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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
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FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
COMMISSION FILE NO. 1-12109
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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 PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:(516) 364-8500
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE NEW YORK STOCK EXCHANGE
(TITLE OF EACH CLASS) (NAME OF EACH EXCHANGE ON WHICH REGISTERED)
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]
As of March 4, 1999, the aggregate market value of the voting stock held by
non-affiliates of the Registrant, based on the closing price of $5.50, was
approximately $27,101,322.
As of March 31, 1999, the Registrant had 15,358,749 shares of Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III, Items 10, 11, 12 and 13 are incorporated by reference from Delta
Financial Corporation's definitive proxy statement to stockholders which will be
filed with the Securities and Exchange Commission no later than 120 days after
December 31, 1998.
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PART I
ITEM 1. BUSINESS
BUSINESS OVERVIEW
Delta Financial Corporation (the "Company" or "Delta") is a Delaware
corporation which was organized in August 1996. On October 31, 1996, in
connection with its initial public offering, the Company acquired all of the
outstanding common stock of Delta Funding Corporation ("Delta Funding"), a New
York corporation which had been organized on January 8, 1982 to originate, sell,
service and invest in residential first and second mortgages. On November 1,
1996, the Company completed an initial public offering of 4,600,000 shares of
common stock, par value $.01 per share.
Delta Financial Corporation, together with its subsidiaries, is a consumer
finance company that has engaged in originating, acquiring, selling and
servicing non-conforming home equity loans since 1982. Throughout its 17 years
of operating history, Delta has focused on lending to individuals who generally
have impaired or limited credit profiles or higher debt-to-income ratios.
Management believes that these borrowers have largely been unsatisfied by the
more traditional sources of mortgage credit, which underwrite loans to
conventional guidelines established by the Federal National Mortgage
Associations ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
The Company makes loans to these borrowers for such purposes as debt
consolidation, home improvement, mortgage refinancing or education, and these
loans are primarily secured by first mortgages on one- to four-family
residential properties.
Through its wholly-owned subsidiary, Delta Funding, the Company originates
home equity loans indirectly through licensed mortgage brokers and other real
estate professionals who submit loan applications on behalf of borrowers
("Brokered Loans") and also purchases loans from mortgage bankers and smaller
financial institutions that satisfy Delta's underwriting guidelines
("Correspondent Loans"). Delta Funding Corporation currently originates and
purchases the majority of its loans in 24 states, through its network of
approximately 1,400 brokers and correspondents.
In February 1997, to broaden its origination sources and to expand its
geographic presence, the Company acquired two related retail originators of home
equity loans, Fidelity Mortgage Inc., based in Cincinnati, Ohio, and Fidelity
Mortgage (Florida), Inc., based in West Palm Beach, Florida, and subsequently
merged the two companies into Fidelity Mortgage Inc. ("Fidelity Mortgage").
Fidelity Mortgage develops retail loan leads primarily through its telemarketing
system and its network of 15 retail offices located in Florida (3), Georgia,
Illinois, Indiana, Missouri, North Carolina, Ohio (4), Pennsylvania (2) and
Tennessee.
In May 1998, the Company and MCAP Mortgage Corporation and MCAP Service
Corporation entered into a strategic alliance to originate, underwrite and
service non-conforming mortgage loans in Canada. In February 1999, the Company
decided to close its Canadian business to focus exclusively on its U.S.-based
business.
For the year ended December 31, 1998, the Company originated and purchased
approximately $1.73 billion of loans, of which approximately $836 million were
originated through its network of brokers, $653 million were purchased from its
network of correspondents, $234 million were originated through its Fidelity
Mortgage retail network and $5 million were originated through its Canadian
brokered network.
Substantially all of the loans originated and purchased by the Company were
sold in securitizations in which the loans were transferred to a trust, which
had raised the cash payment to purchase the loans through the sale of
asset-backed pass-through securities. For the year ended December 31, 1998,
Delta sold a total of $1.72 billion of loans through four real estate mortgage
investment conduit ("REMIC") securitizations. Each of these four securitizations
was credit-enhanced, by an insurance policy provided through a monoline
insurance company and/or a senior-subordinated structure, to receive ratings of
Aaa from Moody's Investors Service, Inc. ("Moody's") and AAA from Standard &
Poor's Ratings Group, a division of The McGraw-Hill Companies, Inc. ("S&P"). The
Company sells loans through securitizations to improve its operating leverage
and liquidity, to minimize financing costs and to reduce its exposure to
fluctuations in interest rates.
The majority of the Company's revenues and cash flows result from its
securitizations and servicing of home-equity loans that it has originated or
purchased. In a securitization, the Company sells the loans to a trust for a
cash
1
payment while retaining (1) the right to service the loans, and receive a
contractual servicing fee and (2) interest-only and residual certificates in the
trust, entitling the Company to receive any "Excess Servicing" income,
consisting of any remaining cash flows collected by the trust from principal and
interest payments on its loans after the trust has first paid (a) all principal
and interest required to be passed through to holders of the trust's securities,
(b) all contractual servicing fees, and (c) other recurring fees and costs of
administering the trust. Upon securitizing a pool of loans, the Company
recognizes a gain on sale of loans ("net gain on sale of mortgage loans") equal
to the difference between cash received from the trust when it sells
asset-backed pass-through certificates and the investment in the loans remaining
after allocating portions of that investment to record the value of servicing
rights and interest-only and residual certificates received in the
securitization. The majority of the net gain on the sale of mortgage loans
results from, and is initially realized in the form of, the retention of the
mortgage servicing rights and interest-only and residual certificates. The
servicing rights and interest-only and residual certificates are each recorded
based on their fair values, estimated based on a discount rate which management
believes reflects the rate market participants would utilize in purchasing
similar servicing rights and interest-only and residual certificates, and the
stated terms of the transferred loans adjusted for estimates of future
prepayment rates and defaults among those loans. If actual prepayments and/or
defaults exceed the Company's estimates, the future cash flows from the
servicing rights and interest-only and residual certificates would be negatively
affected. (See "Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Accounting Considerations.")
Although the Company recognizes income from the securitization of loans at
the time of the securitization, the Company receives cash flows from the
securitization, in particular the retained servicing rights and interest-only
and residual certificates, over the life of the transferred loans.
The Company services substantially all of the loans it has originated or
purchased, including all of the loans sold through securitizations. As of
December 31, 1998, the Company has a loan servicing portfolio of $2.95 billion.
The Company begins to receive cash flows from monthly contractual servicing
fees in the month following a securitization. The Company's servicing fees range
from 0.50% to 0.65% per annum of the outstanding balance of the loans being
serviced.
The Company typically begins to receive cash flows from the interest-only and
residual certificates retained upon securitization approximately eight to
fifteen months after a securitization, with the specific timing depending on the
structure and performance of the securitization. Initially, securitization
trusts utilize the Excess Servicing cash flows to make additional payments of
principal on the pass-through certificates in order to establish a spread
between the principal amount of the trust's outstanding loans and the amount of
outstanding pass-through certificates. Once a spread of between 2% and 3% of the
initial securitization principal (the "overcollateralization limit") is
established, the Excess Servicing cash flows are distributed to Delta as the
holder of the interest-only and residual certificates. The Company utilizes the
more conservative "cash-out" method of valuing future cash flows from residual
certificates (See "Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Accounting Considerations.").
In addition to the income and cash flows earned from the Company's
securitizations, the Company also earns income and generates cash flows from
whole loan sales, the net interest spread earned on loans while they are held
for sale, and from loan origination fees on Brokered Loans and retail loans.
The Company's business strategy is to increase the size of its servicing
portfolio and focus on its more profitable broker and retail channels of
originations (instead of correspondent purchases) by (1) continuing to provide
top quality service to its network of brokers, correspondents and retail
clients, (2) maintaining its underwriting standards, (3) further penetrating its
established and recently-entered markets and expanding into new geographic
markets, (4) expanding its retail origination capabilities, (5) leveraging and
continuing its investment in information and processing technologies, and (6)
strengthening its loan production capabilities through acquisitions.
2
HOME EQUITY LENDING OPERATIONS
OVERVIEW
Delta's consumer finance activities consist of originating, acquiring,
selling and servicing non-conforming mortgage loans. These loans are primarily
secured by first mortgages on one- to four-family residences. Once loan
applications have been received, the underwriting process completed and the
loans funded or purchased, Delta typically packages the loans in a portfolio and
sells the loan portfolio through a securitization. Delta retains the right to
service the loans that it securitizes.
The Company provides its customers with an array of loan products designed to
meet their needs. The Company uses a risk-based pricing strategy and has
developed products for various risk categories. Historically, the Company
offered fixed-rate loan products and, to date, the majority of the Company's
loan production is fixed-rate. As the Company has expanded geographically, it
has expanded its product offerings to include adjustable-rate mortgages and
fixed/adjustable-rate mortgages. However, during the fourth quarter of 1998, the
Company has virtually eliminated originations of its six-month LIBOR (London
Inter Bank Offered Rate) adjustable rate mortgages, which are less profitable
and more prepayment sensitive.
Historically, the Company conducted substantially all of its broker and
correspondent lending operations out of its Woodbury, New York headquarters.
Recently, however, the Company has been opening regional branch offices, which
include loan processing, underwriting and business development functions, to
bring it in closer contact with brokers and correspondents, enhance customer
service and underscore Delta's long-term commitment in newer regions. Typically,
these offices are staffed with a combination of experienced Delta personnel who
oversee implementation of Delta's operating methods and local employees with
established relationships in, and specific knowledge of, the local market.
Currently, the Company's Southeast regional office (Atlanta, Georgia) and West
Coast regional office (Anaheim, California) are the only "full service" regional
branches with full underwriting authority. Delta's Midwest (Chicago, Illinois),
New England (Warwick, Rhode Island) and Southeast (Deerfield Beach, Florida)
regional offices are "full processing" regional branches, for which final
underwriting approval is required from the Woodbury, New York headquarters for
all mortgage loans. As these branches mature and demonstrate their ability to
meet Delta's operating standards, the Company intends to strengthen their
operations by delegating full underwriting authority. Fidelity Mortgage retail
loans are underwritten by two operational offices (Cincinnati, Ohio and West
Palm Beach, Florida), which have full underwriting authority.
LOAN ORIGINATION AND PURCHASES
The Company increased its loan originations and purchases by 38% to $1.73
billion in 1998 from $1.25 billion in 1997, an increase of 90% over 1996
production of $659 million.
The following tables highlight several important trends for the Company,
including: (1) increased overall loan production, (2) a shift to higher credit
quality loans, (3) a de-emphasis of correspondent loan purchases and (4) the
maintenance of geographic diversity.
3
The following table shows the channels of the Company's loan originations and
purchases for the years shown:
YEAR ENDED DECEMBER 31,
1998 1997 1996
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(DOLLARS IN THOUSANDS)
Broker:
Principal balance...................... $ 841,079 $ 481,586 $ 321,733
Average principal balance per loan..... $ 92 $ 87 $ 85
Combined weighted average initial loan-
to-value ratio(1).................... 72.8% 69.9% 67.7%
Weighted average interest rate......... 10.0% 10.8% 11.1%
Correspondent:
Principal balance...................... $ 652,503 $ 632,639 $ 337,033
Average principal balance per loan..... $ 82 $ 77 $ 73
Combined weighted average initial loan-
to-value ratio(1).................... 73.9% 72.8% 69.8%
Weighted average interest rate......... 10.8% 11.3% 11.7%
Retail:
Principal balance...................... $ 234,011 $ 140,386 $ n/a
Average principal balance per loan..... $ 75 $ 69 $ n/a
Combined weighted average initial loan-
to-value ratio(1).................... 79.9% 80.1% n/a
Weighted average interest rate......... 9.4% 10.1% n/a
Total loan purchases and originations:
Principal balance...................... $1,727,593 $1,254,611 $ 658,766
Average principal balance per loan..... $ 85 $ 80 $ 78
Combined weighted average initial loan-
to-value ratio(1).................... 74.2% 72.5% 68.8%
Weighted average interest rate......... 10.2% 11.0% 11.4%
Percentage of loans secured by:
First mortgage......................... 95.5% 94.0% 93.8%
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(1)The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage property
at origination. The weighted average initial loan-to-value ratio of a loan
secured by a second mortgage is determined by taking the sum of the loan
secured by the first and second mortgages and dividing by the lesser of the
purchase price or the appraised value of the mortgage property at
origination.
4
The following table shows the channels of loan originations and purchases on
a quarterly basis for 1998:
THREE MONTHS ENDED
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DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
1998 1998 1998 1998
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(DOLLARS IN THOUSANDS)
Broker:
Number of Brokered Loans...................... 2,711 2,464 2,140 1,798
Principal balance............................. $243,721 $ 231,475 $ 198,327 $167,556
Average principal balance per loan............ $ 90 $ 94 $ 93 $ 93
Combined weighted average initial loan-
to-value ratio(1).......................... 73.1% 73.4% 72.3% 71.9%
Weighted average interest rate................ 10.0% 9.9% 10.0% 10.1%
Correspondent:
Number of Correspondent Loans................. 1,369 2,105 2,404 2,110
Principal balance............................. $108,266 $177,753 $199,057 $167,427
Average principal balance per loan............ $ 79 $ 84 $ 83 $ 79
Combined weighted average initial loan-
to-value ratio(1)........................... 73.5% 74.3% 74.0% 73.8%
Weighted average interest rate................ 10.8% 10.8% 10.7% 11.0%
Retail:
Number of retail loans........................ 883 870 674 714
Principal balance............................. $ 63,049 $ 66,974 $ 52,191 $ 51,797
Average principal balance per loan............ $ 71 $ 77 $ 77 $ 73
Combined weighted average initial loan-
to-value ratio(1)........................... 79.1% 80.3% 80.2% 80.2%
Weighted average interest rate................ 9.4% 9.2% 9.3% 9.6%
Total loan purchases and originations:
Total number of loans......................... 4,963 5,439 5,218 4,622
Principal balance............................. $415,036 $476,202 $449,575 $386,780
Average principal balance per loan............ $ 84 $ 88 $ 86 $ 84
Combined weighted average initial loan-
to-value ratio(1)........................... 74.1% 74.7% 74.0% 73.8%
Weighted average interest rate................ 10.1% 10.1% 10.2% 10.4%
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(1) The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. The weighted average initial loan-to-value ratio
of a loan secured by a second mortgage is determined by taking the sum of
the loan secured by the first and second mortgages and dividing by the
lesser of the purchase price or the appraised value of the mortgage
property at origination.
5
The following table shows lien position, weighted average interest rates and
loan-to-value ratios for the years shown:
YEAR ENDED DECEMBER 31,
-----------------------
1998 1997 1996
---- ---- ----
First mortgage:
Percentage of total purchases and originations... 95.5% 94.0% 93.8%
Weighted average interest rate................... 10.2% 11.0% 11.4%
Weighted average initial loan-to-value ratio(1).. 74.3% 72.6% 68.9%
Second mortgage:
Percentage of total purchases and originations... 4.5% 6.0% 6.2%
Weighted average interest rate................... 10.5% 11.3% 11.5%
Weighted average initial loan-to-value ratio(1).. 70.6% 71.1% 66.6%
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(1) The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. The weighted average initial loan-to-value ratio
of a loan secured by a second mortgage is determined by taking the sum of
the loan secured by the first and second mortgages and dividing by the
lesser of the purchase price or the appraised value of the mortgage
property at origination.
The following table shows the geographic distribution of loan purchases and
originations for the periods indicated:
YEAR ENDED DECEMBER 31,
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1998 1997 1996
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REGION PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE
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(DOLLARS IN MILLIONS)
NY, NJ and PA............. 55.0% $949.3 52.9% $664.3 66.3% $436.9
Midwest................... 19.7 340.3 21.6 270.9 14.9 98.3
Southeast................. 9.3 161.0 9.7 121.4 4.2 27.6
New England............... 7.3 125.8 7.1 89.3 5.9 38.6
Mid-Atlantic*............. 6.9 119.1 6.5 81.3 6.6 43.7
West...................... 1.5 26.6 2.2 27.3 2.1 13.7
Canada.................... 0.3 5.5 n/a n/a n/a n/a
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* Excluding New York (NY), New Jersey (NJ) and Pennsylvania (PA).
BROKER AND CORRESPONDENT MARKETING. Throughout its history Delta has been
successful in establishing and maintaining relationships with brokers and
correspondents offering non-conforming mortgage products to their clientele.
Management believes that this success is primarily attributable to the quality
of service the Company provides to its network of brokers and correspondents.
Delta typically initiates contact with a broker or correspondent through
Delta's Business Development Department, comprised of 33 business development
representatives as of December 31, 1998, supervised by a senior officer with
over ten years of sales and marketing experience in the industry. The Company
usually hires business development representatives who have contacts with
brokers and correspondents that originate nonconforming mortgage loans within
their geographic territory. The business development representatives are
responsible for developing and maintaining the Company's broker and
correspondent networks within their geographic territory by frequently visiting
the broker or correspondent, communicating the Company's underwriting
guidelines, disseminating new product information and pricing changes, and by
demonstrating a continuing commitment to understanding the needs of the
customer. The business development representatives attend industry trade shows
and inform Delta about the products and pricing being offered by competitors and
new market entrants. This information assists Delta in refining its programs and
product offerings in order to remain competitive. Business development
representatives are compensated with a base salary and commissions based on the
volume of loans originated or purchased as a result of their efforts.
6
APPROVAL PROCESS. Before a broker or correspondent becomes part of Delta's
network, it must go through an approval process. Once approved, brokers and
correspondents may immediately begin submitting applications and/or loans to
Delta.
To be approved, a broker must demonstrate that it is properly licensed and
registered in the state in which it seeks to transact business, submit to a
credit check and sign a standard broker agreement with Delta. A correspondent is
eligible to submit loans to Delta for purchase only after an extensive
investigation of the prospective correspondent's lending operations including an
on-site visit, a review of the correspondent's financial statements for the
prior two years, a credit report on the correspondent, a review of sample loan
documentation and business references provided by the correspondent. Once
approved, Delta requires that each correspondent sign an Agreement of Purchase
and Sale in which the correspondent makes representations and warranties
governing both the mechanics of doing business with Delta and the quality of the
loan submissions themselves. Delta also performs an annual review of each
approved correspondent in order to ensure continued compliance with legal
requirements and that lending operations and financial information continue to
meet Delta's standards. In addition, Delta regularly reviews the performance of
loans originated or purchased through its brokers or correspondents.
BROKERED LOANS. For the year ended December 31, 1998, the Company's broker
network accounted for $841.1 million, or 49%, of Delta's loan purchases and
originations compared to $481.6 million, or 38%, of Delta's loan purchases and
originations for the year ended December 31, 1997 and $321.7 million, or 49%, of
Delta's loan purchases and originations for the year ended December 31, 1996. No
single broker contributed more than 5.2%, 5.8% or 11.4% of Delta's total
purchases or originations in the years ended December 31, 1998, 1997 and 1996,
respectively.
Once approved, a broker may submit loan applications for prospective
borrowers to Delta. To process broker submissions, Delta's broker originations
area is organized into teams, each consisting of loan officers and processors,
which are generally assigned to specific brokers. Because Delta operates in a
highly competitive environment where brokers may submit the same loan
application to several prospective lenders simultaneously, Delta strives to
provide brokers with a rapid and informed response. Loan officers analyze the
application and provide the broker with a preliminary approval, subject to final
underwriting approval, or a denial, typically within one business day. If the
application is approved by the Company's underwriters, a "conditional approval"
will be issued to the broker with a list of specific conditions to be met and
additional documents to be supplied prior to funding the loan. The loan officer
and processor team will then work directly with the submitting broker to collect
the requested information and meet all underwriting conditions. In most cases,
the Company funds loans within 14 to 21 days after preliminary approval of the
loan application. In the case of a denial, Delta will make all reasonable
attempts to ensure that there is no missing information concerning the borrower
or the application that might change the decision on the loan.
The Company compensates its loan officers, who on a loan-by-loan basis are
the primary relationship contacts with the brokers, predominantly on a
commission basis. All of the Company's loan officers must complete an extensive
9- to 12-month training program to attain the level of knowledge and experience
integral to the Company's commitment to providing the highest quality service
for brokers. Management believes that by maintaining an efficient, trained and
experienced staff, it has addressed three central factors which determine where
a broker sends its business: (i) the speed with which a lender closes loans,
(ii) the lender's knowledge concerning the broker and his business and (iii) the
support a lender provides.
CORRESPONDENT LOANS. For the year ended December 31, 1998, Delta's
correspondent network accounted for $652.5 million, or 37%, of Delta's loans
purchases and originations compared to $632.6 million, or 51%, of Delta's loan
purchases and originations for the year ended December 31, 1997 and $337.0
million, or 51%, of Delta's loan purchases and originations for the year ended
December 31, 1996. No single correspondent contributed more than 3.8%, 6.5% or
6.3% of Delta's total loan purchases and originations in 1998, 1997 or 1996,
respectively.
An approved correspondent is a licensed mortgage banker or savings and loan
who sells loans to Delta which the correspondent has originated, processed,
closed and funded in its own name in conformity with Delta's underwriting
standards. The loans are sold to Delta either on an individual flow basis or in
block sales. When selling on a flow basis, a correspondent typically will seek a
pre-approval from Delta prior to closing the loan, and Delta will approve the
loan based on a partial or full credit package, stipulating any items needed to
complete the
7
package in adherence to Delta's underwriting guidelines. On a block sale, a
correspondent will offer a group of loans, generally loans that have not been
pre-approved, to Delta for sale, and Delta will purchase those loans in the
block that meet Delta's underwriting criteria.
RETAIL LOANS. The Company acquired its Fidelity Mortgage retail origination
network in 1997. For the year ended December 31, 1998, this channel accounted
for $234.0 million, or 14%, of Delta's loan purchases and originations compared
to $140 million, or 11%, of Delta's loan purchases and originations in 1997.
Through its marketing efforts, Fidelity Mortgage is able to identify, locate and
focus on individuals who, based on historic customer profiles, are likely
customers for the Company's products. Fidelity Mortgage's telemarketing
representatives identify interested customers and refer these customers to loan
officers at the retail branch offices who then proceed to determine the
applicant's qualifications for the Company's loan products, negotiate loan terms
with the borrower and process the loan through completion.
LOAN UNDERWRITING
All of Delta's brokers, correspondents and retail offices are provided with
the Company's underwriting guidelines. Loan applications received from brokers
and correspondents or retail customers are classified according to certain
characteristics, including but not limited to: credit history of the applicant,
ability to pay, condition and location of the collateral, loan-to-value ratio
and general stability of the applicant in terms of employment history and time
in residence. Delta has established classifications with respect to the credit
profile of the applicant, and each loan is placed into one of four letter
ratings "A" through "D", with subratings within those categories. Terms of loans
made by Delta, as well as maximum loan-to-value ratios and debt-to-income
ratios, vary depending on the applicant's classification. Loan applicants with
less favorable credit ratings are generally offered loans with higher interest
rates and lower loan-to-value ratios than applicants with more favorable credit
ratings. The general criteria used by Delta's underwriting staff in classifying
loan applicants are set forth in the following table:
8
DELTA'S UNDERWRITING CRITERIA
"A" RISK "B" RISK "C" RISK "D" RISK
EXCELLENT CREDIT
HISTORY GOOD OVERALL CREDIT GOOD TO FAIR CREDIT FAIR TO POOR CREDIT
---------------- ------------------- ------------------- -------------------
Existing mortgage
history............... Current at Current at Up to 30 days 90 days delinquent
application time application time delinquent at or more
and a maximum of and a maximum of application time
two 30-day late four 30-day late and a maximum of
payments in the payments in the four 30-day late
last 12 months last 12 months payments, two
60-day late
payments and
one 90-day late
payment in the
last 12 months
Other credit............ Minor 30 day Some slow pays Slow pays, some Not a factor.
late items allowed allowed but open delinquencies Derogatory
with a letter of majority of credit allowed. Isolated credit must
explanation; no and installment charge-offs, collec- be paid with
open collection debt paid as agreed. tion accounts or proceeds. Must
accounts, charge- Small isolated judgments case- demonstrate
offs, judgments charge-offs, collec- by-case ability to pay
tion accounts or
judgments case-
by-case
Bankruptcy filings...... Discharged more Discharged more Discharged more May be open at
than three years than two years than one year closing, but must
prior to closing prior to closing prior to closing be paid off with
and excellent and excellent and good proceeds
reestablished reestablished reestablished
credit credit credit
Debt service to
Income ratio.......... Generally 45% Generally 50% Generally 55% Generally 55%
or less or less or less or less
Maximum loan-to-value
ratio:
Owner-occupied........ Generally 80% Generally 80% Generally 75% Generally 65%
(up to 90%*) for (up to 85%*) for (up to 80%*) for (up to 70%*) for
a one- to four- a one- to four- a one- to four- a one- to four-
family residence family residence family residence family residence
Non-owner
occupied............ Generally 70% Generally 70% Generally 65% Generally 55%
(up to 80%*) for (up to 80%*) for (up to 75%*) for (up to 60%*) for
a one- to four- a one- to four a one- to four- a one- to four-
family residence family residence family residence family residence
Employment.............. Minimum 2 years Minimum 2 years No minimum No minimum
employment in the employment in the required required
same field same field
------------
* On an exception basis
Delta uses the foregoing categories and characteristics as guidelines only.
On a case-by-case basis, the Company may determine that the prospective borrower
warrants an exception, if sufficient compensating factors exist. Examples of
such compensating factors are a low loan-to-value ratio, a low debt ratio,
long-term stability of employment and/or residence, excellent payment history on
past mortgages or a significant reduction in monthly housing expenses.
9
The following table sets forth certain information with respect to Delta's
originations and purchases of first and second mortgage loans by borrower
classification, along with weighted average coupons, for the periods shown and
highlights the improved credit quality of the Company's originations and
purchases.
(DOLLARS IN THOUSANDS)
PERCENT
YEAR CREDIT TOTAL OF TOTAL WAC(1) WLTV(2)
- - ---- ---- ----- -------- ------ ------
1998 A $ 990,988 57.3% 9.7% 77.0%
B 425,056 24.6 10.4 73.2
C 248,488 14.4 11.3 69.0
D 63,061 3.7 12.7 57.2
---------- ----- ---- ----
Totals $1,727,593 100.0% 10.2% 74.2%
========== ===== ==== ====
1997 A $ 617,724 49.2% 10.4% 76.2%
B 349,166 27.8 11.0 72.0
C 222,854 17.8 11.8 67.7
D 64,867 5.2 13.2 56.7
---------- ----- ---- ----
Totals $1,254,611 100.0% 11.0% 72.5%
========== ===== ==== ====
1996 A $ 219,550 33.4% 10.6% 72.1%
B 234,589 35.6 11.2 70.2
C 156,296 23.7 12.2 65.7
D 48,331 7.3 13.8 56.9
---------- ----- ---- ----
Totals $ 658,766 100.0% 11.4% 68.8%
========== ===== ==== ====
- - ------------------
(1) Weighted Average Coupon ("WAC").
(2) Weighted Average Initial Loan-to-Value Ratio ("WLTV").
Delta employs experienced nonconforming mortgage loan credit underwriters to
scrutinize the applicant's credit profile and to evaluate whether an impaired
credit history is a result of adverse circumstances or a continuing inability or
unwillingness to meet credit obligations in a timely manner. Personal
circumstances including divorce, family illnesses or deaths and temporary job
loss due to layoffs and corporate downsizing will often impair an applicant's
credit record. Assessment of an applicant's ability and willingness to pay is
one of the principal elements that distinguishes Delta's lending practices from
methods employed by traditional lenders, such as savings and loans and
commercial banks. All lenders utilize debt ratios and loan-to-value ratios in
the approval process, however, in contrast to Delta, many lenders simply use
software packages to score an applicant for loan approval and fund the loan
after auditing the data provided by the borrower.
Delta had 97 underwriters on staff as of December 31, 1998, and its senior
underwriters have an average of more than nine years of non-conforming
underwriting experience. Delta does not delegate underwriting authority to any
broker or correspondent. Delta's Underwriting Department functions independently
of its Business Development and Mortgage Origination Departments and does not
report to any individual directly involved in the origination process. No
underwriter at Delta is compensated on an incentive or commission basis.
Delta has instituted underwriting checks and balances designed to ensure that
every loan is reviewed and approved by a minimum of two underwriters, with
certain higher loan amounts requiring a third approval. Management believes that
by requiring each file be seen by a minimum of two underwriters, a high degree
of accuracy and quality control is ensured throughout the underwriting process.
10
Delta's underwriting of every loan submitted consists not only of a thorough
review of credit and ability to repay, but also (i) a separate appraisal review
conducted by Delta's Appraisal Review Department and (ii) a full compliance
review to ensure that all documents have been properly prepared, all applicable
disclosures have been given in a timely fashion, proper compliance with all
federal and state regulations, the existence of title insurance insuring Delta's
interest as mortgagee and evidence of adequate homeowner's insurance naming
Delta as an additional insured party. Appraisals are performed by third party,
fee-based appraisers or by the Company's staff appraisers and generally conform
to current FNMA/FHLMC secondary market requirements for residential property
appraisals. Each such appraisal includes, among other things, an inspection of
the exterior of the subject property and, where available, data from sales
within the preceding 12 months of similar properties within the same general
location as the subject property.
Delta performs a thorough appraisal review on each loan prior to closing or
prior to purchasing. While Delta recognizes that the general practice by
conventional mortgage lenders is to perform only drive-by appraisals after
closings, management believes this practice does not provide sufficient
protection. In addition to reviewing each appraisal for accuracy, the Company
accesses other sources to validate sales used in the appraisal to determine
market value. These sources include: interfacing with Multiple Listing Services,
Comps, Inc. and other similar databases to access current sales and listing
information; and other sources for verification, including broker price opinions
and market analyses by local real estate agents.
Post closing, in addition to its normal due diligence, the Company selects
one out of every ten appraisals and performs its own drive-by appraisal. This
additional step helps to give the Company an added degree of comfort with
respect to appraisers with which the Company has had limited experience. Delta
actively tracks all appraisers from which it accepts appraisals for quality
control purposes and does not accept work from appraisers who have not conformed
to its review standards.
The Company performs a post-funding quality control review to monitor and
evaluate the Company's loan origination policies and procedures. At least 10% of
all loan originations and purchases are subjected to a full quality control
re-underwriting and review, the results of which are reported to senior
management. Discrepancies noted by this review are analyzed and corrective
actions are instituted. However, to date, this important quality control process
has not revealed material deficiencies in the Company's loan underwriting
procedures. A typical quality control review currently includes: (a) obtaining a
new drive-by appraisal for each property; (b) obtaining a new credit report from
a different credit report agency; (c) reviewing loan applications for
completeness, signatures, and for consistency with other processing documents;
(d) obtaining new written verifications of income and employment; (e) obtaining
new written verification of mortgage to re-verify any outstanding mortgages; and
(f) analyzing the underwriting and program selection decisions. The quality
control process is updated from time to time as the Company's policies and
procedures change.
LOAN SALES
Delta sells substantially all the loans it originates or purchases through
one of two methods: (i) securitizations, which involve the private placement or
public offering by a securitization trust of asset-backed pass-through
securities, and (ii) whole loan sales, which include the sale of blocks of
individual loans to institutional or individual investors. Since 1991, the
Company has sold more than $4.2 billion of the loans it originated or purchased
through securitization and $63 million through whole loan sales.
SECURITIZATIONS. During 1998, Delta completed four securitizations totaling
$1.72 billion. The following table sets forth certain information with respect
to Delta's securitizations (all of which have been rated AAA/Aaa by S&P and
Moody's, respectively) by offering size, which includes prefunded amounts,
weighted average pass-through rate and type of credit enhancement.
11
INITIAL
OFFERING SIZE WEIGHTED AVERAGE CREDIT
SECURITIZATION COMPLETED (MILLIONS) PASS-THROUGH RATE ENHANCEMENT
- - -------------- --------- ------------- ----------------- -----------
1998-1............ 03/31/98 $400.0 7.24% Senior/Sub Structure
1998-2............ 06/29/98 $445.0 7.06% Senior/Sub Structure
1998-3............ 09/29/98 $475.0 7.50% Bond Insured
1998-4............ 12/23/98 $400.0 7.97% Hybrid *
- - ------------------
* Senior/Sub Structure and Bond Insured
When Delta securitizes loans, it sells a portfolio of loans to a trust (a
"Home Equity Loan Trust") for a cash payment and the Home Equity Loan Trust
sells various classes of pass-through certificates representing undivided
ownership interests in such Home Equity Loan Trust. As servicer for each
securitization, the Company collects and remits principal and interest payments
to the appropriate Home Equity Loan Trust which, in turn, passes through such
payments to certificateholders. For each of the 1998 securitizations, Delta
retained 100% of the interests in the residual certificates while selling the
interest-only certificates for cash. Management contemplates continuing to
retain residual certificates in the future as long as, in management's opinion,
this practice maximizes earnings while remaining within the Company's liquidity
requirements.
Each Home Equity Loan Trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which insures the timely payment of interest and the
ultimate payment of principal of the credit-enhanced investor certificate. 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 Servicing amounts are initially
applied as additional payments of principal for the investor certificates,
thereby accelerating amortization of the investor certificates relative to the
amortization of the loans and creating overcollateralization. Once the
overcollateralization limit is reached, the use of Excess Servicing to create
overcollateralization stops unless it subsequently becomes necessary to obtain
or maintain required overcollateralization limits. Overcollateralization is
intended to create a source of cash (the "extra" payments on the loans) to
absorb losses prior to making a claim on the financial guaranty insurance policy
or the subordinated certificates.
Whole Loan Sales Without Recourse. From time to time, the Company has found
that it can receive better execution by selling certain mortgage loans on a
whole loan, non-recourse basis, without retaining servicing rights, generally in
private transactions to institutional or individual investors. The Company
recognizes a gain or loss when it sells loans on a whole loan basis equal to the
difference between the cash proceeds received for the loans and the Company's
investment in the loans, including any unamortized loan origination fees and
costs.
For the years ended December 31, 1998, 1997 and 1996, Delta sold $8.7
million, $0 million and $15.3 million of loans, respectively, on a whole loan,
non-recourse basis, which represents 0.5%, 0.0% and 2.3%, respectively, of its
originations and purchases.
LOAN SERVICING AND COLLECTIONS
Delta has been servicing loans since its inception in 1982, and Delta has
serviced or is servicing substantially all of the loans that it has originated
or purchased. Servicing involves, among other things, collecting payments when
due, remitting payments of principal and interest and furnishing reports to the
current owners of the loans and enforcing such owners' rights with respect to
the loans, including, recovering any delinquent payments, instituting
foreclosure proceedings and liquidating underlying collateral. The Company
receives a servicing fee for servicing residential mortgage loans of 0.50% per
annum (0.65% per annum on all securitizations completed before and including the
1996-1 securitization) on the declining principal balance of all loans sold
through securitization and on the declining principal balance of the loans sold
to investors on a recourse basis. These servicing fees are collected by the
Company out of the monthly mortgage payments. Management believes that servicing
the Company's own portfolio enhances certain operating efficiencies and provides
an additional and profitable revenue
12
stream that is less cyclical than its primary business of originating and
purchasing loans. As of December 31, 1998, Delta had a loan servicing portfolio
of $2.95 billion.
Delta services all loans out of its headquarters in Woodbury, New York,
utilizing a leading in-house loan servicing system ("LSAMS") which it
implemented in 1995. LSAMS has provided Delta with considerably more flexibility
to adapt the system to Delta's specific needs as a nonconforming home equity
lender. As such, Delta has achieved significant cost efficiencies by automating
a substantial number of previously manual servicing procedures and functions
since its conversion to LSAMS on July 1, 1995. Management believes that even
greater cost efficiencies can be realized through further automation provided by
LSAMS.
At the same time that it upgraded its primary servicing system, Delta
purchased a default management sub-servicing system with separate "modules" for
foreclosure, bankruptcy, and REO to provide it with the ability to more
efficiently monitor and service loans in default. These sub-servicing modules
provide detailed tracking of all key events in foreclosure and bankruptcy on a
loan-by-loan and portfolio-wide basis; the ability to track and account for all
pre- and post-petition payments received in bankruptcy from the borrower and/or
trustee; and the ability to monitor, market and account for all aspects
necessary to liquidate an REO property after foreclosure. Additionally, Delta's
Management Information Systems Department has created a market value analysis
program to run with LSAMS, which provides Delta with the ability to monitor its
equity position on a loan-by-loan and/or portfolio-wide basis. These features
have led to cost savings through greater automation and system upgrades and have
helped mitigate loan losses as the Servicing Department has been able to
identify problem loans earlier, thus allowing for earlier corrective action.
Delta's collections policy is designed to identify payment problems
sufficiently early to permit Delta to quickly address delinquency problems and,
when necessary, to act to preserve equity in a pre-foreclosure property. Delta
believes that these policies, combined with the experience level of independent
appraisers engaged by Delta, help to reduce the incidence of charge-offs of a
first or second mortgage loan.
Centralized controls and standards have been established by Delta for the
servicing and collection of mortgage loans in its portfolio. Delta revises such
policies and procedures from time to time in connection with changing economic
and market conditions and changing legal and regulatory requirements.
Borrowers are billed on a monthly basis in advance of the due date.
Collection procedures commence upon identification of a past due account by
Delta's automated servicing system. If timely payment is not received,
proprietary software automatically places loans in the Unison/Davox predictive
dialer auto-queue downloaded from the LSAMS servicing system and collection
procedures are generally initiated on the day immediately following the payment
due date for chronic late payers, or the day immediately following the end of
the grace period for those borrowers who usually pay within the grace period, or
shortly thereafter. The Unison/Davox predictive dialer, through LSAMS,
automatically queues up each loan in the assigned collector's "auto-queue" daily
based upon a particular borrower's payment history over the prior three months.
The account remains in the queue unless and until a payment is received, at
which point LSAMS automatically removes the loan from that collector's auto
queue until the next month's payment is due and/or becomes delinquent.
When a loan appears in a collector's auto queue, a collector will telephone
to remind the borrower that a payment is due. Follow-up telephone contacts are
attempted until the account is current or other payment arrangements have been
made. Standard form letters are utilized when attempts to reach the borrower by
telephone fail and/or, in some circumstances, to supplement the phone contacts.
During the delinquency period, the collector will continue to contact the
borrower. Company collectors have computer access to telephone numbers, payment
histories, loan information and all past collection notes. All collection
activity, including the date collection letters were sent and detailed notes on
the substance of each collection telephone call, is entered into a permanent
collection history for each account on LSAMS. Additional guidance with the
collection process is derived through frequent communication with Delta's senior
management.
For those loans in which collection and initial loss mitigation efforts have
been exhausted without success, the loss mitigation team recommends the loans be
sent to foreclosure at one of the Foreclosure Committee Meetings held each
month. At each such committee meeting, the loss mitigation administrator and
team leader meet with the Servicing Manager, the Default Management Manager and
a member of the Executive Department, to determine
13
whether foreclosure proceedings are appropriate, based upon their analysis of
all relevant factors, including a market value analysis, reason for default and
efforts by the borrower to cure the default.
Regulations and practices regarding the liquidation of properties (e.g.,
foreclosure) and the rights of a borrower in default vary greatly from state to
state. As such, all foreclosures are assigned to outside counsel, located in the
same state as the secured property. Bankruptcies filed by borrowers are
similarly assigned to appropriate local counsel. All aspects of foreclosures and
bankruptcies are closely monitored by Delta through its sub-servicing loan
system described above and through monthly status reports from attorneys.
Prior to foreclosure sale, Delta performs an in-depth market value analysis
on all defaulted loans. This analysis includes: (i) a current valuation of the
property obtained through at least two drive-by appraisals or broker price
opinions conducted by an independent appraiser and/or broker from a network of
real estate brokers, complete with a description of the property, recent list
prices of comparable properties, recent closed comparables, estimated marketing
time, estimated required or suggested repairs and an estimate of the sales
price; (ii) an evaluation of the amount owed, if any, for real estate taxes;
(iii) an evaluation of the amount owed, if any, to a senior mortgagee; and (iv)
estimated carrying costs, broker's fee, repair costs and other related costs
associated with real estate owned properties. Delta bases the amount it will bid
at foreclosure sales on this analysis.
If Delta acquires title to a property at a foreclosure sale or otherwise, the
REO Department immediately begins working the file by obtaining an estimate of
the sale price of the property by sending at least two local real estate brokers
to inspect the premises, and then hiring one to begin marketing the property. If
the property is not vacant when acquired, local eviction attorneys are hired to
commence eviction proceedings and/or negotiations are held with occupants in an
attempt to get them to vacate without incurring the additional time and cost of
eviction. Repairs are performed if it is determined that they will increase the
net liquidation proceeds, taking into consideration the cost of repairs, the
carrying costs during the repair period and the marketability of the property
both before and after the repairs.
Delta's loan servicing software also tracks and maintains homeowners'
insurance information and tax and insurance escrow information. Expiration
reports are generated bi-weekly listing all policies scheduled to expire within
the next 15 days. When policies lapse, a letter is issued advising the borrower
of such lapse and notifying the borrower that Delta will obtain force-placed
insurance at the borrower's expense. Delta also has an insurance policy in place
that provides coverage automatically for Delta in the event that Delta fails to
obtain force-placed insurance.
The following table sets forth information relating to the delinquency and
loss experience of the mortgage loans serviced by Delta (primarily for the
securitization trusts) for the periods indicated. Delta is not the holder of the
securitization loans, but generally holds residual or interest-only certificates
of the trusts, as well as the servicing rights, each of which may be adversely
affected by defaults. (See "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations Certain Accounting
Considerations"):
14
YEAR ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
` ---- ---- ----
(DOLLARS IN THOUSANDS)
Total Outstanding Principal Balance
(at period end)................................... $ 2,950,435 $ 1,840,150 $ 932,958
Average Outstanding(1)................................ $ 2,436,343 $ 1,376,109 $ 686,465
DELINQUENCY (at period end) 30-59 Days:
Principal Balance................................. $ 153,726 $ 90,053 $ 54,583
Percent of Delinquency(2)......................... 5.21% 4.89% 5.85%
60-89 Days:
Principal Balance................................. $ 50,034 $ 28,864 $ 14,273
Percent of Delinquency(2)......................... 1.70% 1.57% 1.53%
90 Days or More:
Principal Balance................................. $ 47,887 $ 17,695 $ 9,224
Percent of Delinquency(2)......................... 1.62% 0.96% 0.99%
Total Delinquencies:
Principal Balance................................. $ 251,647 $ 136,612 $ 78,080
Percent of Delinquency(2)......................... 8.53% 7.42% 8.37%
FORECLOSURES
Principal Balance................................. $ 145,679 $ 85,500 $ 34,766
Percent of Foreclosures by Dollar(2).............. 4.94% 4.65% 3.73%
REO
Principal Balance................................ $ 18,811 $ 10,292 $ 5,673
Percent of REO.................................. 0.64% 0.56% 0.61%
Net Gains/(Losses) on liquidated loans................ $ (8,704) $ (4,986) $ (2,866)
Percentage of Net Gains/(Losses) on liquidated
loans (based on Average Outstanding Balance)...... (0.36%) (0.36%) (0.42%)
- - ---------------
(1) Calculated by summing the actual outstanding principal balances at the end
of each month and dividing the total by the number of months in the
applicable period.
(2) Percentages are expressed based upon the total outstanding principal
balance at the end of the indicated period.
COMPETITION
As an originator and purchaser of mortgage loans, the Company faces intense
competition, primarily from mortgage banking companies, commercial banks, credit
unions, savings and loans, credit card issuers and finance companies. Many of
these competitors in the financial services business are substantially larger
and have more capital and other resources than the Company. Competition can take
many forms, including convenience in obtaining a loan, service, marketing and
distribution channels and interest rates. Furthermore, the level of gains
realized by the Company and its competitors on the sale of the type of loans
originated and purchased has attracted additional competitors into this market
with the effect of lowering the gains that may be realized by the Company on
future loan sales. In addition, efficiencies in the asset-backed market have
generally created a desire for even larger transactions giving companies with
greater volumes of originations a competitive advantage.
Competition may be affected by fluctuations in interest rates and general
economic conditions. During periods of rising rates, competitors which have
"locked in" low borrowing costs may have a competitive advantage. During periods
of declining rates, competitors may solicit the Company's borrowers to refinance
their loans. During economic slowdowns or recessions, the Company's borrowers
may have new financial difficulties and may be receptive to offers by the
Company's competitors. Furthermore, certain large national finance companies and
conforming mortgage originators have recently adapted their conforming
origination programs and allocated resources to the origination of
non-conforming loans and/or have otherwise begun to offer products similar to
those
15
offered by the Company, targeting customers similar to those of the
Company. The entrance of these larger and better capitalized competitors into
the Company's market may have a material adverse effect on the Company's results
of operations and financial condition.
REGULATION
Delta's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and is subject to
various laws and judicial and administrative decisions imposing requirements and
restrictions on part or all of its operations. Delta's consumer lending
activities are subject to the Federal Truth-in-Lending Act and Regulation Z
(including the Home Ownership and Equity Protection Act of 1994), the Equal
Credit Opportunity Act of 1974, as amended (ECOA), the Fair Credit Reporting Act
of 1970, as amended, the Real Estate Settlement Procedures Act (RESPA), and
Regulation X, the Home Mortgage Disclosure Act and the Federal Debt Collection
Practices Act, as well as other federal and state statutes and regulations
affecting Delta's activities. Delta is also subject to the rules and regulations
of, and examinations by HUD and state regulatory authorities with respect to
originating, processing, underwriting and servicing loans. These rules and
regulations, among other things, impose licensing obligations on Delta,
establish eligibility criteria for mortgage loans, prohibit discrimination,
provide for inspections and appraisals of properties, require credit reports on
loan applicants, regulate assessment, collection, foreclosure and claims
handling, investment and interest payments on escrow balances and payment
features, mandate certain disclosures and notices to borrowers and, in some
cases, fix maximum interest rates, fees and mortgage loan amounts. Failure to
comply with these requirements can lead to loss of approved status, termination
or suspension of servicing contracts without compensation to the servicer,
demands for indemnifications or mortgage loans repurchases, certain rights of
rescission for mortgage loans, class action lawsuits and administrative
enforcement actions. Delta believes it is in compliance in all material respects
with applicable federal and state laws and regulations.
ENVIRONMENTAL MATTERS
To date, Delta has not been required to perform any investigation or clean up
activities, nor has it been subject to any environmental claims. There can be no
assurance, however, that this will remain the case in the future. In the
ordinary course of its business, Delta from time to time forecloses on
properties securing loans. Although Delta primarily lends to owners of
residential properties, there is a risk that Delta could be required to
investigate and clean-up hazardous or toxic substances or chemical releases at
such properties after acquisition by Delta, and may be held liable to a
governmental entity or to third parties for property damage, personal injury and
investigation and cleanup costs incurred by such parties in connection with the
contamination. In addition, the owner or former owners of a contaminated site
may be subject to common law claims by third parties based on damages and costs
resulting from environmental contamination emanating from such property.
EMPLOYEES
As of December 31, 1998 Delta had a total of 1,104 employees (full-time and
part-time). None of Delta's employees are covered by a collective bargaining
agreement. Delta considers its relations with its employees to be good.
ITEM 2. PROPERTIES
Delta's executive and administrative offices are located at 1000 Woodbury
Road, Woodbury, New York 11797, where Delta leases approximately 120,000 square
feet of office space at an aggregate annual rent of approximately $2.4 million.
The lease provides for certain scheduled rent increases and expires in 2008.
Delta also maintains a full service office in Atlanta, Georgia and Anaheim,
California, full processing offices in Chicago, Illinois, Warwick, Rhode Island
and Deerfield Beach, Florida, processing offices in Cleveland, Ohio and
Farmington Hills, Michigan, and business development offices in Delaware,
Missouri, New Jersey, Ohio, Pennsylvania and Virginia. Fidelity Mortgage
maintains fifteen retail mortgage origination offices in Florida (3), Georgia,
Illinois, Indiana, Missouri, North Carolina, Ohio (4), Pennsylvania (2) and
Tennessee; one telemarketing
16
hub in Ohio; and one corporate office in Ohio. The terms of the leases vary as
to duration and escalation provisions, with the latest expiring in 2003.
ITEM 3. LEGAL PROCEEDINGS
Because the nature of the Company's business involves the collection of
numerous accounts, the validity of liens and compliance with various state and
federal lending laws, the Company is subject, in the normal course of business,
to numerous claims and legal proceedings, including several class action
lawsuits set forth below. While it is impossible to estimate with certainty the
ultimate legal and financial liability with respect to such claims and actions,
the Company believes that the aggregate amount of such liabilities will not
result in monetary damages which in the aggregate would have a material adverse
effect on the financial condition or results of operations of the Company.
1. Several class-action lawsuits have been filed against a number of consumer
finance companies alleging that the compensation of mortgage brokers through the
payment of yield spread premiums violates various federal and state consumer
protection laws. The Company has been named in three such lawsuits:
a. In or about March 1997, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Eastern District of New York, alleging that the Company's compensation
of mortgage brokers by means of yield spread premiums violates, among
other things, the Real Estate Settlement Procedures Act ("RESPA"). The
complaint seeks (i) certification of a class of plaintiffs, (ii) an
injunction against payment of yield spread premiums by the Company and
(iii) unspecified compensatory and punitive damages (including
attorney's fees). On July 7, 1997, the Company filed an answer to the
plaintiff's amended complaint. In October 1998, the Company agreed to
an individual settlement with plaintiffs, and the lawsuit has been
dismissed with prejudice.
b. In or about February 1998, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Northern District of Mississippi - Greenville Division, alleging that
the Company's compensation or mortgage brokers by means of yield spread
premiums violates RESPA. The complaint seeks (i) certification of a
class of plaintiffs, and (ii) unspecified compensatory damages
(including attorney's fees). On March 31, 1998, the Company filed an
answer to the complaint. On December 1, 1998, the district court judge
denied plaintiff's motion for class certification. Plaintiff petitioned
the Fifth Circuit to accept its interlocutory appeal and, after the
Company submitted opposition papers, Plaintiff withdrew such petition.
The case is now proceeding on an individual basis.
c. In or about October 1998, the Company was served with a lawsuit filed
in the United States District Court for the Northern District of
Georgia, Atlanta Division, alleging that the Company's compensation of
mortgage brokers by means of yield spread premiums violates RESPA. The
complaint seeks (i) certification of a class of plaintiffs, and (ii)
unspecified compensatory and treble damages (including attorney's
fees). In November 1998, the Company filed an answer to the complaint
and Plaintiff filed a motion seeking class certification. In March
1999, the Company submitted its opposition to the motion for class
certification.
2. In or about September 1998, the Company received notice that it had been
named in a lawsuit filed in the Supreme Court of the State of New York, Nassau
County, alleging that the Company did not properly credit payments received from
borrowers to principal and interest. The complaint seeks (i) certification of a
class of plaintiffs, (ii) an accounting, (iii) unspecified compensatory and
punitive damages (including attorneys' fees), and (iv) injunctive relief, based
upon alleged (a) breach of contract, (b) unjust enrichment, (c) fraud, and (d)
deceptive trade practices. The Company's time to answer has been indefinitely
extended pending Plaintiff's determination as to whether to proceed with the
lawsuit.
17
3. In or about November 1998, the Company received notice that it 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 the Company had violated the Home Equity and Ownership Protection
Act, the Truth in Lending Act 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. In January 1999, the Company filed an answer to the amended
complaint. On December 7, 1998, Plaintiff filed a motion seeking a temporary
restraining order and preliminary injunction, enjoining Delta from conducting
foreclosure sales on 11 properties. The district court judge ruled that in order
to consider such a motion, Plaintiff must move to intervene on behalf of these
11 borrowers. Thereafter, Plaintiff moved to intervene on behalf of 3 of the 11
borrowers and sought the injunctive relief on their behalf. The Company 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 enjoining the Company from proceeding with the
foreclosure sales of the three intervenors' properties. The Company has filed a
notice of appeal, and a motion for reconsideration of the December 23, 1998
order.
4. In or about January 1999, the Company received notice that it had been
named in a lawsuit filed in the Court of Common Pleas in Cuyahoga County, Ohio,
alleging that Delta had violated Ohio state law and breached its contract with
Plaintiff by assessing a prepayment penalty and certain other miscellaneous fees
when Plaintiff paid off his loan. The complaint seeks certification of two
classes of plaintiffs. The Company has not yet answered the complaint.
5. In or about March 1999, the Company received notice that it had been named
in a lawsuit filed in the Supreme Court of the State of New York, New York
County, alleging that Delta had improperly charged certain borrowers processing
fees. The complaint seeks (i) certification of a class of plaintiffs, (ii) an
accounting, and (iii) unspecified compensatory and punitive damages (including
attorneys' fees), based upon alleged (a) unjust enrichment, (b) fraud, and (c)
deceptive trade practices. The Company has not yet answered the complaint.
The Company believes that it has meritorious defenses and intends to defend
each of these lawsuits, but cannot estimate with any certainty its ultimate
legal or financial liability, if any, with respect to the alleged claims.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The annual meeting of stockholders was held on May 19, 1998. At the meeting,
Sidney A. Miller and Martin D. Payson were elected as Class II Directors for a
term of three years. Hugh Miller, Richard Blass and Arnold B. Pollard continue
to serve as members of the Board of Directors.
Votes cast in favor of Mr. Miller's election totaled 14,884,446,
while 27,325 votes were withheld.
Votes cast in favor of Mr. Payson's election totaled 14,884,146,
while 27,625 votes were withheld.
The stockholders also voted to ratify the appointment of KPMG LLP as the
Company's independent public accountants for the fiscal year ending December 31,
1998. Votes cast in favor of this ratification were 14,903,146, while votes cast
against were 2,600 and abstentions totaled 6,025.
18
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PRICE RANGE OF COMMON STOCK
The Company's Common Stock was listed on the New York Stock Exchange (the
"NYSE") under the symbol "DFC" on November 1, 1996. The following table sets
forth for the periods indicated the range of the high and low closing sales
prices for the Company's Common Stock on the NYSE.
1998 HIGH LOW
- - ---- ---- ----
First Quarter ............................ $18.56 $ 9.56
Second Quarter ........................... 20.25 17.06
Third Quarter............................. 18.00 4.50
Fourth Quarter ........................... 7.75 3.13
1997 HIGH LOW
- - ---- ---- ----
First Quarter ............................ $24.00 $18.13
Second Quarter ........................... 20.50 13.38
Third Quarter............................. 22.13 18.81
Fourth Quarter ........................... 20.69 13.38
On March 24, 1998, the Company had approximately 95 stockholders of record.
This number does not include beneficial owners holding shares through nominee or
"street" names. The Company believes the number of beneficial stockholders is
approximately 2,400.
DIVIDEND POLICY
The Company did not pay any dividends in 1998 and, in accordance with its
present general policy, has no present intention to pay cash dividends.
19
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Income Statement Data: (DOLLARS IN THOUSANDS, EXCEPT FOR SHARE DATA)
Revenues:
Net gain on sale of mortgage loans............. $ 92,452 $ 86,307 $ 46,525 $ 15,383 $ 6,661
Interest....................................... 12,458 22,341 16,372 13,588 9,839
Servicing fees................................. 9,392 7,094 5,368 2,855 2,183
Origination fees (1) .......................... 25,273 18,108 5,266 4,309 3,114
---------- ---------- ---------- ---------- ----------
Total revenues............................ 139,575 133,850 73,531 36,135 21,797
---------- ---------- ---------- ---------- ----------
Expenses:
Payroll and related costs (1).................. 56,684 41,204 17,633 13,753 9,415
Interest....................................... 30,019 19,972 11,298 7,964 3,735
General & administrative (1)................... 34,376 21,524 11,112 9,832 6,638
---------- ---------- ---------- ---------- ----------
Total expenses........................... 121,079 82,700 40,043 31,549 19,788
---------- ---------- ---------- ---------- ----------
Income before income taxes and
extraordinary item............................. 18,496 51,150 33,488 4,586 2,009
Provision for income taxes(1)...................... 7,168 20,739 9,466 -- --
---------- ---------- ---------- ---------- ----------
Income before extraordinary item................... 11,328 30,411 24,022 4,586 2,009
Extraordinary item:................................
Gain on extinguishment of debt................. -- -- 3,168 -- --
---------- ---------- ---------- ---------- ----------
Net income......................................... $ 11,328 30,411 27,190 4,586 2,009
---------- ---------- ---------- ---------- ----------
Pro forma information (2)(3):
Provision for pro forma income taxes
before extraordinary item...................... N/A N/A 14,400 1,972 864
---------- ---------- ---------- ---------- ----------
Pro forma income before extraordinary item.......... $ 11,328 30,411 19,088 2,614 1,145
---------- ---------- ---------- ---------- ----------
Per share data(2)(4):
Earnings per common share -
basic and diluted........................ $ 0.74 1.98 1.46 0.21 0.09
Weighted average number of
shares outstanding....................... 15,382,161 15,359,280 13,066,485 12,629,182 12,629,182
Selected Balance Sheet Data:
Loans held for sale, net........................... $ 87,170 79,247 82,411 63,324 48,833
Capitalized mortgage servicing rights.............. 33,490 22,862 11,412 3,831 2,421
Interest-only and residual certificates............ 203,803 167,809 83,073 25,310 7,514
Total assets....................................... 481,907 393,232 231,616 139,293 98,589
Senior notes, warehouse financing and
other borrowings............................... 229,660 177,540 95,482 82,756 52,491
Investor payable................................... 63,790 40,852 20,869 13,444 11,091
Total liabilities.................................. 344,219 266,779 138,098 109,460 70,425
Stockholders' equity............................... 137,688 126,453 93,518 29,833 28,164
- - ---------------
(1) In connection with the February 1997 acquisition of Fidelity Mortgage, the
Company incurred additional expenses normally associated with a retail
operation. Fidelity Mortgage's loan origination points when recognized are
reported as origination fee income.
(2) Figures for December 31, 1998 and 1997 are actual; pro forma presentation
for the years 1996, 1995 and 1994.
(3) Prior to October 31, 1996, Delta Funding (a wholly-owned subsidiary) was
treated as an S corporation for Federal and state income tax purposes. The
pro forma presentation reflects a provision for income taxes as if the
Company had always been a C corporation at an assumed tax rate of 43%.
(4) Pro forma earnings per common share has been computed by dividing pro
forma net income by the sum of (a) 10,653,000 shares of the Company's
common stock received by the former shareholders in exchange for their
shares of Delta Funding, and (b) the effect of the issuance of 1,976,182
shares of the Company's common stock issued in the Company's initial
public offering to generate sufficient cash for certain S corporation
distributions paid to the former shareholders, which shares are treated as
if they had always been outstanding.
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED
FINANCIAL STATEMENTS OF THE COMPANY AND ACCOMPANYING NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS SET FORTH THEREIN.
GENERAL
Delta Financial Corporation (the "Company" or "Delta") engages in the
consumer finance business by originating, acquiring, selling and servicing
non-conforming home equity loans. Throughout its 17 year operating history, the
Company has focused on lending to individuals who generally have impaired or
limited credit profiles or higher debt-to-income ratios.
Through its wholly-owned subsidiary, Delta Funding Corporation ("Delta
Funding"), the Company originates home equity loans indirectly through licensed
mortgage brokers and other real estate professionals who submit loan
applications on behalf of the borrower ("Brokered Loans") and also purchases
loans from mortgage bankers and smaller financial institutions that satisfy
Delta's underwriting guidelines ("Correspondent Loans"). Delta Funding currently
originates and purchases the majority of its loans in 24 states, through its
network of approximately 1,400 brokers and correspondents. Through its
wholly-owned subsidiary, Fidelity Mortgage, the Company develops retail loan
leads ("Retail Loans") primarily through its telemarketing system and its
network of 15 retail offices located in 9 states. Through a strategic alliance
between DFC Funding of Canada Limited, an indirectly wholly-owned subsidiary of
Delta Funding Corporation, and MCAP Mortgage Corporation, a Canadian mortgage
loan originator, the Company originated loans in Canada. In February 1999, the
Company decided to close its Canadian business to focus exclusively on its
U.S.-based business.
CERTAIN ACCOUNTING CONSIDERATIONS
As a fundamental part of its business and financing strategy, Delta sells the
majority of its loans through securitization and derives a substantial portion
of its income therefrom. In a securitization, the Company sells a pool of loans
it has originated or purchased to a REMIC trust for a cash purchase price. The
trust, in turn, finances the purchase of the pool of loans it has acquired by
selling "pass-through certificates," or bonds, which represent undivided
ownership interests in the trust. Holders of the pass-through certificates are
entitled to receive monthly distributions of all principal received on the
underlying mortgages and a specified amount of interest, as determined at the
time of the trust offering.
When the Company sells a pool of loans to a securitization trust, it receives
the following economic interests in the trust: (a) the difference between the
interest payments due on the loans sold to the trust and the interest rate paid
to the pass-through certificateholders, less the Company's contractual servicing
fee and other costs and expenses of administering the trust, represented by
interest-only and residual certificates, and (b) the right to service the loans
on behalf of the trust and earn a servicing fee, as well as other ancillary
servicing related fees directly from the borrowers on the underlying loans.
The Company's net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate or acquire the
loan adjusted for (i) any direct loan origination costs incurred (an increase)
and loan origination fees received (a decrease) in connection with the loans,
which are treated as a component of the initial investment in a loan under
Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for
Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases," and (ii) the principal payments received, and
the amortization of the net loan fees or costs, during the period the Company
held the loans prior to their securitization. The Company's investment in the
loans also reflects adjustments for any gains (a decrease in the investment) or
losses (an increase in the investment) the Company has incurred on treasury rate
lock contracts which the Company has typically used to hedge against the effects
of changes in interest rates during the period it holds the loans prior to their
securitization. (See "Hedging.")
Upon the securitization of a pool of loans, the Company (i) recognizes in
income, as origination fees, the unamortized origination fees included in the
investment in the loans sold, and (ii) recognizes a gain on sale of loans
21
equal to the difference between cash received from the trust and the
investment in the loans remaining after the allocation of portions of that
investment to record interest-only and residual certificates and mortgage
servicing rights received in the securitization. The majority of the net gain on
sale of mortgage loans results from, and is initially realized in the form of,
the retention of interest-only and residual certificates.
The Company sold interest-only certificates created in each of the 1998
securitizations for cash proceeds and intends to continue to sell the
interest-only certificate as long as the sale effectively maximizes cash flow
and profitability.
The interest-only and residual certificates received by the Company upon the
securitization of a pool of loans are accounted for as trading securities under
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." In accordance with SFAS No. 115, the amount initially allocated to
the interest-only and residual certificates at the date of a securitization
reflects the fair value of those interests. The amount recorded for the
certificates is reduced for distributions thereon which the Company receives
from the related trust, and is adjusted for subsequent changes in the fair value
of interest-only and residual certificates, which are reflected in the statement
of operations. The Company assesses the fair value of interest-only and residual
certificates based upon updated estimates of prepayment and default rates
relating to loan groups comprised of loans of similar types, terms, credit
quality, interest rates, geographic location and value of loan collateral, which
represent the predominant risk characteristics that would affect prepayments and
default rates.
The Company values the mortgage servicing rights it retains in a
securitization under the provisions of SFAS No. 125, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities." In
accordance with SFAS No. 125, the amount of the investment in the loans
allocated to the retained servicing rights is measured at the allocated carrying
amount of such servicing rights, based on the fair value of the servicing
rights. The fair value of the servicing rights is determined by discounting to a
present value (using a discount rate which management believes reflects the rate
market participants would utilize in purchasing similar loan servicing rights)
the estimated future contractual and ancillary servicing fees the Company will
receive and the estimated costs of servicing the loans. Those estimates are
based on the stated terms of the transferred loans adjusted for estimates of
future prepayment rates made on the basis of interest rate conditions and the
availability of alternative financing, and estimates of future defaults among
those loans, each of which would terminate the servicing of the loan and thus
negatively affect servicing income. The fair value of the servicing rights,
which is classified on the balance sheet as "capitalized mortgage servicing
rights," is then amortized over the period of the estimated net future cash
flows from the servicing income. SFAS No. 125 also requires that the capitalized
mortgage loan servicing rights be assessed periodically to determine if there
has been any impairment of the value of the asset, based on the date of the
assessment. The Company performs this assessment based on the same prepayment
and default estimates used to value interest-only and residual certificates. A
valuation allowance is provided for the capitalized servicing rights relating to
any loan group for which the recorded investment exceeds the fair value of the
servicing rights.
In recording and accounting for mortgage servicing rights and interest-only
and residual certificates, the Company makes estimates of rates of prepayments
and defaults, and the value of collateral, which it believes reasonably reflect
economic and other relevant conditions then in effect. The actual rate of
prepayments, defaults and the value of collateral will generally differ from the
estimates used due to subsequent changes in economic and other relevant
conditions and the implicit imprecision of estimates, and such differences can
be material. Prepayment and default rates, which are higher than those
estimated, would adversely affect the value of both the mortgage servicing
rights (actual mortgage servicing income will be less, and significant changes
could require an impairment of the capitalized mortgage servicing rights) and
the interest-only and residual certificates, for which changes in fair value are
recorded in operations. Conversely, prepayment and default rates, which are
lower than those estimated, would increase the servicing income earned over the
life of the loans and positively impact the value of the interest-only and
residual certificates.
There are currently two methods used to calculate the present value of the
residual interests, the "cash-in" and "cash-out" methods. The "cash-in" method
assumes value as the residual cash flow is received by the securitization trust
even if it is used to create an overcollateralization provision. In contrast,
the "cash-out" method assumes value at the time the residual cash flow is
actually received by the residual certificate holder (Delta) from the
securitization trust, which is only after the required overcollateralization
provision has been met. As the Company
22
receives residual cash flows from the securitization trust, generally 8 to 15
months following the primary issuance, these two methods will create
dramatically different values. The Company uses the more conservative "cash-out"
method, which calculates value at the time the residual cash flow is actually
received by Delta.
The Financial Accounting Standards Board ("FASB") and the Securities and
Exchange Commission have issued proposals relating to SFAS No. 125 that would
require companies to use the "cash-out" (more conservative), not the "cash-in"
(more aggressive), method in accounting for the value of the retained interest
(residual) in securitizations and overcollateralization assets. This would
result in one-time residual asset write-downs for companies that currently use
the "cash-in" method. The Company has always used the more conservative
"cash-out" method for accounting and will not be susceptible to a write-down as
a result of this proposed accounting change.
FAIR VALUE ADJUSTMENTS
During the second quarter of 1998, the Company recorded a $15.5 million
reduction in the carrying amount of its interest-only and residual certificates,
and also recorded a $1.9 million reduction in the carrying amount of its
capitalized mortgage servicing rights to reflect a provision for impairment (the
"fair value adjustments"). Both impairment provisions resulted from reductions
in the Company's estimates of the fair value of those assets. The reductions in
the estimated fair value resulted from a change in the prepayment assumptions
used by the Company to estimate the future cash flows to be derived from the
interest-only and residual certificates and the mortgage servicing rights.
As required by generally accepted accounting principles, at each reporting
period the Company estimates the fair value of its interest-only and residual
certificates and its capitalized mortgage servicing rights. The carrying amount
of the interest-only and residual certificates is adjusted to their current fair
value. For capitalized mortgage servicing rights, a valuation allowance is
recorded if the fair value of such rights is less than the carrying amount.
The fair values of both interest-only and residual certificates and
capitalized mortgage servicing rights are significantly affected by, among other
factors, prepayments of loans and estimates of future prepayment rates. The
Company continually reviews its prepayment assumptions in light of company and
industry experience and makes adjustments to those assumptions when such
experience indicates.
During 1997, the Company made certain changes in its prepayment assumptions,
principally increasing the estimated maximum prepayment rates for
adjustable-rate loan pools. The effect of that change in prepayment assumptions
did not materially affect the fair value of the interest-only and residual
certificates in 1997.
The Company's review of its prepayment experience and assumptions at June 30,
1998 indicated that the prepayment rates during 1998, particularly for
adjustable-rate mortgages ("ARMs"), and in particular during the second quarter
of 1998, were higher than those historically experienced, or previously
projected, by the Company. The Company believes that these increases in
prepayment rates were attributable to the continuation, for a longer period than
historically experienced, of low interest rates, together with changes, to a
flatter or inverted curve, of the relationship between long-term and short-term
interest rates (the "yield curve").
As a result, at June 30, 1998, the Company adjusted its prepayment
assumptions, increasing the maximum prepayment rates for all loans, and changing
the rate at which prepayments are assumed to increase from the initial rate to
the maximum rate from a straight-line build-up to a "vector" curve. These
revised prepayment assumptions were used to estimate the fair value of the
interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in securitizations completed prior to the second
quarter of 1998, requiring the fair value adjustments described above. These
revised prepayment assumptions were also used in initially valuing and recording
the interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in its securitizations completed subsequent to
the first quarter of 1998.
The Company assumes prepayment rates and defaults based upon the seasoning of
its existing securitization loan portfolio. The following table compares the
prepayment assumptions used subsequent to the first quarter of 1998 (the "new"
assumptions) with those used at December 31, 1997 and through the first quarter
of 1998 ( the "old" assumptions):
23
- - --------------------------------------------------------------------------------
LOAN TYPE Curve Description Month 1 Speed Peak Speed
- - --------------------------------------------------------------------------------
New Old New Old New Old
- - --------------------------------------------------------------------------------
Fixed Rate Loans Vector Ramp 4.8% 4.8% 31% 24%
Six-Month LIBOR ARMs Vector Ramp 10.0% 5.6% 50% 28%
Hybrid ARMs Vector Ramp 6.0% 5.6% 50% 28%
- - --------------------------------------------------------------------------------
In addition, in the fourth quarter of 1998, the Company increased its loss
reserve initially established for both fixed- and adjustable-rate loans sold to
the securitizations trusts to approximately 2.00% of the issuance amount
securitized from approximately 1.90% of the issuance amount. The Company made
this change to better reflect what management believes its loss experience will
be, as the Company anticipates slower prepayment rates and a flat to slight
moderate rise in home values as compared to the past few years, which may have
an adverse effect on the Company's non-performing loans. This change resulted in
approximately a $2.8 million reduction in the Company's value of the residual
and interest-only certificates. An annual discount rate of 12.0% was utilized in
determining the present value of cash flows from residual certificates, using
the "cash-out" method, which are the predominant form of retained interests at
both December 31, 1998 and 1997.
The Company uses the same prepayment assumptions in estimating the fair value
of its mortgage servicing rights.
To date, aggregate actual cash flows from the Company's securitization trusts
have either met or exceeded management's expectations and the Company determined
that no further adjustments to the prepayment or default assumptions was
necessary at December 31, 1998.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
GENERAL
The Company's net income for the year ended December 31, 1998 was $11.3
million, or $0.74 per share, compared to $30.4 million, or $1.98 per share, for
the year ended December 31, 1997. Comments regarding the components of net
income are detailed in the following paragraphs.
REVENUES
Total revenues increased $5.7 million, or 4%, to $139.6 million for the
twelve months ended December 31, 1998, from $133.9 million for the comparable
period in 1997. The increase in revenue was primarily attributable to increases
in origination fees and the net gains recognized on the sale of mortgage loans,
reflecting the growth in the Company's level of loan originations and purchases
and securitizations. In addition, servicing fees increased due to an increase in
the aggregate size of the Company's loan servicing portfolio. These increases
were significantly offset by a decline in interest income primarily due to the
fair value adjustments made to the Company's interest-only and residual
certificates and capitalized mortgage servicing rights in the second and fourth
quarters of 1998 (see "--Fair Value Adjustments") and a larger than normal hedge
loss which was not offset by a higher gain on sale because asset-backed
investors who purchase the pass-through certificates issued by securitization
trusts demanded wider spreads (see "net gain on sale of mortgage loans").
The Company originated and purchased $1.73 billion of mortgage loans for the
twelve months ended December 31, 1998, representing a 38% increase from $1.25
billion of mortgage loans originated and purchased for the comparable period in
1997. The Company completed four securitizations and loan sales in 1998 totaling
$1.73 billion, compared to four securitizations totaling $1.24 billion in 1997.
Total loans serviced increased 60% to $2.95 billion at December 31, 1998 from
$1.84 billion at December 31, 1997.
24
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans
represents (1) the sum of (a) the fair value of the interest-only and residual
certificates retained by the Company in a securitization for each period and the
market value of the interest-only certificates sold in connection with each
securitization, (b) the fair value of capitalized mortgage servicing rights
associated with loans securitized in each period, and (c) premiums earned on the
sale of whole loans on a servicing-released basis, (2) less the (x) premiums
paid to originate or acquire mortgage loans, (y) costs associated with
securitizations and (z) any hedge loss (gain) associated with a particular
securitization.
Net gain on sale of mortgage loans increased $6.2 million, or 7%, to $92.5
million for the twelve months ended December 31, 1998, from $86.3 million for
the comparable period in 1997. The increase was primarily due to a 40% increase
in the amount of loans securitized or sold on a whole loan basis to $1.73
billion in 1998, compared to $1.24 billion of loans securitized in 1997, but was
partially offset by a lower weighted average net gain on sale ratio. The
weighted average net gain on sale ratio was 5.4% in 1998 compared to 7.0% in
1997.
Net gain on the sale of loans increased less than the overall increase in
loan securitizations primarily due to (a) the Company's change to more
conservative prepayment assumptions used in initially valuing the residual
certificates and capitalized mortgage servicing rights acquired subsequent to
the first quarter of 1998 (see "--Fair Value Adjustments"), and (b) the impact
of a hedging loss during the third quarter of 1998 resulting from lower interest
rates that was not offset by a higher gain on sale due to substantially wider
spreads demanded by asset-backed investors who purchase the pass-through
certificates issued by securitization trusts.
INTEREST INCOME. Interest income primarily represents the sum of (1) the
difference between the distributions the Company receives on its interest-only
and residual certificates and the adjustments recorded to reflect changes in the
fair value of the interest-only and residual certificates, (2) interest earned
on loans held for sale, and (3) interest earned on cash collection balances.
Interest income decreased $9.9 million, or 44%, to $12.4 million for the
twelve months ended December 31, 1998, from $22.3 million for the comparable
period in 1997. The decrease in interest income was primarily due to the $15.5
million and $2.8 million fair value adjustments made during the second and
fourth quarters of 1998 to the interest-only and residual certificates
previously discussed (see "--Fair Value Adjustments"). The effect of that
adjustment was partially offset by increases in (a) interest-only and residual
certificates income, (b) interest on loans held for sale due to higher average
balances, partially offset by a decline, from 11.0% to 10.2%, in the weighted
average coupon rate on the mortgage loans, reflecting both a lower interest rate
environment and the Company's shift to higher credit quality loans and (c)
interest on bank deposits resulting from a higher average balance held in
securitization trust accounts by the Company.
SERVICING FEES. Servicing fees represent all contractual and ancillary
servicing revenue received by the Company less (1) the offsetting amortization
of the capitalized mortgage servicing rights, and any adjustments recorded to
provide valuation allowances for the impairment in mortgage servicing rights
(see "--Certain Accounting Considerations"), and (2) prepaid interest
shortfalls.
Servicing fees increased $2.3 million, or 32%, to $9.4 million for the twelve
months ended December 31, 1998, from $7.1 million for the comparable period in
1997. The increase was primarily due to an increase in the aggregate size of the
Company's servicing portfolio, partially offset by the recording of the $1.9
million provision for the Company's capitalized mortgage servicing rights. (See
"--Fair Value Adjustments"). The average balance of mortgage loans serviced by
the Company increased 77% to $2.44 billion for the twelve months ended December
31, 1998, from $1.38 billion for the comparable period in 1997.
ORIGINATION FEES. Origination fees represent fees earned on brokered and
retail originated loans. Origination fees increased $7.2 million, or 40%, to
$25.3 million for the twelve months ended December 31, 1998, from $18.1 million
for the comparable period in 1997. The increase was primarily the result of (a)
a 75% increase in broker originated loans and (b) a 67% increase in retail
originated loans.
EXPENSES
Total expenses increased $38.4 million, or 46%, to $121.1 million for the
twelve months ended December 31, 1998, from $82.7 million for the comparable
period in 1997. The increase was primarily the result of (1) an
25
increase in the Company's personnel to support its higher level of loan
originations, (2) an increase in general and administrative costs associated
with the Company's expanded retail, broker and correspondent divisions and (3)
an increase in interest expense associated with (a) the growth in the Company's
loan originations and (b) the $150 million aggregate principal amount of 9.5%
Senior Notes due 2004 issued in July 1997 (the "Senior Notes").
PAYROLL AND RELATED COSTS. Payroll and related costs include salaries,
benefits and payroll taxes for all employees. Payroll and related costs expense
increased $15.5 million, or 38%, to $56.7 million for the twelve months ended
December 31, 1998, from $41.2 million for the comparable period in 1997. The
increase was primarily due to staff increases related to growth in the Company's
loan originations and the costs associated with the Company's broker and
Fidelity Mortgage retail division, which only reflects expenses from February
11, 1997. The Company employed 1,104 full- and part-time employees as of
December 31, 1998, compared to 987 full- and part-time employees as of December
31, 1997.
INTEREST EXPENSE. Interest expense includes the borrowing costs to finance
loan originations and purchases under (1) the Company's credit facilities, (2)
the Senior Notes, and (3) its investment in interest-only and residual
certificates.
Interest expense increased $10.0 million, or 50%, to $30.0 million for the
twelve months ended December 31, 1998, from $20.0 million for the comparable
period in 1997. The increase was primarily attributable to (i) the Company's
issuance of Senior Notes in July 1997 and (ii) growth in loan production, which
increased the level of debt needed throughout 1998 to finance the inventory of
loans held for sale prior to their securitization.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
consist primarily of office rent, insurance, telephone, depreciation, goodwill
amortization, license fees, legal and 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 $12.9 million, or 60%, to $34.4
million for the twelve months ended December 31, 1998, from $21.5 million for
the comparable period in 1997. The increase was primarily attributable to (1) an
increase in expenses associated with the Company's increase in loan originations
and purchases in 1998, (2) the expansion costs associated with the Company's
adding two additional Fidelity Mortgage retail branch offices, and (3)
depreciation expense reflecting the Company's ongoing investment in technology.
INCOME TAXES. Income taxes are accounted for under SFAS No. 109, "Accounting
for Income Taxes." Deferred tax assets and liabilities are recognized on 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.
Prior to October 31, 1996, the Company was an S corporation pursuant to the
Internal Revenue Code of 1986, as amended, and as such did not incur any federal
income tax expense. On October 31, 1996, the Company became a C corporation for
federal and state income tax purposes and, as such, is subject to federal and
state income tax on its taxable income for the period beginning on November 1,
1996.
In connection with the change in tax status from an S corporation to a C
corporation, the Company incurred deferred income tax expense of $3.9 million as
of October 31, 1996. The remaining deferred income tax expense pertaining to the
change in status from an S corporation to a C corporation at December 31, 1998
was approximately $2.3 million.
The Company recorded tax provisions of $7.2 million and $20.7 million for the
years ended December 31, 1998 and 1997, respectively. Income taxes provided a
38.8% effective tax rate for the year ended December 31, 1998, compared to a
40.5% effective tax rate for the year ended December 31, 1997. The reduction in
the effective tax rate is primarily attributable to the Company's expansion into
lower tax rate states and local jurisdictions and to the benefits due to
permanent book/tax differences.
26
YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE YEAR ENDED DECEMBER 31, 1996
GENERAL
The Company's net income for the year ended December 31, 1997 was $30.4
million, or $1.98 per share as compared to $19.1 million (pro forma), or $1.46
per share (pro forma), for the year ended December 31, 1996. Comments regarding
the components of net income are detailed in the following paragraphs.
REVENUES
Total revenues increased $60.4 million, or 82%, to $133.9 million for the
twelve months ended December 31, 1997, from $73.5 million for the comparable
period in 1996. The increase in revenue was primarily attributable to the
increase in net gains recognized on the sale of mortgage loans, reflecting the
growth in the Company's level of loan originations and purchases and
securitizations. Revenue also increased in all other categories including
origination fees, servicing fees, and interest income.
The Company originated and purchased $1.25 billion of mortgage loans for the
twelve months ended December 31, 1997, representing a 90% increase from $659
million of mortgage loans originated and purchased for the comparable period in
1996. The Company issued four quarterly closed-end home equity loan
securitizations in 1997 totaling $1.24 billion, compared to three
securitizations and loan sales of $630 million in 1996. Total loans serviced
increased 97% to $1.84 billion at December 31, 1997 from $933 million at
December 31, 1996.
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans
increased $39.8 million, or 86%, to $86.3 million for the twelve months ended
December 31, 1997, from $46.5 million for the comparable period in 1996. The
increase was primarily due to a 97% increase in the amount of loans securitized
to $1.24 billion in 1997, compared to $630 million of loans sold or securitized
for the comparable period in 1996. Net gains from the sale of loans increased
less than the overall increase in loan securitizations primarily because of
increases in the pass-through rates required by REMIC trust investors in the
fourth quarter of 1997, which reduced the value of the interest-only and
residual certificates the Company received in connection with that quarter's
securitization. The weighted average gain on sale ratio for the twelve months
ended December 31, 1997, and for the comparable period in 1996, was 7.0% and
7.4%, respectively. The weighted average gain on sale ratio is calculated using
the net gain on sale divided by the total amount of loans securitized and sold.
INTEREST INCOME. Interest income increased $5.9 million, or 36%, to $22.3
million for the twelve months ended December 31, 1997, from $16.4 million for
the comparable period in 1996. The increase was primarily due to (a) a higher
average balance of mortgage loans held for sale during the twelve months ended
December 31, 1997 driven by higher loan originations and purchases as noted
above, and (b) an increase in excess servicing received from the Company's
interest-only and residual certificates, partially offset by the fair value
adjustment to the interest-only and residual certificates, primarily related to
distributions received from the securitization trusts.
SERVICING FEES. Servicing fees increased $1.7 million, or 31%, to $7.1
million for he twelve months ended December 31, 1997, from $5.4 million for the
comparable period in 1996. The increase was primarily due to a higher average
loan servicing portfolio, which resulted in increased contractual and ancillary
service fees, partially offset by a $2.9 million increase in amortization of the
Company's capitalized mortgage servicing rights in 1997, compared to 1996. The
average balance of mortgage loans serviced by the Company increased 107% to
$1.38 billion for the twelve months ended December 31, 1997, from $667 million
for the comparable period in 1996. The amount of mortgage loans serviced by the
Company increased at a faster rate than the amount of servicing fees, primarily
as a result of a reduction in the contractual servicing fee rate from 0.65% to
0.50% per annum beginning with the 1996-2 securitization in September 1996.
ORIGINATION FEES. Origination fees increased $12.8 million, or 242%, to $18.1
million for the twelve months ended December 31, 1997, from $5.3 million for the
comparable period in 1996. The increase was primarily the result of (a) the 1997
acquisition of Fidelity Mortgage and the subsequent expansion of its retail
network which accounted for $11.4 million of origination fees in 1997, and (b) a
50% increase in broker originated loans and commensurate increase in broker loan
origination fees.
27
EXPENSES
Total expenses increased $42.7 million, or 107%, to $82.7 million for the
twelve months ended December 31, 1997, from $40.0 million for the comparable
period in 1996. The increase in expenses was primarily the result of (i)
increased interest expense due to (a) higher interest costs generated by the
growth in the Company's loan origination and purchase activities, which
increased the level of debt needed throughout 1997 to finance the resulting
higher inventory of loans held for resale, (b) the Company's issuance in July
1997 of $150 million aggregate principal amount of 9.5% Senior Notes due August
1, 2004 and (c) financing the Company's investment in interest-only and residual
certificates (which was subsequently eliminated using a portion of the proceeds
from the Senior Notes), (ii) an increase in the Company's personnel related to
higher loan origination growth, including the Company's Fidelity Mortgage retail
division and (iii) costs associated with the expansion of the Company's retail,
broker and correspondent divisions.
PAYROLL AND RELATED COSTS. Payroll and related costs expense increased $23.6
million, or 134%, to $41.2 million for the twelve months ended December 31,
1997, from $17.6 million for the comparable period in 1996. The increase was
primarily related to staff increases associated with to the acquisition and
subsequent expansion of Fidelity Mortgage and the increase in loan originations
and purchases at the Company. The Company employed 987 full- and part-time
employees of which 447 were employees of Fidelity Mortgage as of December 31,
1997, compared to 346 full- and part-time employees as of December 31, 1996.
INTEREST EXPENSE. Interest expense increased $8.7 million, or 77%, to $20.0
million for the twelve months ended December 31, 1997, from $11.3 million for
the comparable period in 1996. The increase was primarily attributable to (i)
growth in loan activity, which increased the level of debt needed throughout
1997 to finance the inventory of loans held for sale prior to their
securitization, (ii) the Company's issuance in July 1997 of the Senior Notes,
(iii) financing of the Company's interest-only and residual certificates (which
was subsequently eliminated using a portion of the proceeds from the Senior
Notes), and (iv) a higher cost of funds on the Company's credit facilities which
were tied to one-month LIBOR. The one-month LIBOR index increased to an average
interest rate of 5.7% in 1997, compared to an average interest rate of 5.4% in
1996.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased $10.4 million, or 94%, to $21.5 million for the twelve months ended
December 31, 1997, from $11.1 for the comparable period in 1996. The increase
was primarily attributable to (i) the amortization of acquisition costs
(goodwill) associated with the Company's purchase of Fidelity Mortgage; (ii) the
expansion costs associated with the Company's increasing the number of Fidelity
Mortgage retail branch offices from five to thirteen during 1997, and (iii) an
increase in expenses associated with the Company's increase in loan origination
and purchases in 1997.
INCOME TAXES. The Company recorded a tax provision of $20.7 million and $9.5
million (which included a $3.9 million deferred tax charge in connection with
its change in status from an S corporation to a C corporation in 1996) for the
years ended December 31, 1997 and 1996, respectively.
Income taxes provided a 40.5% effective tax rate for the year ended December
31, 1997, compared to a 42.5% assumed effective tax rate for the year ended
December 31, 1996 if the Company would have been a C corporation for the entire
period. The reduction in the effective tax rate is primarily attributable to the
Company's expansion into lower taxing state and local jurisdictions.
FINANCIAL CONDITION
DECEMBER 31, 1998 COMPARED TO DECEMBER 31, 1997
Cash and interest-bearing deposits increased $16.3 million, or 50%, to $49.2
million at December 31, 1998 from $32.9 million at December 31, 1997. This
increase was primarily the result of additional monies held in securitization
trust accounts by the Company, acting as servicer for its ongoing securitization
program.
Accounts receivable decreased $8.7 million, or 28%, to $22.5 million at
December 31, 1998 from $31.2 million at December 31, 1997. The decrease was
primarily attributable to the receipt of a federal tax refund, partially offset
by an increase in reimbursable servicing advances made by the Company, acting as
servicer on its securitizations,
28
related to a higher average servicing portfolio. The Company's servicing
portfolio increased 60% to $2.95 billion as of December 31, 1998 from $1.84
billion as of December 31, 1997.
Loans held for sale increased $8.0 million, or 10%, to $87.2 million at
December 31, 1998 from $79.2 million at December 31, 1997. This increase was
primarily due to the net difference between loan originations and loans
securitized during 1998.
Accrued interest and late charges receivable increased $17.3 million, or 58%,
to $46.9 million at December 31, 1998 from $29.6 million at December 31, 1997.
This increase was primarily due to a larger loan servicing portfolio, which
resulted in increased reimbursable interest advances made by the Company, acting
as servicer on its securitizations.
Capitalized mortgage servicing rights increased $10.6 million, or 46%, to
$33.5 million at December 31, 1998 from $22.9 million at December 31, 1997. This
increase was directly attributable to the Company's capitalizing the fair market
value of the servicing assets, totaling $19.8 million, resulting from the
Company's completion of four securitizations during 1998, partially offset by
the amortization of capitalized mortgage servicing rights and the fair value
adjustment to the capitalized mortgage servicing rights (see "--Fair Value
Adjustments").
Interest-only and residual certificates increased $36.0 million, or 21%, to
$203.8 million at December 31, 1998 from $167.8 million at December 31, 1997.
This increase is primarily attributable to the Company's receipt of residual
certificates valued and recorded at $85.1 million from its securitizations
during the year ended December 31, 1998. The increase was offset by the effect
of the fair value adjustment (see "--Fair Value Adjustments") and normal
amortization due to cash distributions.
Equipment, net, increased $5.8 million, or 52%, to $17.0 million at December
31, 1998 from $11.2 million at December 31, 1997. The increase was primarily due
to capital expenditures related to new technology and expansion.
Cash held for advance payments increased $3.7 million, or 59%, to $10.0
million at December 31, 1998 from $6.3 million at December 31, 1997. This
increase was primarily due to a higher average loan servicing portfolio
resulting in additional monies held in escrow trust accounts by the Company,
acting as servicer.
Warehouse financing and other borrowings increased $52.1 million, or 185%, to
$80.3 million at December 31, 1998 from $28.2 million at December 31, 1997. This
increase was primarily related to the operating cash deficit and to a lesser
extent, the funding of the Company's investment in technology.
The aggregate principal balance of the Senior Notes, net of unamortized bond
discount totaled $149.4 million at December 31, 1998 compared to $149.3 million
at December 31, 1997. The Senior Notes accrue interest at a rate of 9.5% per
annum, payable semi-annually on February 1 and August 1.
Accounts payable and accrued expenses increased $5.5 million, or 35%, to
$21.0 million at December 31, 1998 from $15.5 million at December 31, 1997. This
increase was primarily attributable to an increase in current income taxes
payable, various operating accruals and an increase in the provision for
recourse loans.
Investor payable increased $22.9 million, or 56%, to $63.8 million at
December 31, 1998 from $40.9 million at December 31, 1997. This increase was
primarily due to the 60% increase in the Company's portfolio of serviced loans
to $2.95 billion at December 31, 1998 from $1.84 billion at December 31, 1997.
Investor payable is comprised of all principal collected on mortgage loans and
accrued interest. Variability in this account is primarily due to the principal
payments collected within a given collection period.
Advance payments by borrowers for taxes and insurance increased $3.8 million,
or 66%, to $9.6 million at December 31, 1998 from $5.8 million at December 31,
1997. This increase is primarily due to a higher average loan servicing
portfolio and the timing of payments collected and disbursed resulting in
additional monies held in escrow trust accounts by the Company acting as a
servicer.
Stockholders' equity increased $11.2 million, or 9%, to $137.7 million at
December 31, 1998 from $126.5 million at December 31, 1997. This increase is
primarily due to net income for the twelve month period of $11.3 million, the
issuance of $1.2 million of the Company's common stock paid to the sellers of
Fidelity Mortgage in August 1998, partially offset by the Company's repurchase
of 116,800 shares of its common stock for $1.3 million.
29
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically operated on a negative cash flow basis primarily
due to increases in the volume of loan purchases and originations and the growth
of its securitization program. In recent quarters, however, the Company reduced
its negative cash flow and achieved a positive cash flow during the fourth
quarter of 1998. The Company's focus is to maintain a neutral cash flow position
for the foreseeable future, as a result of aggregate annual increased cash
inflows from the Company's retained interest-only and residual certificates,
advantageous changes in the securitizations structures the Company has used and
a greater concentration on less cash-intensive broker and retail originations.
Since the second quarter of 1997, the Company has sold the senior interest-only
certificates in each of its securitizations and, in the Company's four most
recent securitizations, it has successfully increased the amount of senior
interest-only certifcates offered to investors, compared to prior
securitizations.
For the years ended December 31, 1998 and 1997, the Company had operating
cash deficits of $24.6 million and $53.5 million, respectively. The improvement
in the Company's operating cash deficit in 1998, compared to 1997, was primarily
due to increased cash inflows from the Company's retained interest-only and
residual certificates, changes in the securitization structures that the Company
has utilized, an increase in the Company's restricted cash held for
securitization trust accounts and a lower percentage of correspondent loan
purchases and lower purchased premiums, a tax refund, partially offset by the
semi-annual Senior Note interest payments made in February 1998 and August 1998.
Currently, the Company's primary cash requirements include the funding of (i)
mortgage originations and purchases pending their pooling and sale, (ii) the
points and expenses paid in connection with the acquisition of correspondent
loans, (iii) interest expense on its Senior Notes and warehouse and other
financings, (iv) fees, expenses and tax payments incurred in connection with its
securitization program and (v) ongoing administrative and other operating
expenses. The Company has relied upon a few lenders to provide the primary
credit facilities for its loan originations and purchases. The Company must be
able to sell loans and obtain adequate credit facilities and other sources of
funding in order to continue to originate and purchase loans.
Historically, the Company has utilized various financing facilities and an
equity financing to offset negative operating cash flows and support the
continued growth of its loan originations and purchases, securitizations and
general operating expenses. On July 23, 1997, the Company completed its offering
of the Senior Notes. A portion of the Senior Notes proceeds were used to pay
down various financing facilities with the remainder used to fund the Company's
growth in loan originations and purchases and its ongoing securitization
program. The Company's primary sources of liquidity continue to be warehouse and
other financing facilities, securitizations and, subject to market conditions,
sales of whole loans and additional debt and equity securities.
To accumulate loans for securitization, the Company borrows money on a
short-term basis through warehouse lines of credit. The Company currently has
three warehouse facilities for this purpose. One warehouse facility is a $200
million committed credit line with a variable rate of interest and a maturity
date of March 2000. This facility was converted from an uncommitted to a
committed line during the three months ended March 31, 1997 and the maturity
date was extended from February 1999 to March 2000 during the three months ended
March 31, 1999. The Company's second warehouse facility is a syndicated $150
million committed revolving line with a variable rate of interest and a maturity
date of June 1999. This facility was increased from $140 million to $150 million
during the three months ended June 30, 1998. The Company's third warehouse
facility is a $200 million committed commercial paper conduit with a variable
rate of interest and a maturity date of September 1999. Additionally, the
Company obtained a fourth warehouse facility - a $200 million committed credit
facility with a variable rate of interest and a maturity date of March 2000 -
during the three months ended March 31, 1999. The outstanding balances on the
$200 million, $150 million, and $200 million facilities as of December 31, 1998
were $58.7 million, $10.7 million, and $0 million, respectively.
The Company has in the past obtained financing facilities for interest-only
and residual certificates acquired as part of its securitizations. In July 1997,
all outstanding balances were eliminated using a portion of the proceeds from
the Senior Notes. In addition, the Company is limited by the terms of the
indenture governing the Senior Notes as to the amount of future indebtedness
permitted to be secured by interest-only and residual certificates.
The Company is required to comply with various operating and financial
covenants as provided in the agreements described above which are customary for
agreements of their type. The Company does not believe that
30
its existing financial covenants will restrict its operations or growth.
The continued availability of funds provided to the Company under these
agreements is subject to the Company's continued compliance with these
covenants. Management believes that the Company is in compliance with all such
covenants under these agreements as of December 31, 1998.
The Company purchased a total of 116,800 shares of its common stock during
the year ended December 31, 1998, under the Company's stock repurchase program,
at a total cost of $1.3 million. All of the repurchased shares were purchased in
open market transactions at then prevailing market prices.
INTEREST RATE RISK
Among the Company's primary market risk exposure is interest rate risk.
Profitability may be directly affected by the level of, and fluctuation in,
interest rates, which affect the Company's ability to earn a spread between
interest received on its loans and the costs of its borrowings, which are tied
to various United States Treasury maturities, commercial paper rates and the
London Inter-Bank Offered Rate ("LIBOR"). The profitability of the Company is
likely to be adversely affected during any period of unexpected or rapid changes
in interest rates. A substantial and sustained increase in interest rates could
adversely affect the Company's ability to purchase and originate loans. A
significant decline in interest rates could increase the level of loan
prepayments thereby decreasing the size of the Company's loan servicing
portfolio. To the extent servicing rights and interest-only and residual classes
of certificates have been capitalized on the books of the Company, higher than
anticipated rates of loan prepayments or losses could require the Company to
write down the value of such servicing rights and interest-only and residual
certificates, adversely impacting earnings. As previously discussed, the fair
value adjustments that the Company recorded in the second quarter of 1998 were
primarily attributable to the Company's change in prepayment assumptions to
reflect higher than originally anticipated rates of prepayments (see "--Fair
Value Adjustments"). In an effort to mitigate the effect of interest rate risk,
the Company has reviewed its various mortgage products and has identified and
modified those that have proven historically more susceptible to prepayments.
However, there can be no assurance that such modifications to its product line
will effectively mitigate interest rate risk in the future.
Fluctuating interest rates also may affect the net interest income earned by
the Company resulting from the difference between the yield to the Company on
loans held pending sales and the interest paid by the Company for funds borrowed
under the Company's warehouse facilities, although the Company undertakes to
hedge its exposure to this risk by using treasury rate lock contracts. (See
"--Hedging" below).
HEDGING
The Company originates and purchases mortgage loans and then sells them
primarily through securitizations. At the time of securitization and delivery of
the loans, the Company recognizes gain on sale based on a number of factors
including the difference, or "spread," between the interest rate on the loans
and the interest rate paid to asset-backed investors who purchase pass-through
certificates issued by securitization trusts, which historically was generally
related to the interest rate on treasury securities with maturities
corresponding to the anticipated life of the loans. If interest rates rise
between the time the Company originates or purchases the loans and the time the
loans are sold at securitization, the excess spread narrows, resulting in a loss
in value of the loans. The Company has implemented a strategy to protect against
such losses and to reduce interest rate risk on loans originated and purchased
that have not yet been securitized through the use of treasury rate lock
contracts with various durations (which are similar to selling a combination of
United States Treasury securities), which equate to a similar duration of the
underlying loans. The nature and quantity of hedging transactions are determined
by the Company based upon various factors including, without limitation, market
conditions and the expected volume of mortgage originations and purchases. The
Company will enter into treasury rate lock contracts through one of its
warehouse lenders and/or one of the investment bankers which underwrite the
Company's securitizations. These contracts are designated as hedges in the
Company's records and are closed out when the associated loans are sold through
securitization.
If the value of the hedges decrease, offsetting an increase in the value of
the loans, the Company, upon settlement with its counterparty, will pay the
hedge loss in cash and realize the corresponding increase in the value
31
of the loans as part of its net gain on sale of mortgage loans and its
corresponding interest-only and residual certificates. Conversely, if the value
of the hedges increase, offsetting a decrease in the value of the loans, the
Company, upon settlement with its counterparty, will receive the hedge gain in
cash and realize the corresponding decrease in the value of the loans through a
reduction in the value of the corresponding interest-only and residual
certificates.
Up to and including the second quarter of 1998, the Company believed that its
hedging strategy of using treasury rate lock contracts was the most effective
way to manage its interest rate risk on loans prior to securitization. However,
in the third quarter of 1998, asset-backed investors, responding to lower
treasury yields and global financial market volatility, demanded substantially
wider spreads over treasuries than historically experienced for newly issued
asset-backed securities. As a result, Delta's $8.8 million hedge loss resulting
from lower interest rates was not offset by a higher gain on sale as the Company
has historically seen.
Given the Company's belief that the volatile market experienced in the third
quarter would likely continue well into the fourth quarter - and, as a result,
that the amount of the spreads demanded by asset-backed securitization investors
would be difficult to predict, as asset-backed securitization investors were
more interested in absolute yields, instead of spreads over treasuries - the
Company did not hedge any of its warehoused loans pending securitization in the
fourth quarter; believing that its historical hedging strategy would continue to
be largely ineffective in such an environment.
The Company has continued to review its hedging strategy in order to best
mitigate risk pending securitization. As the asset-backed securitization market
improved in the first quarter of 1999, and spreads over treasuries became
largely more predictable, the Company resumed its hedging strategy of selling
treasury rate-lock contracts to mitigate its interest rate risk pending
securitization.
INFLATION
Inflation affects the Company most significantly in the area of loan
originations and can have a substantial effect 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 1 of Notes to the Consolidated Financial Statements.
RISK FACTORS
Except for historical information contained herein, certain matters discussed
in this Form 10-K are "forward-looking statements" as defined in the Private
Securities Litigation Reform Act (PSLRA) of 1995, which involve risk and
uncertainties that exist in the Company's operations and business environment,
and are subject to change on various important factors. The Company wishes to
take advantage of the "safe harbor" provisions of the PSLRA by cautioning
readers that numerous important factors discussed below, among others, in some
cases have caused, and in the future could cause the Company's actual results to
differ materially from those expressed in any forward-looking statements made
by, or on behalf of, the Company. The following include some, but not all, of
the factors or uncertainties that could cause actual results to differ from
projections:
* The Company's ability or inability to continue to access lines of
credit, including without limitation, warehouse and other credit
facilities used to finance newly originated mortgage loans held for
sale.
* The Company's ability or inability to continue its practice of
securitization of mortgage loans held for sale.
* 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 the Company's focus on
credit-impaired borrowers, the actual rate of delinquencies,
foreclosures and losses on loans
32
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 the Company's ability to securitize or sell loans in the
secondary market.
* The effects of interest rate fluctuations and the Company's 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.
* Rapid or unforeseen escalation of the cost of regulatory compliance
and/or litigation, including but not limited to, environmental
compliance, licenses, adoption of new, or changes in accounting polices
and practices and the application of such polices and practices.
Failure to comply with various federal, state and local regulations,
accounting policies, and environmental compliance can lead to loss of
approved status, certain rights of rescission for mortgage loans, class
action lawsuits and administrative enforcement action.
* Increased competition within the Company's 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. The Company is currently competing with large finance companies
and conforming mortgage originators many of whom have greater
financial, technological and marketing resources.
* The unanticipated expenses of assimilating newly-acquired businesses
into the Company's structure; as well as the impact of unusual expenses
from ongoing evaluations of business strategies, asset valuations,
acquisitions, divestitures and organizational structures.
* Unpredictable delays or difficulties in development of new product
programs.
* Year 2000 Compliance and Technology Enhancements. The Company is
utilizing both internal and external resources to identify, correct,
reprogram or replace, and test its systems for year 2000 compliance.
Although to date, the Company has been completing its Year 2000
compliance efforts on time, there can be no assurance that the Company
will not experience unexpected delay There can also be no assurance
that the systems of other companies on which the Company's systems rely
will be timely reprogrammed for year 2000 compliance.
INFORMATION SERVICES YEAR 2000 PROJECT
The Year 2000 issue centers on the inability of certain computer hardware and
software systems and associated applications to correctly recognize and process
dates beyond December 31, 1999. Many computer programs used by the Company, its
suppliers and outside service providers were developed using only six digits to
define the date field (two fields each for the month, day and year) and may
recognize "00" as the year 1900, rather than the year 2000. Due to the nature of
financial information, if corrective action is not taken, calculations that rely
on the integrity of the date field for the processing of information could be
significantly misstated.
STATE OF READINESS
The Company has implemented a detailed Year 2000 Plan (the "Plan") to
evaluate the Year 2000 readiness of the computer systems that support the
operation of the Company including vendor computer systems. This Plan is
expected to conclude in June 1999 with all systems year 2000 compliant.
The Plan includes upgrading the origination system software, upgrading the
loan servicing software, upgrading the accounting system software, upgrading the
wide area network software, assessing the proper integration of all systems and
communicating with vendors and liquidity providers to ascertain their Year 2000
compliance.
33
To date the accounting system is Year 2000 compliant and vendors and
liquidity providers have been contacted regarding their readiness. Results of
system tests conducted by the Company and other service providers will continue
to be carefully monitored to ensure that all issues have been identified and
addressed.
The Company believes it has developed an effective Plan to address the Year
2000 issue and that based on the available information, the execution of the
Plan will not have any significant or material impact to the Company's ability
to operate before, during or after the transition to the new millennium.
However, the Company has no control over the process of third parties in
addressing their own Year 2000 issues and, if the necessary changes are not
effected or are not completed in a timely manner, or if unanticipated problems
arise, there may be a material impact on the Company's financial condition and
result of operations.
COST TO ADDRESS THE COMPANY'S YEAR 2000 ISSUES
The Company's costs to resolve the Year 2000 issue are not expected to have a
material financial impact on the Company and are expected to be less than $1.0
million, which the Company intends to fund from its current operations. To date,
the Company has paid and expensed $0.6 million. However, as stated above, there
can be no assurance that all such costs have been identified, or that there may
not be some unforeseen cost which may have a material adverse effect on the
Company's financial condition and results of operations.
RISK OF YEAR 2000 ISSUES
To date, the Company has not identified any system which presents a material
risk of failing to be Year 2000 complaint in a timely manner, or for which a
suitable alternative cannot be implemented. However, as the Company progresses
with its Plan, systems or equipment may be identified which present a material
risk of business interruption. Such disruption may include the inability to
process customer accounting transactions; the inability to process loan
applications; the inability to reconcile and record daily activity; the
inability to track delinquencies; or the inability to generate checks or to
clear funds. In addition, if any of the Company's liquidity providers should
fail to achieve the Year 2000 compliance and they experience a disruption of
their own businesses which prevents them from fulfilling their obligations, the
Company may be materially impacted.
To the extent that the risks posed by the Year 2000 issue, which are beyond
the Company's control, are pervasive in data processing, utility and
telecommunication services worldwide, the Company cannot predict with certainty
that it will remain materially unaffected by issues related to the Year 2000
problem.
CONTINGENCY PLANS
As part of the Plan implemented by the Company, periodic assessments are made
to determine that all Year 2000 issues will be addressed prior to the new
millennium. If this assessment determines that any systems are not Year 2000
compliant, and will not become Year 2000 compliant in a timely manner, then a
contingency plan to implement a suitable alternative will be put in place. At
this time all systems are expected to be compliant and no contingency plan is in
place.
34
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The primary market risk to which the Company is exposed is interest rate
risk, which is highly sensitive to many factors, including governmental monetary
and tax policies, domestic and international economic and political
considerations and other factors beyond the control of the Company. Changes in
the general level of interest rates between the time the Company originates or
purchases mortgage loans and the time the Company sells such mortgage loans at
securitization can affect the value of the Company's mortgage loans held for
sale and, consequently, the Company's net gain on sale revenue by affecting the
"excess spread" between the interest rate on the mortgage loans and the interest
rate paid to asset-backed investors who purchase pass-through certificates
issued by the securirzation trusts. If interest rates rise between the time the
Company originates or purchases the loans and the time the loans are sold at
securitization, the excess spread generally narrows, resulting in a loss in
value of the loans and a lower net gain on sale.
A hypothetical 10 basis point increase in interest rates, which historically
has resulted in approximately a 10 basis point decrease in the excess spread,
would be expected to reduce the Company's net gain on sale by approximately 25
basis points. Many factors, however, can affect the sensitivity analysis
described above including, without limitation, the structure and credit
enhancement used in a particular securitization, the Company's prepayment, loss
and discount rate assumptions, and the spread over treasuries demanded by
asset-backed investors who purchase the Company's asset-backed securities.
To reduce its financial exposure to changes in interest rates, the Company
generally hedges its mortgage loans held for sale by entering into treasury rate
lock contracts (see "Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations - Hedging"). The Company's hedging strategy
has largely been an effective tool to manage the Company's interest rate risk on
loans prior to securitization, by providing the Company 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. This was the case in the third quarter of 1998,
when asset-backed investors, responding to lower treasury yields and global
financial market volatility, demanded substantially wider spreads over
treasuries than historically experienced for newly issued asset-backed
securities. As a result, Delta's $8.8 million hedge loss resulting from lower
interest rates was not offset by a higher gain on sale as the Company has
historically seen.
Changes in interest rates could also adversely affect the Company's ability
to purchase and originate loans and/or could affect the level of loan
prepayments thereby impacting the size of the Company's loan servicing portfolio
and the value of the Company's interest only and residual certificates and
capitalized mortgage servicing rights. (See "Item 7 Management's Discussion and
Analysis of Financial Condition and Results of Operations - Interest Rate
Risk").
35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Delta Financial Corporation:
We have audited the accompanying consolidated balance sheets of Delta Financial
Corporation and subsidiaries (the "Company") as of December 31, 1998 and 1997,
and the related consolidated statements of income, changes in stockholders'
equity, and cash flows for each of the years in the three-year period ended
December 31, 1998. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of the Company as of
December 31, 1998 and 1997, and the results of their operations and their cash
flows for each of the years in the three-year period ended December 31, 1998 in
conformity with generally accepted accounting principles.
/s/ KPMG LLP
Melville, New York
February 16, 1999
36
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
- - --------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
December 31, 1998 and 1997
(DOLLARS IN THOUSANDS) 1998 1997
- - --------------------------------------------------------------------------------
ASSETS
Cash and interest-bearing deposits.................... $ 49,152 $ 32,858
Accounts receivable................................... 22,549 31,209
Loans held for sale, net.............................. 87,170 79,247
Accrued interest and late charges receivable.......... 46,897 29,598
Capitalized mortgage servicing rights................. 33,490 22,862
Interest-only and residual certificates............... 203,803 167,809
Equipment, net........................................ 16,962 11,211
Cash held for advance payments........................ 10,031 6,325
Prepaid and other assets.............................. 5,839 6,224
Goodwill ............................................. 6,014 5,889
- - --------------------------------------------------------------------------------
Total assets.................................. $ 481,907 393,232
================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Bank payable.......................................... $ 1,396 2,222
Warehouse financing and other borrowings.............. 80,273 28,233
Senior Notes.......................................... 149,387 149,307
Accounts payable and accrued expenses................. 20,966 15,503
Investor payable...................................... 63,790 40,852
Advance payment by borrowers for taxes and insurance.. 9,559 5,750
Deferred tax liability................................ 18,848 24,912
- - --------------------------------------------------------------------------------
Total liabilities............................. 344,219 266,779
- - --------------------------------------------------------------------------------
Stockholders' Equity:
Capital stock, $.01 par value. Authorized
49,000,000 shares; 15,475,549 shares
issued and 15,358,749 shares outstanding
at December 31, 1998, and 15,372,688
shares issued and
outstanding at December 31, 1997................... 155 154
Additional paid-in capital............................ 94,700 93,476
Retained earnings..................................... 44,151 32,823
Treasury stock, at cost (116,800 shares).............. (1,318) -
- - --------------------------------------------------------------------------------
Total stockholders' equity.................... 137,688 126,453
- - --------------------------------------------------------------------------------
Total liabilities and stockholders' equity.... $ 481,907 $ 393,232
================================================================================
See accompanying notes to consolidated financial statements.
37
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
- - -----------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31, 1998, 1997 and 1996
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1996
- - -----------------------------------------------------------------------------------------------
Revenues:
Net gain on sale of mortgage loans $ 92,452 86,307 46,525
Interest......................... 12,458 22,341 16,372
Servicing fees................... 9,392 7,094 5,368
Origination fees................. 25,273 18,108 5,266
- - -----------------------------------------------------------------------------------------------
Total revenues.................. 139,575 133,850 73,531
- - -----------------------------------------------------------------------------------------------
Expenses:
Payroll and related costs........ 56,684 41,204 17,633
Interest expense................. 30,019 19,972 11,298
General and administrative....... 34,376 21,524 11,112
- - -----------------------------------------------------------------------------------------------
Total expenses.................. 121,079 82,700 40,043
- - -----------------------------------------------------------------------------------------------
Income before income taxes and extraordinary item 18,496 51,150 33,488
Provision for income taxes........... 7,168 20,739 9,466
- - -----------------------------------------------------------------------------------------------
Income before extraordinary item..... 11,328 30,411 24,022
Extraordinary item:
Gain on extinguishment of debt... -- -- 3,168
- - -----------------------------------------------------------------------------------------------
Net income...................... $ 11,328 30,411 27,190
===============================================================================================
Unaudited pro forma information:
Provision for pro forma income taxes
before extraordinary item... $ N/A N/A 14,400
- - -----------------------------------------------------------------------------------------------
Pro forma income before extraordinary item $ 11,328 30,411 19,088
===============================================================================================
Per share data (1):
Earnings per common share - basic and diluted $ 0.74 1.98 1.46
Weighted average number of shares outstanding 15,382,161 15,359,280 13,066,485
===============================================================================================
(1) Unaudited pro forma presentation for the year ended 1996.
See accompanying notes to consolidated financial statements.
38
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
- - ------------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS'
EQUITY
Years ended December 31, 1998, 1997 and 1996
ADDITIONAL
PAID-IN RETAINED TREASURY
(DOLLARS IN THOUSANDS) CAPITAL STOCK CAPITAL EARNINGS STOCK TOTAL
- - ------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1995................ $ 107 3,225 26,501 -- 29,833
Proceeds from initial public offering of
Common stock........................... 46 69,656 -- -- 69,702
Reclassification of undistributed S
corporation earnings................... -- 18,072 (18,072) -- --
Net income.................................. -- -- 27,190 -- 27,190
Distributions............................... -- -- (33,207) -- (33,207)
- - ------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996................ 153 90,953 2,412 -- 93,518
Issuance of common stock to acquire
Fidelity Mortgage.................. 1 2,516 -- -- 2,517
Proceeds from exercise of stock options..... -- 7 -- -- 7
Net income.................................. -- -- 30,411 -- 30,411
- - ------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1997................ 154 93,476 32,823 -- 126,453
Issuance of common stock related to
Fidelity Mortgage.................. 1 1,199 -- -- 1,200
Purchase of Treasury Stock (116,800 shares) -- -- -- (1,318) (1,318)
Proceeds from exercise of stock options..... -- 25 -- -- 25
Net income.................................. -- -- 11,328 -- 11,328
- - ------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998................ $ 155 94,700 44,151 (1,318) 137,688
==================================================================================================================
See accompanying notes to consolidated financial statements.
39
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
- - -------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1998, 1997 and 1996
(DOLLARS IN THOUSANDS) 1998 1997 1996
- - -------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income.............................................. $ 11,328 30,411 27,190
Adjustments to reconcile net income to net cash used in
Operating activities:
Provision for loan and recourse losses 750 100 101
Depreciation and amortization........................ 4,386 2,603 997
Deferred tax (benefit) expense....................... (6,064) 19,901 5,011
Capitalized mortgage servicing rights, net
of amortization.................................... (10,628) (11,451) (7,581)
Deferred origination costs (fees).................... 1,840 (88) (2,399)
Interest-only and residual certificates received in
securitization transactions, net................... (35,994) (84,736) (57,763)
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable, net...... 5,755 (20,677) (1,654)
(Increase) decrease in loans held for sale, net...... (9,793) 3,222 (17,719)
Increase in accrued interest and late
charges receivable................................. (17,299) (11,139) (3,340)
(Increase) decrease in cash held for advance payments (3,706) (3,836) 631
Decrease in real estate owned........................ -- 135 116
Decrease (increase) in prepaid and other assets...... 385 (4,630) (244)
Decrease in due from stockholders.................... -- -- 990
Increase in accounts payable and accrued expenses.... 7,648 3,211 6,764
Increase in investor payable......................... 22,938 19,984 7,427
Increase (decrease) in advance payment by borrowers
for taxes and insurance 3,809 3,482 (552)
- - -------------------------------------------------------------------------------------------------------------------
Net cash used in operating activities................... (24,645) (53,508) (42,025)
- - -------------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Acquisition of Fidelity Mortgage..................... -- (4,150) --
Purchase of equipment................................ (8,982) (9,933) (2,283)
- - -------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities:.................. (8,982) (14,083) (2,283)
- - -------------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Net proceeds from initial public offering............... -- -- 69,701
Proceeds from (repayments of) warehouse
financing and other borrowings, net.................. 52,040 (67,481) 12,725
Proceeds from Senior Notes.............................. -- 149,307 --
Decrease in bank payable, net........................... (826) (125) (2,805)
Proceeds from exercise of stock options................. 25 7 --
Distributions........................................... -- -- (33,207)
Purchase of treasury stock.............................. (1,318) -- --
- - -------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities............... 49,921 81,708 46,414
- - -------------------------------------------------------------------------------------------------------------------
Net increase in cash and interest-bearing deposits...... 16,294 14,117 2,106
Cash and interest-bearing deposits at beginning of year.... 32,858 18,741 16,635
- - -------------------------------------------------------------------------------------------------------------------
Cash and interest-bearing deposits at end of year.......... $ 49,152 32,858 18,741
===================================================================================================================
Supplemental Information:
Cash paid during the year for:
Interest ............................................... $ 29,576 14,314 10,453
Income taxes ........................................... 7,241 19,972 202
===================================================================================================================
See accompanying notes to consolidated financial statements.
40
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997, AND 1996
(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) ORGANIZATION
Delta Financial Corporation (the "Company" or "Delta") is a Delaware
corporation which was organized in August 1996. On October 31, 1996, the Company
acquired all of the outstanding common stock of Delta Funding Corporation
("Delta Funding"), a New York corporation which had been organized on January 8,
1982 for the purpose of originating, selling, servicing and investing in
residential first and second mortgages. On November 1, 1996, the Company
completed an initial public offering of 4,600,000 shares of common stock, $.01
par value (see note 2).
On February 11, 1997, the Company acquired Fidelity Mortgage Inc. and
Fidelity Mortgage (Florida), Inc. (together referred to herein as "Fidelity
Mortgage"), retail residential mortgage origination companies, for a combination
of cash and stock with a value of $6.3 million. These transactions were
accounted for under the purchase method of accounting. Accordingly, the results
of operations of Fidelity Mortgage from February 11, 1997 have been included in
the Company's consolidated financial statements. In connection with these
acquisitions the Company recorded goodwill of approximately $6.3 million, which
is being amortized on a straight-line basis over seven years. On October 1,
1997, the acquired operations were merged and have continued to operate as
Fidelity Mortgage. As a result of meeting certain production targets for the
twelve month period ended June 30, 1998, the sellers were paid an additional
$1.2 million of purchase price in the form of, and at a fair value equivalent
to, 101,361 shares of the Company's stock in August 1998. The additional
consideration has been recorded as goodwill and will be amortized over the
remaining life of the goodwill.
(B) PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements are prepared on the
accrual basis of accounting and include the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated.
(C) USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management of the Company to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting periods.
Actual results could differ from those estimates.
(D) LOAN ORIGINATION FEES AND COSTS
In accordance with Statement of Financial Accounting Standards ("SFAS") No.
91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases," origination fees received
net of direct costs of originating or acquiring mortgage loans, are recorded as
adjustments to the initial investment in the loan. Such fees are subsequently
amortized over the life of the loan, using the level yield method, and are
eliminated together with the loan at the time a loan is securitized or sold.
(E) LOANS HELD FOR SALE, NET
Loans held for sale are accounted for at the lower of cost or estimated
market value, determined on a net aggregate basis. Cost includes unamortized
loan origination fees and costs. Net unrealized losses are provided for in a
valuation allowance created through a charge to operations. Losses are
recognized when the market value is less than cost.
(F) SECURITIZATION AND SALE OF MORTGAGE LOANS
In accounting for the securitization of its loans with the retention of
mortgage servicing rights, the Company adopted the provisions of SFAS No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishment
of Liabilities" effective January 1, 1997. Previously, the Company followed the
requirements of SFAS No. 122, "Accounting for Mortgage Servicing Rights." The
adoption of SFAS No. 125 did not have a material impact on the Company's results
of operations or financial position.
41
The Company sells loans to a loan securitization trust and receives the
excess value of the loans' economic interests for (i) the difference between the
interest payments due on the loans sold to the trust and the interest payments
due, at the pass-through rates, to the holders of the pass-through certificates,
less the Company's contractual servicing fee and other costs and expenses of
administering the trust, represented by interest-only and residual certificates,
and (b) the right to service the loans on behalf of the trust and earn a
contractual servicing fee, as well as other ancillary servicing related fees
directly from the borrowers on the underlying loans.
Upon the securitization of a pool of loans, the Company recognizes as
origination fees any then unamortized origination fees which had initially been
recorded as adjustments to the investment in the loans, and additionally
allocates portions of the remaining investment in the loans sold to each of (i)
the servicing rights retained by the Company and (ii) the interest-only and
residual certificates received from the trust. The retained servicing rights and
interest-only and residual certificates are initially recorded based upon their
fair value, which is estimated based on the stated terms of the transferred
loans adjusted for estimates of future prepayments or defaults among those
loans. The Company recognizes a gain for the difference between the investment
in the loans remaining after this allocation and the cash payment received from
the trust (see notes 5 and 6).
(G) CAPITALIZED MORTGAGE SERVICING RIGHTS
Effective January 1, 1997, the Company adopted SFAS No. 125, which supersedes
SFAS No. 122 and SFAS No. 65,"Accounting for Certain Banking Activities" to
require that a mortgage banking enterprise recognize as separate assets the
rights to service mortgage loans for others, however those servicing rights are
acquired. The Statement requires the assessment of capitalized mortgage
servicing rights for impairment. Mortgage servicing rights are amortized in
proportion to and over the period of the estimated net servicing income (see
note 5).
(H) INTEREST-ONLY AND RESIDUAL CERTIFICATES
The interest-only and residual certificates, received by the Company upon the
securitization of a pool of loans to the securitization trust, are accounted for
as trading securities under SFAS No. 115, "Accounting for Certain Investments in
Debt and Equity Securities." In accordance with SFAS No. 115, the amount
initially allocated to the interest-only and residual certificates at the date
of a securitization reflects the fair value of those interests. The amount
recorded for the certificates is reduced for distributions thereon which the
Company receives from the related trust, and is adjusted for the subsequent
changes in the fair value of these certificates which are reflected in the
statement of income. The fair value of interest-only and residual certificates
is determined using the same prepayment and default estimates utilized in
valuing servicing rights, together with the consideration of the geographic
location and value of loan collateral, the value of which would affect the
credit loss sustained by a trust upon the default of a loan (see note 6). The
Company has consistently applied the more conservative cash-out method in
valuing the future cash flows of residual certificates.
(I) FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosure About Fair Value of Financial Instruments,"
requires the Company to disclose the fair value of financial instruments for
which it is practicable to estimate fair value. Fair value is defined as the
amount at which a financial instrument could be exchanged in a current
transaction between willing parties, other than in a forced sale or liquidation,
and is best evidenced by a quoted market price. Other than interest-only and
residual certificates which are reported at fair value, and capitalized mortgage
servicing rights, substantially all the Company's assets and liabilities deemed
to be financial instruments are carried at cost, which approximates their fair
value. The fair value of capitalized mortgage servicing rights represents the
Company's estimate of the expected future net servicing revenue based on common
industry assumptions, as well as on the Company's historical experience.
(J) GOODWILL
Goodwill, which represents the excess of the purchase price over the fair
value of the net assets acquired from Fidelity Mortgage, is being amortized on a
straight-line basis over seven years.
(K) REAL ESTATE OWNED
Properties acquired through foreclosure or a deed in lieu of foreclosure are
recorded at the lower of the unpaid loan balance, or fair value, at the date of
acquisition. The carrying value of the individual properties is subsequently
adjusted to the extent it exceeds estimated fair value less costs to sell, at
which time a provision for losses on such real estate is charged to operations.
42
(L) EQUIPMENT, NET
Equipment, including leasehold improvements, is stated at cost, less
accumulated depreciation and amortization. Depreciation of equipment is computed
using the straight-line or accelerated method over the estimated useful lives of
three to seven years. Leasehold improvements are amortized over the lesser of
the terms of the lease or the estimated useful lives of the improvements.
Expenditures for betterments and major renewals are capitalized and ordinary
maintenance and repairs are charged to operations as incurred.
(M) SERVICING FEES
Servicing fees includes servicing income, prepayment penalties and late
payment charges earned for servicing mortgage loans owned by investors. All fees
and charges are recognized into income when earned.
(N) INCOME TAXES
The Company accounts for income taxes in conformity with SFAS No. 109,
"Accounting for Income Taxes," under which deferred tax assets and liabilities
are recognized for the future tax effects of differences between the financial
reporting and tax bases of assets and liabilities. These deferred taxes are
measured by applying current enacted tax rates.
Through October 31, 1996, the Company was an S corporation pursuant to the
Internal Revenue Code of 1986, as amended. On October 31, 1996, the Company
became a C corporation for Federal and state income tax purposes and as such is
subject to Federal and state income tax on its taxable income for the period
beginning on November 1, 1996.
In order to provide information on results of operations comparable to that
for the periods during which the Company has been taxed as a C corporation,
unaudited pro forma income taxes, which were computed at an assumed rate of 43%,
and unaudited pro forma net income are presented on the accompanying
consolidated statement of income.
(O) EARNINGS PER SHARE
Effective December 15, 1997, the Company adopted SFAS No. 128, "Earnings Per
Share" and restated all prior period EPS data presented. Basic EPS excludes
dilution and is computed by dividing income available to common stockholders by
the weighted-average number of common shares outstanding for the period. Diluted
EPS reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock or
resulted in the issuance of common stock that then shared in the earnings of the
entity (see note 17).
EPS data for the period November 1, 1996 to December 31, 1996 has not been
presented in the accompanying consolidated financial statements because
management believes that such data would not be meaningful given the relatively
short period and the impact of the recognition of the deferred tax liability in
connection with the change in tax status.
(P) STOCK OPTION PLAN
During 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based
Compensation," which permits entities to continue to apply provisions of the
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and provide pro forma net income and pro forma earnings per share
disclosures for employee stock option grants as if the fair-value based method
defined in SFAS No. 123 had been applied. The Company elected to continue to
apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure
provisions of SFAS No. 123 (see note 15).
(Q) RECLASSIFICATIONS
Certain prior period amounts in the financial statements and notes have been
reclassified to conform with the current year presentation.
(R) SEGMENT REPORTING
The Company operates as one reporting segment, as such, the segment
disclosure requirements under SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information", are not applicable to the Company.
43
(S) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
SFAS NO. 133
In June 1998, SFAS No. 133 was issued, "Accounting for Derivative Instruments
and Hedging Activities." SFAS No. 133 is effective for fiscal years that begin
after June 15, 1999, and in general requires that entities recognize all
derivative financial instruments as assets or liabilities, measured at fair
value, and include in earnings the changes in the fair value of such assets and
liabilities. SFAS No. 133 also provides that changes in the fair value of assets
or liabilities being hedged with recognized derivative instruments be recognized
and included in earnings. Management of the Company believes the implementation
of SFAS No. 133 will not have a material impact on the Company's financial
condition or results of operations.
SFAS No. 134
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise". SFAS No. 134 conforms the
accounting for securities retained after the securitization of mortgage loans by
a mortgage banking enterprise with the accounting for securities retained after
the securitization of other types of assets by a non-mortgage banking
enterprise. SFAS No. 134 is effective for the first quarter beginning after
December 15, 1998. Management of the Company believes the implementation of SFAS
No. 134 will not have a material impact on the Company's financial condition or
results of operations.
(2) REORGANIZATION AND INITIAL PUBLIC OFFERING
On October 31, 1996, the Company acquired all of the outstanding stock of
Delta Funding Corporation in exchange for 10,653,000 shares of common stock of
the Company. Prior to the exchange, Delta Funding Corporation was treated for
Federal income tax purposes as an S corporation under Subchapter S of the
Internal Revenue Code of 1986, as amended, and as such, the historical earnings
of Delta Funding Corporation through October 31, 1996 were taxed directly to the
stockholders of Delta Funding Corporation. As a result of the exchange, the
Company and Delta Funding Corporation, which became a wholly-owned subsidiary of
the Company, became subject to Federal and state income taxes and the Company
recorded a deferred tax liability on its balance sheet relating to the tax
effect of temporary differences between book and tax accounting, principally
relating to recognition of gain on sale of mortgage loans.
On November 1, 1996, the Company completed an initial public offering (IPO)
of 4,600,000 shares of common stock at an offering price of $16.50 per share.
The net proceeds of the offering to the Company, exclusive of underwriting
discounts and commissions and other expenses, was $69.7 million. In November
1996, $32.6 million of the proceeds raised in the offering were distributed to
the former S corporation shareholders with respect to declared distributions of
undistributed S corporation earnings. Remaining undistributed S corporation
earnings of $18.1 million were reclassified as additional paid-in capital.
(3) LOANS HELD FOR SALE, NET
The Company's inventory consists of first and second mortgages which had a
weighted average interest rate of 10.5% at December 31, 1998. These mortgages
are being held, at the lower of cost or estimated market value, for future sale.
Certain of these mortgages are pledged as collateral for a portion of the
warehouse financing and other borrowings.
Included in loans held for sale are deferred origination fees and purchase
premiums in the amount of $1.7 million and $3.5 million at December 31, 1998 and
1997, respectively and an allowance for loan losses of $0.3 million at December
31, 1998 and 1997. Mortgages are payable in monthly installments of principal
and interest and have terms varying from five to thirty years.
44
Activity in the allowance for loan losses for the years ended December 31, is
as follows:
(DOLLARS IN THOUSANDS) 1998 1997 1996
- - --------------------------------------------------------------------------------
Balance at beginning of year $300 270 240
Provisions 30 30 31
Charge-offs - - (1)
- - --------------------------------------------------------------------------------
Balance at end of year $330 300 270
- - --------------------------------------------------------------------------------
The Company also maintained an allowance for recourse losses of $1.4 million,
$0.7 million and $0.6 million at December 31, 1998, 1997 and 1996, respectively,
which is included in accounts payable and accrued expenses (see note 14).
(4) ACCOUNTS RECEIVABLE
Accounts receivable as of December 31, consist of the following:
(DOLLARS IN THOUSANDS) 1998 1997
- - --------------------------------------------------------------------------------
Securitization advances $ 17,058 12,090
Prepaid insurance premiums 1,691 1,478
Current tax assets 904 14,803
Other 2,896 2,838
- - --------------------------------------------------------------------------------
Total accounts receivable $22,549 31,209
- - --------------------------------------------------------------------------------
(5) CAPITALIZED MORTGAGE SERVICING RIGHTS
The Company sells mortgage loans and retains the servicing rights which
generate servicing income and provide funds for additional investment and
lending activities. Effective January 1, 1997, the Company adopted SFAS No. 125,
which superseded SFAS No. 122 and SFAS No. 65. SFAS No. 125 prospectively
changed the methodology for capitalized mortgage servicing rights and the
methodology used to measure impairment of its capitalized mortgage servicing
rights asset. These Statements require that upon the sale or securitization of a
loan, an asset be recognized for any retained servicing rights based on the
present value of the future servicing cash flows. The cash flow has been
computed over the average estimated life of the mortgages, adjusted for
prepayments and recorded as capitalized mortgage servicing rights.
Capitalized mortgage servicing rights are assessed periodically to determine
if there has been any impairment of the asset, based on the fair value of the
rights at the date of the assessment. The Company performs this assessment on
the basis of the Company's historical experience, and updated estimates of
prepayment and default rates for servicing rights relating to loan groups
comprised of loans of similar types, terms, credit quality and interest rates,
which represent the predominant risk characteristics affecting prepayment and
default rates. A valuation allowance is provided for the capitalized servicing
rights relating to any loan group for which the recorded investment exceeds the
fair value. At December 31, 1998 and 1997, the fair value of the capitalized
mortgage servicing rights approximated their recorded amounts and, accordingly,
no valuation allowance was recorded. During the second quarter of 1998, the
Company recorded a $1.9 million reduction in the carrying amount of its
capitalized mortgage servicing rights to reflect a provision for impairment.
45
The activity related to the Company's capitalized mortgage servicing rights
for the years ended December 31, is as follows:
(DOLLARS IN THOUSANDS) 1998 1997 1996
- - --------------------------------------------------------------------------------
Balance, beginning of year $22,862 11,412 3,831
Additions 19,833 15,118 8,336
Amortization and FV adjustments (9,205) (3,668) (755)
- - --------------------------------------------------------------------------------
Balance, end of year $33,490 22,862 11,412
- - --------------------------------------------------------------------------------
(6) INTEREST-ONLY AND RESIDUAL CERTIFICATES
The interest that the Company receives upon sales through securitizations is
in the form of interest-only and residual mortgage securities which are
classified as interest-only and residual certificates.
In accordance with SFAS No. 125, upon the sale or securitization of a loan, a
gain on sale and a corresponding asset is recognized for any interest-only and
residual certificates. This asset is classified as "trading securities" and, as
such, they are recorded at their fair value. Fair value of these certificates
has been determined by the Company based on various economic factors, including
loan type, sizes, interest rates, dates of origination, terms and geographic
locations, using the more conservative cash-out method. The Company also uses
other available information such as reports on prepayment rates, interest rates,
collateral value, economic forecasts and historical default and prepayment rates
of the portfolio under review. In accordance with SFAS No. 115, any fair value
adjustment of the interest-only and residual certificates is recognized in the
statement of income and is reflected as a component of interest income.
Although the Company believes it has made reasonable estimates of the fair
value of the interest-only and residual certificates likely to be realized, the
rate of prepayments and the amount of defaults utilized by the Company are
estimates and actual experience may vary. The gain on securitization recognized
by the Company upon the sale of loans through securitizations will be overstated
if prepayments or losses are greater than anticipated. Higher than anticipated
rates of loan prepayments or losses would require the Company to write down the
fair value of the interest-only and residual certificates, adversely impacting
earnings. Similarly, if delinquencies, liquidations or interest rates were to be
greater than was initially assumed, the fair value of the interest-only and
residual certificates would be negatively impacted, which would have an adverse
effect on income for the period in which such events occurred. Should the
estimated loan life assumed for this purpose be shorter than the actual life,
the amount of cash actually received over the lives of the loans would exceed
the gain previously recognized at the time the loans were sold through
securitizations and would result in additional income.
The Company assumes prepayment rates and defaults based upon the seasoning of
its existing securitization loan portfolio. As of December 31, 1998 and 1997,
the Company's underlying assumptions used in determining the fair value of its
interest-only and residual certificates are as follows:
(a)The following table compares the prepayment assumptions used subsequent
to the first quarter of 1998 (the "new" assumptions) with those used at
December 31, 1997 and through the first quarter of 1998 (the "old"
assumptions):
- - --------------------------------------------------------------------------------
LOAN TYPE Curve Description Month 1 Speed Peak Speed
- - --------------------------------------------------------------------------------
New Old New Old New Old
- - --------------------------------------------------------------------------------
Fixed Rate Loans Vector Ramp 4.8% 4.8% 31% 24%
Six-Month LIBOR ARMs Vector Ramp 10.0% 5.6% 50% 28%
Hybrid ARMs Vector Ramp 6.0% 5.6% 50% 28%
- - --------------------------------------------------------------------------------
(b)A default reserve for both fixed- and adjustable-rate loans sold to the
securitization trusts of 2.00% of the amount initially securitized at
December 31, 1998 compared to 1.90% at December 31, 1997;
46
(c)Under the "cash-out" method, an annual discount rate of 12.0% was used in
determining the present value of cash flows from residual certificates,
which represent the predominant form of retained interest.
The changes in prepayment assumptions from December 31, 1997 to December 31,
1998 were made at June 30, 1998, based upon the Company's on-going analysis of
industry and Company pool trends, and resulted in a $15.5 million fair value
adjustment charged to income during the second quarter of 1998. A further fair
value adjustment of $2.8 million was charged to income during the fourth quarter
of 1998 related to a change in default assumptions.
To date, aggregate actual cash flows from the Company's securitization trusts
have either met or exceeded management's expectations.
The activity related to the Company's interest-only and residual certificates
for the years ended December 31, is as follows:
(DOLLARS IN THOUSANDS) 1998 1997 1996
- - --------------------------------------------------------------------------------
Balance, beginning of year $ 167,809 83,073 25,310
Additions 85,092 102,072 57,456
Cash remittances, accretion
of discount and FV
adjustments, net (49,098) (17,336) 307
- - --------------------------------------------------------------------------------
Balance, end of year $ 203,803 167,809 83,073
- - --------------------------------------------------------------------------------
(7) HEDGING TRANSACTIONS
The Company regularly securitizes and sells fixed-rate mortgage loans. To
offset the effects of interest rate fluctuations on the value of its fixed-rate
loans held for sale, the Company in certain cases will hedge its interest rate
risk related to loans held for sale through the use of treasury lock contracts
which function similar to a short-sale of US Treasury securities. The Company
accounts for these contracts as hedges of specific loans held for sale. The gain
or loss derived from these contracts is deferred and recognized as an adjustment
to the carrying amounts of the loans for which the contracts were interest rate
hedges.
As of December 31, 1998 and 1996, the Company did not have open hedge
positions. As of December 31, 1997, the Company had open hedge loss positions of
$0.5 million. The Company included losses of $10.2 million, $2.0 million and
$0.5 million on the treasury lock contracts as part of gains on sale of loans in
1998, 1997 and 1996, respectively.
(8) WAREHOUSE FINANCING AND OTHER BORROWINGS
The Company has three warehouse credit facilities for a combined amount of
$750.0 million as of December 31, 1998. These lines are collateralized by
specific mortgage receivables, which are equal to or greater than the
outstanding balances under the line at any point in time.
The following table summarizes certain information regarding warehouse
financing and other borrowings at December 31, (DOLLARS IN MILLIONS):
Balance
Facility ------- Expiration
Facility Description Amount Rate 1998 1997 Date
- - ------------------------------------------------------------------------------------------------
Warehouse line of credit $400.0 Libor + 0.75% $58.7 $23.9 February 1999
Warehouse line of credit 200.0 CP + 0.05% -- -- September 1999
Warehouse line of credit 150.0 Libor + 0.75% 10.7 -- June 1999
Term loan n/a Prime + 1.00% 0.2 0.2 Apr. 1999 - June 1999
Capital leases n/a 6.63% - 8.97% 10.7 4.1 Mar 1999 - Dec. 2003
- - ------------------------------------------------------------------------------------------------
Balance at December 31, $750.0 $80.3 $28.2
- - ------------------------------------------------------------------------------------------------
47
Subsequent to year end, the first warehouse line of credit ("line") was
renewed at similar terms for $200 million for a period of one year and a new
$200.0 million line, maturing March 2000, was secured by the Company.
(9) SENIOR NOTES
9.5% Senior Notes due 2004 (the "notes") totaled $149.4 million at December
31, 1998, and $149.3 million at December 31, 1997 net of unamortized bond
discount. The notes bear interest at a rate of 9.5% per annum, payable
semi-annually commencing on February 1, 1998. The notes were issued on July 23,
1997, and mature on August 1, 2004 when all outstanding principal is due. On or
after August 1, 2001, the notes are redeemable at the option of the Company, in
whole or in part, at the redemption price set forth in the Indenture, dated July
23, 1997, governing the issuance of the notes (the "Indenture"), plus accrued
and unpaid interest through the date of redemption.
The Company is required to comply with various operating and financial
covenants in the Indenture. These covenants limit or restrict, among other
things, the ability of the Company to consummate assets sales, pay dividends,
incur additional indebtedness and incur additional liens. Costs incurred with
the issuance of the notes, in the amount of $4.8 million, have been deferred and
are being amortized over the seven year term using a method that approximates
level-yield. The unamortized debt issuance cost was $4.1 million at December 31,
1998 and $4.6 million at December 31, 1997.
(10) BANK PAYABLE
In order to maximize its cash management practices, the Company has
instituted a procedure whereby checks written against its operating account are
covered as they are presented to the bank for payment, either by drawing down
its lines of credit or from subsequent deposits of operating cash. Bank payable
represents the checks outstanding at December 31, 1998 and 1997, to be paid in
this manner.
(11) INVESTOR PAYABLE
Investor payable represents the collection of mortgage payments by the
Company as servicer, from mortgagors, which are due to the investors. These
funds, when collected, are placed in segregated bank accounts as provided by the
related servicing agreements and are reflected on the Company's balance sheet as
a component of cash and interest-bearing deposits.
(12) RELATED PARTY TRANSACTIONS
Miller Planning Corporation, a company which is wholly-owned by Sidney A.
Miller, Chairman of the Company, acts as the Company's agent in procuring the
Company's group health, disability and life insurance policies from independent
insurance carriers and receives commissions from the insurance companies on the
same which, in 1998, totaled approximately $3,000 and in 1997 totaled
approximately $13,000. Miller Planning Corporation previously offered life and
disability credit insurance to the Company's borrowers for which it received
commissions.
Long Island Closing Corporation, a company wholly owned by Rona V. Miller,
spouse of Sidney A. Miller, was hired by title abstract companies as closing
agent to clear titles on substantially all of the Company's brokered loan
closings held at the Company's headquarters until approximately August 1997. All
fees for these services were paid by the borrowers, which totaled $0 for 1998
and approximately $84,000 for 1997. In or about August 1997, Long Island Closing
ceased acting as closing agent for abstract companies on the Company's brokered
loan closings.
48
(13) EMPLOYEE BENEFIT PLANS
The Company had an employee profit sharing plan covering all eligible
employees, as defined, with at least 30 months of service. The Company
contributed $0.2 million to the plan for the year ended December 31, 1996.
Effective January 1, 1997, the employee profit sharing plan was merged with the
Company's 401(k) Retirement Savings Plan.
The Company sponsors a 401(k) Retirement Savings Plan. Substantially all
employees of the Company who are at least 21 years old are eligible to
participate in the plan after completing one year of service. Contributions are
made from employees' elected salary deferrals. The Company elected to make
discretionary contributions to the Plan of $0.5 million and $0.3 million for
1998 and 1997, respectively. During 1996, the Company made contributions to the
Profit Sharing Plan noted in the preceding paragraph and no contributions to
this plan.
(14) COMMITMENTS AND CONTINGENCIES
The Company has repurchase agreements with certain of the institutions that
have purchased mortgages. Currently, some of the agreements provide for the
repurchase by the Company of any of the mortgage loans that go to foreclosure
sale. At the foreclosure sale, the Company will repurchase the mortgage, if
necessary, and make the institution whole. The dollar amount of loans which were
sold with recourse is $10.1 million at December 31, 1998 and $13.6 million at
December 31, 1997.
Included in accounts payable and accrued expenses is an allowance for
recourse losses of $1.4 million, $0.7 million and $0.6 million at December 31,
1998, 1997 and 1996, respectively. The Company recognized, as a charge to
operations, a provision for recourse losses of $720,000, $70,000 and $70,000 for
the years 1998, 1997 and 1996, respectively. Additions to the allowance for loan
losses are provided by charges to income based upon various factors, which, in
management's judgment, deserve current recognition in estimating probable
losses. The loss factors are determined by management based upon an evaluation
of historical loss experience, delinquency trends, loan volume and the impact of
economic conditions in our market area.
The Company previously subleased it Woodbury offices from an affiliated
company. In August 1996, the lease was assigned to the Company. This lease
provides for rent to be paid on a month-to-month basis. Rental expense, net of
sublease income, for the years ended December 31, 1998, 1997 and 1996 amounted
to $5.4 million, $2.6 million and $1.0 million, respectively.
Minimum future rentals under non-cancelable operating leases as of December
31, 1998 are as follows:
(DOLLARS IN THOUSANDS)
- - --------------------------------------------------------------------------------
Year Amount
- - --------------------------------------------------------------------------------
1999 $ 4,812
2000 4,859
2001 4,808
2002 4,005
2003 3,054
Thereafter 13,345
- - --------------------------------------------------------------------------------
Total $ 34,883
- - --------------------------------------------------------------------------------
Because the nature of the Company's business involves the collection of
numerous accounts, the validity of liens and compliance with various state and
federal lending laws, the Company is subject, in the normal course of business,
to numerous legal proceedings and claims, including several class action
lawsuits. The resolution of these lawsuits, in management's opinion, will not
have a material adverse effect on the financial position or results of
operations of the Company.
49
(15) STOCK OPTION PLAN
On October 4, 1996, the Board of Directors ratified the 1996 Stock Option
Plan (the "Plan") and authorized the reserve of 2,200,000 shares of authorized
but unissued common stock for issuance pursuant to the Plan. Substantially all
of the options issued vest over a five-year period at 20% per year and expire
seven years from the grant date.
The following table summarizes certain information regarding the Plan at
December 31:
1998 1997
- - -----------------------------------------------------------------------------------------------
Number Weighted-Average Number Weighted-Average
of Shares Exercise Price of Shares Exercise Price
- - -----------------------------------------------------------------------------------------------
Balance, beginning of year 848,760 $17.01 464,850 $16.50
Options granted 77,000 17.35 426,610 17.67
Options exercised 1,500 16.50 400 16.50
Options canceled 129,200 17.54 42,300 18.06
- - -----------------------------------------------------------------------------------------------
Balance at end of year 795,060 $17.00 848,760 $17.01
- - -----------------------------------------------------------------------------------------------
Options exercisable 242,862 $16.77 96,510 $16.50
- - -----------------------------------------------------------------------------------------------
The Company applies APB Opinion No. 25, and related Interpretations in
accounting for the Plan. There was no intrinsic value of the options granted, as
the exercise price was equal to the quoted market price at the grant date.
Accordingly, no compensation cost has been recognized for the years ended
December 31, 1998 and 1997.
Had compensation cost for the Plan been determined based on the fair value at
the grant dates for awards under the Plan consistent with the method of SFAS No.
123, the Company's net income would have been $10.8 million and $30.1 million
for 1998 and 1997, respectively. Earnings per share for 1998 and 1997 would have
been $0.71 and $1.96, respectively.
The weighted-average fair value of options granted during 1998 and 1997 was
$9.14 and $3.54, respectively. For purposes of the pro forma calculation under
SFAS No. 123, the fair value of the options granted is estimated using the
Black-Scholes option-pricing model with the following weighted-average
assumptions used for the 1998 and 1997 grants:
1998 1997
- - --------------------------------------------------------------------------------
Dividend yield 0% 0%
Expected volatility 55% 45%
Risk-free interest rate 4.54% 5.71%
Expected life 5 years 5 years
(16) INCOME TAXES
The provision for income taxes for the years ended December 31, 1998, 1997
and 1996 is as follows:
(DOLLARS IN THOUSANDS) 1998 1997 1996
- - --------------------------------------------------------------------------------
Current: Federal $ 11,291 75 3,305
State 1,941 763 1,150
- - --------------------------------------------------------------------------------
Total current income taxes $ 13,232 838 4,455
- - --------------------------------------------------------------------------------
Deferred:Federal $ (4,586) 16,982 3,727
State (1,478) 2,919 1,284
- - --------------------------------------------------------------------------------
Total deferred income taxes $ (6,064) 19,901 5,011
- - --------------------------------------------------------------------------------
Total tax provision $ 7,168 20,739 9,466
- - --------------------------------------------------------------------------------
50
As discussed in Note 1, the Company was an S corporation through October 31,
1996 pursuant to the Internal Revenue Code of 1986, as amended, and as such did
not incur any Federal income tax expense.
On October 31, 1996, the Company became a C corporation for Federal and state
income tax purposes and as such was subject to federal and state income tax on
its taxable income for the period beginning on November 1, 1996. In connection
with the change in its tax status from an S corporation to a C corporation, the
Company incurred deferred income tax expense of $3.9 million as of October 31,
1996. The remaining deferred income tax expense pertaining to the change in
status from an S corporation to a C corporation at December 31, 1998 was
approximately $2.3 million.
Significant components (temporary differences and carryforwards) that give
rise to the Company's net deferred tax liability as of December 31, 1998 and
1997 were as follows (DOLLARS IN THOUSANDS):
DEFERRED TAX LIABILITIES: 1998 1997
- - ------------------------- ---- ----
Capitalized cost of future servicing income $ 14,149 9,631
Book/tax difference in interest-only and residual certificate
carrying amount 17,359 16,784
Tax over book depreciation 791 259
Capitalized origination fees and related cost 702 1,507
- - -------------------------------------------------------------------------------------------
Total deferred tax liabilities $ 33,001 28,181
- - -------------------------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Book over tax basis in mortgage servicing asset $ 158 278
Loss reserves 1,918 1,270
U.S. net operating loss carryforwards 12,077 1,721
- - -------------------------------------------------------------------------------------------
Total deferred tax assets $ 14,153 3,269
- - -------------------------------------------------------------------------------------------
Net deferred tax liabilities $ 18,848 24,912
- - -------------------------------------------------------------------------------------------
Under SFAS No. 109, "Accounting for Income Taxes," the Company is required to
recognize all or a portion of its net deferred tax assets if it believed that it
was more likely than not, given the weight of all available evidence, that all
or a portion of the benefits of the carryforward losses and other deferred tax
assets would be realized. Management believes that, based on the available
evidence, it is more likely than not that the Company will realize the benefit
from its net deferred tax assets.
A reconciliation of the statutory income tax provision to the effective
income tax provision, as applied to income for the years ended December 31,
1998, 1997 and 1996 is as follows:
1998 1997 1996
- - --------------------------------------------------------------------------------
Tax at statutory rate 35.0% 35.0% 35.0%
Income earned as S corporation n/a n/a (22.6)
Change in tax status n/a n/a 11.6
State & local taxes, net of Federal benefit 1.7 4.7 3.0
Non-deductible expenses and other 2.1 0.8 1.3
- - --------------------------------------------------------------------------------
Total provision 38.8% 40.5% 28.3%
- - --------------------------------------------------------------------------------
51
(17) EARNINGS PER SHARE
The following is a reconciliation of the denominators used in the
computations of basic and diluted EPS. The numerator for calculating both basic
and diluted EPS is net income.
For the years ended December 31: Pro forma
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT EPS DATA) 1998 1997 1996
- - --------------------------------------------------------------------------------
Net income $ 11,328 30,411 19,088
Weighted-average shares 15,382 15,359 13,066
Basic EPS $ 0.74 1.98 1.46
Weighted-average shares 15,382 15,359 13,066
Incremental shares-options 23 32 10
- - --------------------------------------------------------------------------------
15,405 15,391 13,076
Diluted EPS $ 0.74 1.98 1.46
- - --------------------------------------------------------------------------------
(18) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table is a summary of financial data by quarter for the years
ended December 31, 1998 and 1997:
For the quarters ended
(Dollars in thousands, except per share data) March 31, June 30, Sept. 30, Dec. 31,
- - --------------------------------------------------------------------------------------------------
1998
Revenues $41,154 20,682 38,086 39,653
Expenses 28,053 28,718 32,993 31,315
Net income (loss) 8,251 (4,902) 3,106 4,873
Earnings (loss) per common share-basic and diluted 0.54 (0.32) 0.20 0.32
1997
Revenues $27,305 30,467 37,414 38,664
Expenses 15,064 17,848 23,735 26,053
Net income 6,990 7,225 7,883 8,313
Earnings per common share-basic and diluted 0.45 0.47 0.51 0.54
52
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEMS 10-13
Registrant incorporates by reference herein information in its proxy
statement which complies with the information called for by Items 10-13 of Form
10-K. The proxy will be filed at a later date with the Commission.
PART IV
ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a)(1) FINANCIAL STATEMENTS
PAGE(S)
-------
The following Consolidated Financial Statements of Delta
Financial Corporation and Subsidiaries are included in
Part II, Item 8 of this report
Independent Auditors' Report........................................ 30
Consolidated Balance Sheets--December 31, 1998 and 1997............. 31
Consolidated Statements of Income--Years ended December 31,
1998, 1997 and 1996................................................. 32
Consolidated Statement of Changes in Stockholders' Equity--
Years ended December 31, 1998, 1997 and 1996........................ 33
Consolidated Statements of Cash Flows--Years ended December 31,
1998, 1997 and 1996................................................. 34
Notes to Consolidated Financial Statements.......................... 35
(a)(2) FINANCIAL STATEMENT SCHEDULES
Exhibits 11.1 and 27 (See - Exhibit List)
(A)(3) EXHIBITS:
EXHIBIT
NUMBER DESCRIPTION
- - ------- -----------
*3.1 -- Certificate of Incorporation of Delta Financial Corporation
+++3.2 -- Second Amended Bylaws of Delta Financial Corporation
**4.1 -- Indenture dated July 23, 1997, between Delta Financial Corporation,
its subsidiary guarantors and The Bank of New York, as Trustee
*10.1 -- Employment Agreement dated October 1, 1996 between the Registrant and
Sidney A. Miller
*10.2 -- Employment Agreement dated October 1, 1996 between the Registrant and
Hugh Miller
*10.3 -- Employment Agreement dated October 1, 1996 between the Registrant and
Christopher Donnelly
*10.4 -- Employment Agreement dated October 1, 1996 between the Registrant and
Randall F. Michaels
***10.5 -- Employment Agreement dated March 4, 1997 between the Registrant and
Richard Blass
*10.6 -- Lease Agreement between Delta Funding Corporation and the Tilles
Investment Company
+10.7 -- Fifth, Sixth and Seventh Amendments to Lease Agreement between Delta
Funding Corporation and the Tilles Investment Company
++10.8 -- Eighth Amendment to Lease Agreement between Delta Funding Corporation
and the Tilles Investment Company
*10.9 -- 1996 Stock Option Plan of Delta Financial Corporation
+++11.1 -- Statement re: Computation of Per Share Earnings
+++21.1 -- Subsidiaries of Registrant
+++27 -- Financial Data Schedule
- - ---------------
* Incorporated by reference from the Company's Registration Statement on
Form S-1 (No. 333-11289) filed with the Commission on October 9, 1996.
** Incorporated by reference from the Company's Current Report on Form 8-K
(No. 001-12109) filed with the Commission on July 30, 1997.
*** Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1997 (File No. 1-12109)
53
filed with the Commission on May 15, 1997.
+ Incorporated by reference from the Company's Annual Report on Form 10-K for
the year ended December 31, 1997 (File No. 1-12109) filed with the
Commission on March 31, 1998.
++ Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1998 (File No. 1-12109) filed with the
Commission on May 12, 1998.
+++ Filed herewith
(B) REPORTS ON FORM 8-K. None.
54
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereto duly authorized.
DELTA FINANCIAL CORPORATION
(Registrant)
Dated: March 30, 1999 By: /S/ HUGH MILLER
------------------------------
Hugh Miller
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE CAPACITY IN WHICH SIGNED DATE
- - --------------------- ----------------------------------- --------------
/S/ SIDNEY A. MILLER Chairman of the Board of Directors March 30, 1999
- - -----------------------
Sidney A. Miller
/S/ HUGH MILLER Chief Executive Officer, President
- - ----------------------- and Director March 30, 1999
Hugh Miller (Principal Executive Officer)
/S/ RICHARD BLASS Senior Vice President, Chief Financial
- - ----------------------- Officer and Director March 30, 1999
Richard Blass (Principal Financial Officer)
/S/ MARTIN D. PAYSON Director March 30, 1999
- - -----------------------
Martin D. Payson
/S/ ARNOLD B. POLLARD Director March 30, 1999
- - -----------------------
Arnold B. Pollard
55