75.00%
If mortgage loans prepay faster than anticipated, we will earn less income
in connection with the mortgage loans and receive less excess cash flow in
the future because the mortgage loans have paid off. Conversely, if
mortgage loans prepay slower than anticipated, we earn more income and
more excess cash flow in the future.
(B) DEFAULT RATE. At March 31, 2003 and March 31, 2002, on each newly issued
securitization, we apply a default reserve for both fixed- and
adjustable-rate loans sold to the securitization trusts totaling 5.00% of
the amount initially securitized. We apply a default or loss rate to the
excess cashflow certificate because it is the "first-loss" piece and is
subordinated in right of payment to all other securities issued by the
securitization trust. If defaults are higher than we anticipate, we will
receive less income and less excess cash flow than expected in the future;
conversely, if defaults are lower than we expected, we will receive more
income and more excess cash flow than expected in the future.
(C) LIBOR FORWARD CURVE. The LIBOR forward curve is used to project future
interest rates, which affects both the rate paid to the floating rate
pass-through security investors (primarily the 1 month LIBOR index) and
the adjustable rate mortgage loans sold to the securitization trust (a
fixed rate of interest for either the first 24 or 36 months then a 6 month
variable rate of interest thereafter using the 6 month LIBOR index). A
significant portion of our loans are fixed rate mortgages and a
significant amount of these fixed rate loans are backed by floating rate
securities (I.E., 1 month LIBOR). As such, our excess cashflow
certificates are subject to significant basis risk and a change in LIBOR
will, therefore, impact our excess spread. If LIBOR is lower than
anticipated we will receive more income and more excess cash flows than
expected in the future; conversely, if LIBOR is higher than expected, we
will receive less income and less excess cash flows than expected in the
future. In each of our securitizations in which we sold NIM note(s), we
purchased, on behalf of the NIM owner trust, an interest rate cap for the
benefit of the NIM noteholder(s), which helps mitigate the basis risk for
the approximate time that the NIM notes are outstanding.
(D) DISCOUNT RATE. We use a discount rate that we believe reflects the risks
associated with our excess cashflow certificates. 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
19
of the underlying securitized mortgage pools to comparable industry
performance. The discount rate we use to determine the present value of
cash flows from excess cashflow certificates reflects increased
uncertainty surrounding current and future market conditions, including
without limitation, uncertainty concerning inflation, recession, home
prices, interest rates and equity markets.
We utilized a discount rate of 15% at March 31, 2003 and March 31, 2002 on
all excess cashflow certificates.
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 cash flows that are to be received by the
excess cashflow certificates after the release or "stepdown" of the
overcollateralization account.
Our valuation of retained excess cashflow certificates is highly dependent
upon the reasonableness of our assumptions and the predictiveness of the
relationships that drive the results of our valuation model. The assumptions we
utilize, described above, are complex, as we must make judgment calls about the
effect of matters that are inherently uncertain. As the number of variables and
assumptions affecting the possible future resolution of the uncertainties
increase, those judgments become even more complex.
In volatile markets, like those we have experienced over the past several
quarters, there is increased risk that our actual results may vary significantly
from our assumed results. 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 March 31, 2003, 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.
As of March 31, 2003, we have a gross deferred tax asset of $45.4 million and
a valuation allowance of $39.8 million. We established this valuation allowance
in 2001, in the midst of two successive years of posting significant losses
(2000 and 2001), and the modest amount of earnings we had projected to earn over
the ensuing several quarters. We believe it was appropriate to establish this
valuation allowance in accordance with GAAP. Since then, we have now posted six
consecutive quarters of profitability. If we are able to continue to record
positive earnings over the next several quarters and demonstrate a reliable
future earnings stream, we expect to:
20
o utilize a larger amount of the gross deferred tax asset to offset the tax
that would otherwise be recorded on the majority of such earnings; and
o potentially reduce the amount of, and/or eliminate, the valuation
allowance in accordance with GAAP (upon any reduction or elimination of
the valuation allowance net earnings and retained earnings will increase;
however, in subsequent quarters net earnings and retained earnings will be
reduced by the amount of the tax provision).
As of March 31, 2003, Federal and State net operating loss carryforwards
("NOLs") totaled $66.4 million, expiring in 2021.
Our deferred tax asset of $45.4 million consists primarily of NOLs, net of
tax, of $26.6 million, and the excess of the tax basis over book basis on our
excess cashflow certificates, net of tax, of $17.0 million.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2003 COMPARED TO THE THREE MONTHS ENDED MARCH
31, 2002
GENERAL
Our net income for the three months ended March 31, 2003 was $6.7 million, or
$0.42 per share basic and $0.36 per share diluted, compared to $2.2 million, or
$0.14 per share basic and diluted, for the three months ended March 31, 2002.
Comments regarding the components of net income are detailed in the following
paragraphs.
REVENUES
Total revenues increased $6.9 million, to $26.5 million for the three months
ended March 31, 2003, from $19.6 million for the comparable period in 2002. The
increase in revenue was primarily attributable to us securitizing a higher
amount of mortgage loans during the period ended March 31, 2003, compared to the
same period in 2002 and the consequent increase in net gain on sale of mortgage
loans.
We originated $323.0 million of mortgage loans for the three months ended
March 31, 2003, representing a 70% increase from $190.0 million of mortgage
loans originated for the comparable period in 2002. We securitized and sold
$273.2 million of loans during the three months ended March 31, 2003, compared
to $213.7 million of loans during the same period in 2002.
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans is
represented by the following:
(1) the sum of :
(a) the cash purchase price we receive in connection with selling one or
more of the following securities in connection with our
securitization(s) for a particular period: (i) a NIM note, net of
overcollateralization amount and interest rate cap and/or (ii) an
interest-only certificate;
(b) the fair value of the non-cash excess cashflow certificates we
retain in a securitization for each period;
21
(c) the cash premium received from selling mortgage servicing rights in
connection with each securitization; and
(d) the cash premium earned from selling whole loans on a
servicing-released basis,
(2) less the (i) costs associated with securitizations, (ii) any hedge loss
(gain) associated with a particular securitization, and (iii) any loss
associated with loans sold at a discount.
Net gain on sale of mortgage loans increased $5.9 million, or 48%, to $18.2
million for the three months ended March 31, 2003, from $12.3 million for the
comparable period in 2002. This increase was primarily due to an increase in the
amount of loans securitized and sold compared to the first quarter of 2002. We
securitized $261.0 million of mortgage loans and sold $12.2 million of mortgage
loans on a servicing-released basis in the first quarter of 2003, compared to
$175.0 million of mortgage loans securitized and $38.7 million of mortgage loans
sold on a servicing-released basis during the same period in 2002. Loan
production totaled $323.0 million in the first quarter of 2003, compared to
$190.0 million during the same period in 2002. The weighted average net gain on
sale ratio for the three months ended March 31, 2003, and for the comparable
period in 2002, was 6.66% and 5.77%, respectively. The weighted-average net gain
on sale ratio is calculated by dividing the net gain on sale by the total amount
of loans securitized and sold.
INTEREST INCOME. Interest income primarily represents the sum of:
(1) the gross 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;
(4) cash interest earned on bank accounts; and
(5) miscellaneous interest income including prepayment penalties received
on certain of our securitizations prior to 2002.
Interest income decreased $1.1 million, or 28%, to $2.8 million for the three
months ended March 31, 2003, from $3.9 million for the comparable period in
2002. The decrease in interest income was primarily due to a lower weighted
average interest rate on loans held for sale (and, consequently, less interest
earned on loans held for sale) in the first quarter of 2003 compared to the same
period in 2002 - 8.60% and 9.70%, respectively. In addition, 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 cash flows that are to be received by the excess cashflow certificate
after the release or "stepdown" of the overcollateralization account.
NET ORIGINATION FEES AND OTHER INCOME. Origination fees represent (1) fees
earned on broker and retail originated loans, (2) premiums paid to originate
mortgage loans, (3) distributions from the LLC, and (4) other miscellaneous
income, if any.
Net origination fees and other income increased $2.2 million, or 65%, to $5.6
million for the three months ended March 31, 2003, from $3.4 million for the
comparable period in 2002. The
22
increase was primarily the result of higher mortgage loan production, and
consequently higher fees (associated with the higher loan production) during the
first quarter of 2003, compared to the same period in 2002.
EXPENSES
Total expenses increased by $2.3 million, or 13%, to $19.6 million for the
three months ended March 31, 2003, from $17.3 million for the comparable period
in 2002. The increase was primarily related to higher payroll and related costs
associated with an increase in our mortgage loan production.
PAYROLL AND RELATED COSTS. Payroll and related costs include salaries,
benefits and payroll taxes for all employees.
Payroll and related costs increased by $3.0 million, or 31%, to $12.7 million
for the three months ended March 31, 2003, from $9.7 million for the comparable
period in 2002. The increase was primarily the result of higher commissions paid
and more employees, related to the increase in our loan production. As of March
31, 2003, we employed 695 full- and part-time employees, compared to 609 full-
and part-time employees as of March 31, 2002.
INTEREST EXPENSE. Interest expense includes the borrowing costs under our
warehouse credit facility to finance loan originations, equipment financing and
the Senior notes.
Interest expense decreased by $0.4 million, or 27%, to $1.1 million for the
three months ended March 31, 2003 from $1.5 million for the comparable period in
2002. The decrease was primarily due to 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 1.3%
for the first quarter 2003, compared to an average of 1.8% for the first quarter
2002.
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 $0.3 million and $0.1 million, primarily
related to excess inclusion income generated by our excess cashflow
certificates, for the periods ended March 31, 2003 and 2002, 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.
FINANCIAL CONDITION
MARCH 31, 2003 COMPARED TO DECEMBER 31, 2002
Loans held for sale, net increased $36.0 million, or 106%, to $70.0 million
at March 31, 2003, from $34.0 million at December 31, 2002. This represents
mortgage loans held in
23
inventory awaiting either a whole loan sale or securitization. This increase was
primarily due to the net difference between loan originations and loans
securitized or sold during the three months ended March 31, 2003.
Excess cashflow certificates, net increased $1.4 million, or 6%, to $26.0
million at March 31, 2003, from $24.6 million at December 31, 2002. This
increase was primarily due to us recording a new excess cashflow certificate,
totaling $2.6 million from loans securitized in the first quarter of 2003. This
increase was partially offset by the change in fair value of such excess
cashflow certificates- which incorporates any change in value (accretion or
reduction) in the carrying value of the excess cashflow certificates and the
cash distributions we received from such excess cashflow certificates. (See
"-Footnote 4 of the Notes to Consolidated Financial Statements - Excess Cashflow
Certificates, Net")
Prepaid and other assets increased $0.4 million, or 24%, to $2.1 million at
March 31, 2003, from $1.7 million at December 31, 2002. This increase was
primarily attributable to the renewal of insurance policies.
Warehouse financing and other borrowings increased $29.9 million, or 182%, to
$46.3 million at March 31, 2003, from $16.4 at December 31, 2002. This increase
was primarily attributable to a higher amount of mortgage loans held for sale
(mortgage loans held in inventory awaiting either a whole loan sale or
securitization) to be financed under our warehouse credit facilities.
Accounts payable and accrued expense increased $1.2 million, or 10%, to $13.5
million at March 31, 2003 from $12.3 million at December 31, 2002. This increase
was primarily the result of timing of various operating accruals and payables.
Stockholders' equity increased $6.7 million, or 23%, to $36.2 million at
March 31, 2003 from $29.5 million at December 31, 2002. This increase represents
our positive earnings for the period.
LIQUIDITY AND CAPITAL RESOURCES
We require substantial amounts of cash to fund our loan originations,
securitization activities and operations. We have organically increased our
working capital over the last six quarters. In the past, however, we operated
generally on a negative cash flow basis. Embedded in our current cost structure
are many fixed costs, which are not likely to be significantly affected by a
relatively substantial increase in loan originations. If we can continue to
increase our loan production to generate sufficient cash revenues from our
securitizations and sales of such loans to offset our current cost structure and
cash uses, we believe we can continue to generate positive cash flow in 2003.
However, there can be no assurance that we will be successful in this regard. To
do so, we must generate sufficient cash from:
o the premiums we receive from selling NIM and/or interest-only certificates
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 excess cashflow certificates we retain in connection with our
securitizations;
24
o interest income we receive on our loans held for sale prior to
securitization and/or whole loans sales; and
o distributions from the LLC (an unaffiliated entity to us).
There can be no assurance, however, that we will continue generating positive
cash flow in 2003 or at all.
Currently, our primary uses of cash requirements include the funding of:
o interest expense on warehouse lines of credit, the Senior notes and other
financing;
o scheduled principal paydowns on other financing;
o expenses incurred in connection with our securitization program;
o tax payments on excess inclusion income generated from our excess cashflow
certificates; and
o general ongoing administrative and operating expenses, including the cost
to originate loans.
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-only certificates and/or NIM notes
(sold in conjunction with each of our securitizations) to offset our negative
operating cash flow and support our originations, securitizations, and general
operating expenses.
Currently, our primary sources of liquidity, subject to market conditions,
continue to be:
o on-balance sheet warehouse financing and other secured financing
facilities (i.e., capital leasing);
o securitizations of mortgage loans and our corresponding sale of NIM
certificates, (and/or interest-only certificates, depending upon the
securitization structure) and mortgage servicing rights;
o sales of whole loans;
o cash flows from retained excess cashflow certificates;
o distributions from the LLC;
o origination fees, interest income and other cash revenues; 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 and
at March 31, 2003, we had two warehouse facilities for this purpose, both of
which were due to expire in May 2003. We renewed one warehouse facility and
allowed the second warehouse facility to expire, replacing it with a new $200
million warehouse facility from a new creditor. Both $200 million credit
facilities have a variable rate of
25
interest and are due to expire in May 2004. There can be no assurance that we
will be able to either renew or replace these warehouse facilities at their
maturities at terms satisfactory to us or at all.
In addition to our common stock, we currently have the following securities
outstanding:
o Series A preferred stock having an aggregate preference of $13.9 million,
for which we are required to pay 10% annual dividends, payable
semi-annually, commencing in July 2003;
o Ten-year warrants to purchase approximately 1.3 million shares of our
common stock, currently at an exercise price of $0.01 per share; and
o Approximately $10.8 million of senior notes due 2004, paying 9.5% annual
interest, payable semi-annually.
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 March 31, 2003.
We have repurchase agreements with certain of the institutions that have
purchased mortgage loans from us. Currently, some of the agreements provide for
the repurchase by us of any of the mortgage loans that go to foreclosure sale.
At the foreclosure sale, we will repurchase the mortgage, if necessary, and make
the institution whole. The dollar amount of loans that were sold with recourse
and are still outstanding totaled $2.5 million at March 31, 2003 and $2.6
million at December 31, 2002. Included in accounts payable is an allowance for
recourse losses of $1.3 million at March 31, 2003 and $1.2 million at December
31, 2002, 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.
26
INTEREST RATE RISK
Our primary market risk exposure is interest rate risk. Profitability may be
directly affected by the level of, and fluctuation in, interest rates, which
affect our ability to earn a spread between interest received on our loans and
the 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 may, 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 significantly affect net interest income (the excess
cash flows from our excess cashflow certificates) as certain of our asset-backed
securities are priced based on one-month LIBOR, but the collateral that backs
such securities are comprised of mortgage loans with either fixed interest rates
or "hybrid" interest rates - fixed for the initial two or three years of the
mortgage loan, and adjusting thereafter every six months - which creates basis
risk. (See "- Excess Cashflow Certificate, Net")
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 loans
and sell them in the
27
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 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 benchmark
interest rate (i.e., the treasury rate or the interest rate swap with a similar
duration and average life) and the 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, to the extent we hedge, 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 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. These strategies are designated as hedges on
our financial statements and are closed out when we sell the associated loans.
We will review continually the frequency and effectiveness of our hedging
strategy to mitigate risk pending a securitization or loan sale.
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
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 premiums.
We believe our hedging strategy has historically 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.
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 did not hedge during the quarter ended March 31, 2003 nor during the year
ended December 31, 2002, primarily due to the considerable uncertainty in the
United States economy resulting from an overall weakened economy, depressed
stock market, threat of war, among other things, that has caused U.S. interest
rates to remain at or near 40 year historical lows.
28
We will continue to review our hedging strategy in order to best mitigate
risk pending securitization or loan sales.
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 8 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. A forward-looking statement may
contain words such as "anticipate that," "believes," "continue to," "estimates,"
"expects to," "hopes," "intends," "plans," "to be," "will be," "will continue to
be," or similar words. Such statements are subject to the "safe harbor"
provisions of the PSLRA. We caution readers that numerous important factors
discussed below, among others, in some cases have caused, and in the future
could cause our actual results to differ materially from those expressed in any
forward-looking statements made 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 cash uses;
o Our ability or inability to continue our practice of securitizing mortgage
loans held for sale, as well as our ability to utilize optimal
securitization structures (including the sale of NIM and/or interest-only
certificates, and the sale of servicing rights, at the time of
securitization) at terms favorable to us to generate sufficient cash
proceeds to offset our current cost structure;
o Our ability or inability to continue to access lines of credit at
favorable terms and conditions, including without limitation, warehouse
and other credit facilities used to finance newly-originated mortgage
loans held for sale;
o The potential effect that possible conflicts with other sovereign nations
or terrorist acts and/or threats, may have on the capital markets, and in
particular the asset-backed market;
o The effect that the adoption of new, or changes in, federal, state or
local lending laws and regulations and the application of such laws and
regulations may have on our ability to originate loans within a particular
area, or ultimately sell those loans through securitization or on a
whole-loan basis. Many states and local municipalities have adopted and/or
are considering adopting laws that are intended to further regulate our
29
industry. Many of these laws and regulations seek to impose broad
restrictions on certain commonly accepted lending practices, including
some of our practices. In some cases, the restrictions and/or costs and
risks associated with complying with the laws have been so onerous that we
have decided to not lend in a state (I.E., Georgia, before it was amended)
or municipality (I.E., Oakland). In those cases where we continue to do
business, our costs of complying with a variety of potentially
inconsistent federal, state and local laws has increased our compliance
costs, as well as the risk of litigation or administrative action
associated with complying with these proposed and enacted federal, state
and local laws, particularly those aspects of such proposed and enacted
laws that contain subjective (as opposed to objective) requirements, among
other things. In addition, enacted federal, state and local laws could
impact overcollateralization requirements set by the ratings agencies,
which could decrease the cash proceeds we may receive from our
securitizations.
o Costs associated with litigation 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 and/or environmental compliance can lead to loss of
approved status, certain rights of rescission for mortgage loans, class
action lawsuits and administrative enforcement action against us;
o Our ability or inability to continue monetizing our existing excess
cashflow certificates, including without limitation, selling, financing or
securitizing (through NIM transactions) such assets;
o 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;
o The unanticipated expenses of assimilating newly-acquired businesses into
our structure,
30
as well as the impact of unusual expenses from ongoing evaluations of
business strategies, asset valuations, acquisitions, divestitures and
organizational structures; and
o Regulatory actions which may have an adverse impact on our lending.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We originate mortgage loans and then sell the mortgage loans through a
combination of whole loan sales and securitizations. As a result, our primary
market risk is interest rate risk. In turn, interest rates are highly sensitive
to many factors, including:
o governmental monetary and tax policies;
o domestic and international economic and political considerations; and
o other factors beyond our control.
Changes in the general interest rate levels between the time we originate
mortgage loans and the time when we sell such mortgage loans in securitization
transactions can affect the value of our mortgage loans held for sale and,
consequently, our net gain on sale revenue by affecting the "excess spread"
between the interest rate on the mortgage loans and the interest rate paid to
asset-backed investors who purchase pass-through certificates issued by the
securitization trusts. If interest rates rise between the time we originate the
loans and the time we sell the loans in a securitization transaction, the excess
spread generally narrows, resulting in a loss in value of the loans and a lower
net gain on sale for us. Since we close and fund mortgage loans at a specified
interest rate with an expected gain on sale to be booked at the time of their
sale, our exposure to decreases in the fair value of the mortgage loans arises
when moving from a lower to a higher interest rate environment. A higher
interest rate environment results in our having higher cost of funds. This
decreases both the fair value of the mortgage loans, and the net spread we earn
between the mortgage interest rate on each mortgage loan and our cost of funds
under available warehouse lines of credit used to finance the loans prior to
their sale in a securitization transaction. As a result, we may experience a
lower gain on sale.
The following table illustrates the impact on our earnings resulting from a
hypothetical 10 basis point change in interest rates. Historically, such a basis
point increase has resulted in an approximately 10 basis point change in the
excess spread or "yield." The product of 10 basis points in yield (0.10%) and
the duration of 2.5 years equals a 25.0 basis point or 0.25% change in the net
gain on sale as shown below.
10 BASIS POINT DECREASE IN 10 BASIS POINT INCREASE IN
DESCRIPTION INTEREST RATES BASE INTEREST RATES
- -----------------------------------------------------------------------------------------------
Securitization amount $100,000,000 $100,000,000 $100,000,000
Net gain on sale % 5.25% 5.00% 4.75%
Net gain $5,250,000 $5,000,000 $4,750,000
The table below demonstrates the sensitivity, at March 31, 2003, of the
estimated fair value of our excess cashflow certificates caused by an immediate
10% and 20%, respectively, adverse change in the key assumptions we use to
estimate fair value:
31
Fair value of excess Impact to
(Dollars in thousands) cashflow certificates earnings
Fair value as of 03/31/03: $ 25,976
10% increase in prepayment speed 20,659 $5,317
20% increase in prepayment speed 17,583 8,393
10% increase in credit losses 20,057 5,919
20% increase in credit losses 14,459 11,517
10% increase in discount rates 24,346 1,630
20% increase in discount rates 22,910 3,066
10% increase in one- & six-month LIBOR 22,820 3,156
20% increase in one- & six-month LIBOR 19,841 6,135
These sensitivities are hypothetical and are presented for illustrative
purposes only. Changes in the fair value resulting from a change in assumptions
generally cannot be extrapolated because the relationship of the change in
assumption to the resulting change in fair value may not be linear. Each change
in assumptions presented above was calculated independently without changing any
other assumption. However, in reality, changes in one assumption may result in
changes in another assumption, which may magnify or counteract the
sensitivities. For example, a change in market interest rates may simultaneously
impact prepayment speeds, credit losses and the discount rate. It is impossible
to predict how one change in a particular assumption may impact other
assumptions.
To reduce our financial exposure to changes in interest rates, we may hedge
our mortgage loans held for sale through hedging products that are correlated to
the pass-though certificates issued in connection with the securitization of our
mortgage loans (I.E., interest rate swaps) (See "-Hedging"). Changes in interest
rates also could adversely affect our ability to originate loans and/or could
affect the level of loan prepayments thereby impacting the size of the loan
portfolio underlying our excess cashflow certificates and, consequently, the
value of our excess cashflow certificates. (See "-Interest Rate Risk" and
"-Forward -Looking Statements and Risk Factors").
ITEM 4. CONTROLS AND PROCEDURES
During the 90 days prior to the filing date of this report, management,
including the Chief Executive Officer and Chief Financial Officer, evaluated the
effectiveness and operation of the Company's disclosure controls and procedures.
The Company's Chief Executive Officer and Chief Financial Officer concluded that
these disclosure controls and procedures were effective, in all material
respects, to ensure that information required to be disclosed in the reports the
Company files and submits under the Securities and Exchange Act is recorded,
processed, summarized and reported as and when required. There have been no
significant changes in the Company's internal controls or in other factors that
could significantly affect these internal controls following the date that the
Company performed its evaluation. There were no
32
significant deficiencies or material weaknesses identified during the course of
this evaluation and therefore, no corrective actions were taken.
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, including class actions. The current status of
these class 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 Law ss.
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 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. The Court preliminarily approved the
settlement and a fairness hearing was held in May 2002. We are awaiting a
decision from the Court on the fairness hearing. We believe that the Court
will approve the settlement, but if it does not, we believe that we have
meritorious defenses and intend to defend this suit, but
33
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 appealed. The Appellate Court denied our
appeal in December 2001. In or about June 2001, we filed a motion for summary
judgment to dismiss the complaint, which was denied by the Court in October
2001. We appealed that decision, but the appellate court denied our appeal in
November 2002. We filed a motion to reargue in December 2002, which was
denied by the Court in January 2003. Discovery will now continue in the lower
court. We believe that we have meritorious defenses and intend to defend this
suit, but cannot estimate with any certainty our ultimate legal or financial
liability, if any, with respect to the alleged claims.
o In 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 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
reached an agreement in principal with plaintiffs' counsel and our insurer to
settle the action on a class-wide basis in or about August 2002 and executed
a settlement agreement in January 2003 (pursuant to which we denied all
wrongdoing). The Court approved the settlement at a fairness hearing in April
2003, and the settlement will be administered in the coming months.
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
34
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 September 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. In May 2003, the court preliminarily approved the settlement and
scheduled a fairness hearing for July 2003, at which point we anticipate that
the Court will approve the settlement. In the event that 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.
During the three months ended March 31, 2003, approximately 281,240 warrants
(out of the 1.6 million warrants issued in December 2000 in connection our first
exchange offer) were exercised, for an aggregate exercise price of approximately
$2,800. The issuance of these shares was exempt from the registration
requirements of the Securities Act of 1993, as amended, pursuant to Section 4(2)
thereof.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None
ITEM 4. SUBMISSION TO A VOTE OF SECURITY HOLDERS. None
ITEM 5. OTHER INFORMATION. None
ITEM 6. EXHIBITS AND CURRENT REPORTS ON FORM 8-K.
(a) Exhibits:
EXH.
NO. FILED DESCRIPTION
- --- ---- ----------
10.11 * -- Tenth Amendment to Lease Agreement between Delta Funding
Corporation and the Tilles Investment Company, dated April 10, 2003
99.1 * -- Certification pursuant to Section 906 of the Sarbanes-Oxley Act 2002
99.2 * -- Certification pursuant to Section 906 of the Sarbanes-Oxley Act 2002
- ---------------
(*) Filed herewith
(b) Reports on Form 8-K: None
35
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: May 15, 2003
By: /S/ HUGH MILLER
---------------------------------------
Hugh Miller
PRESIDENT & CHIEF EXECUTIVE OFFICER
By: /S/ RICHARD BLASS
---------------------------------------
Richard Blass
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
36
CERTIFICATION
I, Hugh Miller, Chief Executive Officer of Delta Financial Corporation
(the "Company"), certify that:
1. I have reviewed this quarterly report on Form 10-Q of the Company;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the Company as of, and for, the periods presented in this
quarterly report;
4. The Company's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the Company and we
have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) evaluated the effectiveness of the Company's disclosure controls and
procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Company's other certifying officer and I have disclosed, based on our
most recent evaluation, to the Company's auditors and the audit committee
of the Company's board of directors (or persons performing the equivalent
function):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Company's ability to record,
process, summarize and report financial data and have identified for
the Company's auditors any material weaknesses in internal controls;
and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the Company's internal
controls; and
37
6. The Company's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: May 15, 2003
By: /S/ HUGH MILLER
---------------------------
Hugh Miller
CHIEF EXECUTIVE OFFICER
38
CERTIFICATION
I, Richard Blass, Chief Financial Officer of Delta Financial Corporation
(the "Company"), certify that:
1. I have reviewed this quarterly report on Form 10-Q of the Company;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the Company as of, and for, the periods presented in this
quarterly report;
4. The Company's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the Company and we
have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) evaluated the effectiveness of the Company's disclosure controls and
procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Company's other certifying officer and I have disclosed, based on our
most recent evaluation, to the Company's auditors and the audit committee
of the Company's board of directors (or persons performing the equivalent
function):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Company's ability to record,
process, summarize and report financial data and have identified for
the Company's auditors any material weaknesses in internal controls;
and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the Company's internal
controls; and
39
6. The Company's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: May 15, 2003
By: /S/ RICHARD BLASS
---------------------------
Richard Blass
CHIEF FINANCIAL OFFICER
40