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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended:  December 31, 2010

OR

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:  333-103293

Pioneer Financial Services, Inc.

(Exact name of Registrant as specified in its charter)

(Former name, former address and former fiscal year, if
changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§ 232.405 of this chapter) during the preceding 12  months (or such shorter periods that the Registrant was required to submit and post such files).

Yes  o  No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of February 14, 2011, one share of the registrant’s common stock is outstanding. The registrant is a wholly owned subsidiary of MidCountry Financial Corp.

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PIONEER FINANCIAL SERVICES, INC.

FORM 10-Q

December 31, 2010

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PART I - FINANCIAL INFORMATION

ITEM 1.  Condensed Consolidated Financial Statements

PIONEER FINANCIAL SERVICES, INC.

Condensed Consolidated Balance Sheets

As of December 31, 2010 and September 30, 2010

(unaudited)

See Notes to Condensed Consolidated Financial Statements

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PIONEER FINANCIAL SERVICES, INC.

Condensed Consolidated Statements of Operations

For the three months ended December 31, 2010 and 2009

(unaudited)

See Notes to Condensed Consolidated Financial Statements

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PIONEER FINANCIAL SERVICES, INC.

Condensed Consolidated Statements of Stockholder’s Equity

For the three months ended December 31, 2010 and

year ended September 30, 2010

(unaudited)

See Notes to Condensed Consolidated Financial Statements

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PIONEER FINANCIAL SERVICES, INC.

Consolidated Statements of Cash Flows

For the three months ended December 31, 2010 and 2009

(unaudited)

See Notes to Condensed Consolidated Financial Statements

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PIONEER FINANCIAL SERVICES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the three months ended December 31, 2010 and 2009 and as of September 30, 2010

(unaudited)

NOTE 1:  NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of Pioneer Financial Services, Inc. and its wholly owned subsidiaries (collectively “we,” “us,” “our” or the “Company”). Intercompany balances and transactions have been eliminated.  We were acquired on May 31, 2007 by MidCountry Financial Corp., a Georgia corporation (“MCFC”) as a wholly owned first-tier subsidiary (the “Transaction”).

Nature of Operations and Concentration

We are headquartered in Kansas City, Missouri.  We purchase finance receivables from the Military Banking Division (“MBD”) of MidCountry Bank, a federally chartered stock savings bank and wholly owned subsidiary of MCFC (“MCB”). These receivables represent loans exclusively to active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.  We also purchase finance receivables from retail merchants that sell consumer goods to active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.

Use of Estimates

The preparation of condensed consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the unaudited condensed consolidated financial statements and in disclosures of contingent assets and liabilities.  We use estimates and employ judgments in determining the amount of our allowance for credit losses, insurance claims and policy reserves, deferred loan origination costs, and establishing the fair value of our financial instruments.

Information with respect to December 31, 2010 and 2009, and the periods then ended, have not been audited by our independent auditors, but in the opinion of management reflect all adjustments (which include only normal recurring adjustments) necessary for the fair presentation of the financial condition and operations.  The results of operations for the three months ended December 31, 2010 and 2009 are not necessarily indicative of results to be expected for the entire fiscal year.  The condensed consolidated balance sheet as of September 30, 2010 and statement of stockholder’s equity for the year ended September 30, 2010 have been derived from the audited consolidated balance sheet and statement of stockholder’s equity. All the information in these condensed financial statements should be considered in conjunction with the financial statements and the notes thereto included in our latest Annual Report on Form 10-K.

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NOTE 2:  FINANCE RECEIVABLES

Our finance receivables are comprised of military loans and retail installment contracts.  During the first quarter of 2011, we purchased $123.3 million military loans from MBD compared to $93.4 million during the first quarter of 2010.  We acquired $8.6 million retail installment contracts during the first quarter of 2011 compared to $11.8 million during the first quarter of 2010.  We have not sold any finance receivables in the first quarter of 2011; we do not sell finance receivables in the normal course of business. Our finance receivables are disaggregated as military loans and retail installment contracts.

Finance receivables as of December 31, 2010 and September 30, 2010, consisted of the following:

(1) Prepaid customer payments consist of principal amount due on January 1, 2011 which was received and applied on December 30, 2010.

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Management has an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. Our portfolio consists of a large number of relatively small, homogenous accounts.  No account is large enough to warrant individual evaluation for impairment. For purposes of determining the allowance for loan losses, the Company has segmented the loan portfolio by military loans and retail installment contracts.

The allowance for credit losses for military loans and retail installment contracts is maintained at an amount that management considers sufficient to cover estimated future losses.  The Company’s allowance for loan losses is sensitive to risk ratings assigned to evaluated segments and economic assumptions and delinquency trends driving statistically modeled reserves. We consider numerous qualitative and quantitative factors in estimating losses in our finance receivable portfolio, including the following:

·                  Prior credit losses and recovery experience

·                  Current economic conditions

·                  Current finance receivable delinquency trends

·                  Demographics of the current finance receivable portfolio

We also use internally developed and vendor supplied data in this process. We utilize a statistical model based on potential credit risk trends, growth rate and charge off data when incorporating both historical and prospective factors to estimate losses. These results and management’s judgment are used to project future losses and to establish the allowance for credit losses for each segment of our finance receivables.

There is uncertainty inherent in these estimates, making it possible that they could change in the near term. In the first quarter of 2011 we did not have a change in our allowance methodology.

As part of the on-going monitoring of the credit quality of the Company’s entire loan portfolio, management tracks certain credit quality indicators of our customers including trends related to (i) net charge-offs,  (ii) non-performing loans (iii) rank of service member.

The following table sets forth changes in the components of our allowance for credit losses on finance receivables as of the end of the period presented:

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The accrual of interest income is suspended when a full payment on either military loans or retail installment contracts has not been received for 90 days or more and the interest due exceeds an amount equal to 60 days of interest charges. As of December 31, 2010, we had $7.8 million in military loans and $1.2 million in retail installment contracts that were not accruing interest compared to $6.4 million in military loans and $1.6 in retail installment contracts as of December 31, 2009.  We do not have finance receivables greater than 90 days past due accruing interest as of December 31, 2010 or December 31, 2009.  The accrual of interest is resumed when a full payment (95% or more of the contracted payment amount) is received.  Nonperforming assets represent those finance receivables of which both the accrual of interest income has been suspended and for which no full payment of principal or interest has been received for more than 90 days.  We consider a loan impaired after 180 days of past due and is removed from our finance receivables portfolio.  We do not restructure troubled debt as a form of curing delinquencies.

As of December 31, 2010, the past due finance receivables are as follows:

Additionally, MBD uses our underwriting criteria, which was developed from our past customer credit repayment experience and is periodically evaluated based on current portfolio performance.  These criteria require the following:

·                  All borrowers must be active duty or career retired U.S. military personnel or U.S. Defense Department employees.

·                  All potential borrowers must complete standardized credit applications either in person at one of MBD’s loan production offices or online via the Internet.

·                  A thorough review must be conducted on all applicants’ military service history.  This includes verification of status including rank and credit history using major credit reporting.  Other review procedures may be conducted as deemed necessary.

·                  Loan repayment terms must generally be structured to repay the entire loan prior to the customer’s estimated separation from the military.

MBD also examines the individual’s debt to income ratio, discretionary income, military rank, time served in the military and prior credit experience when evaluating the creditworthiness of potential customers. These indicators are used to help minimize the risk of unwillingness or inability to repay for both military loans and retail installment contracts.  These guidelines were developed from past customer credit repayment experience and are periodically revalidated based on current portfolio performance. Loans are limited to amounts that the customer could reasonably be expected to repay from discretionary income.  Loan repayment terms are generally structured to repay the entire loan prior to the customer’s estimated separation from the military.

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NOTE 3:  GOODWILL AND INTANGIBLES

In connection with the Transaction, MCFC paid the shareholders of Pioneer Financial Industries (the “Sellers”) approximately $68.8 million in cash and 882,353 shares of MCFC’s common stock. Under the related purchase agreement, MCFC was also required to pay the Sellers an additional $5 million in contingent payments, of which $4 million was contributed to us and $1 million to MBD.  The final contingent payment was made on March 31, 2009.  The total purchase price was $90,229,762.

The fair value assigned to intangible assets acquired and assumed liabilities is supported by valuations using estimates and assumptions provided by management.

Due to the Transaction, we recorded goodwill and amortizable intangible assets in the form of customer, agent and vendor relationships, trade name, technology for the lending system and the value of business acquired.  Goodwill and intangible assets at December 31, 2010 and September 30, 2010 are as follows:

Intangible assets other than goodwill, which are determined to have finite lives, are amortized on a straight-line or accelerated basis over their estimated useful lives between three and ten years.

Management evaluated goodwill at September 30, 2010, and determined that there was no impairment as the estimated fair value substantially exceeded the carrying value.  Management also evaluates amortizable intangible assets and goodwill for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  There were no impairments of amortizable intangible assets as of December 31, 2010.

NOTE 4: NET INCOME PER SHARE

Net income per share is computed based upon the weighted-average common shares outstanding of one share for the three months ended December 31, 2010.  There are no potentially dilutive securities issued and outstanding.

NOTE 5: RELATED PARTY TRANSACTIONS

We entered into an amended and restated Loan Sale and Master Services Agreement (“LSMS Agreement”) with MBD in June 2009.  Under the LSMS Agreement, we buy certain military loans that MBD originates and receive management and recordkeeping services.  Total loans purchased from MBD (net of noncash items), pursuant to the LSMS Agreement were $73.9 million and $59.3 million for the first quarter of fiscal 2011 and 2010, respectively.  Total expenses paid to MBD for services received for management and record keeping services pursuant to the LSMS agreement were $11.7 million and $11.0 million in the first quarter of fiscal 2011 and 2010, respectively.  Management fee expense paid to MBD totaled $9.8 million and $9.2 million for the first quarter of fiscal 2011 and fiscal 2010, respectively.  During the first quarter of 2011, we paid down our parent company debt by $1.5 million.  As of December 31, 2010, the principal balance outstanding on our parent company debt was $10.4 million.  See further discussion in the section entitled “Borrowings”.

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NOTE 6:  DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that creates a contractual obligation or right to deliver or receive cash or another financial instrument from a second entity on potentially favorable or unfavorable terms.

Fair value estimates are made at a point in time, based on relevant market data and information about the financial instrument. Fair values should be calculated based on the value of one trading unit without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications, estimated transaction costs that may result from bulk sales or the relationship between various financial instruments. No readily available market exists for a significant portion of the Company’s financial instruments. Fair value estimates for these instruments are based on judgments regarding current economic conditions, currency and interest rate risk characteristics, loss experience, and other factors. Many of these estimates involve uncertainties and matters of significant judgment and cannot be determined with precision. Therefore, the calculated fair value estimates in many instances cannot be substantiated by comparison to independent markets and, in many cases, may not be realizable in a current sale of the instrument. Changes in assumptions could significantly affect the estimates.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

Cash and Cash Equivalents — The carrying value approximates fair value due to their liquid nature.

Investment Securities — Fair value for investment securities are based on quoted market prices.

Finance Receivables — The fair values of finance receivables is estimated by discounting future cash flows using current rates at which similar finance receivables would be made to borrowers with similar credit ratings and for the same remaining maturities. The carrying amount of finance receivables approximate fair value due to their stated interest rates approximating a market rate for instruments with similar remaining maturities and credit profiles.

Revolving Line of Credit — The carrying amounts of a revolving line of credit approximate their fair value due to the variable interest rates.

Amortizing Term Notes — The fair value of the amortizing term notes with fixed interest rates are estimated using the discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Investment Notes — The fair value of investment notes is estimated by discounting future cash flows using current rates at which similar investment notes would be offered to lenders for the same remaining maturities.

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Financial instruments measured and reported at fair value are classified and disclosed in one of the following categories:

·                  Level 1 — Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

·                  Level 2 — Inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs).

·                  Level 3 — Unobservable inputs reflect the Company’s judgments about the assumptions market participants would use in pricing the asset or liability since limited market data exists. The Company develops these inputs based on the best information available, including the Company’s own data.

As of December 31, 2010 and September 30, 2010 our restricted investments were $5.9 million and $6.0 million, respectively, which are classified as Level 1.

We record our restricted investments at fair market value.  The following table represents our restricted investments as of December 31, 2010 and September 30, 2010:

(1) The net unrealized gain on investments of $183,635 net of tax of $64,272 represents the accumulated other comprehensive income of $119,363.

In the first quarter of 2011, we did not recognize any material realized gains or losses on investments. As of December 31, 2010, there were no unrealized losses present.  As of September 30, 2010, none of the investments with unrealized losses were determined to be other than temporarily impaired and none of those investments have unrealized losses for more than one year.

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NOTE 7:  BORROWINGS

Secured Senior Lending Agreement

On June 12, 2009, we entered into a Secured Senior Lending Agreement (the “SSLA”) with the lenders listed on the SSLA (“the lenders”) and UMB Bank, N.A. (the “Agent”).  The SSLA replaces and supersedes the Senior Lending Agreement, dated as of June 9, 1993, as subsequently amended and restated (the “SLA”).  The term of the current SSLA ends on March 31, 2011 and is automatically extended annually unless any lender gives written notice of its objection by March 1 of each calendar year.  Our assets secure the loans extended under the SSLA for the benefit of the lenders and other holders of the notes issued pursuant to the SSLA or the SLA (the “Senior Debt”).  The facility is an uncommitted facility that provides common terms and conditions pursuant to which the individual lenders that are a party to the SSLA may choose to make loans to us in the future.  If a lender were to choose not to participate in future fundings, the outstanding amortizing notes would be repaid based on the original terms of the note .  As of December 31, 2010, we could request up to $65.3 million in additional funds and remain in compliance with the terms of the SSLA.  No lender, however, has any contractual obligation to lend us these additional funds.

As of December 31, 2010, the lenders have indicated a willingness to participate in fundings up to an aggregate of $298.0 million during the next 12 months, including $232.7 million that is currently outstanding. Included in this amount are borrowings of $28.7 million from withdrawing banks that previously participated in the SLA or SSLA. On December 30, 2010, we received the January 1, 2011, allotment payments of $15.1 million. These funds were used to pay down the revolving line of credit and are not taken into consideration when presenting the $232.7 million that is currently outstanding.

In the third quarter of fiscal year 2010, we amended the SSLA to allow additional banks to become parties to the SSLA under a modified non-voting role.  We have identified each lender that has voting rights under the SSLA as “voting bank(s)” and lenders that do not having voting rights under the SSLA as “non-voting bank(s).”  While all voting and non-voting banks have the same rights to the collateral and are a party to the same terms and conditions of the SSLA, all of the non-voting banks acknowledge and agree that they have no right to vote on any matter nor to prohibit or limit any action by us, or the voting banks.  As of December 31, 2010, the principal balance outstanding to non-voting banks under the SSLA was $33.2 million.

Interest on the amortizing notes is fixed at 270 basis points over the 90-day moving average of like-term treasury notes when issued.  The interest rate may not be less than 6.25%.  All amortizing notes have terms not to exceed 48 months, payable in equal monthly principal and interest payments.  Interest on amortizing notes is payable monthly.  In addition, we are paying our lenders a quarterly uncommitted availability fee in an amount equal to ten basis points multiplied by the average, aggregate outstanding principal amount of all amortizing notes held by the lenders.  For the quarter ended December 31, 2010, we paid our lenders $0.2 million in uncommitted availability fees.

Substantially all of our assets secure the debt under the SSLA.  The SSLA also limits, among other things, our ability to (1) incur additional debt from the lenders beyond that allowed by specific financial ratios and tests, (2) borrow or incur other additional debt except as permitted in the SSLA, (3) pledge assets, (4) pay dividends, (5) consummate certain asset sales and dispositions, (6) merge, consolidate or enter into a business combination with any other person, (7) pay to MCFC service charge fees each year except as provided in the SSLA, (8) purchase, redeem, retire or otherwise acquire any of our outstanding equity interests, (9) issue additional equity interests, (10) guarantee the debt of others without reasonable compensation and only in the ordinary course of business or (11) enter into management agreements with our affiliates.

Under the SSLA, we are subject to certain financial covenants that require that we, among other things, maintain specific financial ratios and satisfy certain financial tests.  In part, these covenants require us to: (1) maintain an allowance for credit losses equal to or greater than the allowance for credit losses shown on our audited financial statements as of the end of our most recent fiscal year and at no time less than 5.25% of our consolidated net receivables unless otherwise required by generally accepted accounting principles (“GAAP”), (2) limit our senior indebtedness as of the end of each quarter to not greater than four times our tangible net worth, (3) maintain a positive net income in each fiscal year, (4) limit our senior indebtedness as of the end of each quarter to not greater than 80% of our consolidated net receivables, and (5) maintain a consolidated total required capital of at least $75 million plus 50% of the cumulative positive net income earned by us during each of our fiscal years ending after September 30, 2008.  Any part of the 50% of positive net income not distributed by us as a dividend for any fiscal year within 120 days after the last day of such fiscal year must be added to our consolidated total required capital and may not be distributed as a dividend or otherwise.  No part of the consolidated total required may be distributed as a dividend.  As of December 31, 2010, we were in compliance with all loan covenants.

In connection with the execution of the SSLA, MCFC entered into an Unlimited Continuing Guaranty and a Negative Pledge Agreement in favor of the Agent.

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Subordinated Debt - Parent

In fiscal year 2010, we amended our SSLA to convert the parent note from a term facility to a revolving line of credit.  Funding on this line of credit is provided as needed at our discretion and dependent upon the availability of funds from our parent and is due upon demand.  The maximum principal balance on this facility is $25.0 million.  Interest is payable monthly and is based on prime or 5.0%, whichever is greater.  As of December 31, 2010, the outstanding balance was $10.4 million.  We expect to receive no additional borrowings from the parent during the next 12 months and may repay a portion of this balance.

Maturities

The following table represents outstanding obligations of our current SSLA lenders and banks that are not participating in our current SSLA listed within as withdrawing banks as of December 31, 2010:

Investment Notes

We also have borrowings through the issuance of investment notes (with accrued interest) with an outstanding notional balance of $52.9 million, which includes a $0.5 million purchase adjustment at December 31, 2010, and $40.0 million, which includes a $0.5 million purchase adjustment at September 30, 2010.  The purchase adjustments relate to fair value adjustments recorded as part of the Transaction.  These investment notes are nonredeemable before maturity by the holders, issued at various rates and mature one to ten years from date of issue. At our option, we may redeem and retire any or all of the debt upon 30 days written notice. The average investment note payable was $48,581 and $35,324, with a weighted interest rate of 9.35% and 9.52% at December 31, 2010 and 2009, respectively.

On January 21, 2010, the Securities and Exchange Commission (“SEC”) declared effective our registration statement on Form S-1 (Amendment No. 1) (File No. 333-164109) registering $25 million of investment notes (“2010 Registration Statement”).  We filed our final prospectus and prospectus supplement containing certain pricing information on January 21, 2010.  We began offering these investment notes on January 22, 2010.  As of December 31, 2010, we issued 235 investment notes in conjunction with this offering with an aggregate value of $21.1 million.

NOTE 8: SUBSEQUENT EVENTS

On January 28, 2011, the SEC declared our post effective amendment to the 2010 Registration Statement (File No. 333-164109) effective with the related Offering expected to terminate on January 28, 2013, unless terminated earlier at our discretion.  The SEC also declared effective a new registration statement on Form S-1 (File No. 333-171745) (“2011 Registration Statement”) under which along with the accompanying prospectus, we registered and are offering an additional $50 million in aggregate principal amount of our investment notes, with a maximum aggregate offering price of $50 million, on a continuous basis with an expected termination date of January 28, 2013, unless terminated earlier at our discretion.

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ITEM 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

The discussion set forth below, in the quarterly report of Pioneer Financial Services, Inc. (“PFS”), with its wholly owned subsidiaries (collectively “we,” “us,” “our” or the “Company”), contains forward-looking statements within the meaning of federal securities law.  Words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “continue,” “predict,” or other similar words, identify forward-looking statements.  Forward-looking statements include statements regarding our management’s intent, belief or current expectation about, among other things, trends affecting the markets in which we operate our business, financial condition and growth strategies.  Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, forward-looking statements are not guarantees of future performance and involve risks and uncertainties.  Actual results may differ materially from those predicted in the forward-looking statements as a result of various factors, including, but not limited to, those risk factors set forth in our annual report on Form 10-K for the period ended September 30, 2010 (“annual report”) under Part I— Item 1A—Risk Factors.  Other factors not identified herein could also have such an effect.  If any of these risk factors occur, they could have an adverse effect on our business, financial condition and results of operation.  When considering forward-looking statements keep these risk factors in mind.  These forward-looking statements are made as of the date of this filing.  You should not place undue reliance on any forward-looking statement.  We are not obligated to update forward-looking statements and will not update any forward-looking statements in this quarterly report on Form 10-Q to reflect future events or developments.

Overview

We are a wholly owned subsidiary of MidCountry Financial Corp., a Georgia corporation (“MCFC”).  We purchase consumer loans, on a worldwide basis, made exclusively to active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.  We purchase primarily from two different types of sources.  Our largest source of military loans is the Military Banking Division (“MBD”) of MidCountry Bank, a federally chartered stock savings bank and wholly owned subsidiary of MCFC (“MCB”), an affiliate who originates military loans through a network of loan production offices and via the Internet. Military families use these loan proceeds to purchase goods and services.  On June 12, 2009, we entered into an Amended and Restated Non-Recourse Loan Sale and Master Services Agreement (“LSMS Agreement”) with MBD that outlines the terms of the sale and servicing of these loans.  We also purchase retail installment contracts from retail merchants that sell consumer goods to active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.  We plan to hold these military loans and retail installment contracts until repaid.

Our finance receivables, whether originated or purchased, are effectively unsecured and consist of loans originated by us or purchased from MBD and retail merchants.  All finance receivables have fixed interest rates and typically have a maturity of less than 48 months. During the first quarter of fiscal 2011, the average size of a loan when purchased was approximately $3,404.  A large portion of our customers are unable to obtain financing from traditional sources due to factors such as their age, frequent relocations and lack of credit history.  These factors may not allow them to build relationships with traditional sources of financing.

Improvement of our profitability is dependent upon the growth in amount of finance receivables we are able to acquire from MBD or retail merchants and the maintenance of loan quality.

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Lending and Servicing Operations

Primary Supplier of Loans

We have retained MBD as our primary supplier of loans.  Under the LSMS Agreement, MBD uses our underwriting criteria (which was developed from our past customer credit repayment experience and is periodically revalidated based on current portfolio performance).  These criteria primarily require the following:

·                  All borrowers must be active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.

·                  All potential borrowers must complete standardized credit applications either in person at one of MBD’s loan production offices or online via the Internet.

·                  A thorough review must be conducted on all applicants’ military service history.  This includes verification of status including rank and credit history using major credit reporting.  Other review procedures may be conducted as deemed necessary.

·                  Loan repayment terms must generally be structured to repay the entire loan prior to the customer’s estimated separation from the military.

To the extent MBD originates loans under these standards, MBD is obligated to sell such loans to us and we are obligated to purchase such loans.  Loans purchased from MBD and those originated by us prior to MCFC acquiring us in June 2007 (the “Transaction”) are referred to as “military loans.”  See our annual report under “Item 1A.  Risk Factors— MBD may modify underwriting and servicing standards and does not have to lend to the traditional customers who meet our business model and lending guidelines, which may materially adversely affect our business operations, cash flow, results of operations, financial condition and profitability.”

Loan Purchasing

Generally.  Prior to the Transaction, we had over 20 years of experience underwriting, originating, monitoring and servicing consumer loans to the military market and developed a deep understanding of the military and the military lifestyle. Through this extensive knowledge of our customer base, we developed a proprietary credit scoring model that focuses on the unique characteristics of the military market, as well as traditional credit scoring variables that are currently utilized by MBD when originating loans in this market.   Prior to the Transaction, we incorporated these proprietary underwriting guidelines and scoring model into our loan origination system to facilitate auto-decisioning and risk-based pricing on our loans.

For the loans we purchase, MBD uses our proprietary underwriting guidelines and scoring model when it originates loans.  Under these guidelines, in evaluating the creditworthiness of potential customers, MBD primarily examines the individual’s debt to income ratio, discretionary income, military rank, time served in the military and prior credit experience. Loans are limited to amounts that the customer could reasonably be expected to repay from that discretionary income.  In general, the majority of finance receivables we own are under $10,000, repayable in equal monthly installments and have terms no longer than 48 months.  Loan repayment terms are generally structured to repay the entire loan prior to the customer’s estimated separation from the military. However, when we purchase loans from MBD, we cannot predict when or whether a customer may unexpectedly leave the military or when or whether other events could occur that result in not being repaid prior to a customer’s departure from the military.

A risk in all consumer lending and retail sales financing transactions is the customer’s unwillingness or inability to repay obligations. An unwillingness to repay is usually evidenced by a consumer’s historical credit repayment record. An inability to repay occurs after initial credit evaluation and funding and usually results from lower income due to early separation from the military or reduction in rank, major medical expenses, or divorce.  Occasionally, these types of events are so economically severe that the customer files for protection under the bankruptcy laws.  Standard underwriting guidelines are used at the time the customer applies for a loan to help minimize the risk of unwillingness or inability to repay.  These guidelines were developed from past customer credit repayment experience and are periodically revalidated based on current portfolio performance.  MBD uses these guidelines to predict the relative likelihood of credit applicants repaying their obligation to us.  We purchase loans made to consumers who fit our underwriting guidelines.  The amount and interest rate of the military loan or retail sales finance transaction purchased are set by MBD or the retail merchant based upon our underwriting guidelines considering the estimated credit risk assumed.

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As a customer service, we consider purchasing a new loan from MBD that includes a refinanced portion if the existing borrower has demonstrated a positive payment history with us and where the transaction creates an economic benefit to the customer after fully underwriting the new loan request to ensure proper debt ratio, credit history and payment performance. We will not purchase refinancings made to cure delinquency or for the sole purpose of creating fee income.  Generally, we purchase refinancing of existing loans when a portion of the new loan proceeds is used to repay the balance of the existing loan and the remaining portion is advanced to the customer.  Approximately 27.5% of the amount of military loans we purchased in the first quarter of fiscal 2011 were refinancings of outstanding loans compared to 28.9% during the first quarter of fiscal 2010.

Military Loans Purchased from MBD.   We purchase military loans from MBD if they meet our lending guidelines.  In connection with the Transaction, MBD was provided the rights to our lending guidelines and extensive experience with lending to the military marketplace.  Pursuant to the LSMS Agreement, we transferred the right to use our underwriting model and system to MBD.  However, we retained ownership of this model and the lending system.  MBD originates these loans directly through its loan production offices and over the Internet.

Retail Installment Contracts.  We purchase retail installment contracts that meet our quality standards and return on investment objectives from approximately 305 active retail merchant locations.  Retail installment contracts are finance receivable notes generated during the purchase of consumer goods by active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.  These customers have demonstrated an apparent need to finance a retail purchase and a willingness to use credit.  We generally acquire these contracts without recourse to the originating merchant.  However, reserve agreements with many retail merchants allow us to withhold funds from the merchant’s proceeds to create reserves to be used in the event a customer defaults and the loan is deemed uncollectible.  Retail installment contracts generally have maximum terms of 48 months.

Management and Recordkeeping Services

We have retained MBD to provide management and recordkeeping services.  MBD services our finance receivables in the same manner we did prior to the Transaction. For these management and recordkeeping services, we pay MBD a monthly fee in an amount equal to 0.7% (8.4% annually) of the outstanding principal balance of the military loans and retail installment contracts serviced as of the last day of each month. The fee can be adjusted annually on the basis of the annual increase or decrease in the Consumer Price Index.  Also, as part of its compensation for performing these management and recording keeping services, MBD retains all ancillary revenue, including late charges and insufficient funds fees, associated with these loans and retail installment contracts.  For these services, we also pay MBD an annual fee of $33.86 for each military loan and retail installment contract owned by us at the end of the prior fiscal year. The annual fee is paid in monthly installments. This fee can be adjusted annually on the basis of the annual increase or decrease in the Consumer Price Index.

To facilitate MBD’s servicing of the military loans and retail installment contracts, we have granted MBD (i) the non-exclusive rights to use certain intellectual properties, including our trade names and service marks, and (ii) the right to use our Daybreak loan processing system and related hardware and software. We have also granted MBD non-exclusive rights to market additional products and services to our U.S. military borrowers. We retain all other borrower relationships.

Sources of Income

We generate revenues primarily from interest income earned on the military loans purchased from MBD, loans previously originated by us and retail installment contracts purchased from retail merchants. We also earn revenues from credit reinsurance premiums and credit protection fees. For purposes of the following discussion, “revenues” means the sum of our finance income and fees.

During the second quarter of fiscal 2010, MBD began offering a debt protection product to our customers.  During the third quarter of fiscal 2010, this product replaced the credit insurance products we previously offered to customers.  If our customers are killed, injured, become ill among other events, including during war, our subsidiary will have payment obligations.  The liability we establish for possible losses related to our reinsurance and debt protection operations and the corresponding charges to our income to maintain this amount are actuarially evaluated and we consider this amount adequate.

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Finance Receivables

Our finance receivables are comprised of military loans and retail installment contracts.  The following table sets forth certain information about the components of our finance receivables as of the end of the periods presented: