UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x                              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal year ended December 31, 2004

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from          to          

Commission File Number: 000-50938

Fieldstone Investment Corporation

(Exact name of registrant as specified in its charter)

 

Securities registered pursuant to Section 12(b) of the Act:

NONE

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $.01

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 o No x

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. x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o No x.

As of June 30, 2004, the last trading day of our last second fiscal quarter, our common stock was not listed on any exchange or over-the-counter market. Our common stock began trading on the NASDAQ National Market on February 3, 2005.

Number of shares of Common Stock outstanding at March 22, 2005: 48,839,626

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Definitive Proxy Statement to be filed with the Commission pursuant to Regulation 14A in connection with the registrant’s 2005 Annual Meeting of Stockholders, subsequent to the date hereof, are incorporated by reference into Part III of this Report. Such Definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the conclusion of the registrant’s fiscal year ended December 31, 2004.

 

Table of Contents

		Page
Part I
Item 1.	Business	2
Item 2.	Properties	50
Item 3	Legal Proceedings	50
Item 4.	Submission of Matters to a Vote of Security Holders	51
Part II
Item 5.	Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	52
Item 6.	Selected Financial Data	53
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operation	56
	Executive Overview	56
	Key Components of Financial Results of Operations	56
	Critical Accounting Policies	59
	Results of Operations	65
	Consolidated Statements of Condition	72
	Business Segment Results	76
	Liquidity and Capital Resources	80
	Commitments and Contingencies	84
	Impact of New Accounting Standards	85
	Effect of Inflation	86
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	86
Item 8.	Financial Statements and Supplementary Data	88
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	88
Item 9A.	Controls and Procedures	88
Item 9B.	Other Information	88
Part III
Item 10.	Directors and Executive Officers of the Registrant	89
Item 11.	Executive Compensation	89
Item 12.	Security Ownership of Certain Beneficial Owners and Management	89
Item 13.	Certain Relationships and Related Transactions	89
Item 14.	Principal Accountant Fees and Services	89
Part IV
Item 15.	Exhibits and Financial Statement Schedules	90

 

 

 

 

Cautionary Advice Regarding Forward-Looking Statements

Statements contained in this Form 10-K which are not historical fact may be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 21E of the Exchange Act. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date this Form 10-K is filed with the SEC.

The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or are within our control. If a change occurs, our business, financial condition and results of operations may vary materially from those expressed in our forward-looking statements. These statements (none of which is intended as a guarantee of performance) are subject to certain risks and uncertainties which could cause our actual future results, achievements or transactions to differ materially from those projected or anticipated. Some of the important factors that could cause our actual results, performance or financial condition to differ materially from expectations are:

·       general volatility of the capital markets;

·       availability, terms and deployment of capital;

·       changes in our industry, interest rates or the general economy;

·       increased rates of default under or prepayments of our mortgage loans;

·       changes in government regulations that affect our ability to originate mortgage loans;

·       the degree and nature of our competition; and

·       the other factors referenced in this Report, including those set forth under the sections entitled “ ITEM 1. Business—Risk Factors,” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

PART I

ITEM 1.                BUSINESS.

Overview

We are a fully integrated mortgage banking company that has a portfolio of mortgage loans we originated and that originates, securitizes, sells and services non-conforming and conforming single-family residential mortgage loans. We have elected to be taxed as a real estate investment trust, or REIT, for federal income tax purposes. We originate loans for borrowers nationwide through our operating subsidiary, Fieldstone Mortgage Company (Fieldstone Mortgage). Fieldstone Mortgage has been operating since 1995, and we believe we have developed processes and criteria that promote sound underwriting and pricing decisions and provide the ability to approve and fund quality non-conforming and conforming loans efficiently.

We originate loans through our two primary channels: non-conforming and conforming. Each channel has wholesale and retail lending divisions. We maintain a wholesale network of over 4,700 independent mortgage brokers, of which approximately 4,200 are non-conforming brokers and 500 are conforming brokers serviced by 15 regional operations centers. In addition, we operate a network of non-conforming retail branch offices and conforming retail branch offices located in 26 states throughout the country.

In August 2003, we began implementing our current business strategy of retaining a portion of the non-conforming loans that we originate on a long-term basis in a portfolio, financed primarily by issuing mortgage-backed securities secured by these loans. Our goal is to build and manage a portfolio of loans with superior risk-adjusted returns to generate for our stockholders stable cash flows and dividends based on managing the credit quality of loans, the interest rate risk of the portfolio and the level of leverage we use to finance our portfolio. As of December 31, 2004, we have completed six securitizations totaling $4.7 billion and added $4.8 billion to our portfolio of loans held for investment. We continue to sell to third parties a portion of the non-conforming loans and all of the conforming loans that we originate, on a servicing-released basis.

History and Structure

We were formed on August 20, 2003 as a Maryland corporation and a wholly owned subsidiary of Fieldstone Holdings Corp., a Delaware corporation. In 1998, Fieldstone Holdings acquired Fieldstone Mortgage Company, a Maryland corporation formed in 1995 that has been originating and selling residential mortgage loans since 1996. On November 14, 2003, we completed a private offering of 47.15 million shares of our common stock pursuant to Rule 144A, Regulation S and Regulation D under the Securities Act of 1933, as amended (referred to herein as the 144A Offering), which yielded net proceeds of approximately $658.1 million. In connection with the private offering, we merged with Fieldstone Holdings. As the surviving entity, we succeeded to all of the assets and liabilities of Fieldstone Holdings, and Fieldstone Mortgage became our wholly owned principal operating subsidiary.

Pursuant to the merger, the shareholders of Fieldstone Holdings received 565.38168 shares of our common stock for each share of common stock of Fieldstone Holdings. Immediately following the closing of the 144A Offering, we redeemed the shares of common stock held by a group of former shareholders of Fieldstone Holdings for approximately $188.1 million of the net proceeds of the 144A Offering.

We have elected to be taxed as a REIT under Sections 856 through 859 of the Internal Revenue Code. Our qualification as a REIT depends upon our ability to meet, on an annual or in some cases quarterly basis, various complex requirements under the Internal Revenue Code relating to, among other things, the sources of gross income, the composition and values of assets, distribution levels and the diversity of ownership of shares.

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We have elected to treat Fieldstone Mortgage as a taxable REIT subsidiary (TRS). This entity earns income and engages in activities that are not meant to occur in a REIT. For example, a TRS could earn income from the servicing and origination and sale of loans, which would not be qualifying income for purposes of the REIT income tests. A TRS is taxed as a regular corporation, and its net income is, therefore, subject to federal, state and local corporate level tax.

In addition to Fieldstone Mortgage, we have two other wholly owned subsidiaries, Fieldstone Mortgage Ownership Corp. (FMOC) and Fieldstone Servicing Corp. (FSC), which were formed on February 3, 2004 as Maryland corporations and are treated as qualified REIT subsidiaries. FMOC holds securities and ownership interests in owner trusts and other securitization entities, including securities issued by us or on our behalf. FMOC holds the equity interests in our securitized pools of mortgage loans, as well as any derivatives designated as interest rate hedges related to our securitized debt. FSC holds the rights to direct the servicing of our loans held for investment.

Strengths

We believe that we possess the following strengths that allow us to compete effectively and will enable us to continue to expand our business:

·       Corporate Culture of Integrity, Service, Efficiency and Teamwork.   We have grown over the past 10 years with a focus on the integrity of our personnel and our loans, a commitment to customer service and a commitment to constant improvement of our operations to achieve higher service levels, greater efficiencies and lower costs. Our entire team, including senior management, regional managers, branch managers, loan originators, processors, underwriters, funders and shippers, together with the quality control, secondary, shipping, servicing, information systems, accounting, legal, human resources, finance, internal audit and treasury employees in our home office, work as a team in the loan origination, sales, interim servicing and securitization processes. Our philosophy is that each aspect of originating a loan, from setting underwriting guidelines to processing loan applications to funding loans to entering loan data, is equally important in the origination process.

·       Disciplined and Efficient Underwriting Guidelines and Supporting Processes and Technology.   We believe we have a disciplined approach to underwriting mortgage loans using complex and integrated risk management techniques, together with effective implementation of technology to support operating efficiency and to lower our costs, maintain the consistency of our credit decisions and drive loss mitigation efforts. We believe that this allows us to make reliable and timely credit underwriting decisions and to offer a competitive price.

·       Quality Customer Service.   Our loan officers and account executives work closely with our customers and our internal customer-focused processing and underwriting teams to provide high quality service and to be responsive to borrowers’ and brokers’ needs. We believe our focus on service, quality and efficiency results in increased originations through referrals and repeat business from brokers and other financial service companies.

·       Comprehensive Product Offering.   We offer a wide array of loan products to our customers. We offer first and second lien loan programs as either fixed-rate loans or adjustable-rate mortgage loans (ARMs), including hybrid loans with an initial fixed interest rate that subsequently converts to an adjustable rate. In addition, we offer ARM loans with an “interest only” feature for the first five years of the loan.

·       Management Experience and Expertise.   Our management team has an average of over 17 years of experience in mortgage banking, securitization and specialty finance businesses. Our experienced management team has developed the comprehensive originating processes, procedures and

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technology that we believe help to position us as a high quality, low-cost, customer-focused residential mortgage loan originator.

·       Successful Securitizations.   As of December 31, 2004, we have completed six securitizations. In connection with these securitizations, we believe that we have (i) established a credible relationship with various nationally recognized credit rating organizations, (ii) begun to establish a track record with investors in mortgage-backed securities and (iii) begun to monitor a number of performance characteristics of each loan pool by building a loan performance database to improve risk management, loan product design and pricing, and to ensure adequate risk-adjusted returns. We use securitizations to match fund the maturities of our debt with the scheduled repayment of our loans. We believe that building a history of issuing successful securitizations will facilitate our ability to execute additional securitizations and create a continued source of long-term financing for our portfolio in the future.

Production Segments

We have been originating mortgage loans since 1996. We originate loans through our two primary channels: non-conforming and conforming. A non-conforming loan is a loan that is ineligible for purchase by Fannie Mae or Freddie Mac due to either loan size, credit characteristics of the borrower or documentation standards in connection with the underwriting of the borrower’s income. The credit characteristics that cause a loan to be ineligible include those where there is a relatively higher level of debt service carried by the borrower, higher LTV, and loans by borrowers who may have a record of credit write-offs, outstanding judgments, prior bankruptcies and other credit items that do not satisfy the Fannie Mae or Freddie Mac underwriting guidelines. Documentation standards that are not eligible may include borrowers who provide limited or no documentation of their income in connection with the underwriting of the related mortgage loan. During 2004 and 2003, we originated approximately $7.5 billion and $7.4 billion, respectively, of mortgage loans, of which approximately 83% and 70%, respectively, were non-conforming loans and 17% and 30%, respectively, were conforming loans.

Each channel has a wholesale and retail lending division. The primary difference between wholesale and retail lending is the borrower’s point of contact. For wholesale loans, an independent mortgage broker is the borrower’s primary contact. The broker sends a completed loan application to us for underwriting. For retail loans, we contact the borrower directly. For all loans that we fund, we control the credit underwriting, documentation and closings. We maintain a wholesale network of over 4,700 independent mortgage brokers, of which approximately 4,200 are non-conforming brokers and 500 are conforming brokers. We operate our own network of non-conforming retail branch offices and conforming branch offices located in 26 states throughout the country.

Our business, therefore, is divided into four production segments, non-conforming wholesale, non-conforming retail, conforming wholesale and conforming retail. You will find information concerning the financial results of our four production segments in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in the section entitled “Production Segment Results.”

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The following table summarizes information regarding our total loan originations in 2004 and 2003 by production segment (in thousands):

				Year Ended December 31,
				2004							2003
Production Segment				Loans Originated			Percentage of Total Originations				Loans Originated			Percentage of Total Originations
Non-Conforming Wholesale Segment				$	5,529,824			74	%		$	4,477,756			61	%
Non-Conforming Retail Segment				655,221				9	%		670,426				9	%
Conforming Wholesale Segment				922,335				12	%		1,523,920				21	%
Conforming Retail Segment				367,867				5	%		699,948				9	%
Total Originations				$	7,475,247			100	%		$	7,372,050			100	%

 

Non-Conforming Wholesale Segment

We have non-conforming wholesale operations centers in the following 12 states: Arizona, California (4), Colorado, Florida, Georgia, Illinois, Kansas, Maryland, Massachusetts, Minnesota, Texas and Washington. We originate wholesale non-conforming loans through a network of over 4,200 independent mortgage brokers that are solicited by and have contact with our account executives. Our account executives provide on-site training to broker personnel on the use of our products and services and help facilitate the funding of loans. In the wholesale origination process, brokers identify the prospective borrower, assist the borrower with completion of the loan application, gather necessary documentation and serve as the borrowers’ initial “point of contact.”

We conduct due diligence on independent mortgage brokers with whom we consider doing business. Our due diligence process includes reviewing the broker’s financial condition, running credit checks on its principals, and verifying a good standing status with applicable regulators. Once approved, we require that a mortgage broker sign an agreement that governs the mechanics of doing business with us and sets forth the representations and warranties the broker makes to us regarding each loan.

We review and underwrite every loan application submitted by our broker network, approve or deny each application and set the interest rates, costs, fees and other terms of the loan (which the broker evaluates with the borrower). Once all conditions to the closing of the loan have been met to our satisfaction, we create the closing documents for the loan, arrange an insured closing with a title company or closing agent and then fund the loan. The brokers conduct all marketing to borrowers for our wholesale loans and earn a brokerage fee on the loans they originate, including both fees paid by the borrower directly and premiums we pay directly to the brokers in addition to those fees, known as “yield spread premiums.” Our wholesale broker network allows us to increase our volume of loan originations without incurring the significantly greater overhead or marketing expenses associated with direct sales to consumers.

Non-Conforming Retail Segment

We have non-conforming retail lending offices in the following 19 states: Arizona, California (2), Colorado, Florida, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Minnesota, Missouri, Nebraska, Nevada, Oklahoma, Oregon, Tennessee, Texas and Washington. We market retail non-conforming loans through a variety of methods, including direct mailings, the Internet, print and telephone directory advertisement, and affinity lending relationships. Our loan officers identify loan applicants and assist the applicants in gathering their loan documentation. Our processors enter the borrower information into FieldScore, our proprietary automated pre-qualification system. We believe that this regional presence enables us to provide better service to our customers and allows us to satisfy the lender criterion most important to our customers: speed of approval and funding. We also believe that local loan officers and

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branch managers are better suited to avoiding fraudulent loan applications based on their knowledge of their local market.

Conforming Wholesale Segment

We have conforming wholesale operations centers in the following four states: California, Colorado, Florida and Massachusetts. We originate wholesale conforming loans through a network of approximately 500 independent mortgage brokers that are solicited by and have contact with our account executives. Our account executives provide on-site training to broker personnel on the use of our products and services and help facilitate the funding of loans. In the wholesale origination process, brokers identify the prospective borrower, assist the borrower with completion of the loan application, gather necessary documentation and serve as the borrowers’ initial “point of contact.”

We conduct due diligence on independent mortgage brokers with whom we consider doing business. Our due diligence process includes reviewing the broker’s financial condition, running credit checks on its principals, checking business references and verifying a good standing status with applicable regulators. Once approved, we require that a mortgage broker sign an agreement that governs the mechanics of doing business with us and sets forth the representations and warranties the broker makes to us regarding each loan.

We review and underwrite every loan application submitted by our broker network, or approve or deny each application and set the interest rates, costs, fees and other terms of the loan (which the broker evaluates with the borrower). Once all conditions to the closing of the loan have been met to our satisfaction, we create the closing documents for the loan, arrange an insured closing with a title company or closing agent and then fund the loan. The brokers conduct all marketing to borrowers for our wholesale loans and earn a brokerage fee on the loans they originate, including both fees paid by the borrower directly and premiums we pay directly to the brokers in addition to those fees. Our wholesale broker network allows us to increase our volume of loan originations without incurring the significantly greater overhead or marketing expenses associated with direct sales to consumers.

Conforming Retail Segment

We have conforming retail lending offices in the following eight states: Arizona, Colorado, Kentucky, Maryland, North Carolina, Virginia, Tennessee and Texas. We market retail conforming loans through a variety of methods, including the Internet and print advertisement. Our loan officers identify loan applicants and assist the applicants in gathering their loan documentation. Our loan officers or processors enter the borrower information into the automated underwriting systems of Fannie Mae, Freddie Mac or one of our institutional investors. We believe that this regional presence enables us to provide better service to our customers and allows us to satisfy the lender criterion most important to our customers: speed of approval and funding. We also believe that our local loan officers and branch managers are better suited to identify potentially fraudulent loan applications based on their knowledge of the local market.

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Loan Originations by Borrower Purpose

The following table sets forth information about our 2004 and 2003 loan production based on borrower purpose (in thousands):

		Year Ended December 31,
		2004							2003
		Loans Funded			Percentage of Total Loans				Loans Funded			Percentage of Total Loans
Non-Conforming:
Refinance of existing mortgage		$	2,519,273			41	%		$	2,056,092			40	%
Purchase of home		3,665,772				59	%		3,092,090				60	%
Total Non-Conforming		$	6,185,045			100	%		$	5,148,182			100	%
Conforming:
Refinance of existing mortgage		$	727,908			56	%		$	1,567,495			70	%
Purchase of home		562,294				44	%		656,373				30	%
Total Conforming		$	1,290,202			100	%		$	2,223,868			100	%

 

Our non-conforming division focuses on lending to borrowers for the purchase of a home. We believe these originations, as well as cash-out refinances, are less dependent on the relative level of interest rates than rate-term refinances.

Geographic Concentration of Originations

The following tables set forth aggregate dollar amounts and the percentage of all loans we originated in 2004 and 2003 by state (in thousands):

		Year Ended December 31,
		2004						2003
Non-Conforming
California		$	2,772,306		45	%		$	2,616,298		51	%
Illinois		495,075			8	%		426,020			8	%
Colorado		386,844			6	%		395,098			8	%
Arizona		299,392			5	%		222,222			4	%
Texas		262,816			4	%		201,689			4	%
Massachusetts		259,530			4	%		127,178			2	%
Florida		242,680			4	%		158,922			3	%
Washington		210,678			3	%		141,942			3	%
Maryland		118,919			2	%		96,423			2	%
Minnesota		99,854			2	%		72,598			1	%
Other		1,036,951			17	%		689,792			14	%
Total		$	6,185,045		100	%		$	5,148,182		100	%

 

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		Year Ended December 31,
		2004						2003
Conforming
California		$	575,476		45	%		$	969,115		44	%
Maryland		126,610			10	%		235,669			11	%
Massachusetts		118,549			9	%		20,037			1	%
Colorado		104,068			8	%		327,981			15	%
Texas		91,627			7	%		169,021			8	%
Illinois		40,199			3	%		100,805			4	%
Virginia		37,364			3	%		50,683			2	%
New Hampshire		32,488			3	%		7,313			0	%
Florida		30,783			2	%		120,945			5	%
Arizona		26,726			2	%		36,507			2	%
Other		106,312			8	%		185,792			8	%
Total		$	1,290,202		100	%		$	2,223,868		100	%

 

Our loan originations are concentrated heavily in California because it is the largest mortgage market and, for our non-conforming loans, our underwriting, product design and pricing philosophies address the apparent needs of California borrowers: non-standard credit profiles, interest in low downpayment products, payment-focused and higher home values.

Loan Products

We offer both fixed-rate loans and adjustable-rate loans, or ARMs, to our non-conforming and conforming borrowers, including hybrid loans with an initial fixed interest rate that subsequently convert to an adjustable rate. The payments on our ARM loans are adjustable from time to time as interest rates change, generally after an initial two-year period during which the loans’ interest rates are fixed and do not change. After an initial fixed rate period, the borrowers’ payments on our ARM loans generally adjust once every six months to a pre-determined margin over a measure of market interest rates, generally the London InterBank Offered Rate (LIBOR) for one-month deposits. In addition, we offer ARM loans with an “interest only” feature for the first five years of the loan. Borrowers with this loan feature do not begin to re-pay the principal balance of the loans until after the fifth year of the loan. After the fifth year, the borrowers’ payments increase to amortize the entire principal balance owed over the remaining 25 years of the loan. Our loan products are available at different interest rates and with different origination and application points and fees, depending on the particular borrower’s risk classification. See “Business—Underwriting Guidelines.” If permitted by applicable law and agreed to by the borrower, we may include a prepayment fee that is triggered by a loan’s full or substantial prepayment early in the loan’s term. Approximately 62.2% of the loans we originated in 2004 and approximately 56.8% of the loans we originated in 2003 included some form of prepayment fee.

Non-Conforming Loan Products

We underwrite each non-conforming loan that we originate in accordance with our underwriting guidelines. Our underwriting guidelines are established by our credit committee, which is composed of our senior management team, including our President and Chief Executive Officer, Executive Vice President—Secondary Marketing, Chief Financial Officer, Chief Credit Officer, Senior Vice President—Investment Portfolio and the Executive Vice President—Non-Conforming Wholesale Division. The credit committee meets on an as-needed basis to review proposed changes to our underwriting guidelines. We have developed underwriting processes and criteria that we believe generate high quality loans and give us the ability to approve and fund loans quickly. Our guidelines help us evaluate a borrower’s credit history,

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willingness and ability to repay the loan as well as the value and adequacy of the collateral, based on the experience we have had with similar loans in the past, and on industry performance data. Our underwriting guidelines are designed to generate loans that balance the credit risk of the borrower with the LTV and interest rate of the loan to provide stable risk-adjusted returns for our portfolio. In addition, our guidelines are designed to afford us the opportunity to sell any of our loan products to two or more institutional buyers of mortgages.

We consider a combination of factors in order to assess the borrower’s ability and willingness to repay the loan according to its terms, which is the basis for our underwriting guidelines and risk-based pricing:

·       Credit History:   A borrower’s past mortgage payment history, foreclosure history, bankruptcy history as well as other consumer debt payment history. We obtain a credit report on each borrower from a third-party vendor that merges the credit data from the three national credit data repositories (Equifax, TransUnion, and Experian). We segment loans based upon risk grades determined by the borrower’s credit history.

·       Credit Score:   Typically referred to as either the “credit score” or “FICO score”, which is a statistical ranking of likely future credit performance developed by Fair Isaac, & Company. We require a minimum credit score, or FICO, of 500 and use the middle of the three scores (or lower of two) from the three national credit bureaus when classifying a borrower.

·       Debt-to-Income:   The debt-to-income, or DTI, is the ratio of a borrower’s total mortgage and consumer monthly debt payments to total monthly income. The maximum DTI varies based upon the loan-to-value, credit history and income documentation of a particular borrower.

·       Appraisal:   We require a full appraisal of each property that is prepared by a licensed, third-party, fee-based appraiser. The appraisals include an inspection of the exterior and interior of the subject property. The appraisal contains a cost analysis based on the current cost of constructing a similar home, a market value analysis based upon recent sales of comparable homes in the area and an income analysis (where appropriate). Before we fund any mortgage loan, a non-affiliated appraisal review firm or one of our qualified underwriters reviews every appraisal using additional data to evaluate the appraisal. Except under defined circumstances, we order either automated valuation models (AVMs), desk reviews, field reviews or second full appraisals or other valuation tools on all of our non-conforming loans to validate the appraisals.

·       Loan-to-Value:   The loan-to-value, or LTV, is the ratio of the amount of the loan to the appraised value. Combined-loan-to-value, or CLTV, is the ratio of first and second lien loans to the appraised value. Our guidelines allow for loans up to 100% LTV or 100% CLTV. As a borrower’s credit history and credit score decline in quality, the maximum allowable LTV or CLTV available to a borrower declines. Substantially all of our second lien loans are funded simultaneously with a first lien. In 2004 and 2003, these simultaneous fundings had an average CLTV of 98.7% and 99.9%, respectively.

·       Property Type:   We lend against residential real estate, which includes properties up to 4 units, condominiums and planned unit developments.

·       Owner Occupancy Status:   We provide separate requirements depending upon whether the property securing the loan will be the borrower’s primary residence, second home or an investment property, and generally we require a lower LTV and higher interest rate for second homes and investment properties.

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·       Loan Size:   Our minimum loan size for first liens is $50,000 and for second liens is $20,000; our maximum loan size for first liens is $1 million and for second liens is $250,000. Our maximum loan size is $1 million on the combination of a first lien and second lien. With larger loan amounts, we generally require a lower LTV or CLTV.

Conforming Loan Products

The most common types of loans we offer through our conforming division (which does business as Broad Street Mortgage Co.) consist of:

·       Conventional Loans.   Loans that meet the underwriting standards of Fannie Mae, Freddie Mac or institutional investors. These conventional loans are considered by us to be of the A+ and A risk classifications.

·       FHA Loans.   Loans to buyers who qualify through the Federal Housing Authority’s loan mortgage insurance program, designed to help give prospective home buyers the opportunity to qualify for a mortgage when they may not otherwise qualify. The Department of Housing and Urban Development assumes some of the risk on the loan by providing levels of guarantees provided that the loans are underwritten to their guidelines.

·       VA Loans.   Loans guaranteed by the Veterans Administration pursuant to a loan guarantee program available to qualified veterans of the U.S. armed services. This guarantee provides protection to us and the purchaser of our VA loans against defaults and delinquencies, and enables veterans to obtain mortgages when they might not otherwise qualify, and with little to no down payment.

·       Jumbo Loans.   Loans that generally meet the underwriting standards of Fannie Mae and Freddie Mac, except for the amount of the loan. Fannie Mae and Freddie Mac are prohibited from owning or guaranteeing single-family residential mortgage loans with balances greater than a certain dollar limit which is re-set annually. Loans with balances in excess of this amount are referred to as jumbo loans.

Underwriting

Our underwriting process requires a rigorous application review and documentation designed to maximize the value of our mortgage loans. If an individual loan application does not meet our formal written underwriting guidelines, but the underwriter has a documented belief both that the borrower has the ability and willingness to pay and that the property provides adequate collateral for the borrower’s obligations, our underwriters can make underwriting exceptions according to our written exception policies and approval authorities. We may, from time to time, apply underwriting criteria that are either more stringent or more flexible depending upon the economic conditions of a particular geographic market. For many of our higher debt ratio and LTV loan programs, we do not allow exceptions to our underwriting guidelines.

We do not permit variations from our guidelines without significant equity in the property securing the loan or other compensating factors. However, for lower LTV loans or for borrowers with higher credit scores or lower debt ratios, our underwriting policy is to analyze the overall situation of the borrower and to take into account compensating factors that may be used to offset areas of weakness. These compensating factors include credit scores, proposed reductions in the borrower’s debt service expense, employment stability, number of years in residence and net disposable income. Based upon this analysis and the information generated by our FieldScore software, we can make pre-qualification decisions generally within minutes. We then determine loan terms and conditions to produce loans that we believe

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are appropriately priced relative to principal amount and other factors, meet our quality standards and are profitable.

All of our non-conforming loans are underwritten by our on-staff underwriting personnel. We do not delegate underwriting authority to any broker or third party. Our underwriters review each non-conforming loan in one of our 15 regional operations centers. We regularly train our loan originators on emerging trends in production, and we believe that our originators and underwriters are highly qualified and experienced and are familiar with our underwriting guidelines.

We underwrite and process all of our conforming loans according to the automated underwriting systems or guidelines of Fannie Mae, Freddie Mac, FHA, VA or institutional investors, or these loans are underwritten by our correspondent or the purchaser on a pre-funded basis. In addition, for our conforming loans we review credit scores from one or more nationally recognized credit scoring models. We perform our conforming loan underwriting using our on-staff underwriting personnel or by contract personnel dedicated to one of our branches. We submit our conforming loans to the automated underwriting systems of Fannie Mae (Desktop Underwriter) or Freddie Mac (Loan Prospector) or to the automated underwriting systems of other secondary market participants.

Originated Non-Conforming Loan Characteristics

The following tables provide a summary of the characteristics of our total non-conforming loan originations for the year ended December 31, 2004 (in thousands):

Income Documentation

		Aggregate Principal Balance			Percent of Originations				Weighted Average Coupon				Weighted Average Credit Score				Average Principal Balance					Weighted Average LTV				Weighted Average CLTV
Full Documentation		$	3,096,608			50.1	%			7.1	%			630				$	143				85.7	%			91.3	%
Stated Income Wage Earner		1,574,074				25.4	%			7.2	%			691				150					83.1	%			94.9	%
Stated Income Self Employed		905,961				14.6	%			7.4	%			673				152					82.3	%			93.3	%
24 Month Bank Statements		290,914				4.7	%			7.1	%			633				191					87.0	%			92.6	%
12 Month Bank Statements		289,149				4.7	%			7.1	%			641				174					84.0	%			91.6	%
Limited Documentation		28,339				0.5	%			7.2	%			639				149					81.0	%			89.7	%
Total		$	6,185,045			100.0	%
Weighted Average/Average										7.2	%			652				$	149				84.5	%			92.6	%

 

Credit Score

		Aggregate Principal Balance			Percent of Originations				Weighted Average Coupon				Weighted Average Credit Score				Average Principal Balance					Weighted Average LTV				Weighted Average CLTV				Percent Full Documentation
500 – 549		$	375,871			6.1	%			7.8	%			530				$	152				79.2	%			80.3	%			82.7	%
550 – 599		788,176				12.7	%			7.4	%			577				160					84.6	%			86.3	%			77.4	%
600 – 649		1,639,393				26.5	%			7.2	%			627				152					86.0	%			92.2	%			67.5	%
650 – 699		2,105,717				34.1	%			7.1	%			673				144					84.5	%			95.5	%			33.3	%
700 or greater		1,275,888				20.6	%			6.9	%			732				148					84.0	%			95.8	%			29.0	%
Total		$	6,185,045			100.0	%
Weighted Average/Average										7.2	%			652				$	149				84.5	%			92.6	%			50.1	%

 

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Product Type

		Aggregate Principal Balance			Percent of Originations				Weighted Average Coupon				Weighted Average Credit Score				Average Principal Balance					Weighted Average LTV				Weighted Average CLTV				Percent Full Documentation
6 month LIBOR ARM		$	3,384			0.1	%			6.4	%			686				$	260				79.7	%			91.2	%			6.5	%
6 month LIBOR ARM IO		11,667				0.2	%			6.6	%			688				220					80.9	%			95.3	%			20.0	%
2/28 LIBOR ARM		1,894,070				30.6	%			7.3	%			628				153					84.7	%			91.6	%			56.8	%
2/28 LIBOR ARM IO		2,716,827				43.9	%			6.7	%			660				250					82.9	%			93.8	%			45.0	%
3/27 LIBOR ARM		116,952				1.9	%			7.1	%			633				152					84.0	%			90.0	%			64.0	%
3/27 LIBOR ARM IO		149,006				2.4	%			6.6	%			657				239					81.4	%			90.9	%			59.8	%
5/25 Treasury ARM		73,820				1.2	%			6.5	%			662				173					79.2	%			86.1	%			64.4	%
5/25 Treasury ARM IO		152,283				2.5	%			6.4	%			674				253					81.3	%			89.7	%			67.5	%
Fixed Rate		392,372				6.3	%			7.0	%			661				145					78.1	%			83.6	%			62.7	%
Fixed Rate IO		87,135				1.4	%			7.1	%			682				252					79.6	%			91.3	%			39.1	%
2nd		587,529				9.5	%			9.7	%			681				46					98.7	%			98.7	%			34.1	%
Total		$	6,185,045			100.0	%
Weighted Average/Average										7.2	%			652				$149					84.5	%			92.6	%			50.1	%

 

The following tables provide a summary of the characteristics of our total non-conforming loan originations for the year ended December 31, 2003 (in thousands):

Income Documentation

		Aggregate Principal Balance			Percent of Originations				Weighted Average Coupon				Weighted Average Credit Score				Average Principal Balance					Weighted Average LTV				Weighted Average CLTV
Full Documentation		$	2,517,590			48.9	%			7.3	%			628				$	148				87.7	%			91.6	%
Stated Income Wage Earner		1,483,140				28.8	%			7.3	%			693				139					84.2	%			95.4	%
Stated Income Self Employed		808,877				15.7	%			7.5	%			669				145					83.4	%			93.7	%
24 Month Bank Statements		202,412				3.9	%			7.3	%			629				185					88.8	%			93.1	%
12 Month Bank Statements		112,918				2.2	%			7.6	%			637				174					84.7	%			91.2	%
Limited Documentation		23,245				0.5	%			7.2	%			630				180					82.0	%			88.9	%
Total		$	5,148,182			100.0	%
Weighted Average/Average										7.3	%			653				$	147				86.0	%			93.1	%

 

Credit Score

		Aggregate Principal Balance			Percent of Originations				Weighted Average Coupon				Weighted Average Credit Score				Average Principal Balance					Weighted Average LTV				Weighted Average CLTV				Percent Full Documentation
500 – 549		$	319,874			6.2	%			7.9	%			531				$	145				79.3	%			80.2	%			81.3	%
550 – 599		679,551				13.2	%			7.5	%			577				159					86.1	%			87.4	%			78.8	%
600 – 649		1,308,322				25.4	%			7.3	%			627				155					88.3	%			93.2	%			68.0	%
650 – 699		1,707,370				33.2	%			7.3	%			673				140					86.0	%			95.7	%			31.5	%
700 or greater		1,133,065				22.0	%			7.0	%			733				141					85.1	%			96.0	%			26.0	%
Total		$	5,148,182			100.0	%
Weighted Average/Average										7.3	%			653				$	147				86.0	%			93.1	%			48.9	%

 

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Product Type

		Aggregate Principal Balance			Percent of Originations				Weighted Average Coupon				Weighted Average Credit Score				Average Principal Balance					Weighted Average LTV				Weighted Average CLTV				Percent Full Documentation
2/28 LIBOR ARM		$	2,735,386			53.1	%			7.2	%			637				$	171				85.9	%			92.5	%			54.5	%
2/28 LIBOR ARM IO		1,232,611				24.0	%			6.6	%			670				251					84.9	%			95.3	%			40.8	%
3/27 LIBOR ARM		63,954				1.2	%			7.0	%			645				165					85.3	%			90.3	%			66.0	%
3/27 LIBOR ARM IO		39,528				0.8	%			6.6	%			666				258					83.5	%			90.4	%			55.0	%
5/25 Treasury ARM		14,716				0.3	%			5.7	%			696				177					77.4	%			84.2	%			62.4	%
5/25 Treasury ARM IO		7,540				0.1	%			6.4	%			694				279					79.6	%			96.6	%			56.9	%
Fixed Rate		534,775				10.4	%			7.3	%			669				149					80.6	%			87.5	%			54.5	%
Fixed Rate IO		102,187				2.0	%			7.0	%			687				250					80.1	%			92.8	%			45.5	%
2nd		417,485				8.1	%			10.5	%			686				44					98.5	%			98.5	%			26.2	%
Total		$	5,148,182			100.0	%
Weighted Average/Average										7.3	%			653				$	147				86.0	%			93.1	%			48.9	%

 

Regulatory Compliance, Quality Control and Licensing

Regulatory Compliance

We regularly monitor the laws, rules and regulations that apply to our business and analyze any changes. We integrate many legal and regulatory requirements into our automated loan origination system to reduce the prospect of inadvertent non-compliance due to human error. We also maintain policies and procedures, and summaries and checklists, to help our origination personnel comply with these laws. Our loans and practices are also reviewed regularly in connection with the due diligence that we do and that is performed by the purchasers of our loans, our securitization dealers and our warehouse lenders. Our state regulators also review our practices and loan files regularly and report the results to us.

In May 2004, the conforming division of Fieldstone Mortgage, d/b/a Broad Street Mortgage Co., received notification from HUD’s Regional Office of the Inspector General for Audit, in Fort Worth, Texas (the HUD IG), that an audit would be conducted to review loan origination procedures and the quality control plan for FHA loans originated by one of the division’s San Antonio branches. The HUD IG audit was triggered by the relatively high delinquency rate of loans originated by this San Antonio branch, even though the delinquency rate on FHA loans originated by all of Fieldstone Mortgage’s other branches is not above the national average. On August 31, 2004, we closed this San Antonio branch and terminated the staff through a reduction in force.

We received a draft audit report from the HUD IG dated February 28, 2005. In the draft audit report, the HUD IG has recommended that we indemnify HUD for any loan losses for 27 loans that may be, or have previously been, incurred, and that we make certain amendments to our quality control plan for our conforming division. We will meet with the HUD IG and submit a response to the draft audit report in April 2005. The HUD IG will then issue a final audit report to the FHA Commissioner (who also serves as the Chairman of HUD’s Mortgagee Review Board) and to us. At that point, HUD staff of the Office of Program Enforcement will make a decision whether to refer the audit to the Mortgagee Review Board for its consideration, handle the matter within that office, or refer it to the appropriate HUD Homeownership Center for resolution.

The Mortgagee Review Board could impose a civil money penalty for some or all of the 27 loans referenced in the draft audit report.

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Quality Control

Our quality control group is an integral part of our origination team and is dedicated to improving the quality of our operations. The professional staff are all full-time employees and consist of a manager, two audit supervisors (one specializing in conforming loans and one specializing in non-conforming loans), five auditors and one special auditor located at our home office, who have an average of 15 years of industry experience. Each month, our quality control group, working in conjunction with other managers, selects a random sample of at least 10% of all loans originated through our non-conforming and conforming origination channels during the prior month, and a targeted sample of at least 5% of all loans originated through our non-conforming and conforming origination channels during the prior month. The targeted sample may include loans with a first payment default or early payoff, loans originated by a branch that was recently cited for failing to comply with company policies and procedures, loans that are the subject of an employee or consumer complaint, loans originated by a branch or through an operation center for which management has requested additional reviews about loan quality or others groups of loans requested by management.

Once the random and targeted samples are selected, our quality control group re-verifies the sources of income and employment for all borrowers in connection with all loans in the sample and imaged versions of the loan files are forwarded to a recognized third party provider, who, using its own personnel, reviews, re-underwrites and audits the entire sample to ensure compliance with our underwriting guidelines and applicable regulations. Once the audit results are received back from the third party provider, our quality control group investigates, audits, reviews and re-underwrites loans cited by the third party provider as having errors or irregularities. Specifically, the quality control group:

·       re-underwrites these loans, comparing the underwriting at the time of origination with our underwriting guidelines;

·       investigates any waivers of the underwriting guidelines;

·       reviews, investigates and analyzes the reverification data received in response to our reverification requests;

·       reviews borrowers’ signatures for authenticity and consistency;

·       reviews all closing documents to ensure all conditions have been met;

·       reviews the fee labeling by brokers and title companies to verify regulatory compliance;

·       performs specific loan tests to verify our compliance with the relevant regulatory requirements; and

·       reviews appraisals to ensure collateral values for the loans are supported.

Our quality control group also conducts on-site audits of each of our branch offices. These on-site audits involve an in-person and comprehensive review and determination of compliance in the following areas: data collection, account reconciliation, advertising (for content and compliance with regulations), a sample of declined loans, credit approval process and licensing and employment practices.

The quality control group reports all of its findings on a regular basis to the respective managers in order to implement corrective actions where necessary. The group’s findings are also reported to members of senior management and, on a quarterly basis to our Board of Directors. Management analyzes the results of these audits as well as performance trends and servicing issues. Based upon this analysis, further corrective actions and/or training may be recommended and implemented for a particular branch, operations center or employee. Any costs or expenses incurred as a consequence of an error made by a particular branch or operations center that is discovered in the course of a closed loan or on-site audit by the quality control group is deducted from the internal profit and loss calculation for that branch or

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operations center. Our branch managers’ compensation is also tied partly to the quality control results of the loans originated by their branch.

Licensing

We originate all our loans through Fieldstone Mortgage, our primary operating subsidiary. As of December 31, 2004, Fieldstone Mortgage was licensed or exempt from licensing requirements to originate residential mortgages in 48 states and the District of Columbia.

With respect to our portfolio of non-conforming loans held for investment, Fieldstone Mortgage closes the loans using funds advanced by us, with a simultaneous assignment of the loans to us. Fieldstone Mortgage services the loans for us for a fee until the loans are transferred to a sub-servicer. As of December 31, 2004, Fieldstone Investment was licensed or exempt from licensing requirements to fund residential mortgage loans and acquire closed residential mortgage loans in all states in which it conducts business.

Portfolio Strategy—Loans Held for Investment

During 2004, our portfolio of non-conforming loans held for investment increased to $4.8 billion and generated $137.4 million of net interest income before provision for loan losses, or 4.4% of average loans held for investment. During 2003, our portfolio of non-conforming loans held for investment increased to $1.3 billion and generated $12.6 million of net interest income before provision for loan losses, or 4.7% of average loans held for investment. Our provision for loan losses was $21.6 million and $2.1 million for 2004 and 2003, respectively.

Our portfolio strategy is to build a portfolio of non-conforming loans with stable risk-adjusted returns, considering the inherent volatility in returns and cash flows, by managing the credit quality of the loans we originate, the interest rate risk associated with our portfolio of loans and the amount of leverage we use to finance our portfolio. We retain primarily hybrid non-conforming loans in our portfolio to reduce the duration of our assets and mitigate the interest rate risk inherent in our portfolio. We utilize interest rate swaps and caps to mitigate the risk of our LIBOR-based financing costs increasing during the period in which the interest on the hybrid loan is fixed, generally 2 to 3 years. As of December 31, 2004 and 2003, over 86.6% and 84.5%, respectively, of the loans in our portfolio contain a prepayment fee. The inclusion of this fee reduces prepayment speed volatility and allows us to recover our investment in the loan if it prepays in the first two or three years after origination. We manage the credit risk by focusing upon a disciplined loan origination and underwriting process as well as constructing a portfolio with an average credit score of approximately 650.

For the year ended December 31, 2004, we retained 66% of the non-conforming loans we originated during that period, and from August 1, 2003 through December 31, 2003, we retained 50% of the non-conforming loans we originated during that period. We expect to continue to retain approximately 65% of the non-conforming loans we originate until we reach our targeted leverage ratio or we otherwise determine to change our portfolio investment strategies.

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