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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 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 June 30, 2003, 16,245,589 shares of the Registrant's common stock,
par value $0.01 per share, were outstanding.
INDEX TO FORM 10-Q
Page No.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Consolidated Balance Sheets as of June 30, 2003 and
December 31, 2002................................................. 1
Consolidated Statements of Operations for the Three and Six Months
Ended June 30, 2003 and June 30, 2002............................. 2
Consolidated Statements of Cash Flows for the Six Months Ended
June 30, 2003 and June 30, 2002................................... 3
Notes to Consolidated Financial Statements........................ 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 9
Item 3. Quantitative and Qualitative Disclosures about Market Risk....... 33
Item 4. Controls and Procedures.......................................... 35
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.................................................35
Item 2. Changes in Securities and Use of Proceeds.........................37
Item 3. Defaults upon Senior Securities...................................37
Item 4. Submission of Matters to a Vote of Security Holders...............38
Item 5. Other Information.................................................38
Item 6. Exhibits and Current Reports on Form 8-K..........................38
Signatures.................................................................39
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS (UNAUDITED)
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
(DOLLARS IN THOUSANDS, EXCEPT FOR SHARE DATA) 2003 2002
---------- -----------
ASSETS (UNAUDITED) (AUDITED)
Cash and interest-bearing deposits $ 3,740 3,405
Accounts receivable 2,228 1,700
Loans held for sale, net 71,146 33,984
Excess cash flow certificates, net 28,301 24,565
Equipment, net 2,464 2,553
Prepaid and other assets 3,068 1,737
Deferred tax asset, net 5,600 5,600
-------- --------
Total assets $116,547 73,544
========= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Bank payable $ 498 1,369
Warehouse financing and other borrowings 41,330 16,352
Senior notes 10,844 10,844
Accounts payable and accrued expenses 13,826 12,327
Income taxes payable 2,817 3,155
-------- --------
Total liabilities 69,315 44,047
-------- --------
STOCKHOLDERS' EQUITY:
Preferred stock, Series A, $.01 par value.
Authorized 150,000 shares, 139,156 shares
outstanding at June 30, 2003 and
December 31, 2002 13,916 13,916
Common stock, $.01 par value.
Authorized 49,000,000 shares; 16,362,389
and 16,022,349 shares issued and 16,245,589
and 15,905,549 shares outstanding at June 30,
2003 and December 31, 2002, respectively 164 160
Additional paid-in capital 99,511 99,482
Accumulated deficit (65,041) (82,743)
Treasury stock, at cost (116,800 shares) (1,318) (1,318)
--------- ---------
Total stockholders' equity 47,232 29,497
--------- --------
Total liabilities and stockholders' equity $116,547 73,544
========= ========
See accompanying notes to consolidated financial statements.
1
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
(DOLLARS IN THOUSANDS, EXCEPT PER
SHARE DATA) 2003 2002 2003 2002
------- ------- ------- -------
REVENUES
Net gain on sale of mortgage loans $ 24,351 14,725 42,516 27,063
Interest 3,409 3,225 6,219 7,127
Net origination fees and other income 6,325 3,627 11,896 7,031
------- ------- -------- --------
Total revenues 34,085 21,577 60,631 41,221
------- ------- -------- --------
EXPENSES
Payroll and related costs 13,960 10,099 26,689 19,776
Interest expense 1,396 1,469 2,475 3,016
General and administrative 6,993 5,905 12,766 11,960
------- ------- -------- --------
Total expenses 22,349 17,473 41,930 34,752
-------- ------- -------- --------
Income before income
tax expense 11,736 4,104 18,701 6,469
Provision for income tax expense 35 132 303 252
------- -------- -------- --------
Net income $ 11,701 3,972 18,398 6,217
======== ======== ======== ========
PER SHARE DATA:
Basic -weighted average number of
shares outstanding 16,207,593 15,888,014 16,065,175 15,885,893
========== ========== ========== ==========
Diluted -weighted average number of
shares outstanding 19,137,433 16,941,584 18,952,356 16,855,349
========== ========== ========== ==========
Net income applicable to common shares $ 11,005 3,972 17,702 6,217
========== ======= ======== =======
Basic earnings per share - net income $ 0.68 0.25 1.10 0.39
========== ======= ======== ========
Diluted earnings per share - net income $ 0.58 0.23 0.93 0.37
========== ======= ======== ========
See accompanying notes to consolidated financial statements.
2
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
--------------------------
(DOLLARS IN THOUSANDS) 2003 2002
------ ------
Cash flows from operating activities:
Net income $ 18,398 6,217
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 881 1,810
Deferred origination costs (176) 529
Excess cashflow certificates received in
securitization transactions, net (3,736) (4,000)
Changes in operating assets and liabilities:
Increase in accounts receivable (528) (516)
(Increase) decrease in loans held for sale, net (36,986) 59,460
(Increase) decrease in prepaid and other assets (1,331) 636
Increase (decrease) in warehouse lines of credit 25,649 (64,475)
Increase (decrease) in accounts payable and accrued expenses 1,435 (1,339)
(Decrease) increase in income taxes payable (338) 131
--------- --------
Net cash provided by (used in) operating activities 3,332 (1,106)
--------- --------
Cash flows from investing activities:
Purchase of equipment (792) (184)
--------- --------
Net cash used in investing activities (792) (184)
--------- --------
Cash flows from financing activities:
Decrease in bank payable (871) (457)
Repayments of other borrowings (671) (1,764)
Cash dividends paid on preferred stock (696) --
Proceeds from exercise of warrants 3 --
Proceeds from exercise of stock options 30 9
--------- --------
Net cash used in financing activities (2,205) (2,212)
--------- --------
Net decrease in cash and interest-bearing deposits 335 (3,502)
Cash and interest-bearing deposits at beginning of period 3,405 6,410
-------- --------
Cash and interest-bearing deposits at end of period $ 3,740 2,908
======== ========
Supplemental Information:
Cash paid during the period for:
Interest $ 2,492 2,916
========= ========
Income taxes $ 641 121
========= ========
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, 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 and six-month periods
ended June 30, 2003 are 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 a result, the financial statement impact of stock
option expensing is not known at this time. The following
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table illustrates the effect on net income if the fair-value-based method had
been applied:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -----------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------
Net income, as reported $11,701 3,972 18,398 6,217
==============================================================================================
Deduct total stock-based employee
compensation expense determined
under fair-value-based method for
all awards, net of tax 127 117 235 235
- ----------------------------------------------------------------------------------------------
Pro forma net income $11,574 3,855 18,163 5,982
==============================================================================================
Earnings per share:
Basic - as reported $0.68 0.25 1.10 0.39
Basic - pro forma $0.67 0.24 1.09 0.38
Diluted - as reported $0.58 0.23 0.93 0.37
Diluted - pro forma $0.57 0.23 0.92 0.35
(3) LOANS HELD FOR SALE, NET
Our inventory consists of first and second mortgages, which had a
weighted-average interest rate of 8.06% at June 30, 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 maturities varying
from five to thirty years.
Loans held for sale, net, are summarized as follows:
(DOLLARS IN THOUSANDS) June 30, 2003 December 31, 2002
- --------------------------------------------------------------------------------
Loans held for sale $ 71,156 34,170
Net deferred origination cost 425 249
Valuation allowance (435) (435)
- --------------------------------------------------------------------------------
Loans held for sale, net $ 71,146 33,984
- --------------------------------------------------------------------------------
(4) EXCESS CASHFLOW CERTIFICATES, NET
The activity related to our excess cashflow certificates, net is as follows:
(DOLLARS IN THOUSANDS) June 30, 2003 December 31, 2002
- --------------------------------------------------------------------------------
Balance, beginning of year $ 24,565 16,765
New excess cashflow certificates 5,959 10,499
Cash received from excess cashflow certificates (3,460) (2,588)
Net accretion of excess cashflow certificates 1,237 1,974
Fair value adjustments -- (2,085)
- --------------------------------------------------------------------------------
Balance, end of period $ 28,301 24,565
- --------------------------------------------------------------------------------
In August 2003, we sold three of our excess cashflow certificates to a third
party purchaser
5
for $10.2 million, representing a slight premium to our book value at June 30,
2003. The proceeds of this sale will be used for working capital.
(5) WAREHOUSE FINANCING AND OTHER BORROWINGS
At June 30, 2003 and December 31, 2002, we had two warehouse credit
facilities for a combined amount of $400.0 million. 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
floating interest rates based on one-month London Inter-Bank Offered Rate
("LIBOR") + 1.125%, and are collateralized by specific mortgage loans, which are
equal to or greater than the outstanding balances under the line at any point in
time. Available borrowings under these lines are based on the amount of the
collateral pledged.
The following table summarizes certain information regarding warehouse
financing and other borrowings at the respective dates:
(DOLLARS IN MILLIONS)
BALANCE
Facility ------- Expiration
Facility Description Amount Rate 6/30/03 12/31/02 Date
- -----------------------------------------------------------------------------------------------------------
Warehouse line of credit $200.0 LIBOR + 1.125% $ 39.4 -- May 2004
Warehouse line of credit $200.0 LIBOR + 1.125% -- n/a May 2004
Warehouse line of credit n/a LIBOR + 1.125% n/a 13.8 May 2003
Capital leases n/a 3.76% - 12.50% 1.9 2.6 July 2003 - Jun 2006
- -----------------------------------------------------------------------------------------------------------
Total $ 41.3 16.4
- -----------------------------------------------------------------------------------------------------------
Warehouse agreements require us to comply with various operating and
financial covenants. 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 that we are in compliance with these covenants
as of June 30, 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 available to common
shareholders.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- ------------------
(DOLLARS IN THOUSANDS, EXCEPT EPS DATA) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------
Net income $11,701 3,972 18,398 6,217
Less preferred stock dividends 696 -- 696 --
- --------------------------------------------------------------------------------------------------------------
Net income available to common shareholders 11,005 3,972 17,702 6,217
Basic - weighted-average shares 16,207,593 15,888,014 16,065,175 15,885,893
Basic EPS $0.68 0.25 1.10 0.39
6
Basic - weighted-average shares 16,207,593 15,888,014 16,065,175 15,885,893
Incremental shares-options 2,929,840 1,053,570 2,887,181 969,456
- --------------------------------------------------------------------------------------------------------------
Diluted - weighted-average shares 19,137,433 16,941,584 18,952,356 16,855,349
Diluted EPS $0.58 0.23 0.93 0.37
- --------------------------------------------------------------------------------------------------------------
(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 adjustment. In December
2002, the exercise price for the warrants was adjusted to $0.01 per share in
accordance with the terms of the warrant agreement pursuant to which the
warrants were granted. During the six months ended June 30, 2003, 281,240
warrants were exercised. At June 2003, warrants to purchase 1,287,953 shares of
common stock were outstanding.
(8) PREFERRED STOCK - SERIES A
In August 2001, as part of our second exchange offer, the holders of
approximately $139.2 million (of the initial $150.0 million) principal amount of
our 9 1/2% senior notes due 2003 exchanged their notes for, among other
interests, 139,156 shares of our newly issued Series A preferred stock, having
an aggregate preference amount of $13.9 million.
Holders of the Series A preferred stock are entitled to receive cumulative
preferential dividends at the rate of 10% per annum of the preference amount,
payable in cash semi-annually on the first business date of January and July. On
June 30, 2003, we transferred $695,780 to the transfer agent for the first
dividend payment to the Series A holders on July 1st.
(9) IMPACT OF NEW ACCOUNTING STANDARDS
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150
addresses the accounting for certain financial instruments that, under previous
guidance, issuers could account for as equity. The statement requires that those
instruments be classified as liabilities in statements of financial position.
SFAS No. 150 is effective for all financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003. Management does not expect
that the provisions of SFAS No. 150 will impact our results of operations or
financial condition.
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 entered into 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
In January 2003, the FASB issued Interpretation No. 46 ("FIN No. 46"),
"Consolidation of Variable Interest Entities," which is an interpretation of ARB
No. 51. This Interpretation addresses consolidation by business enterprises of
variable interest entities. The Interpretation applies immediately to variable
interest entities created after January 31, 2003, and to variable interest
entities in which an enterprise obtains an interest after that date. It applies
in the first fiscal year or interim period beginning after June 15, 2003, to
various interest entities in which an enterprise holds a variable interest that
it acquired before February 1, 2003. Management does not expect that the
provisions of FIN No. 46 will impact our results of operations or financial
condition.
8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATED
FINANCIAL STATEMENTS AND NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INCLUDED IN
OUR FORM 10-K FOR OUR YEAR ENDED DECEMBER 31, 2003. SEE "-FORWARD LOOKING
STATEMENTS AND RISK FACTORS" BELOW.
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. The future excess cash flows generally consists of:
o The positive difference between the interest paid on the underlying
mortgage loans and the interest paid on bonds issued in the
securitization (which, when we sell net interest margin ("NIM") notes, is
only received after the NIM notes are paid in full);
o In our 2003 securitizations, prepayment penalties received from borrowers
who payoff their loans generally within the first few years of their
lives (which, when we sell NIM notes, is only received after the NIM
notes are paid in full ); and
o Additional mortgage loans pledged as collateral in excess of the
principal amount of bonds issued and outstanding; the
"overcollateralization" is designed to provide additional assurance that
the securities sold in the securitization will be paid according to their
terms (and which we describe in greater detail under "-Securitizations").
The excess cash flows we receive are highly dependent upon the interest rate
environment, because "basis risk" exists between the securitization trust's
assets and liabilities. For example, in each of the securitizations that we
issued since 2002, the cost of financing for the securitized loans is indexed
against one-month LIBOR, meaning that each month, the interest rate received by
the pass-through certificate holders may adjust upwards or downwards as
one-month LIBOR changes (liability), while the majority of the underlying
mortgage loans in the securitization trust have a fixed note rate for at least
three years (asset). As a result, as rates rise and fall, the amount of our
excess cash flows will fall and rise, respectively, 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.
The accounting estimates related to the valuation of our excess cashflow
certificates is a "critical accounting estimate" because it can materially
affect our net income. The valuation of our excess cashflow certificates
requires us to forecast interest rates, mortgage principal payments, prepayments
and loan loss assumptions, each of which is highly uncertain and requires 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 to value future expected excess cash flows. We believe that the
value of our excess cashflow certificates is fair, but can provide no assurance
that future prepayment and loss experience, changes in LIBOR or changes in their
required market discount rate will not require write-downs of our excess
cashflow certificate asset. We have written down the value of our excess
cashflow certificates in the past. Write-
9
downs would reduce our income in future periods.
GENERAL
Delta Financial Corporation (together with its subsidiaries, "Delta, 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 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 complies 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 exceeds 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 a network of approximately 1,500 brokers.
The broker's role is to source the business, identify the applicant, assist in
completing the loan application, and to process the loans, which include the
gathering necessary information and documents and serving 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 that we impose 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
maintain contact with borrowers - for which they charge a broker fee that is
commensurate with their services - originating loans through our broker network
is designed to allow us to increase our loan volume without incurring the higher
marketing and employee costs associated with increased retail originations.
RETAIL LOAN CHANNEL. Through our retail distribution channel, we develop
retail loan leads ("retail loans") primarily through our telemarketing system
and our network of eight retail offices and four origination centers located in
nine states. Our origination centers are typically staffed with considerably
more loan officers and cover a broader area than our retail offices. We
10
continually monitor the performance of our retail operations and evaluate
current and potential retail office locations on the basis of selected
demographic statistics, marketing analyses and other criteria developed by us.
In July 2003, we opened our eighth retail office in Kansas City, Kansas.
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 June 30, 2003, we originated $348 million of
loans, an increase of 66% over the $210 million of loans originated in the
comparable period in 2002. Of these amounts, approximately $195 million were
wholesale loans and $153 million were retail loans, compared to $141 million and
$69 million, respectively, during the three months ended June 30, 2002. Loan
production in the second quarter of 2003 increased 8% from $323 million of
mortgage loan originations in the first quarter of 2003. Our first quarter 2003
loan production consisted of $175 million of wholesale loans and $148 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 though a warehouse line of credit
for only a limited time - generally, not more than three months -long enough so
we can pool enough loans to sell them either through a securitization or as
whole-loans. 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 substantial 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 loans than we do when we sell whole loans. We apply the
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.
11
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 our securitizations and on a whole loan basis during the quarter ended
June 30, 2003, (dollars in thousands):
AMOUNT PERCENTAGE
------------------------
Loan securitizations $ 334,865 97%
Whole loan sales 9,116 3%
------------------------
Total securitizations and loans sold $ 343,981 100%
========================
SECURITIZATION. When we securitize loans, we create securitization 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 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 connection 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. These securities are known as asset-backed
pass-through securities, and they 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. 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:
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;
12
o third, to build or maintain the overcollateralization provision described
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 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
use 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, such as 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.
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. In 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"
13
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, in which we sold a
net interest margin certificate, or NIM, in lieu of selling an interest-only
certificate in each of our 2002 securitizations, and in addition to
interest-only certificate in each of our 2003 securitizations. The NIM is
generally structured where we sell the excess cashflow certificate and P
certificate to a QSPE or owner trust. This owner trust is referred to as a "NIM
trust." 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), together with an
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. The NIM 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 a 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 second 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 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
14
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 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
that we 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, including
prepayment penalties for certain securitization servicing rights we
previously sold, in such capacity.
At the time we completed the second 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.
The gain on sale we recorded and cash we received from our second quarter
2003 and 2002 securitizations is summarized below. "Loans Sold" is the principal
amount of loans actually transferred to the securitization trusts during the
period.
GAIN ON SALE 2003 2002
------------ ---- ----
Loans Sold (in thousands) $334,865 $200,000
NIM Proceeds, Net of Up Front Overcollateralization 5.61 % 5.15 %
Interest-Only Certificate Proceeds 0.51 % -
Excess Cashflow Certificate (owner trust certificate) 1.00 % 1.29 %
Mortgage Servicing Rights 0.56 % 0.89 %
Less: Transaction Costs (0.53)% (0.78)%
------- -------
Net Gain on Sale Recorded 7.15 % 6.55 %
======= =======
CASH RECEIVED
-------------
NIM Proceeds, Net of Up Front Overcollateralization 5.61 % 5.15 %
Interest-Only Certificate Proceeds 0.51 % -
Mortgage Servicing Rights 0.56 % 0.89 %
Less: Transaction Costs (0.53)% (0.78)%
------- -------
Cash at Closing 6.15 % 5.26 %
======= =======
Our net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate the loans,
adjusted for the following:
o any direct loan origination costs incurred (an increase in the
investment) and loan origination fees received (a decrease in the
investment) in connection with the loans, which are treated as a
component of the initial investment in loans;
o the principal payments received, and the amortization of the net loan
fees or costs, during the period we held the loans prior to their
securitization; and
15
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 helps ensure 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 at the time of sale under net gain on sale of
mortgage loans. The cash premiums ranged between 5.0% to 5.6% (prior to reserve)
of the principal amount of mortgage loans sold in the second quarter of 2003.
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 borrower less the financing costs we pay to our
warehouse lender to fund our loans);
o net loan origination fees on wholesale loans and retail loans;
o retained excess cashflow certificates;
o distributions from 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. We did not receive the quarterly
distribution of $142,000 due on or about June 30, 2003, which has led us
to commence a lawsuit to recover all amounts due to us. (See "Part II,
Item 1-Litigation" for a description of this matter); and
o miscellaneous interest income, including prepayment penalties received on
certain of the loans we sold in securitizations prior to 2002.
16
EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the present
value of the related excess cashflow certificates (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
one-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 six-month variable rate of interest
thereafter using the six-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 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 the mortgage pools we previously
securitized, and the performance of
17
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; and
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 funds; and
o a default by the borrower, resulting in foreclosure by the lender.
It is unusual for a borrower to prepay a mortgage loan during the first
few months because of the following:
o it typically takes at least several months after the mortgage loans
are originated for any of the above events to occur;
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our current prepayment assumptions for the
month one and peak speed. The assumptions have not changed since
September 2001.
18
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 at a slower rate than anticipated, we earn more
income and more excess cash flow in the future.
(b) DEFAULT RATE. At June 30, 2003 and 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 one-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
six-month variable rate of interest thereafter using the six-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, such as one-month LIBOR. As such, our excess cashflow
certificates are subject to significant basis risk and a change in LIBOR
will, 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. Because quoted market
prices on comparable excess cashflow certificates are not available, we
compare our valuation assumptions and performance experience to our
competitors in the non-conforming mortgage industry. Our discount rate
takes into account the asset quality and the performance of our
securitized mortgage loans compared to that of the industry and other
characteristics of our securitized loans. We quantify the risks
associated with our excess cashflow certificates by comparing the asset
quality and payment and loss performance experience of the underlying
securitized mortgage pools to comparable industry performance. 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 conditions in the equity markets.
19
We utilized a discount rate of 15% at June 30, 2003 and 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 longer the time period over which the uncertainty
will exist, the greater the potential volatility for our valuation assumptions.
For example, assumptions regarding prepayment speeds, defaults and LIBOR
rates are used in estimating fair values of our excess cashflow certificates. If
loans prepay faster than estimated, or loan loss levels are higher than
anticipated, or LIBOR is higher than anticipated, we may be required to write
down the value of such certificates. While we believe that our assumptions are
reasonable estimates using our historical loan performance and the performance
of similar mortgage pools from other lenders - in addition to accessing other
public information about market factors such as interest rates, inflation,
recession, unemployment and real estate market values, among other things -
these are just estimates and it is virtually impossible to predict the actual
level of prepayments and losses, which are also driven by consumer behavior.
DEFERRED TAX ASSET
As of June 30, 2003, we carried a net deferred tax asset 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 June 30, 2003, we have a gross deferred tax asset of $42.8 million and
a valuation allowance of $37.2 million. We established this valuation allowance
in 2001, during the second of two successive years of posting significant losses
(2000 and 2001), and the modest amount of earnings we had projected at that time
that we would earn over the ensuing several quarters. We believe that it was
appropriate to establish this valuation allowance in accordance with generally
accepted accounting principles ("GAAP.") Since then, we have now posted seven
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:
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
20
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 June 30, 2003, Federal and State NOLs totaled $81.0 million, expiring
in 2021.
Our deferred tax asset of $42.8 million consists primarily of NOLs, net of
tax, of $32.4 million, and the excess of the tax basis over book basis on our
excess cashflow certificates, net of tax, of $8.3 million.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO THE THREE MONTHS ENDED JUNE 30,
2002
GENERAL
Our net income for the three months ended June 30, 2003 was $11.7 million,
or $0.68 per share basic and $0.58 per share diluted, compared to $4.0 million,
or $0.25 per share basic and $0.23 per share diluted, for the three months ended
June 30, 2002.
REVENUES
Total revenues increased $12.5 million, to $34.1 million for the three
months ended June 30, 2003, from $21.6 million for the comparable period in
2002. The increase in revenue was primarily attributable to (1) us selling a
higher number of mortgage loans due to a larger amount of mortgage loans
originated during the period ended June 30, 2003, compared to the same period in
2002 (and the consequent increase in net gain on sale of mortgage loans and net
origination fees and other income), and (2) an increase to our gain on sale of
approximately 83 basis points for the quarter ended June 30, 2003 primarily due
to more favorable securitization market conditions, compared to the same period
one year ago.
We originated $348.2 million of mortgage loans for the three months ended
June 30, 2003, representing a 66% increase from $210.1 million of mortgage loans
originated for the comparable period in 2002. We securitized and sold $344.0
million of loans during the three months ended June 30, 2003 - securitized
$334.9 million of mortgage loans and sold $9.1 million of mortgage loans on a
servicing-released basis - compared to $235.4 million of loans during the same
period in 2002 - $200.0 million of mortgage loans securitized and $35.4 million
of mortgage loans sold on a servicing-released basis.
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
the 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;
(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,
21
(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 $9.7 million, or 66%, to $24.4
million for the three months ended June 30, 2003, from $14.7 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 second quarter of 2002 and
an increase in our weighted average net gain on sale ratio to 7.08% for the
three months ended June 30, 2003 from 6.25% for the comparable period in 2002,
due to more favorable securitization market conditions, leading to a higher net
interest margin (which is the spread between the average mortgage rate on the
pool of mortgage loans securitized, minus the cost of funds and related expenses
on our securitized loans). 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. 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 (up
or down) 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 increased $0.2 million, or 6%, to $3.4 million for the three
months ended June 30, 2003, from $3.2 million for the comparable period in 2002.
The increase in interest income is due to the higher average loan balance on the
loans we originated; offset by the lower weighted-average interest rate on loans
held for sale in the second quarter of 2003, compared to the same period in
2002. In addition, interest income increased due to higher excess cash flows
that we received; partially offset by lower prepayment penalties received in the
second quarter of 2003, compared to the same period in 2002.
NET ORIGINATION FEES AND OTHER INCOME. Origination fees represent the sum
of:
(1) fees earned on broker and retail originated loans,
(2) distributions from the LLC, and
(3) other miscellaneous income, if any,
less premiums paid to originate mortgage loans.
Net origination fees and other income increased $2.7 million, or 75%, to
$6.3 million for the three months ended June 30, 2003, from $3.6 million for the
comparable period in 2002. The increase was primarily the result of higher
mortgage loan production, and consequently higher fees (associated with the
higher loan production) during the second quarter of 2003, compared to the same
period in 2002.
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EXPENSES
Total expenses increased by $4.8 million, or 27%, to $22.3 million for the
three months ended June 30, 2003, from $17.5 million for the comparable period
in 2002. The increase was primarily related to higher payroll and related costs
required to support the significant 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 $3.9 million, or 39%, to $14.0
million for the three months ended June 30, 2003, from $10.1 million for the
comparable period in 2002. The increase was primarily the result of higher
commissions paid and our higher number of employees, related to the increase in
our loan production. As of June 30, 2003, we employed 790 full- and part-time
employees, compared to 594 full- and part-time employees as of June 30, 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 $0.1 million, or 7%, to $1.4 million for the
three months ended June 30, 2003 from $1.5 million for the comparable period in
2002. The decrease was primarily due to lower warehouse financing costs arising
from our 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 second quarter 2003, compared to an average of 1.8% for
the second quarter 2002.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
consist primarily of office rent, insurance, telephone, depreciation, legal
reserves and fees, license fees, accounting fees, travel and entertainment
expenses, advertising and promotional expenses and the provision for loan losses
on the inventory of loans held for sale and recourse loans.
General and administrative expenses increased by $1.1 million, or 19%, to
$7.0 million for the three months ended June 30, 2003 from $5.9 million for the
comparable period in 2002. The increase was primarily due to an increase in
expenses associated with higher loan production and ongoing expansion of our
retail division. This was partially offset by lower depreciation expenses
resulting from fully depreciated assets.
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 approximately $35,000 and $132,000, primarily
related to excess inclusion income generated by our excess cashflow
certificates, for the three months ended June 30, 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.
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In the future, we expect to continue to incur a modest amount of excess
inclusion income, which we will be unable to offset with our NOL's.
SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2002
GENERAL
Our net income for the six months ended June 30, 2003 was $18.4 million, or
$1.10 per share basic and $0.93 per share diluted, compared to $6.2 million, or
$0.39 per share basic and $0.37 per share diluted for the six months ended June
30, 2002.
REVENUES
Total revenues increased $19.4 million, to $60.6 million for the six months
ended June 30, 2003, from $41.2 million for the comparable period in 2002. The
increase in revenue was primarily attributable to (1) us selling a higher number
of mortgage loans due to a larger amount of mortgage loans originated during the
six months ended June 30, 2003, compared to the same period in 2002 (and the
consequent increase in net gain on sale of mortgage loans and net origination
fees and other income), and (2) an increase in our gain on sale of approximately
85 basis points for the six months ended June 30, 2003 primarily due to more
favorable securitization market conditions, compared to the same period one year
ago.
We originated $671.6 million of mortgage loans for the six months ended June
30, 2003, representing a 68% increase from $400.1 million of mortgage loans
originated for the comparable period in 2002. We securitized and sold $617.2
million of loans during the six months ended June 30, 2003 - securitized $595.9
million of mortgage loans and sold $21.3 million of mortgage loans on a
servicing-released basis - compared to $449.1 million of loans during the same
period in 2002 - securitized $375.0 million of mortgage loans and sold $74.1
million of mortgage loans on a servicing-released basis.
Net gain on sale of mortgage loans increased $15.4 million, or 57%, to $42.5
million for the six months ended June 30, 2003, from $27.1 million for the
comparable period in 2002. This increase was primarily due to (1) an increase in
the amount of loans securitized and sold compared to the six months ended June
30, 2002, and (2) an increase in our weighted-average net gain on sale ratio for
the six months ended June 30, 2003, and for the comparable period in 2002, of
6.88% and 6.03%, respectively, due to more favorable securitization market
conditions leading to a higher net interest margin.
Interest income decreased $0.9 million, or 13%, to $6.2 million for the six
months ended June 30, 2003, from $7.1 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
these loans) during the six months ended June 30, 2003 compared to the same
period in 2002 - 8.40% and 9.73%, respectively. In addition, we had lower
prepayment penalties received in the six months ended June 30, 2003 compared to
the same period in 2002. We also recorded a charge to interest income to reflect
a fair value adjustment to our excess cashflow certificates totaling $2.1
million during the six months ended June 30, 2002.
Net origination fees and other income increased $4.9 million, or 70%, to
$11.9 million for the six months ended June 30, 2003, from $7.0 million for the
comparable period in 2002. The increase was primarily the result of higher
mortgage loan production, and consequently higher
24
fees earned (associated with the higher loan production) during the six months
ended June 30, 2003, compared to the same period in 2002.
EXPENSES
Total expenses increased by $7.1 million, or 20%, to $41.9 million for the
six months ended June 30, 2003, from $34.8 million for the comparable period in
2002. The increase was primarily related to higher payroll and related costs
required to support the significant increase in our mortgage loan production.
Payroll and related costs increased by $6.9 million, or 35%, to $26.7 million
for the six months ended June 30, 2003, from $19.8 million for the comparable
period in 2002. The increase was primarily the result of higher commissions paid
and our higher number of employees, related to the increase in our loan
production.
Interest expense decreased by $0.5 million, or 17%, to $2.5 million for the
six months ended June 30, 2003 from $3.0 million for the comparable period in
2002. The decrease was primarily due to lower warehouse financing costs arising
from our 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 six months ended June 30, 2003, compared to an average
of 1.8% for the same period in 2002.
General and administrative expenses increased by $0.8 million, or 7%, to
$12.8 million for the six months ended June 30, 2003 from $12.0 million for the
comparable period in 2002. The increase was primarily due to an increase in
expenses associated with higher loan production and ongoing expansion of our
retail division. This was partially offset by lower depreciation expenses
resulting from fully depreciated assets.
We recorded a tax provision of $0.3 million, primarily related to excess
inclusion income generated by our excess cashflow certificates, for the six
months ended June 30, 2003 and 2002.
FINANCIAL CONDITION
JUNE 30, 2003 COMPARED TO DECEMBER 31, 2002
Accounts receivable increased $0.5 million, or 29%, to $2.2 million at June
30, 2003, from $1.7 million at December 31, 2002. The increase is primarily due
to the timing of interest on mortgage loans collected by our loan servicing
provider, which is paid to us in the following period.
Loans held for sale, net increased $37.1 million, or 109%, to $71.1 million
at June 30, 2003, from $34.0 million at December 31, 2002. This asset represents
mortgage loans held in inventory that we plan to sell in 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 six months ended June
30, 2003.
Excess cashflow certificates, net increased $3.7 million, or 15%, to $28.3
million at June 30, 2003, from $24.6 million at December 31, 2002. This increase
was primarily due to new excess cashflow certificates, totaling $6.0 million,
from loans securitized during 2003, partially offset by the change in fair value
of such excess cashflow certificates. Changes in fair value incorporate any
change in value (accretion or reduction) in the carrying value of the excess
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cashflow certificates and the cash distributions we received from such excess
cashflow certificates. (See "-Footnote 4 to the Notes to Consolidated Financial
Statements - Excess Cashflow Certificates, Net").
Prepaid and other assets increased $1.4 million, or 82%, to $3.1 million at
June 30, 2003, from $1.7 million at December 31, 2002. This increase was
primarily due to prepaid expenses associated with the pre-funding feature in our
second quarter 2003 securitization transaction.
Bank payable decreased $0.9 million, or 64%, to $0.5 million at June 30,
2003, from $1.4 million at December 31, 2002. This account represents the
outstanding balance of checks issued that have not been presented to the bank
for payment by individual payees.
Warehouse financing and other borrowings increased $24.9 million, or 152%, to
$41.3 million at June 30, 2003, from $16.4 million at December 31, 2002. This
increase was primarily attributable to a higher amount of mortgage loans held
for sale (mortgage loans held in inventory that we plan to sell in a whole loan
sale or securitization) financed under our warehouse credit facilities.
Accounts payable and accrued expense increased $1.5 million, or 12%, to $13.8
million at June 30, 2003 from $12.3 million at December 31, 2002. This increase
was primarily the result of the timing of various operating accruals and
payables.
Stockholders' equity increased $17.7 million, or 60%, to $47.2 million at
June 30, 2003 from $29.5 million at December 31, 2002. This increase is
primarily due to our positive earnings for the six-month 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 seven 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
originate a sufficient amount of mortgage loans and generate sufficient cash
revenues from our securitizations and sales of these 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
in connection with our securitizations;
o the premiums we receive from selling our 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;
o interest income we receive on our loans held for sale prior to
securitization and/or whole loans sales; and
26
o distributions from the LLC.
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 general ongoing administrative and operating expenses, including the cost
to originate loans;
o tax payments on excess inclusion income generated from our excess cashflow
certificates; and
o preferred stock dividends.
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
and mortgage servicing rights 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, such as 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.
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 June 30, 2003, we had two warehouse facilities for this purpose. Both credit
facilities have a variable rate of 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.
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.
In addition to our common stock, we currently have the following securities
outstanding:
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o Series A preferred stock having an aggregate preference of $13.9
million, for which we are required to pay a 10% annual dividend, 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.
Our warehouse agreements require us to comply with various operating and
financial covenants. 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 these covenants as of June 30, 2003.
We have repurchase agreements with certain 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 $2.1 million at June 30, 2003 and $2.6 million
at December 31, 2002. Included in accounts payable is an allowance for recourse
losses of $1.2 million at June 30, 2003 and December 31, 2002, respectively.
In August 2003, we sold three of our excess cashflow certificates to a third
party purchaser for $10.2 million, representing a slight premium to our book
value at June 30, 2003. The proceeds of this sale will be used for working
capital.
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. From July through August 2003, we repurchased in
the open market approximately $85,000 principal amount of our 9 1/2% senior
notes due 2004 at a discount to its face value. As a result, we will recognize a
gain on the extinguishment of this debt in the third quarter of 2003. There is
no assurance that we will effectuate any further repurchases of this debt 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 at least the next 12 months.
INTEREST RATE RISK
Our primary market risk exposure is interest rate risk. Our results of
operations may be significantly 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, including the cost of
interest rate caps, if any, that are tied to various interest rate swap
maturities, LIBOR, and other interest rate spread products, such as mortgage,
auto and credit card backed receivable certificates. 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
28
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
sale 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 the excess cash flows from our
excess cashflow certificates, as the interest rate on certain of our
asset-backed securities change monthly 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 their 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 whole loan sales and
securitizations. Between the time we originate the mortgage loans and sell them
in the secondary market, we may hedge the risk of fluctuations in interest
rates. Our risk begins subsequent to originating mortgage loans and prior to
selling or securitizing such mortgage loans. Since we have a closed (and funded)
mortgage loan at a specified interest rate with an expected gain at 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.
29
The cost of funds is generally composed of two components - the benchmark
interest rate, such as the LIBOR 1 month index or the interest rate swap with a
similar duration and average life, and the spread or profit margin required by
the investors. In the past, we had 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 Eurodollar interest rate swaps or Eurodollar interest rate caps and, to the
extent we hedge, we will likely use interest rate swaps or interest rate caps to
hedge our mortgage loans in inventory pending securitization pricing. While none
of the above are perfect hedges, we believe these hedging instruments will
demonstrate the highest correlation to our cost of funds in the future.
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 six month period ended June 30, 2003, or during
the year ended December 31, 2002, primarily due to the considerable uncertainty
in the United States economy resulting from an overall weakened economy, the
depressed stock market, uncertainties in the Middle East, among other things,
that have caused U.S. interest rates to remain at or near 40 year historical
lows.
By not hedging, we are more susceptible to interest rate fluctuations between
the time we originate mortgage loans and the time we sell such loans:
o If interest rates decrease between the time we originate our mortgage
loans and the time we sell them, our earnings and cash proceeds may be
higher at the time of sale;
30
o Alternatively, if interest rates increase between the time we originate
our mortgage loans and the time we sell them, our earnings and cash
proceeds may be lower at the time of sale;
o If interest rates are unchanged, our earnings may not be significantly
affected.
We will continue to review our hedging strategy in order to attempt to
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 9 of the 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 (the "PSLRA") of 1995, which involve risk and
uncertainties that exist in our operations and business environment, and are
subject to change on a variety of 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 herein. The following include
some, but not all, of the factors or uncertainties that could cause our actual
results to differ from our projections:
o Our ability or inability to earn a sufficient spread between our cost of
funds and our average mortgage rates to generate sufficient revenues and
cash flows to offset our current cost structure and cash uses;
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 Our ability or inability to originate a sufficient amount of mortgage
loans, 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
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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,
including the conflict in Iraq, 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 amendments 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 to 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
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 make
mortgage loans, 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. Moreover, regulations adopted by the Office of Thrift
Supervision recently became effective that eliminated the ability of
state-chartered financial institutions and bankers to charge prepayment
penalties on alternative mortgages under the Federal Alternative Mortgage
Transactions Parity Act, while federally-regulated entities still enjoy
that right, providing a competitive disadvantage for state-chartered
entities, such as Delta, in certain states with respect to alternative
mortgages;
o The effect that the FTC's Do Not Call Registry may have on our ability to
utilize telemarketing to generate retail leads and originate retail loans,
and our ability or inability to find alternative methods of generating
retail leads and originating retail loans;
o Costs associated with litigation and rapid or unforeseen escalation of the
cost of regulatory compliance, generally including but not limited to, the
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, the 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 the 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,
32
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 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 the development of new product
programs;
o The unanticipated expenses of assimilating newly-acquired businesses into
our structure, as well as the impact of unusual expenses from ongoing
evaluations of business strategies, asset valuations, acquisitions,
divestitures and organizational structures; 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 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 the mortgage loans in securitization
transactions or whole loan sales can affect their value 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 on the 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.
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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 June 30, 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:
FAIR VALUE OF EXCESS IMPACT TO
(Dollars in thousands) CASHFLOW CERTIFICATES EARNINGS
--------------------- --------
Fair value as of 06/30/03: $ 28,301
10% increase in prepayment speed 22,859 $5,442
20% increase in prepayment speed 19,758 8,543
10% increase in credit losses 22,235 6,066
20% increase in credit losses 16,104 12,197
10% increase in discount rates 26,597 1,704
20% increase in discount rates 25,097 3,204
10% increase in one- & six-month LIBOR 24,635 3,666
20% increase in one- & six-month LIBOR 21,283 7,018
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
34
"-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
At June 30, 2003 management, including the Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness and operation of our disclosure
controls and procedures. Our Chief Executive Officer and Chief Financial Officer
concluded that, as of June 30, 2003, these disclosure controls and procedures
were effective, in all material respects, to ensure that information required to
be disclosed in the reports we file and submit under the Securities and Exchange
Act is recorded, processed, summarized and reported as and when required. There
have been no significant changes in our internal controls or in other factors
that could significantly affect these internal controls following the date that
we performed our evaluation. There were no 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 and other litigation 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 three 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
35
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 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
36
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 principle 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
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 granted by the Court in June 2001.
In August 2001, plaintiffs appealed the decision. In September 2002, we
executed a settlement agreement with plaintiffs in which we denied all
wrongdoing, but agreed to resolve the litigation on a class-wide basis. The
Court approved the settlement at a fairness hearing in July 2003, and the
settlement will be administered in the coming months.
o In July 2003, we commenced a lawsuit in the Supreme Court of the State of
New York, Nassau County, against the LLC, Delta Funding Residual Management,
Inc. ("DFRM"), and James E. Morrison (President of the LLC and DFRM),
alleging that (1) the LLC breached its contractual duties by failing to pay
approximately $142,000 due to us in June 2003, and (2) that Mr. Morrison and
DFRM knowingly and intentionally caused the default, thereby breaching their
respective fiduciary duties to the LLC. The complaint seeks (a) payment of
amounts past due under our agreement with the LLC, plus interest; (b)
specific performance of the LLC's obligations to us in the future; and (c)
monetary damages for breach of fiduciary duty, in an amount to be determined
by the Court. Although the defendants have not answered the complaint, in
correspondence prior to the commencement of the lawsuit they claimed our
restatement of the value of certain assets in 2001 raised questions, and
created a conflict of interest, or an apparent conflict of interest under our
August 2001 management agreement with the LLC and DFRM. The letter, signed by
Mr. Morrison, also advised that the LLC would not make further contractually
required payments to us unless and until these matters are resolved. We
responded that their claims are baseless and lack merit, and that we will
prosecute our claims vigorously. The defendants have until September 19, 2003
to answer.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None
37
ITEM 4. SUBMISSION TO A VOTE OF SECURITY HOLDERS.
Our annual meeting of stockholders was held on May 13, 2003. At the meeting,
Richard Blass and Arnold B. Pollard were elected as Class I Directors for a term
of three years. Sidney A. Miller, Martin D. Payson, Hugh Miller and Margaret A.
Williams continue to serve as members of the Board of Directors.
o Votes cast in favor of Mr. Blass's selection totaled 13,238,587, while
23,080 votes were withheld.
o Votes cast in favor of Mr. Pollard's selection totaled 13,238,587, while
23,080 votes were withheld.
The stockholders also voted to ratify the appointment of KPMG LLP as our
independent auditors for the fiscal year ending December 31, 2003. Votes cast in
favor of this ratification were 13,256,102, while votes cast against were 4,300
and abstentions totaled 1,265.
ITEM 5. OTHER INFORMATION. None
ITEM 6. EXHIBITS AND CURRENT REPORTS ON FORM 8-K.
(a) Exhibits:
EXH.
NO. DESCRIPTION
--- ----------
10.4 -- Employment Agreement dated August 13, 2003 between the Registrant and
Randall F. Michaels
31.1 -- Certification pursuant to Section 302 of the Sarbanes-Oxley Act 2002
31.2 -- Certification pursuant to Section 302 of the Sarbanes-Oxley Act 2002
32.1 -- Certification pursuant to Section 906 of the Sarbanes-Oxley Act 2002
32.2 -- Certification pursuant to Section 906 of the Sarbanes-Oxley Act 2002
(b) Reports on Form 8-K:
On May 1, 2003, we filed a Form 8-K containing our April 30, 2003 earnings
press release.
38
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, as
amended, the Registrant has duly caused this Report on Form 10-Q to be signed on
its behalf by the undersigned, thereunto duly authorized.
DELTA FINANCIAL CORPORATION
(Registrant)
Dated: August 13, 2003
By: /S/ HUGH MILLER
-------------------------------------
Hugh Miller
PRESIDENT AND CHIEF EXECUTIVE OFFICER
By: /S/ RICHARD BLASS
-------------------------------------
Richard Blass
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
39