AMERICAN BUSINESS FINANCIAL SERVICES INC /DE/ - 10-K - 20041013 - FORM
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 June 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to ________________
Commission file number 000-22474
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
Delaware 87-0418807
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 Penn Square East, Philadelphia, PA 19107
(Address of principal executive offices) (Zip Code)
(215) 940-4000
(Registrant's telephone number, including area code)
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 $.001 per share
(Title of class)
Series A Convertible Preferred Stock, par value $.001 per share
(Title of class)
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. [X] YES [ ] NO
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). [ ] YES [X] NO
The aggregate market value of the registrant's common stock, par value
$.001 per share, held by non-affiliates of the registrant based on the price at
which the common stock was last sold as of the last business day of the
registrant's most recently completed second fiscal quarter was $5.8 million.
The number of shares outstanding of the registrant's sole class of
common stock as of September 30, 2004, the latest practicable date before the
filing of this Form 10-K, was 3,598,342 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the registrant's definitive proxy statement, in
connection with its 2004 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days after June 30, 2004, are
incorporated by reference into Part III of this Annual Report on Form 10-K.
2
PART I
ITEM 1. BUSINESS
FORWARD LOOKING STATEMENTS
Some of the information in this Annual Report on Form 10-K may contain
forward-looking statements. You can identify these statements by words or
phrases such as "will likely result," "may," "are expected to," "will continue
to," "is anticipated," "estimate," "believe," "projected," "intends to" or other
similar words. These forward-looking statements regarding our business and
prospects are based upon numerous assumptions about future conditions, which may
ultimately prove to be inaccurate. Actual events and results may materially
differ from anticipated results described in those statements. Forward-looking
statements involve risks and uncertainties described under "Risk Factors" as
well as other portions of this Annual Report on Form 10-K, which could cause our
actual results to differ materially from historical earnings and those presently
anticipated. When considering forward-looking statements, you should keep these
risk factors in mind as well as the other cautionary statements in this Form
10-K. You should not place undue reliance on any forward-looking statement.
GENERAL INFORMATION REGARDING OUR BUSINESS
American Business Financial Services, Inc. is a financial services
organization operating mainly in the eastern and central portions of the United
States. Recent expansion has positioned us to increase our operations in the
western portion of the United States, especially California. Through our
principal direct and indirect subsidiaries, we currently originate, sell and
service home equity and purchase money mortgage loans, to which we refer as home
mortgage loans, secured by first or second mortgages on one-to-four family
residences, which may not satisfy the eligibility requirements of Fannie Mae,
Freddie Mac or similar buyers and which we refer to in this document as home
mortgage loans. During fiscal 2004, 89.9% of loans originated by us were secured
by first mortgages and 10.1% of loans originated by us were secured by second
mortgages. See "-- Lending Activities -- Home Mortgage Loans" for a description
of our home mortgage loan lending activities.
Additionally, we service loans to businesses secured by real estate and
other business assets that we had originated and sold in prior periods, which we
refer to in this document as business purpose loans. To the extent we obtain a
credit facility to fund business purpose loans, we may originate and sell
business purpose loans in future periods.
Our customers are primarily credit-impaired borrowers who are generally
unable to obtain financing from banks or savings and loan associations and who
are attracted to our products and services. This type of borrower is commonly
referred to as a subprime borrower. Loans made to subprime borrowers are
frequently referred to as subprime loans. Financial institutions utilize a
credit rating system referred to as a FICO score to evaluate the
creditworthiness of borrowers and as a means to establish their risk associated
with lending to a particular borrower. The higher the FICO score, which can
range from 300 to 850, the more creditworthy the borrower is. Generally,
borrowers with FICO scores of 720 to 850 would receive the most favorable
interest rates. During fiscal 2004, the average FICO score of our subprime home
mortgage borrowers was 623. According to Standard & Poor's, subprime lenders
issued securitized transactions with mixed collateral (fixed and adjustable rate
mortgage loans) with a range of average FICO scores between 584 and 642 during
the second quarter of calendar 2004.
3
We originate loans through a combination of channels including a
national processing center located at our centralized operating office in
Philadelphia, Pennsylvania, and a network of mortgage brokers. During fiscal
2004, we acquired broker operations in West Hills, California and Austin, Texas,
and opened new offices in Edgewater, Maryland and Irvine, California to support
our broker operations. We also process and purchase home mortgage loans through
our Bank Alliance Services program. Through this program, we purchase home
mortgage loans from other financial institutions and hold these loans as
available for sale until they are sold in a whole loan sale or in connection
with a future securitization. Our loan servicing and collection activities were
performed at our Bala Cynwyd, Pennsylvania office, and were relocated to our
Philadelphia office on July 12, 2004. See "-- Lending Activities."
We were incorporated in Delaware in 1985 and began operations as a
finance company in 1988, initially offering business purpose loans to customers
whose borrowing needs we believed were not being adequately serviced by
commercial banks. Since our inception, we have significantly expanded our
product line and geographic scope and currently have licenses or are otherwise
qualified to offer our home mortgage loan products in 46 states.
Our business strategy has generally involved the sale of substantially
all of the loans we originate through a combination of loan sales with servicing
released, which we refer to as whole loan sales, and securitizations. Our
determination as to whether to dispose of loans through securitizations or whole
loan sales depends on a variety of factors including market conditions,
profitability and cash flow considerations. From 1995 through the fourth quarter
of fiscal 2003, we have elected to utilize securitization transactions
extensively due to the favorable conditions we experienced in the securitization
markets. We generally realized higher gain on sale in our securitization
transactions than on whole loan sales for cash. In whole loan sale transactions,
the gain on sale is generally significantly lower than the gains realized in
securitization transactions, but we receive the gain in cash. Due to our
inability to securitize our loans in the fourth quarter of fiscal 2003, we
adjusted our business strategy to emphasize more whole loan sales. The use of
whole loan sales enables us to more rapidly generate cash flow, protect against
volatility in the securitization markets and reduce risks inherent in retaining
an interest in the securitized loans. However, unlike securitizations, where we
may retain the right to service the loans we sell for a fee, which we refer to
as servicing rights, whole loan sales are typically structured as a sale with
servicing rights released and do not result in our receipt of interest-only
strips. As a result, using whole loan sales more extensively in the future will
reduce our income from servicing activities and limit the amount of
securitization assets created. Of the $982.7 million of loans originated by us
in fiscal 2004, at June 30, 2004, approximately 10% of these loans were
securitized, approximately 60% of these loans were sold in whole loan sales with
servicing released and the remainder were on our balance sheet at June 30, 2004
as available for sale pending future sale. We do not intend to hold any of these
loans on our balance sheet permanently. See "-- Recent Developments,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Whole Loan Sales" and "-- Whole Loan Sales."
When we securitize loans originated by our subsidiaries, we may retain
interests in the securitized loans in the form of interest-only strips and
servicing rights, which we refer to as our securitization assets. A
securitization is a financing technique often used by originators of financial
assets to raise capital. A securitization involves the transfer of a pool of
financial assets, in our case, loans, to a trust in exchange for certificates,
notes or other securities issued by the trust and representing an undivided
interest in the trust assets. The transfer to the trust involves a sale and
pledge of the financial assets, as well as providing representations and
warranties regarding these transferred assets, depending on the particular
transaction. Next, the trust sells a portion of the certificates, notes or other
securities to investors for cash. Often the originator of the loans retains the
servicing rights and may also retain an interest in the cash flows generated by
the securitized loans which is subordinate to the interest represented by the
notes or certificates sold to investors in the securitizations. This interest in
the cash flows generated by the securitized loans is called an interest-only
strip. See "-- Securitizations" and "-- Loan Servicing and Administrative
Procedures" for further information.
4
Loans and leases in which we have interests, either because the loans
and leases are on our balance sheet or sold into securitizations in which we
have retained interests, are referred to as our total portfolio. The managed
portfolio includes loans held as available for sale on our balance sheet and
loans serviced for others.
In addition to other sources, we fund our operations with subordinated
debentures that we offer from our principal operating office located in
Philadelphia, Pennsylvania. We offer these debentures without the assistance of
an underwriter or dealer. At June 30, 2004, we had $522.6 million in
subordinated debentures outstanding which included investment notes and
uninsured money market notes. These debentures had a weighted-average interest
rate of 9.91% and a weighted-average remaining maturity of 13.5 months. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
Our principal corporate office is located at 103 Springer Building,
3411 Silverside Road, Wilmington, Delaware 19810. The telephone number at that
address is (302) 478-6160. Our principal operating office is located at The
Wanamaker Building, 100 Penn Square East, Philadelphia, Pennsylvania 19107. The
telephone number at the Philadelphia office is (215) 940-4000. We maintain a web
site on the World Wide Web at www.abfsonline.com. The information on our web
site is not and should not be considered part of this document and is not
incorporated into this prospectus by reference. This web site is only intended
to be an inactive textual reference.
RECENT DEVELOPMENTS
EXCHANGE OFFERS. On December 1, 2003, we mailed the Offer to Exchange,
referred to as the first exchange offer in this document, to holders of our
subordinated debentures issued prior to April 1, 2003. On May 14, 2004, we
mailed a second exchange offer, referred to as the second exchange offer in this
document, to holders of our subordinated debentures issued prior to November 1,
2003. The first exchange offer and the second exchange offer are collectively
referred to as the exchange offers in this document. Pursuant to the terms of
the exchange offers, eligible holders of subordinated debentures had the ability
to exchange their debentures for (i) equal amounts of senior collateralized
subordinated notes and shares of 10.0% Series A convertible preferred stock
referred to as Series A preferred stock in this document; and/or (ii)
dollar-for-dollar for shares of Series A preferred stock. Pursuant to the terms
of the first exchange offer, we exchanged $117.2 million of subordinated
debentures for 61.8 million shares of Series A preferred stock and $55.4 million
of senior collateralized subordinated notes. As a result of the second exchange
offer, we exchanged $91.4 million of subordinated debentures for 47.6 million
shares of Series A preferred stock and $43.8 million of senior collateralized
subordinated notes. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Overview -- Exchange Offers" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources -- Subordinated Debentures" for a
more detailed discussion of the exchange offers.
Depending on market conditions and our financial condition, we may
engage in additional exchange offers in the future and we are considering
another exchange offer in our second quarter of fiscal 2005. See "Risk Factors
-- We may issue additional preferred stock which could be entitled to dividends,
liquidation preferences and other special rights and preferences not shared by
holders of our common stock or which could have anti-takeover effects."
OUR RECENT FINANCIAL DIFFICULTIES AND LIQUIDITY CONCERNS. Several
events and issues, which occurred beginning in the fourth quarter of fiscal
2003, have negatively impacted our short-term liquidity and contributed to our
losses for fiscal 2003 and fiscal 2004. These events included our inability to
complete publicly underwritten securitizations during the fourth quarter of
fiscal 2003 and all of fiscal 2004 (we completed a privately-placed
securitization in the second quarter of fiscal 2004), our inability to draw down
upon and the expiration of several of our credit facilities, and our temporary
discontinuation of sales of new subordinated debentures for approximately a
six-week period during the first quarter of fiscal 2004. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Overview" for information regarding our continued inability to complete
publicly underwritten securitizations.
5
As a result of these liquidity issues our loan origination volume
during fiscal 2004 was substantially reduced. From July 1, 2003 through June 30,
2004, we originated $982.7 million of loans, as compared to originations of
$1.67 billion of loans for the same period in fiscal 2003. We anticipate that
depending upon the size of our future quarterly securitizations, if any, we will
need to increase our loan originations to approximately $400.0 million to $500.0
million per month to return to profitable operations. If we are unable to
complete quarterly securitizations, we will need to increase our loan
originations to approximately $550.0 million to $650.0 million per month to
return to profitability. Our ability to achieve the levels of loan originations
necessary to achieve profitable operations could be hampered by our failure to
continue to successfully implement our adjusted business strategy, funding
limitations under existing credit facilities and our ability to obtain new
credit facilities and renew existing facilities. Our plan is to increase loan
originations through the continued application of our business strategy
adjustments, particularly as related to building our expanded broker channel and
offering adjustable rate mortgages, purchase money mortgages and more
competitively priced fixed rate mortgages. See "-- Business Strategy" for a
discussion of our plans to achieve this level of originations. For a detailed
discussion of our losses, capital resources and commitments, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
On June 30, 2004, we had unrestricted cash of approximately $0.9
million and up to $210.4 million available under our warehouse credit
facilities. We can only use advances under these credit facilities to fund loan
originations and not for any other purposes. The combination of our current cash
position and expected sources of operating cash may not be sufficient to cover
our operating cash requirements.
6
For the next six to twelve months, we intend to augment our sources of
operating cash with proceeds from the issuance of subordinated debentures. In
addition to repaying maturing subordinated debentures, proceeds from the
issuance of subordinated debentures may be used to fund overcollateralization
requirements, as defined below, in connection with our loan originations and to
fund our operating losses. Under the terms of our credit facilities, our credit
facilities will advance us 75% to 97% of the value of loans we originate. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources" for a discussion of the terms of
our credit facilities. As a result of this limitation, we must fund the
difference between the loan value and the advances, which we refer to as the
overcollateralization requirement, from our operating cash. We can provide no
assurances that we will be able to continue issuing subordinated debentures.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources -- Remedial Steps Taken
to Address Liquidity Issues" for a discussion of the specific actions we
undertook to address liquidity concerns.
RECENT OPERATING LOSSES AND SALE OF ASSETS. We incurred a net loss
attributable to common stock of $115.1 million and $29.9 million for the fiscal
years ended June 30, 2004 and 2003, respectively. In addition, depending on our
ability to recognize gains on our future securitizations, we anticipate
incurring operating losses at least through the first quarter of fiscal 2005.
The loss for fiscal 2004 primarily resulted from liquidity issues we
have experienced since the fourth quarter of fiscal 2003, including the absence
of credit facilities until the second quarter of fiscal 2004, which
substantially reduced our loan origination volume and our ability to generate
revenues, our inability to complete a publicly underwritten securitization
during fiscal 2004, our shift in business strategy to focus on whole loan sales,
and charges to the income statement of $46.4 million for pre-tax valuation
adjustments on our securitization assets. Additionally, operating expense levels
that would support greater loan origination volume also contributed to the loss
for fiscal 2004.
During fiscal 2004, we recorded total pre-tax valuation adjustments on
our interest-only strips and servicing rights of $63.8 million, of which $46.4
million was charged as expense to the income statement and $17.4 million was
charged to other comprehensive income, a component of stockholders' equity. The
fiscal 2004 adjustments primarily reflect the impact of higher than anticipated
prepayments on securitized loans experienced in fiscal 2004 due to the low
interest rate environment experienced during fiscal 2004. Additionally, the
fiscal 2004 valuation adjustment also includes a write down of $5.4 million of
the carrying value of our interest-only strips and servicing rights related to
five of our mortgage securitization trusts to reflect their values under the
terms of a September 27, 2004 sale agreement. The sale of these assets was
undertaken to raise cash to pay fees on new warehouse credit facilities and as a
result, we did not realize their full value as reflected on our books. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Application of Critical Accounting Estimates - Interest-Only
Strips" for a discussion of how valuation adjustments are recorded.
AMOUNT OF OUR INDEBTEDNESS. At June 30, 2004, we had total
indebtedness of approximately $847.4 million, comprised of amounts outstanding
under our credit facilities, senior collateralized subordinated notes issued in
the exchange offers, capitalized leases and subordinated debentures. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" for a comparison at June 30, 2004
of our secured and unsecured obligations to assets which were available to repay
those obligations.
7
BUSINESS STRATEGY ADJUSTMENTS. In response to our inability to
securitize and liquidity issues described above, we adjusted our business
strategy at the beginning of fiscal 2004 to shift from gain-on-sale accounting
and the use of securitization transactions as our primary method of selling
loans to a more diversified strategy which utilizes a combination of whole loan
sales and securitizations, while protecting revenues, controlling costs and
improving liquidity. See "-- Business Strategy."
If we fail to generate sufficient liquidity through the sales of our
loans, the sale of our subordinated debentures, the maintenance of credit
facilities or a combination of the foregoing, we will have to restrict loan
originations and make additional changes to our business strategy, including
restricting or restructuring our operations which could result in losses and
impair our ability to repay our subordinated debentures and other outstanding
debt. While we currently believe that we will be able to restructure our
operations, if necessary, we cannot assure you that such restructuring will
enable us to attain profitable operations or repay the subordinated debentures
when due. If we fail to successfully implement our adjusted business strategy,
we will be required to consider other alternatives, including raising additional
equity, seeking to convert an additional portion of our subordinated debentures
to equity, seeking protection under federal bankruptcy laws, seeking a strategic
investor, or exploring a sale of the company or some or all of its assets. See
"Risk Factors -- We depend upon the availability of financing to fund our
continuing operations. Any failure to obtain adequate funding could hurt our
ability to operate profitably, restrict our ability to repay our outstanding
debt, and negatively impact the value of our capital stock" and "-- If we are
unable to obtain additional financing, we may not be able to restructure our
business to permit profitable operations or repay our outstanding debt and the
value of our capital stock will be negatively impacted."
In addition to these restrictions and changes to our business strategy
in the event we are unable to offer additional subordinated debentures for any
reason, we have developed a contingent financial restructuring plan including
cash flow projections for the next twelve-month period. Based on our current
cash flow projections, we anticipate being able to make all scheduled
subordinated debenture maturities and vendor payments.
The contingent financial restructuring plan is based on actions that we
would take, in addition to those indicated in our adjusted business strategy, to
reduce our operating expenses and conserve cash. These actions would include
reducing capital expenditures, selling all loans originated on a whole loan
basis, eliminating or downsizing various lending, overhead and support groups,
and obtaining working capital funding. No assurance can be given that we will be
able to successfully implement the contingent financial restructuring plan, if
necessary, and repay the outstanding debt when due. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources -- Remedial Steps Taken to Address Liquidity Issues."
CREDIT FACILITIES, SERVICING AGREEMENTS AND WAIVERS RELATED TO
FINANCIAL COVENANTS. At various times since June 30, 2003, we have been out of
compliance with one or more financial covenants contained in our $200.0 million
credit facility (reduced to $100.0 million on September 30, 2004). We have
continued to operate on the basis of waivers granted by the lender under this
facility. We currently anticipate that we will be out of compliance with one or
more of these financial covenants at October 31, 2004 and will need a waiver
from this lender for this noncompliance to continue to operate. The expiration
date of this facility was originally September 21, 2004, but the lender agreed
to extend the expiration date until November 5, 2004 in consideration for, among
other things, a reduction in the amount that could be borrowed under this
facility to $100.0 million.
8
At various times since June 30, 2003 we have also been out of
compliance with the net worth requirement in several of our pooling and
servicing agreements and sale and servicing agreements (collectively referred to
in this document as the servicing agreements) and have been required to obtain
waivers from and amendments to these agreements. As a result of the amendments
to our servicing agreements, all of our servicing agreements associated with
bond insurers now provide for term-to-term servicing and, in the case of our
servicing agreements with two bond insurers, our rights as servicer may be
terminated at the expiration of a servicing term in the sole discretion of the
bond insurer.
We cannot assure you that we will continue to receive the waivers and
servicing agreement extensions that we need to operate or that they will not
contain conditions that are unacceptable to us. Because we anticipate incurring
losses through at least the first quarter of fiscal 2005, we anticipate that we
will need to obtain additional waivers from our lenders and bond insurers as a
result of our non-compliance with financial covenants contained in our credit
facilities and servicing agreements. To the extent we are not able to obtain
waivers under our credit facilities, we may be unable to pay dividends on the
Series A preferred stock. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" for
additional information regarding the waivers obtained. See also "Risk Factors --
Restrictive covenants in the agreements governing our indebtedness may reduce
our operating flexibility and limit our ability to operate profitability, and
our ability to repay our outstanding debt may be impaired and the value of our
capital stock could be negatively impacted" and " -- Our servicing rights may be
terminated if we fail to satisfactorily perform our servicing obligations, or
fail to meet minimum net worth requirements or financial covenants which could
hinder our ability to operate profitably, impair our ability to repay our
outstanding debt and negatively impact the value of our capital stock."
9
SECURITIES CLASS ACTION LAWSUITS AND SHAREHOLDER DERIVATIVE ACTION. In
January and February of 2004, four class action lawsuits were filed against us
and certain of our officers and directors. A consolidated amended class action
complaint that supersedes these four complaints was filed on August 19, 2004 in
the United States District Court for the Eastern District of Pennsylvania. The
consolidated complaint alleges that, during the applicable class period, our
forbearance and deferment practices enabled us to, among other things, lower our
delinquency rates to facilitate the securitization of our loans which
purportedly allowed us to collect interest income from our securitized loans and
inflate our financial results and market price of our common stock. The
consolidated amended class action complaint seeks unspecified compensatory
damages, costs and expenses related to bringing the action, and other
unspecified relief.
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania and alleges that the named directors and officers breached their
fiduciary duties to the Company, engaged in the abuse of control, gross
mismanagement and other violations of law. The lawsuit seeks unspecified
compensatory damages, equitable or injunctive relief and costs and expenses
related to bringing the action, and other unspecified relief. The parties have
agreed to stay this case pending disposition of any motion to dismiss the
consolidated amended complaint filed in the putative consolidated securities
class action. See "Legal Proceedings" and "Risk Factors -- We are subject to
private litigation, including lawsuits resulting from the alleged "predatory"
lending practices, as well as securities class action and derivative lawsuits,
the impact of which on our financial position is uncertain. The inherent
uncertainty related to litigation of this type and the preliminary stage of
these suits makes it difficult to predict the ultimate outcome or potential
liability that we may incur as a result of these matters."
WHERE YOU CAN GET ADDITIONAL INFORMATION
We file annual, quarterly and current reports, proxy statements and
other information with the SEC. You may read and copy our reports or other
filings made with the SEC at the SEC's Public Reference Room, located at 450
Fifth Street, N.W., Washington, DC 20549. You can obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. You
can also access these reports and other filings electronically on the SEC's web
site, www.sec.gov.
We also make these reports and other filings available free of charge
on our web site, www.abfsonline.com, as soon as reasonably practicable after
filing with the SEC. We will provide, at no cost, paper or electronic copies of
our reports and other filings made with the SEC. Requests should be directed to:
Stephen M. Giroux, Esquire
American Business Financial Services, Inc.
100 Penn Square East
Philadelphia, PA 19107
(215) 940-4000
The information on the web sites listed above, is not and should not be
considered part of this Annual Report on Form 10-K and is not incorporated by
reference in this document. These web sites are and are only intended to be
inactive textual references.
10
BUSINESS STRATEGY
Our adjusted business strategy focuses on a shift from gain-on-sale
accounting and the use of securitization transactions as our primary method of
selling loans to a more diversified strategy which utilizes a combination of
whole loan sales and securitizations, while protecting revenues, controlling
costs and improving liquidity.
Our adjusted business strategy involves significantly increasing the
use of loan brokers to increase loan origination volume and retaining and hiring
senior officers to manage the broker program. In December 2003, we hired an
experienced industry professional who manages our wholesale business and
acquired a broker operation with 35 employees (67 employees at June 30, 2004)
located in California. In March 2004, we opened a mortgage broker office in
Maryland and hired three experienced senior managers and a loan origination
staff of 40 (56 employees at June 30, 2004). In June 2004, we acquired a broker
operation with 35 employees in Texas. In addition, we hired 25 account
executives to develop relationships with mortgage brokers and to expand our
broker presence in the eastern, southern and mid-western areas of the United
States and retained 67 employees in our Upland Broker Services Philadelphia
headquarters to support our growing broker network. In total at June 30, 2004,
we had 285 employees in our broker operations, including 136 account executives.
Our business strategy includes the following:
o Selling substantially all of the loans we originate through a
combination of whole loan sales and securitizations. Whole loan
sales are generally completed on a weekly basis.
o Shifting from a predominantly publicly underwritten securitization
strategy and gain-on-sale business model to a strategy focused on a
combination of whole loan sales and smaller securitization
transactions. When securitization opportunities are available to us,
the size of our quarterly loan securitizations will be reduced from
previous levels. We expect to execute our securitizations, if any,
as private placements to institutional investors or publicly
underwritten securitizations, subject to market conditions.
Historically, the market for whole loan sales has provided reliable
liquidity for numerous originators as an alternative to
securitization. Whole loan sales provide immediate cash premiums to
us, while securitizations generate cash over time but generally
result in higher gains at the time of sale. We intend to rely less
on gain-on-sale accounting and loan servicing activities for our
revenue and earnings and will rely more on cash premiums earned on
whole loan sales. This strategy is expected to result in relatively
lower earnings levels at current loan origination volumes, but will
increase cash flow, accelerate the timeframe for becoming cash flow
positive and improve our liquidity position. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" for more detail on
cash flow.
o Broadening our mortgage loan product line and increasing loan
originations. Historically we have originated primarily fixed-rate
home equity loans. Under our business strategy, we originate
adjustable-rate, alt-A and alt-B mortgage loans which have higher
credit scores as well as a wide array of fixed-rate and adjustable
rate mortgage loans in order to appeal to a broader base of
prospective customers and increase loan originations. During the
three months ended June 30, 2004, 46.7% of the loans which we
originated were adjustable-rate mortgage loans. We have also begun
to originate purchase money mortgage loans primarily through our
broker channel. In fiscal 2004, we originated $176.9 million of
purchase money mortgages, or 18.0% of total home mortgage loans
originated.
11
o Offering more competitive interest rates charged to borrowers on new
products. By offering more competitive interest rates charged on new
products, we originate loans to borrowers with higher credit
quality. In addition, by offering more competitive interest rates
our loans appeal to a wider customer base which we expect will
substantially reduce our marketing costs, make more efficient use of
marketing leads and increase loan origination volume.
o Reducing origination of the types of loans that are not well
received in the whole loan sale and securitization markets. During
fiscal 2004, we originated only $587,000 of business purpose loans.
In the future, we may originate business purpose loans to meet
demand in the whole loan sale and securitization markets to the
extent we obtain a credit facility to fund business purpose loans.
We can utilize our current credit facilities only to fund home
mortgage loans.
o Expanding the use of e-commerce in our retail and broker channels.
This is expected to increase loan applications and reduce the cost
to originate loans.
o Reducing the cost of loan originations. We have implemented plans
to:
o reduce the cost to originate in our Upland Mortgage
direct retail channel by broadening the product line and
offering more competitive interest rates in order to
increase origination volume, and reducing marketing
costs;
o reduce the cost to originate in our broker channel by:
a) increasing volume by broadening the mortgage loan
product line, b) consolidating some of the broker
channel's operating functions to our centralized
operating office in Philadelphia, and c) developing and
expanding broker relationships; we also introduced Easy
Loan Advisor on our Internet-based website for our
offices supporting our broker operations. Easy Loan
Advisor offers significant efficiencies by automating
the origination and underwriting of loans; and
o reduce the cost to originate in the Bank Alliance
Services program by broadening our product line and
increasing the amount of fees we would charge to any new
participating financial institutions.
o Reducing the amount of outstanding subordinated debentures. The
increase in cash flow expected under our business strategy is
expected to accelerate a reduction in our reliance on issuing
subordinated debentures to meet our liquidity needs and allow us to
begin to pay down existing subordinated debentures.
o Reducing operating costs. From June 30, 2003 to June 30, 2004, our
workforce has experienced a net reduction of 150 employees. With our
business strategy's focus on whole loan sales and offering a broader
mortgage product line that we expect will appeal to a wider array of
customers, we currently require a smaller employee base with fewer
sales, servicing and support positions. However, we expect to
increase our sales, servicing and support positions as necessary in
the future to handle higher levels of loan originations. Since June
30, 2003 we reduced our workforce by approximately 255 employees and
experienced a net loss of approximately 90 additional employees who
resigned. Partially offsetting this workforce reduction, we have
added 195 loan origination employees in our broker channel as part
of our business strategy's focus on expanding our broker operations.
12
Our business strategy is dependent on our ability to emphasize lending
related activities that provide us with the most economic value. The
implementation of this strategy will depend in large part on a variety of
factors outside of our control, including, but not limited to, our ability to
obtain adequate financing on reasonable terms and to profitably securitize or
sell our loans on a regular basis. Our failure with respect to any of these
factors could impair our ability to successfully implement our strategy, which
could adversely affect our results of operations and financial condition. See
"Risk Factors -- If we are unable to successfully implement our adjusted
business strategy which focuses on whole loan sales, we may be unable to attain
profitable operations which could impair our ability to repay our outstanding
debt and could negatively impact the value of our capital stock."
SUBSIDIARIES
As a holding company, our activities have been limited to:
o providing management oversight over subsidiary operations;
13
o holding the shares of our subsidiaries; and
o raising capital for use in the subsidiaries' lending and loan
servicing operations.
We are the parent holding company of American Business Credit, Inc. and
its primary subsidiaries, HomeAmerican Credit, Inc. (doing business as Upland
Mortgage), American Business Mortgage Services, Inc., and Tiger Relocation
Company.
American Business Credit, Inc., a Pennsylvania corporation incorporated
in 1988 and acquired by us in 1993, currently services business purpose loans
and home mortgage loans. In the past, this subsidiary also originated and sold
business purpose loans.
HomeAmerican Credit, Inc., a Pennsylvania corporation incorporated in
1991, originates, purchases, sells and services home mortgage loans.
HomeAmerican Credit, Inc. acquired Upland Mortgage Corp. in 1996 and since that
time has conducted business as "Upland Mortgage." HomeAmerican Credit, Inc. also
administers the Bank Alliance Services program. See "-- Lending Activities --
Home Mortgage Loans."
American Business Mortgage Services, Inc., a New Jersey corporation
organized in 1938 and acquired by us in October 1997, originates, purchases,
sells and services home mortgage loans.
Tiger Relocation Company, a Pennsylvania corporation, was incorporated
in 1992 to hold, maintain and sell real estate properties acquired due to the
default of a borrower under the terms of our loan documents.
We also have numerous special purpose subsidiaries that were
incorporated solely to facilitate our securitizations and off-balance sheet
mortgage conduit facilities. None of these corporations engage in any business
activity other than holding the subordinated certificate, if any, and the
interest-only strips created in connection with completed securitizations. See
"-- Securitizations" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Securitizations." We also utilize special
purpose entities in connection with our financing activities, including credit
facilities. We also have several additional subsidiaries that are inactive or
not significant to our operations.
14
The following chart sets forth our basic organizational structure and
our primary subsidiaries.(a)
AMERICAN BUSINESS FINANCIAL
SERVICES, INC.
Holding Company
Management oversight over subsidiary
operations and raising capital for lending
and servicing operations
|
|
AMERICAN BUSINESS CREDIT, INC.
Services business purpose loans and
home mortgage loans
---------------------------------------------
|
-------------------------------------------------------
| | |
| | |
---------------- ---------------------- ---------------------
AMERICAN HOMEAMERICAN TIGER
BUSINESS CREDIT, INC. D/B/A RELOCATION
MORTGAGE UPLAND COMPANY
SERVICES, INC. MORTGAGE
---------------- ---------------------- ---------------------
---------------- ---------------------- ---------------------
Originates, Originates, purchases, Holds, maintains
purchases, sells sells and services and sells foreclosed
and home mortgage loans real estate
services home and administers the
mortgage Bank Alliance
loans Services program
---------------- ---------------------- ---------------------
____________________________
(a) In addition to the corporations pictured in this chart, we organized at
least one special purpose corporation for each securitization and have
several other subsidiaries that are inactive or not significant to our
operations.
15
LENDING ACTIVITIES
GENERAL. The following table sets forth information concerning our loan
origination, purchase and sale activities for the periods indicated.
YEAR ENDED JUNE 30,
-------------------------------------
2004 2003 2002
--------- ------ ---------
(DOLLARS IN THOUSANDS)
Loans Originated/Purchased
Business purpose loans.................... $ 587 $ 122,790 $ 133,352
Home mortgage loans....................... $ 982,093 $ 1,543,730 $ 1,246,505
Number of Loans Originated/Purchased
Business purpose loans.................... 2 1,340 1,372
Home mortgage loans....................... 8,281 17,003 14,015
Average Loan Size
Business purpose loans.................... $ 293 $ 92 $ 97
Home mortgage loans....................... $ 119 $ 91 $ 89
Weighted-Average Interest Rate on Loans
Originated/Purchased
Business purpose loans.................. 14.62% 15.76% 15.75%
Home mortgage loans..................... 7.86% 9.99% 10.91%
Combined................................ 7.86% 10.42% 11.38%
Weighted-Average Term (in months)
Business purpose loans.................... 150 160 161
Home mortgage loans....................... 294 272 260
Loans Securitized or Sold
Business purpose loans.................... $ 18,931 $ 112,025 $ 129,074
Home mortgage loans....................... $ 930,853 $ 1,339,752 $ 1,279,740
Number of Loans Securitized or Sold
Business purpose loans.................... 198 1,195 1,331
Home mortgage loans....................... 9,932 14,952 14,379
The following table sets forth information regarding the average
loan-to-value ratios for loans we originated and purchased during the periods
indicated.
YEAR ENDED JUNE 30,
------------------------------
LOAN TYPE 2004 2003 2002
--------- ---- ---- ----
Business purpose loans........................ 70.1% 62.2% 62.6%
Home mortgage loans........................... 81.3 78.2 77.8
16
The following table shows the geographic distribution of our loan
originations and purchases during the periods indicated.
(a) No individual state included in "Other" constitutes more than 1.5% of
total loan originations for the fiscal year ended June 30, 2004.
CUSTOMERS. Our loan customers are primarily credit-impaired borrowers
who are generally unable to obtain financing from banks or savings and loan
associations and who are attracted to our products and services. These
institutions have historically provided loans only to individuals with the most
favorable credit characteristics. These borrowers generally have impaired or
unsubstantiated credit histories and/or unverifiable income. Our experience has
indicated that these borrowers are attracted to our loan products as a result of
our marketing efforts, the personalized service provided by our staff of highly
trained lending officers and our timely response to loan requests. Historically,
our customers have been willing to pay our origination fees and interest rates
even though they are generally higher than those charged by traditional lending
sources. This type of borrower is commonly referred to as a subprime borrower.
Loans made to subprime borrowers are frequently referred to as subprime loans.
See "-- Business Strategy."
HOME MORTGAGE LOANS. We originate home mortgage loans, consisting of
home equity loans and purchase money mortgage loans, through Upland Mortgage and
American Business Mortgage Services, Inc. We also process and purchase loans
through the Bank Alliance Services program. We originate home mortgage loans
primarily to credit-impaired borrowers through various channels including retail
marketing and broker operations. Our retail channel includes direct mail and our
subsidiaries' interactive web sites, and have included radio and television
advertisements.
In total at June 30, 2004, we had 285 employees in our broker
operations including 136 account executives. Our broker operations originate
loans using a broker network that after recent expansion is spread
geographically throughout the continental United States. During fiscal 2004, we
added four offices with 192 employees at June 30, 2004 to support our broker
operations and hired 25 account executives to expand our broker presence and
increase loan originations. We also introduced Easy Loan Advisor on our
Internet-based broker website for our offices supporting our broker operations.
Easy Loan Advisor offers significant efficiencies by automating the origination
and underwriting of these loans.
17
We entered the home equity loan market in 1991. With the recent
expansion of our broker operations, we added purchase money mortgage loans in
2004. Currently, we are licensed or otherwise qualified to originate home
mortgage loans in 46 states. We also hired 25 account executives to develop
relationships with mortgage brokers and to expand our broker presence in the
eastern, southern and mid-western areas of the United States. We generally sell
on a whole loan basis with servicing released, or securitize the loans
originated and funded by our subsidiaries.
The business strategy that we are emphasizing beginning in fiscal 2004
has impacted our origination of home mortgage loans. Our business strategy is
designed to appeal to a broader prospective customer base and increase the
amount of loan originations. We have broadened our mortgage loan product line to
include adjustable-rate, alt-A and alt-B and purchase money mortgage loans. Our
strategy also emphasizes reducing the cost to originate loans by expanding our
broker network and reducing retail marketing costs. Our business strategy also
focuses on shifting from a predominantly publicly underwritten securitization
strategy and gain-on-sale business model to a strategy focused on a combination
of whole loan sales and smaller securitization transactions. For a discussion of
our business strategy and its potential impact on our home mortgage loan
business, see "-- Business Strategy."
Our retail operations receive home mortgage loan applications from
potential borrowers over the phone, in writing, in person or through our
subsidiaries' interactive web sites, and most recently through third-party
lending-related web sites with whom we have working agreements. The loan request
is then evaluated for possible loan approval. The loan processing staff
generally provides its home mortgage applicants who qualify for loans with a
conditional loan approval within 24 hours and closes its home mortgage loans
within approximately fifteen to twenty days of obtaining a conditional loan
approval.
Our broker operations receive home mortgage loan applications from
third-party unrelated brokers both in writing and increasingly through our newly
introduced broker Internet web site. The loan request is then evaluated for
possible loan approval. The loan processing staff generally provides the brokers
with a conditional loan approval within 24 hours and closes its home mortgage
loans within approximately fifteen to twenty days of obtaining a conditional
loan approval.
18
The following table presents the amounts of loans we originated in 2004
in our retail and broker operations channels (in thousands):
Home mortgage loans ranged from $7,700 to $658,500 with an average loan
size of approximately $119,000 during 2004 and $91,000 during 2003. We
originated $982.1 million of home mortgage loans during fiscal 2004 and $1.5
billion during fiscal 2003. These loans were made both at fixed rates of
interest and adjustable rates of interest, which were tied to 6 month LIBOR, and
for terms ranging from five to thirty years, generally, with average origination
fees of approximately 1.5% of the aggregate loan amount. The weighted-average
interest rate received on home mortgage loans during fiscal 2004 was 7.86% and
during fiscal 2003 was 9.99%. The average loan-to-value ratios for the loans
originated by us during fiscal 2004 and fiscal 2003 were 81.3% and 78.2%,
respectively.
We attempt to maintain our interest rates and other charges on home
mortgage loans to be competitive with the lending rates of other sub-prime
mortgage finance companies. To the extent permitted by law, borrowers are given
an option to choose between a loan without a prepayment fee at a higher interest
rate or a loan with a prepayment fee at a lower interest rate. We may waive the
collection of a prepayment fee, if any, in the event the borrower refinances a
home mortgage loan with us.
We have business arrangements with several financial institutions,
which provide for our purchase of home mortgage loans that meet our underwriting
criteria, but do not meet the guidelines of the selling institution for loans to
be held in its portfolio. This program is called the Bank Alliance Services
program. The Bank Alliance Services program is designed to provide an additional
source of home mortgage loans. This program targets traditional financial
institutions, such as banks, which because of their strict underwriting and
credit guidelines for loans held in their portfolio have generally provided
mortgage financing only to the most credit-worthy borrowers. This program allows
these financial institutions to originate loans to credit-impaired borrowers in
order to achieve community reinvestment goals and to generate fee income and
subsequently sell such loans to one of our subsidiaries.
Pursuant to the program, a financial institution adopts our
underwriting criteria for home mortgage loans not intended to be held in its
portfolio. If an applicant meets our underwriting criteria, as adopted by the
program, we process the application materials and underwrite the loan for final
approval by the financial institution. If the financial institution approves the
loan, we close the loan for the financial institution in its name with funding
provided by the financial institution. We purchase the loan from the financial
institution shortly after the closing. Following our purchase of the loans
through this program, we hold these loans as available for sale until they are
sold in a whole loan sale or securitization.
19
During fiscal 2004, we received referrals from approximately ten
financial institutions participating in this program. As of June 30, 2004, seven
financial institutions located in the eastern portion of the United States were
actively participating in this program. These financial institutions provide us
with the opportunity to process and purchase loans generated by the branch
networks of such institutions, which consists of approximately 575 branches.
These seven financial institutions accounted for approximately 20.5% of the
referrals received by us under the Bank Alliance Services program during fiscal
2004. Pursuant to this program, our subsidiaries purchased approximately $142.3
million of loans during the year ended June 30, 2004 and $201.9 million of loans
during the fiscal year ended June 30, 2003. During the year ended June 30, 2004,
our top three financial institutions under the Bank Alliance Services program
accounted for approximately 96.1% of our loan volume from this program. Only one
of the seven remaining active participants was in our top three volume providers
in fiscal 2004. We intend to expand the Bank Alliance Services program with
financial institutions across the United States. See "-- Business Strategy."
During fiscal 1999, we launched a retail Internet loan distribution
channel through Upland Mortgage's web site. Through this interactive web site,
borrowers can examine available loan options and calculate monthly principal and
interest payments. The Upland Mortgage Internet platform provides borrowers with
convenient access to the mortgage loan information 7 days a week, 24 hours a
day. Throughout the loan processing period, borrowers who submit applications
are supported by our staff of highly trained loan officers. Currently, in
addition to the ability to utilize an automated rapid pre-approval process,
which we believe reduces time and manual effort required for loan approval, the
site features our proprietary software, Easy Loan Advisor, which provides
personalized services and solutions to retail customers through interactive web
dialog. We have applied to the U.S. Patent and Trademark Office to patent this
product.
During fiscal 2004, using our Easy Loan Advisor (referred to as ELA in
this document) proprietary software, we launched a broker Internet loan
distribution channel. We have added functionality to service the brokerage
community and sales channels through its automated underwriting engine thereby
providing access to the brokerage communities 7 days a week, 24 hours a day as
well as loan structuring options to provide the various loan solutions to
borrowers. The ELA software is a state of the art loan restructuring system
which provides brokers almost instantaneous loan structure options. This
technology is key to our forecasted loan growth.
BUSINESS PURPOSE LOANS. Through our subsidiary, American Business
Credit, Inc., we service business purpose loans that we originated and sold in
prior periods predominantly in the eastern and central portions of the United
States through a network of salespeople, loan brokers and through our business
loan web site.
During prior periods, we originated business purpose loans to
corporations, partnerships, sole proprietors and other business entities for
various business purposes including, but not limited to, working capital,
business expansion, equipment acquisition, tax payments and debt-consolidation.
We did not target any particular industries or trade groups and, in fact, took
precautions against a concentration of loans in any one industry group. All
business purpose loans originated generally were collateralized by a first or
second mortgage lien on a principal residence of the borrower or a guarantor of
the borrower or some other parcel of real property, such as office and apartment
buildings and mixed use buildings, owned by the borrower, a principal of the
borrower, or a guarantor of the borrower. In most cases, these loans were
further collateralized by personal guarantees, pledges of securities,
assignments of contract rights, life insurance and lease payments and liens on
business equipment and other business assets. Prior to the fourth quarter of
fiscal 2003, we generally securitized business purpose loans subsequent to their
origination. We originated less than $1.0 million of business purpose loans in
fiscal 2004. We are currently not originating these loans; however, in the
future, we may originate business purpose loans to meet demand in the whole loan
sale and securitization markets to the extent we obtain a credit facility to
fund business purpose loans. If we originate business purpose loans in the
future, we will focus our marketing efforts on small businesses that do not meet
all of the credit criteria of commercial banks and small businesses that our
research indicates may be predisposed to using our products and services. See
"-- Business Strategy."
20
We originated $587,000 in business purpose loans during the year ended
June 30, 2004, and originated $122.8 million during fiscal 2003. When we
originated larger volumes of business purpose loans, these loans generally
ranged from $14,000 to $685,000 and had an average loan size of approximately
$92,000 for the loans originated during the fiscal year ended June 30, 2003.
Generally, our business purpose loans are made at fixed interest rates and for
terms ranging from five to fifteen years. We generally charged origination fees
for these loans of 4.75% to 5.75% of the outstanding principal balance. The
weighted-average interest rate charged on the business purpose loans originated
by us during the year ended June 30, 2004 was 14.62% and during fiscal year 2003
was 15.76%. Business purpose loans we originated during fiscal 2004 and fiscal
2003 had a loan-to-value ratio, based solely upon the real estate collateral
securing the loans, of 70.1% and 62.2%, respectively.
Generally, we compute interest due on our outstanding business purpose
loans using the simple interest method. We generally impose a prepayment fee.
Although prepayment fees imposed vary based upon applicable state law, the
prepayment fees on our business purpose loan documents can be a significant
portion of the outstanding loan balance. Whether a prepayment fee is imposed and
the amount of such fee, if any, is negotiated between the individual borrower
and American Business Credit, Inc. prior to closing of the loan. We may waive
the collection of a prepayment fee, if any, in the event the borrower refinances
a business loan with us.
PREPAYMENT FEES. Approximately 80% to 85% of our home mortgage loans
serviced had prepayment fees at the time of their origination. On home mortgage
loans where the borrower has elected the prepayment fee option, the prepayment
fee is generally a certain percentage of the outstanding principal balance of
the loan. Our typical prepayment fee structure provides for a fee of 5% or less
of the outstanding principal loan balance and will not extend beyond the first
three years after a loan's origination. Prepayment fees on our existing home
mortgage loans range from 1% to 5% of the outstanding principal balance and
remain in effect for one to five years. At the time of their origination,
approximately 90% to 95% of our business purpose loans had prepayment fees. The
prepayment fee on business purpose loans is generally 8% to 12% of the
outstanding principal balance, provided that no prepayment option is available
until after the 24th scheduled payment is made and no prepayment fee is due
after the 60th scheduled payment is made. From time to time, a different
prepayment fee arrangement may be negotiated or we may waive prepayment fees for
borrowers who refinance their loans with us. At June 30, 2004, approximately 50%
to 55% of securitized home mortgage loans in our total portfolio had prepayment
fees and approximately 50% to 55% of securitized business purpose loans in our
total portfolio had prepayment fees.
State law sometimes restricts our ability to charge a prepayment fee
for both home mortgage and business purpose loans. Prior to its preclusion, we
used the Parity Act to preempt these state laws for home mortgage loans which
meet the definition of alternative mortgage transactions under the Parity Act.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations - Legal and Regulatory Considerations" for a discussion of how the
adoption by the Office of Thrift Supervision in July 2003 of a rule which
precludes us from using the Parity Act to preempt state prepayment penalty and
late fees laws may impact our new loan originations.
In states which have overridden the Parity Act and in the case of some
fully amortizing home mortgage loans, state laws may restrict prepayment fees
either by the amount of the prepayment fee or the time period during which it
can be imposed. Federal law restrictions in connection with certain high
interest rate and fee loans may also preclude the imposition of prepayment fees
on these loans. Similarly, in the case of business purpose loans, some states
prohibit or limit prepayment fees when the loan is below a specific dollar
threshold or is secured by residential property.
21
MARKETING STRATEGY
RETAIL LOAN ORIGINATION CHANNEL. Historically, we concentrated our
marketing efforts for home mortgage loans primarily on credit-impaired borrowers
who are generally unable to obtain financing from banks or savings and loan
associations and who are attracted to our products and services. Although we
still intend to lend to credit-impaired borrowers under our current business
strategy, we have broadened our mortgage loan product line to include
adjustable-rate, alt-A and alt-B and purchase money mortgage loans and to offer
competitive interest rates in order to appeal to a wider range of customers. See
"-- Business Strategy" and "Risk Factors -- Lending to credit-impaired borrowers
may result in higher delinquencies in our total portfolio, which could hinder
our ability to operate profitably, impair our ability to repay our outstanding
debt and negatively impact the value of our capital stock."
We market home mortgage loans through direct mail campaigns and our
interactive web sites, and have in the past used telemarketing, radio and
television advertising. Recently, we have begun to accept applications forwarded
to us by third-party lending-related web sites with whom we have working
agreements. We believe that our targeted direct mail strategy delivers more
leads at a lower cost than broadcast marketing channels. Our integrated approach
to media advertising that utilizes a combination of direct mail and Internet
advertising is intended to maximize the effect of our advertising campaigns. We
expect the implementation of our business strategy to improve our response and
conversion rates, which will reduce our overall marketing costs. We also use the
Bank Alliance Services program as additional sources of loans.
Our marketing efforts for home mortgage loans in our retail channel are
focused on the eastern and central portions of the United States and continuing
to expand to the western portion of the United States. We previously utilized
branch offices in various states to market our loans. Effective June 30, 2003,
we no longer originate loans through retail branch offices.
BROKER OPERATIONS CHANNEL. We also use a network of loan brokers as a
source of home mortgage loans. We continue to expand our network of loan brokers
as part of our focus on whole loan sales in order to increase the amount of
loans originated and reduce origination costs. During fiscal 2004, we acquired
broker operations in West Hills, California and Austin, Texas, and opened new
offices in Edgewater, Maryland and Irvine, California to support our broker
operations.
We market our broker operations though various sources including direct
broker solicitation, trade shows and trade advertising. We also introduced Easy
Loan Advisor on our Internet-based website for our offices supporting our broker
operations. Additionally, we market our programs and rates through e-mail.
BUSINESS PURPOSE LOANS. In prior fiscal years, our marketing efforts
for business purpose loans focused on our niche market of selected small
businesses located in our market area, which generally included the eastern and
central portions of the United States. We targeted businesses, which might
qualify for loans from traditional lending sources, but elected to use our
products and services. Our experience had indicated that these borrowers were
attracted to us as a result of our marketing efforts, the personalized service
provided by our staff of highly trained lending officers and our timely response
to loan applications. Historically, such customers had been willing to pay our
origination fees and interest rates, which were generally higher than those
charged by traditional lending sources.
We had marketed business purpose loans through various forms of
advertising, including large direct mail campaigns, our business loan web site
and a direct sales force and loan brokers, and had in the past used newspaper
and radio advertising. Although we originated only $587,000 of business purpose
loans during the year ended June 30, 2004, we may originate and sell business
purpose loans in future periods to the extent we obtain a credit facility to
fund business purpose loans. Certain business purpose loans originated by us in
prior periods are held for sale. See "-- Business Strategy" and "-- Lending
Activities -- Business Purpose Loans."
22
UNDERWRITING PROCEDURES AND PRACTICES
Summarized below are some of the policies and practices which are
followed in connection with the origination of home mortgage loans and business
purpose loans. These policies and practices may be altered, amended and
supplemented, from time to time, as conditions warrant. We reserve the right to
make changes in our day-to-day practices and policies at any time.
Our loan underwriting standards are applied to evaluate prospective
borrowers' credit standing and repayment ability as well as the value and
adequacy of the mortgaged property as collateral. Initially, the prospective
borrower is required to provide pertinent credit information in order to
complete a detailed loan application. As part of the description of the
prospective borrower's financial condition, the borrower is required to provide
information concerning assets, liabilities, income, credit, employment history
and other demographic and personal information. If the application demonstrates
the prospective borrower's ability to repay the debt as well as sufficient
income and equity, loan processing personnel generally obtain and review an
independent credit bureau report on the credit history of the borrower and
verify the borrower's income. Once all applicable employment, credit and
property information is obtained, a determination is made as to whether
sufficient unencumbered equity in the property exists and whether the
prospective borrower has sufficient monthly income available to meet the
prospective borrower's monthly obligations.
The following table outlines the key parameters of the major credit
grades of our current home mortgage loan underwriting guidelines. During fiscal
2004, we adjusted our credit grade and underwriting guidelines. We believe these
adjustments provide more consistency with the guidelines used by institutional
purchasers in the whole loan sale secondary market. As a result, we have
broadened our home mortgage loan products to include loan programs allowing
higher overall loan-to-value ratios, which are offset by compensating credit
characteristics. These loans are originated with the primary intent of being
sold as whole loans on the secondary market. The implementation of the new
credit and underwriting guidelines allows us to be more competitive in the whole
loan sale secondary market and enhances our ability to execute our adjusted
business strategy. We will continue to monitor our credit and underwriting
guidelines to maintain consistency with demand by institutional purchasers of
whole loans. During the year ended June 30, 2004, home mortgage loans
represented 99.9% of the loans we originated.
23
"A" CREDIT GRADE "B" CREDIT GRADE "C" CREDIT GRADE HOPE
-------------------- ------------------------- ------------------------- ------------------------- -------------------------
General Repayment Has good credit but might Pays the majority of Marginal credit history Designed to provide a
have some minor accounts on time but has which is offset by other borrower with poor credit
delinquency some 30 and/or 60 day positive attributes. history an opportunity to
delinquency correct past credit
problems through lower
monthly payment.
Existing Mortgage Cannot exceed a maximum Cannot exceed a maximum Cannot exceed two 60 day Cannot exceed a maximum
Loans of three 30 day of four 30 day delinquencies and/or one of one 120 day
delinquencies in the past delinquencies/ one 60 day 90 day delinquency in the delinquency in the past
12 months. delinquency in the past past 12 months. 12 months.
12 months.
Non-Mortgage Credit Major credit and Major credit and Major credit and Major and minor credit
installment debt should installment debt can installment debt can delinquency is
be current but may exhibit some minor 30 exhibit some minor 30 acceptable, but must
exhibit some minor 30 day and/or 60 day and/or 90 day demonstrate some payment
delinquency. Minor credit delinquency. Minor credit delinquency. Minor credit regularity.
may exhibit some minor may exhibit up to 90 day may exhibit more serious
delinquency. delinquency. delinquency.
Bankruptcy Filings Discharged more than 2 Discharged more than 18 Discharged more than 1 Discharged more than 2
Chapter 7 years with reestablished months with reestablished year with reestablished years with reestablished
credit. credit. credit. credit.
Chapter 13 Filed more than 2 years, Filed more than 18 Filed more than 1 year, Filed more than 1 year,
satisfactory payment plan months, satisfactory satisfactory payment plan satisfactory payment plan
performance payment plan performance performance performance
Debt Service-to- Generally not to exceed Generally not to exceed Generally not to exceed Generally not to exceed
Income 50%. 50%. 55%. 55%.
Owner Occupied: Generally 80% to 100% for Generally 80% to 85% for Generally 70% to 80% for Generally 65% to 70% for
Loan-to-value ratio a 1-4 family dwelling a 1-4 family dwelling a 1-4 family dwelling a 1-4 family dwelling
residence; 90% for a residence; 85% for a residence; 70% for a residence.
condominium. condominium. condominium.
Non-Owner Occupied: Generally 85% for a 1-4 Generally 75% for a 1-4 Generally 70% for a 1-4 N/A
Loan-to-value ratio family dwelling or family dwelling or family dwelling or
condominium. condominium. condominium.
24
In addition to the home mortgage loans we originate under the standard
home mortgage loan underwriting guidelines outlined in the preceding table, we
also originate a limited number of second mortgage home equity loans that have
loan-to-value ratios ranging from 90% to 100%. We consider these loans to be
high loan-to-value home equity loans and we underwrite these loans with a more
restrictive approach to evaluating the borrowers' qualifications and we require
a stronger credit history than our standard guidelines. The borrowers' existing
mortgage and installment debt payments must generally be paid as agreed, with no
more than one 30-day delinquency on a mortgage within the last 12 months. No
bankruptcy or foreclosure is permitted in the last 24 months.
Pursuant to our current business strategy, a greater number of loans
that we originate will be offered to the secondary market through whole loan
sales. These loans will be underwritten, allocated and sold to specific third
party purchasers based on agreed upon products and underwriting guidelines. The
purchaser products and guidelines currently being utilized generally conform to
key parameters outlined in the preceding table. See "-- Business Strategy."
If originated, business purpose loans generally are secured by
residential real estate and at times commercial real estate. Loan amounts
generally ranged from $14,000 to $685,000. The loan-to-value ratio (based solely
on the appraised fair market value of the real estate collateral securing the
loan) on the properties collateralizing the loans generally has a maximum range
of 50% to 75%. The actual maximum loan-to-value ratio varies depending on a
variety of factors including, the credit grade of the borrower, whether the
collateral is a one to four family residence, a condominium or a commercial
property and whether the property is owner occupied or non-owner occupied. The
credit grade of a business purpose loan borrower will vary depending on the
payment history of their existing mortgages, major lines of credit and minor
lines of credit, allowing for delinquency but generally requiring major credit
to be current at closing. The underwriting of the business purpose loan included
confirmation of income or cash flow through tax returns, bank statements and
other forms of proof of income and business cash flow. Generally, we made loans
to businesses whose bankruptcy was discharged at least two years prior to
closing, but we had made exceptions to allow for the bankruptcy to be discharged
just prior to or at closing. In addition, we generally received additional
collateral in the form of, among other things, personal guarantees, pledges of
securities, assignments of contract rights, assignments of life insurance and
lease payments and liens on business equipment and other business assets, as
available. Based solely on the value of the real estate collateral securing our
business purpose loans, the average loan-to-value ratio of business purpose
loans we originated during fiscal 2004 and 2003 were 70.1% and 62.2%,
respectively.
Generally, the maximum acceptable loan-to-value ratio for home mortgage
loans to be securitized is 100%. The average loan-to-value ratios of home
mortgage loans we originated during the years ended June 30, 2004 and 2003 were
81.3% and 78.2%, respectively. We generally obtain title insurance in connection
with our loans.
In determining whether the mortgaged property is adequate as
collateral, we have an appraisal performed for each property considered for
financing. The appraisal is completed by a licensed qualified appraiser on a
Fannie Mae form and generally includes pictures of comparable properties and
pictures of the property securing the loan.
Any material decline in real estate values reduces the ability of
borrowers to use home equity to support borrowings and increases the
loan-to-value ratios of loans previously made by us, thereby weakening
collateral coverage and increasing the possibility of a loss in the event of
borrower default. Further, delinquencies, foreclosures and losses generally
increase during economic slowdowns or recessions. As a result, we cannot assure
that the market value of the real estate underlying the loans will at any time
be equal to or in excess of the outstanding principal amount of those loans.
Although we have expanded the geographic area in which we originate loans, a
downturn in the economy generally or in a specific region of the country may
have an effect on our originations. See "Risk Factors -- A decline in value of
the collateral securing our loans could result in an increase in losses on
foreclosure, which could hinder our ability to attain profitable operations,
limit our ability to repay our outstanding debt and negatively impact the value
of our capital stock."
25
LOAN SERVICING AND ADMINISTRATIVE PROCEDURES
We service the loans in accordance with our established servicing
procedures. The loans we service include loans we hold as available for sale and
most of the loans we have securitized. Our servicing procedures include
practices regarding processing of mortgage payments, processing of disbursements
for tax and insurance payments, maintenance of mortgage loan records,
performance of collection efforts, including disposition of delinquent loans,
foreclosure activities and disposition of real estate owned and performance of
investor accounting and reporting processes, which in general conform to the
mortgage servicing practices of prudent mortgage lending institutions. We
generally receive contractual servicing fees for our servicing responsibilities
for securitized loans, calculated as a percentage of the outstanding principal
amount of the loans serviced. In addition, we receive other ancillary fees
related to the loans serviced. On July 12, 2004, our servicing and collections
activities, which were previously located at our operating office in Bala
Cynwyd, Pennsylvania, were relocated to our Philadelphia, Pennsylvania office.
At June 30, 2004, the portfolio we serviced consisted of 27,165 loans with an
aggregate outstanding balance of $2.1 billion.
In servicing loans, we send an invoice to borrowers on a monthly basis
advising them of the required payment and its scheduled due date. We begin the
collection process promptly after a borrower fails to make a scheduled monthly
payment. When a loan becomes 45 to 60 days delinquent, it is transferred to a
senior collector in the collections department. The senior collector tries to
resolve the delinquency by reinstating a delinquent loan, seeking a payoff, or
entering into a deferment or forbearance arrangement with the borrower to avoid
foreclosure. All proposed arrangements are evaluated on a case-by-case basis,
based on, among other things, the borrower's past credit history, current
financial status, cooperativeness, future prospects and the reasons for the
delinquency. If a mortgage loan becomes 45 days delinquent and we do not reach a
satisfactory arrangement with the borrower, our legal department will mail a
notice of default to the borrower. If the delinquency is not cured within the
time period provided for in the loan documents, we generally start a foreclosure
action. The collection department maintains normal collection efforts during the
cure periods following a notice of default and the initiation of foreclosure
action. If a borrower declares bankruptcy, our in-house attorneys and paralegals
promptly act to protect our interests. We may initiate legal action earlier than
45 days following a delinquency if we determine that the circumstances warrant
such action.
We employ a staff of experienced mortgage collectors and managers
working in shifts seven days a week to manage delinquent loans. In addition, a
staff of in-house attorneys and paralegals works closely with the collections
staff to optimize collection efforts. The primary goal of our labor-intensive
collections program is to emphasize delinquency and loss prevention.
From time to time, borrowers are confronted with events, usually
involving hardship circumstances or temporary financial setbacks that adversely
affect their ability to continue payments on their loan. To assist borrowers, we
may agree to enter into a deferment or forbearance arrangement. Prevailing
economic conditions, which may affect the borrower's ability to make their
regular payments, may also have an impact on the value of the real estate or
other collateral securing the loans, resulting in a change to the loan-to-value
ratio. We may take these conditions into account when we evaluate a borrower's
request for assistance for relief from the borrower's financial hardship.
26
Our policies and practices regarding deferment and forbearance
arrangements, like all of our collections policies and practices, are designed
to manage customer relationships, maximize collections and avoid foreclosure (or
repossession of other collateral, as applicable) if reasonably possible. We
review and regularly revise these policies and procedures in order to enhance
their effectiveness in achieving these goals.
In a deferment arrangement, we make advances on behalf of the borrower
in amounts equal to the delinquent loan payments, which include principal and
interest. Additionally, we may pay taxes, insurance and other fees on behalf of
the borrower. Based on our review of the borrower's current financial
circumstances, the borrower must repay the advances and other payments and fees
we make on the borrower's behalf either at the termination of the loan or on a
payment plan. Borrowers must provide a written explanation of their hardship,
which generally requests relief from their delinquent loan payments. We review
the borrower's current financial situation and based upon this review, we may
create a payment plan for the borrower which allows the borrower to pay past due
amounts over a period ranging from approximately 12 to 42 months, depending on
the period for which deferment is requested, but not beyond the maturity date of
the loan, in addition to making regular monthly loan payments. Each deferment
arrangement must be approved by two of our managers. Deferment arrangements
which defer two or more past due payments must also be approved by at least two
senior vice presidents.
Principal guidelines currently applicable to the deferment process
include: (i) the borrower may have up to six payments deferred during the life
of the loan; (ii) no more than three payments may be deferred during a
twelve-month period; and (iii) the borrower must have made a minimum of six
payments on the loan and twelve months must have passed since the last deferment
in order to qualify for a new deferment arrangement. Any deferment arrangement,
which includes an exception to our guidelines, must be approved by two senior
vice presidents. If the deferment arrangement is approved, a collector contacts
the borrower regarding the approval and the revised payment terms.
For borrowers who are three or more payments delinquent, we will
consider using a forbearance arrangement. In a forbearance arrangement, we make
advances on behalf of the borrower in amounts equal to the delinquent loan
payments, which include principal and interest. Additionally, we may pay taxes,
insurance and other fees on behalf of the borrower. We assess the borrower's
current financial situation and based upon this assessment, we will create a
payment plan for the borrower which allows the borrower to pay past due amounts
over a longer period than a typical deferment arrangement, but not beyond the
maturity date of the loan. We typically structure a forbearance arrangement to
require the borrower to make payments of principal and interest equivalent to
the original loan terms plus additional monthly payments, which in the aggregate
represent the amount that we advanced on behalf of the borrower.
Principal guidelines currently applicable to the forbearance process
include the following: (i) the borrower must have first and/or second mortgages
with us; (ii) the borrower's account was originated at least six months prior to
the request for forbearance; (iii) the borrower's account must be at least three
payments delinquent to qualify for a forbearance agreement; (iv) the borrower
must submit a written request for forbearance containing an explanation for his
or her previous delinquency and setting forth the reasons that the borrower now
believes he or she is able to meet his or her loan obligations; and (v) the
borrower must make a down payment of at least one month's past due payments of
principal and interest in order to enter into a forbearance agreement, and the
borrower who is six or more payments delinquent must make a down payment of at
least two past due payments. No request for forbearance may be denied without
review by our senior vice president of collections or his designee.
27
We do not enter into a deferment or forbearance arrangement based
solely on the fact that a loan meets the criteria for one of the arrangements.
Our use of any of these arrangements also depends upon one or more of the
following factors: our assessment of the individual borrower's current financial
situation, reasons for the delinquency and our view of prevailing economic
conditions. Because deferment and forbearance arrangements are account
management tools which help us to manage customer relationships, maximize
collection opportunities and increase the value of our account relationships,
the application of these tools generally is subject to constantly shifting
complexities and variations in the marketplace. We attempt to tailor the type
and terms of the arrangement we use to the borrower's circumstances, and we
prefer to use deferment over forbearance arrangements, if possible.
As a result of these arrangements, we reset the contractual status of a
loan in our managed portfolio from delinquent to current based upon the
borrower's resumption of making their principal and interest loan payments. A
loan remains current after a deferment or forbearance arrangement with the
borrower only if the borrower makes the principal and interest payments as
required under the terms of the original note (exclusive of delinquent payments
advanced or fees paid by us on the borrower's behalf as part of the deferment or
forbearance arrangement), and we do not reflect it as a delinquent loan in our
delinquency statistics. However, if the borrower fails to make principal and
interest payments, we will declare the account in default, reflect it as a
delinquent loan in our delinquency statistics and resume collection actions. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Total Portfolio Quality -- Deferment and Forbearance Arrangements"
for information regarding the impact of these arrangements on our operations.
Based on information learned by our in-house legal staff while
participating in industry forums and conferences and statements made by outside
attorneys to us in the course of their legal representation of us, we believe we
are among a small number of non-conforming lenders that have an in-house legal
staff dedicated to the collection of delinquent loans and the handling of
bankruptcy cases. As a result, we believe our delinquent loans are reviewed from
a legal perspective earlier in the collection process than is the case with
loans made by traditional lenders so that troublesome legal issues can be noted
and, if possible, resolved earlier. For example, if in the course of the
collection of a loan or fee the servicing department or collections department
becomes aware of problems with a loan, such as title issues, department
personnel will immediately notify an in-house attorney who will review the file
and immediately initiate any necessary corrective action, including referral to
outside counsel if appropriate. Also as an example, every notice of default and
bankruptcy proof of claim is signed by an in-house attorney. Frequently, when
reviewing the file relevant to a particular notice of default or proof of claim,
the reviewing attorney will become aware of inconsistencies or issues and
immediately initiate any necessary corrective action, including referral to
outside counsel if appropriate. This frequent day-to-day contact between our
servicing and collections departments, our in-house legal staff and outside
counsel, and the early involvement of an in-house attorney in emerging legal
issues that this facilitates, enables our in-house attorneys to resolve issues
before they become costly disputes and to negotiate alternatives to foreclosure
for problem loans.
Real estate acquired as a result of foreclosure or by deed in lieu of
foreclosure is classified as real estate owned until it is sold. After
acquisition, all costs incurred in maintaining the property are accounted for as
expenses. When carried on our balance sheet, we record real estate owned at the
lower of cost or estimated fair value.
Most foreclosures are handled by outside counsel who are managed by our
in-house legal staff to ensure that the time period for handling foreclosures
meets or exceeds established industry standards. Frequent contact between
in-house and outside counsel ensures that the process moves quickly and
efficiently in an attempt to achieve a timely and economical resolution to
contested matters.
28
Our ability to foreclose on some properties may be affected by state
and federal environmental laws. The costs of investigation, remediation or
removal of hazardous substances may be substantial and can easily exceed the
value of the property. The presence of hazardous substances, or the failure to
properly eliminate the substances from the property, can hurt the owner's
ability to sell or rent the property and prevent the owner from using the
property as collateral for another loan. Even parties who arrange for the
disposal or treatment of hazardous or toxic substances may be liable for the
costs of removal and remediation, whether or not the facility is owned or
operated by the party who arranged for the disposal or treatment. See "Risk
Factors -- Environmental laws and regulations and other environmental
considerations may restrict our ability to foreclose on loans secured by real
estate or increase costs associated with those loans which could hinder our
ability to operate profitably, limit the funds available to repay our
outstanding debt and negatively impact the value of our capital stock." The
technical nature of some laws and regulations, such as the Truth in Lending Act,
can also contribute to difficulties in foreclosing on real estate and other
assets, as even immaterial errors can trigger foreclosure delays or other
difficulties.
As the servicer of securitized loans, we are obligated to advance funds
for scheduled interest payments that have not been received from the borrower
unless we determine that our advances will not be recoverable from subsequent
collections of the related loan payments. See "-- Securitizations" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Securitizations." We are also required to compensate investors
(without a right to reimbursement) for interest shortfall resulting from loan
prepayments up to the amount of our servicing fee. See "Risk Factors -- Our
securitization agreements impose obligations on us to make cash outlays which
could impair our ability to operate profitably and our ability to repay our
outstanding debt and could negatively impact the value of our capital stock."
Beginning in the fourth quarter of fiscal 2002, we offered customer
retention incentives to borrowers who were exploring loan refinancing
opportunities for the purpose of lowering their monthly loan payments. In an
attempt to retain the loans we were servicing for these borrowers, we offered
the borrowers the opportunity to receive a monthly cash rebate equal to a
percentage of their scheduled monthly loan payments for periods of six to twelve
months. When we were successful in retaining these loans, we reduced the level
of loan prepayments in our managed portfolio of securitized loans. To initially
qualify for this program, a borrower has to be current on their loan principal
and interest payments and to continue to qualify and receive each month's cash
rebate, a borrower has to remain current. The percentage of rebates on scheduled
monthly loan payments offered to participants ranged from 15% to 20%. At June
30, 2004, $344.8 million in principal amount outstanding on loans were
participating in this program on which we expect to pay rebates of approximately
$1.3 million.
SECURITIZATIONS
We were unable to complete quarterly publicly underwritten
securitizations during the fourth quarter of fiscal 2003 and all of fiscal 2004.
We completed a privately-placed securitization in the second quarter of fiscal
2004. Our inability to complete a publicly underwritten securitization during
the fourth quarter of fiscal 2003 was the result of our investment bankers'
decision in late June 2003 not to underwrite the contemplated June 2003
securitization transaction. Management believes that a number of factors
contributed to this decision, including a highly-publicized lawsuit finding
liability of an underwriter in connection with the securitization of loans for
another unaffiliated subprime lender, an inquiry by the Civil Division of the
U.S. Attorney's Office in Philadelphia regarding our forbearance practices, an
anonymous letter regarding us received by our investment bankers, the SEC's
enforcement action against another unaffiliated subprime lender related to its
loan restructuring practices and related disclosure, a federal regulatory agency
investigation of practices by another subprime servicer and our investment
bankers' prior experience with securitization transactions with non-affiliated
originators.
29
During the year ended June 30, 2004, we completed a securitization of
$135.9 million of loans in the second quarter and sold $5.5 million of loans
into an off-balance sheet mortgage conduit facility. During fiscal 2003, we
securitized $112.0 million of business purpose loans and $1.3 billion of home
equity loans. During fiscal 2002, we securitized $129.1 million of business
purpose loans and $1.2 billion of home equity loans. The securitization of loans
and sale into the mortgage conduit facility generated gains on sale of loans of
$15.1 million during the year ended June 30, 2004, $171.0 million during fiscal
2003 and $185.6 million during fiscal 2002. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Securitizations"
for additional information regarding our securitizations.
Securitization is a financing technique often used by originators of
financial assets to raise capital. A securitization involves the sale of a pool
of financial assets, in our case loans, to a trust in exchange for cash and a
retained interest in the securitized loans which is called an interest-only
strip. The trust issues multi-class securities which derive their cash flows
from a pool of securitized loans. These securities, which are senior to our
retained interest-only strips in the trust, are sold to public or private
investors. We may also retain servicing on securitized loans. See "-- Loan
Servicing and Administrative Procedures."
As the holder of the interest-only strips received in a securitization,
we are entitled to receive excess (or residual) cash flows. These cash flows are
the difference between the payments made by the borrowers on securitized loans
and the sum of the scheduled and prepaid principal and pass-through interest
paid to trust investors, servicing fees, trustee fees and, if applicable, surety
fees. Surety fees are paid to an unrelated insurance entity to provide
protection for the trust investors. These cash flows also include cash flows
from overcollateralization. Overcollateralization is the excess of the aggregate
principal balances of loans in a securitized pool over investor interests.
Overcollateralization requirements are established to provide credit enhancement
for the trust investors.
We may be required either to repurchase or to substitute loans which do
not conform to the representations and warranties we made in the agreements
entered into when the loans are sold through a securitization. As of June 30,
2004, we have been required to substitute only one such loan from the
securitization trusts for this reason.
When borrowers are delinquent in making scheduled payments on loans
included in a securitization trust, we are obligated to advance interest
payments with respect to such delinquent loans if we deem that these advances
will ultimately be recoverable. These advances can first be made out of funds
available in the trust's collection account. If the funds available from the
collection account are insufficient to make the required interest advances, then
we are required to make the advances from our operating cash. The advances made
from a trust's collection account, if not recovered from the borrower or
proceeds from the liquidation of the loan, require reimbursement from us. These
advances may require funding from our capital resources and may create greater
demands on our cash flow than either selling loans with servicing released or
maintaining a portfolio of loans on our balance sheet. However, any advances we
make from our operating cash can be recovered from the subsequent mortgage loan
payments to the applicable trust prior to any distributions to the certificate
holders. See "Risk Factors -- Our securitization agreements impose obligations
on us to make cash outlays which could impair our ability to operate profitably
and our ability to repay our outstanding debt and could negatively impact the
value of our capital stock."
30
At times we elect to repurchase some delinquent loans from the
securitization trusts, some of which may be in foreclosure. Repurchasing loans
benefits us by allowing us to limit the level of delinquencies and losses in the
securitization trusts and as a result, we can avoid exceeding specified limits
on delinquencies and losses that trigger a temporary reduction or
discontinuation of residual or stepdown overcollateralization cash flows from
our interest-only strips until the delinquencies or losses no longer exceed the
triggers. We have the right, but are not obligated, to repurchase a limited
amount of delinquent loans from securitization trusts. The purchase price of a
delinquent loan is at the loan's outstanding contractual balance plus accrued
and unpaid interest and unreimbursed servicing advances, however, unpaid
interest and unreimbursed servicing advances are returned to us by the trust. A
foreclosed loan is one where we, as servicer, have initiated formal foreclosure
proceedings against the borrower and a delinquent loan is one that is 31 days or
more past due. The foreclosed and delinquent loans we typically elect to
repurchase are usually 90 days or more delinquent and the subject of foreclosure
proceedings, or where a completed foreclosure is imminent. In addition, we elect
to repurchase loans in situations requiring more flexibility for the
administration and collection of these loans in order to maximize their economic
recovery. See "Risk Factors - Our securitization agreements impose obligations
on us to make cash outlays which could impair our ability to operate profitably
and our ability to repay our outstanding debt and could negatively impact the
value of our capital stock." See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Securitizations -- Trigger
Management" for a description of the impact of these repurchases on our
business.
In the past, certain of our securitizations included a prefunding
option where a portion of the cash received from investors is withheld until
additional loans are transferred to the trust. The loans to be transferred to
the trust to satisfy the prefund option must be substantially similar in terms
of collateral, size, term, interest rate, geographic distribution and
loan-to-value ratio as the loans initially transferred to the trust. We had no
prefund obligations at June 30, 2004.
WHOLE LOAN SALES
Our determination to engage in whole loan sales depends upon a variety
of factors, including market conditions in the securitization markets and the
secondary loan markets, profitability and cash flow considerations. Due to our
inability to complete a quarterly securitization during the fourth quarter of
fiscal 2003, we adjusted our business strategy from a predominantly publicly
underwritten securitization strategy to a strategy focused on a combination of
whole loan sales and securitizations. See "Managements Discussion and Analysis
of Financial Condition and Results of Operations -- Whole Loan Sales" for more
detail.
COMPETITION
We have significant competition for home mortgage loans. We concentrate
our marketing efforts for home mortgage loans on credit-impaired borrowers.
Through Upland Mortgage and American Business Mortgage Services, Inc., we
compete with banks, thrift institutions, mortgage bankers and other finance
companies. Many large financial institutions have gradually expanded their
sub-prime lending capabilities. Many of these companies have name recognition
and greater access to capital at a cost lower than our cost of capital.
Additionally, federally chartered banks and thrifts can preempt some of the
state and local lending laws to which we are subject, thereby giving them a
competitive advantage.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, customer service, marketing and distribution
channels, amount and term of the loan, loan origination fees and interest rates.
Additional competition may lower the interest rates we can charge borrowers,
thereby potentially lowering gain on future whole loan sales and
securitizations.
31
We attempt to mitigate these factors through a highly trained staff of
professionals, rapid response to prospective borrowers' requests and by
maintaining a relatively short average loan processing time. See "-- Marketing
Strategy" for information regarding the markets in which we compete. See "--
Business Strategy" for discussion of our emphasis on broadening our mortgage
loan product line and offering competitive interest rates. See "Risk Factors --
Competition from other lenders could adversely affect our ability to attain
profitable operations and our ability to repay our outstanding debt may be
impaired and the value of our capital stock could be negatively impacted."
REGULATION
GENERAL. Our business is regulated by federal, state and, in certain
cases, local laws. All home mortgage loans must meet the requirements of, among
other statutes and regulations, the Truth in Lending Act, the Real Estate
Settlement Procedures Act, the Equal Credit Opportunity Act of 1974, and their
associated Regulations Z, X and B, respectively.
TRUTH IN LENDING. The Truth in Lending Act and Regulation Z contain
disclosure requirements designed to provide consumers with uniform,
understandable information about the terms and conditions of loans and credit
transactions so that consumers may compare credit terms. The Truth in Lending
Act also guarantees consumers a three-day right to cancel certain transactions
described in the act and imposes specific loan feature restrictions on some
loans, including some of the same types of loans originated by us. If we were
found not to be in compliance with the Truth in Lending Act, some aggrieved
borrowers could, depending on the nature of the non-compliance, have the right
to recover actual damages, statutory damages, penalties, rescind their loans
and/or to demand, among other things, the return of finance charges and fees
paid to us and third parties. Other fines and penalties can also be imposed
under the Truth in Lending Act and Regulation Z.
EQUAL CREDIT OPPORTUNITY ACT, FAIR CREDIT REPORTING ACT AND OTHER LAWS.
We are also required to comply with the Equal Credit Opportunity Act and
Regulation B, which prohibit creditors from discriminating against applicants on
the basis of race, color, religion, national origin, sex, age or marital status.
Regulation B also restricts creditors from obtaining certain types of
information from loan applicants. Among other things, it also requires lenders
to advise applicants of the reasons for any credit denial. Equal Credit
Opportunity Act violations can also result in fines, penalties and other
remedies.
In instances where the applicant is denied credit or the rate of
interest for a loan increases as a result of information obtained from a
consumer credit reporting agency, the Fair Credit Reporting Act of 1970, as
amended, requires lenders to supply the applicant with the name and address of
the reporting agency whose credit report was used in making such determinations.
It also requires that lenders provide other information and disclosures about
the loan application rejection. In addition, we are subject to the Fair Housing
Act and regulations under the Fair Housing Act, which broadly prohibit
discriminatory practices in connection with our home equity and other lending
businesses.
Pursuant to the Home Mortgage Disclosure Act and Regulation C, we are
also required to report information on loan applicants and certain other
borrowers to the Department of Housing and Urban Development, which is among
numerous federal and state agencies which monitor compliance with fair lending
laws.
We are also subject to the Real Estate Settlement Procedures Act and
Regulation X. This law and this regulation, which are administered by the
Department of Housing and Urban Development, impose limits on the amount of
funds a borrower can be required to deposit with us in any escrow account for
the payment of taxes, insurance premiums or other charges; limits the fees which
may be paid to third parties; and imposes various disclosure and other
requirements.
We are subject to various other federal, state and local laws, rules
and regulations governing the licensing of mortgage lenders and servicers. We
must comply with procedures mandated for mortgage lenders and servicers, and
must provide disclosures to consumer applicants and borrowers. Failure to comply
with these laws, as well as with the laws described above, may result in civil
and criminal liability.
32
Several of our subsidiaries are licensed and regulated by the
departments of banking or similar entities in the various states in which they
are conducting business. The rules and regulations of the various states impose
licensing and other restrictions on lending activities, such as prohibiting
discrimination and regulating collection, foreclosure procedures and claims
handling, disclosure obligations, payment feature restrictions and, in some
cases, these laws fix maximum interest rates and fees. Failure to comply with
these requirements can lead to termination or suspension of licenses, rights of
rescission for mortgage loans, individual and class action lawsuits and/or
administrative enforcement actions. Our in-house compliance staff, which
includes attorneys, and our outside counsel review and monitor the lending
policies of our subsidiaries for compliance with the various federal and state
laws.
The Gramm-Leach-Bliley Act, which was signed into law at the end of
1999, contains comprehensive consumer financial privacy restrictions. Various
federal enforcement agencies, including the Federal Trade Commission, have
issued final regulations to implement this act. These restrictions fall into two
basic categories. First, a financial institution must provide various notices to
consumers about such institution's privacy policies and practices. Second, this
act imposes restrictions on a financial institution and gives consumers the
right to prevent a financial institution from disclosing non-public personal
information about the consumer to non-affiliated third parties, with exceptions.
We have prepared the appropriate consumer disclosures and internal procedures to
address these requirements.
In addition, on December 22, 2003, we entered into a joint agreement
with the Civil Division of the U.S. Attorney's Office for the Eastern District
of Pennsylvania, which ended the inquiry by the U.S. Attorney focused on our
forbearance policy initiated pursuant to the civil subpoena dated May 14, 2003.
See "Legal Proceedings."
The previously described laws and regulations are subject to
legislative, administrative and judicial interpretation. Some of these laws and
regulations have recently been enacted or amended. Some of these laws and
regulations are rarely challenged in, or interpreted by, the courts. Infrequent
interpretations, an insignificant number of interpretations and/or conflicting
interpretations of these enacted or amended laws and regulations can make it
difficult for us to always know what is permitted conduct under these laws and
regulations. Any ambiguity or vagueness under the laws and regulations to which
we are subject may lead to regulatory investigations or enforcement actions and
private causes of action, such as class action lawsuits, with respect to our
compliance with the applicable laws and regulations. See "Risk Factors -- Our
residential lending business is subject to government regulation and licensing
requirements, which may hinder our ability to operate profitably, negatively
impair our ability to repay our outstanding debt and negatively impact the value
of our capital stock."
PREDATORY LENDING REGULATIONS. State and federal banking regulatory
agencies, state attorneys general offices, the Federal Trade Commission, the
U.S. Department of Justice, the U.S. Department of Housing and Urban Development
and state and local governmental authorities have increased their focus on
lending practices by some companies in the subprime lending industry, more
commonly referred to as "predatory lending" practices. State, local and federal
governmental agencies have imposed sanctions for practices including, but not
limited to, charging borrowers excessive fees, imposing higher interest rates
than the borrower's credit risk warrants and failing to adequately disclose the
material terms of loans to the borrowers. For example, the Pennsylvania Attorney
General reviewed fees our subsidiary, HomeAmerican Credit, Inc., charged
Pennsylvania customers. Although we believe that these fees were fair and in
compliance with applicable federal and state laws, in April 2002, we agreed to
reimburse borrowers approximately $221,000 with respect to a particular fee paid
by borrowers from January 1, 1999 to mid-February 2001 and to reimburse the
Commonwealth of Pennsylvania $50,000 for its costs of investigation and for
future public protection purposes. We discontinued charging this particular fee
in mid-February 2001. As a result of these initiatives, we are unable to predict
whether state, local or federal authorities will require changes in our lending
practices in the future, including reimbursement of fees charged to borrowers,
or will impose fines on us. These changes, if required, could impact our
profitability. These laws and regulations may limit our ability to securitize
loans originated in certain states or localities due to rating agency, investor
or market restrictions. As a result, we have limited the types of loans we offer
in some states and may discontinue originating loans in other states or
localities. See "Risk Factors -- Our residential lending business is subject to
government regulation and licensing requirements, which may hinder our ability
to operate profitably, negatively impair our ability to repay our outstanding
debt and negatively impact the value of our capital stock."
33
Additionally, the United States Congress is currently considering a
number of proposed bills or proposed amendments to existing laws, such as the
"Ney - Lucas Responsible Lending Act of 2003" introduced on February 13, 2003
into the U.S. House of Representatives, which could affect our lending
activities and make our business less profitable. These bills and amendments, if
adopted as proposed, could reduce our profitability by limiting the fees we are
permitted to charge, including prepayment fees, restricting the terms we are
permitted to include in our loan agreements and increasing the amount of
disclosure we are required to give to potential borrowers. While we cannot
predict whether or in what form Congress may enact legislation, we are currently
evaluating the potential impact of these legislative initiatives, if adopted, on
our lending practices and results of operations.
State law sometimes restricts our ability to charge a prepayment fee
for both home equity and business purpose loans. Prior to its preclusion, we
used the Parity Act to preempt these state laws for home equity loans which meet
the definition of alternative mortgage transactions under the Parity Act. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Legal and Regulatory Considerations" for a discussion of how the
adoption by the Office of Thrift Supervision in July 2003 of a rule which
precludes us from using the Parity Act to preempt state prepayment penalty and
late fees laws may impact our new loan originations.
SERVICEMEMBERS CIVIL RELIEF ACT. Under the Servicemembers Civil Relief
Act (formerly known as the Soldiers' and Sailors' Civil Relief Act of 1940),
referred to as the Relief Act in this document, members of all branches of the
military on active duty, including draftees and reservists in military service
and state national guard called to federal duty:
o are entitled to have interest rates reduced and capped at 6%
per annum, on obligations (including mortgage loans) incurred
prior to the commencement of military service for the duration
of military service;
o may be entitled to a stay of proceeding on any kind of
foreclosure or repossession action in the case of defaults on
obligations entered into prior to military service for the
duration of military service; and
o may have the maturity of obligations stayed and may have
obligations adjusted in a manner to preserve the interests of
all parties.
If a borrower's obligation to repay amounts otherwise due on a mortgage
loan included in a trust is relieved pursuant to the Relief Act, none of the
trust, the servicer, the back-up servicer, the seller, the depositor, the
originators or the trustee will be required to advance these amounts, and any
resulting loss may reduce the amounts available to be paid to the holders of the
certificates. Any shortfalls in interest collections on mortgage loans included
in the trust resulting from application of the Relief Act will be allocated to
the certificates in reduction of the amounts payable to such certificates on the
related distribution date.
34
As a result of the current military actions in Iraq and Afghanistan,
President Bush authorized the placement of tens of thousands of military
reservists and members of the National Guard on active duty status. To the
extent that any such person is a borrower under a loan, the interest rate
limitations and other provisions of the Relief Act would apply to the loan
during the period of active duty. The number of reservists and members of the
National Guard placed on active duty status in the near future may increase. In
addition, other borrowers who enter military service after the origination of
their loans (including borrowers who are members of the National Guard at the
time of the origination of their loans and are later called to active duty)
would be covered by the terms of the Relief Act. See "Risk Factors - If many of
our borrowers become subject to the Servicemembers Civil Relief Act, our cash
flows and interest income may be adversely affected which would negatively
impair our ability to repay our outstanding debt and would negatively impact the
value of our capital stock."
We have procedures and controls to monitor compliance with numerous
federal, state and local laws and regulations. However, because these laws and
regulations are complex and often subject to interpretation, or as a result of
inadvertent errors, we may, from time to time, inadvertently violate these laws
and regulations.
If more restrictive laws, rules and regulations are enacted or more
restrictive judicial and administrative interpretations of those laws are
issued, compliance with the laws could become more expensive or difficult.
RISK FACTORS
YOU SHOULD CAREFULLY CONSIDER RISK FACTORS SET FORTH BELOW TOGETHER
WITH ALL OF THE OTHER INFORMATION INCLUDED IN THIS FORM 10-K AND INCORPORATED BY
REFERENCE INTO THIS FORM 10-K WHICH COULD IMPACT THE VALUE OF OUR CAPITAL STOCK
AND OUR ABILITY TO REPAY OUR OUTSTANDING DEBT.
BECAUSE WE HAVE HISTORICALLY EXPERIENCED NEGATIVE CASH FLOWS FROM OPERATIONS, WE
WILL BE REQUIRED TO RELY, IN PART, ON SALES OF ADDITIONAL SUBORDINATED
DEBENTURES TO FUND OUR CONTINUING OPERATIONS AND TO REPAY OUR OUTSTANDING DEBT.
TO THE EXTENT THAT WE ARE UNABLE TO SELL ADDITIONAL SUBORDINATED DEBENTURES OR
OTHER SECURITIES, OUR ABILITY TO REPAY OUR OUTSTANDING DEBT COULD BE IMPAIRED
AND THE VALUE OF OUR CAPITAL STOCK COULD BE NEGATIVELY IMPACTED.
We have historically experienced negative cash flows from operations
since 1996 primarily because our previous business strategy of selling loans
primarily through securitization required us to build an inventory of loans over
time. During the period we are building this inventory of loans, we incur costs
and expenses. We do not recognize a gain on the sale of loans until we complete
a securitization or a whole loan sale, which may not occur until a subsequent
period. In addition, our gain on a securitization results from a combination of
cash proceeds received and our retained interests in the securitized loans,
consisting primarily of interest-only strips which do not generate cash flows
immediately. Our cash flow from operations for the fiscal year ended June 30,
2003, was a negative of $285.4 million compared to a negative $13.3 million for
fiscal 2002. Negative cash flow from operations increased $272.1 million for the
fiscal year ended June 30, 2003 mainly due to our inability to complete a
securitization or otherwise sell our loans in the fourth quarter of fiscal 2003.
If our adjusted business strategy changes to include a sale of loans through
securitizations, then, depending on the size and frequency of our future
securitizations, we may experience negative cash flow from operations in the
future. We anticipate that we will be required to rely, in part, on the offering
of additional securities, including subordinated debentures, to fund both our
operations and repay our outstanding debt for at least the next two years.
35
During the fiscal year ended June 30, 2004, we experienced positive
cash flow from operations of $6.8 million primarily due to whole loan sales of
loans we originated. However, the combination of our current cash position and
expected sources of operating cash may not be sufficient to cover our operating
cash requirements. Should we experience negative cash flows from operations in
the future, and if we are unable to sell subordinated debentures to fund our
operations, our ability to repay our outstanding debt could be impaired and the
value of our capital stock could be negatively impacted. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
BECAUSE WE HAD NEGATIVE RETAINED EARNINGS IN FISCAL 2004, WE HAVE NOT GENERATED
SUFFICIENT EARNINGS TO COVER OUR FIXED CHARGES, WHICH MAY NEGATIVELY IMPAIR OUR
ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE OF OUR
CAPITAL STOCK.
At June 30, 2004, we had negative retained earnings of $98.3 million
on our balance sheet as a result of our losses for fiscal 2004 and fiscal 2003.
Our earnings before income taxes and fixed charges were insufficient to cover
fixed charges by $183.4 million for the fiscal year ended June 30, 2004. To the
extent that we are unable to generate earnings sufficient to cover our fixed
charges, we may have insufficient funds to repay our outstanding debt, which
would have a negative impact on the value of our capital stock.
SINCE WE DO NOT SET ASIDE FUNDS TO REPAY OUR OUTSTANDING DEBT AND TO THE EXTENT
THE COLLATERAL SECURING SENIOR COLLATERALIZED SUBORDINATED NOTES IS NOT
SUFFICIENT FOR THE REPAYMENT OF THE NOTES, HOLDERS OF OUR OUTSTANDING DEBT MUST
RELY ON OUR CASH FLOW FROM OPERATIONS AND OTHER SOURCES FOR REPAYMENT. IF OUR
SOURCES OF REPAYMENT ARE NOT ADEQUATE, WE MAY BE UNABLE TO REPAY OUR OUTSTANDING
DEBT, WHICH WOULD HAVE A NEGATIVE IMPACT ON THE VALUE OF OUR CAPITAL STOCK.
We do not contribute funds on a regular basis to a separate account,
commonly known as a sinking fund, to repay our outstanding debt upon maturity.
Because funds are not set aside periodically for the repayment of the
outstanding debt over its term, holders of the subordinated debentures and
senior collateralized subordinated notes, to the extent that the cash flow from
interest-only strips securing the senior collateralized subordinated notes is
not sufficient for the repayment of the senior collateralized subordinated notes
over their terms, must rely on our cash flow from operations and other sources
for repayment, such as funds from the sale of additional subordinated debentures
and proceeds from whole loan sales. We anticipate that during fiscal 2005 we
will incur significant contractual obligations that will negatively impact our
cash flow from operations, including, but not limited to: (i) the payment of
maturing subordinated debentures and the accrued interest on outstanding
subordinated debentures of $326.2 million and $20.0 million, respectively; (ii)
the payment of maturing senior collateralized subordinated notes and the accrued
interest on senior collateralized subordinated notes of $28.1 million and $1.0
million, respectively; (iii) the payment of dividends on Series A preferred
stock of $ 10.9 million; and (iv) the repayment of the warehouse lines of credit
of $239.6 million. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources --
Contractual Obligations" for a discussion of our contractual obligations. To the
extent revenues from operations and other sources are not sufficient to repay
the outstanding debt, holders of outstanding debt may lose all or a part of
their investment. Our ability to repay the outstanding debt at maturity and our
ability to meet other financial obligations may depend, in part, on our ability
to raise new funds through the sale of additional subordinated debentures. At
June 30, 2004, $522.6 million of subordinated debentures were outstanding. We
estimate that during fiscal 2005 we will not generate sufficient after-tax
earnings to pay the principal and interest on maturing subordinated debentures
and we will need to sell approximately $260.0 million to $275.0 million of
additional subordinated debentures to pay the principal and interest on our
outstanding subordinated debentures and to pay our other obligations, including
the principal and interest on the senior collateralized subordinated notes and
dividends on our Series A preferred stock. In addition, we use the proceeds from
sales of additional subordinated debentures to pay maturities on existing
subordinated debentures because we have been unable to issue subordinated
debentures with maturities long enough to fund our business. In essence, we
replace maturing short-term subordinated debentures with new short-term
subordinated debentures to achieve the longer term funding effect we need in
order to implement our business strategy. Once cash flows from after tax
earnings become available, as anticipated under our adjusted business strategy,
we anticipate having cash available to begin paying down maturing subordinated
debentures and reducing the amount of maturing short-term subordinated
debentures we replace with new subordinated debentures. See "-- Because we have
historically experienced negative cash flows from operations, we will be
required to rely, in part, on sales of additional subordinated debentures to
fund our continuing operations and to repay our outstanding debt. To the extent
that we are unable to sell additional subordinated debentures or other
securities, our ability to repay our outstanding debt could be impaired and the
value of our capital stock could be negatively impacted," "-- We depend upon the
availability of financing to fund our continuing operations. Any failure to
obtain adequate funding could hurt our ability to operate profitably, restrict
our ability to repay our outstanding debt and negatively impact the value of our
capital stock," and "-- Delinquencies and prepayments in the pools of
securitized loans could adversely affect the cash flow we receive from our
interest-only strips, impair our ability to sell or securitize loans in the
future, impair our ability to repay our outstanding debt and negatively impact
the value of our capital stock."
36
SINCE WE DO NOT SET ASIDE FUNDS TO REPAY HOLDERS OF OUR MONEY MARKET NOTES UPON
DEMAND, HOLDERS OF MONEY MARKET NOTES MUST RELY ON OUR CASH FLOW FROM OPERATIONS
AND OTHER SOURCES FOR REPAYMENT OF THEIR UNINSURED MONEY MARKET NOTES. IF OUR
SOURCES OF REPAYMENT ARE NOT ADEQUATE, WE MAY BE UNABLE TO SATISFY THE HOLDERS'
REDEMPTION REQUESTS ON A TIMELY BASIS.
Holders of our uninsured money market notes may request a full or
partial repayment of their notes at any time by delivering a written notice to
us specifying the amount of the redemption. Redemption requests by written
notice may be for any amount and we may take up to 10 business days after the
receipt of the notice to mail the proceeds of the redemption to the holder. In
fiscal 2004, we repaid $26.9 million of money market notes pursuant to
redemption requests. At June 30, 2004, we had $12.7 million of money market
notes outstanding and $0.9 million of cash and cash equivalents available to
repay these money market notes. Since we do not set aside funds to repay money
market notes upon the holder's demand, holders must rely on our available cash
and cash equivalents when a request is made for repayment. If holders of all of
our money market notes requested repayment as of June 30, 2004, we did not have
sufficient cash or cash equivalents to repay all money market notes outstanding
as of such date. If we do not have sufficient cash to repay all holders
requesting redemption, we may take up to 10 business days to mail the proceeds
to the holders. To the extent that we continue to experience liquidity issues,
are unable to sell additional subordinated debentures or other sources for
repayment are not available, we may be unable to satisfy the holders' redemption
requests when made. In the event we are unable to mail proceeds to redeeming
holders within 10 business days, we would be in default under the terms of our
indenture governing the money market notes.
Absent a waiver, our failure to repay the money market notes within a
10 business day period provided for pursuant to the terms of the indenture would
result in an event of default which could accelerate debt repayment terms under
our credit facilities and indentures due to various cross default provisions
contained in the agreements evidencing our outstanding debt, which would have a
material adverse effect on our liquidity and capital resources.
Subject to the consent of the trustee under the indenture governing the
rights of holders of uninsured money market notes, we have the ability to change
the redemption procedures without the approval of holders of money market notes,
provided that no changes can be made that will adversely affect the rights of
holders of outstanding money market notes. If we experience a significant
increase in requests for the redemption of money market notes, we may request
that the trustee approve an extension of the 10 business day period provided for
the redemption of money market notes. In such event, this modification would
only be effective with respect to money market notes issued subsequent to the
date of the trustee's consent and our notice regarding the extension to
prospective investors. See "-- Since we do not set aside funds to repay our
outstanding debt and to the extent the collateral securing senior collateralized
subordinated notes is not sufficient for the repayment of the notes, holders of
our outstanding debt must rely on our cash flow from operations and other
sources for repayment. If our sources of repayment are not adequate, we may be
unable to repay our outstanding debt, which would have a negative impact on the
value of our capital stock."
37
WE DEPEND UPON THE AVAILABILITY OF FINANCING TO FUND OUR CONTINUING OPERATIONS.
ANY FAILURE TO OBTAIN ADEQUATE FUNDING COULD HURT OUR ABILITY TO OPERATE
PROFITABLY, RESTRICT OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY
IMPACT THE VALUE OF OUR CAPITAL STOCK.
For our ongoing operations, we depend upon frequent financings,
including the sale of our unsecured subordinated debentures and warehouse credit
facilities or lines of credit. If we are unable to maintain, renew or obtain
adequate funding under a warehouse credit facility, or other borrowings,
including the sale of additional subordinated debentures, the lack of adequate
funds would hinder our ability to operate profitably, restrict our ability to
repay our outstanding debt and negatively impact the value of our capital stock.
On September 22, 2003, we entered into definitive agreements with a
financial institution for a $200.0 million credit facility. In addition, on
October 14, 2003, we entered into definitive agreements with a warehouse lender
for a $250.0 million credit facility to fund loan originations. This $200.0
million credit facility was extended to November 5, 2004 and reduced to $100.0
million. We have entered into a commitment letter and anticipate entering into
a definitive agreement regarding a $100.0 million credit facility to replace our
expiring credit facility. However, there can be no assurances as to whether we
will enter into the definitive agreement prior to November 5, 2004 or that this
agreement will contain terms and conditions acceptable to us.
If we are unable to comply with the terms of our credit facilities,
these lenders have the option to accelerate payment on these facilities and
would have no further obligation to make additional advances under these
facilities. In addition, absent a waiver, our inability to comply with the
financial and other terms of this debt could accelerate debt repayment terms
under our other outstanding debt due to the various cross default provisions
contained in the agreements evidencing our outstanding debt. Additionally, our
ability to obtain alternative financing sources may be limited to the extent we
have agreed to pledge our interest-only strips and residual interests, which
represent a significant amount of our assets, to secure our obligations in an
amount not to exceed 10% of the outstanding principal balance of, and the
payment of fees on, the $250.0 million credit facility and a portion of the cash
flows from our interest-only strips to secure the senior collateralized
subordinated notes outstanding, and by our current financial condition. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" for further discussion of these
facilities.
38
Although we obtained two warehouse credit facilities totaling $450.0
million in fiscal 2004, and after November 5, 2004 we expect to have at least
two warehouse credit facilities totaling at a minimum $500.0 million, the
proceeds of these credit facilities could only be used to fund loan originations
and could not be used for any other purpose. Consequently, we need to generate
cash to fund the balance of our business operations from other sources, such as
whole loan sales, additional financings and sales of subordinated debentures.
Additionally, our warehouse credit facilities have been obtained at high costs,
which have a significant impact on our liquidity.
We are currently negotiating additional credit facilities to provide
additional borrowing capacity to fund the increased level of loan originations
expected under our adjusted business strategy, however, no assurances can be
given that we will succeed in obtaining new credit facilities or that these
facilities will contain terms and conditions acceptable to us.
While we currently believe we will continue to have credit facilities
available to finance new loan obligations, we cannot assure you that we will be
successful in maintaining or replacing existing credit facilities or obtaining
alternative financing sources necessary to fund our operations, and to the
extent that we are not successful, we may have to limit our loan originations or
sell loans earlier than intended and restructure our operations. Limiting our
originations or earlier sales of loans would hinder our ability to operate
profitably or result in losses, restrict our ability to repay our outstanding
debt and negatively impact the value of our capital stock. Our ability to repay
our outstanding debt at maturity may depend, in part, on our ability to raise
new funds through the sale of additional subordinated debentures. As the
servicer of securitized loans, we could also incur certain additional cash
requirements with respect to the securitization trusts which could increase our
dependence on borrowed funds to the extent funds from non-credit sources were
unavailable. If this additional cash requirement were to arise at a time when
our access to borrowed funds was restricted, our ability to repay some or all of
our outstanding debt as it comes due could be impaired. See "-- Our
securitization agreements impose obligations on us to make cash outlays which
could impair our ability to operate profitably and our ability to repay our
outstanding debt and could negatively impact the value of our capital stock" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
In the event we are unable to offer subordinated debentures for any
reason, we have developed a contingent financial restructuring plan including
cash flow projections for the next twelve-month period. Based on our current
cash flow projections, we anticipate being able to make all scheduled debt
maturities and vendor payments.
The contingent financial restructuring plan is based on actions that we
would take, in addition to those indicated in our adjusted business strategy, to
reduce our operating expenses and conserve cash. These actions would include
reducing capital expenditures, selling all loans originated on a whole loan
basis, eliminating or downsizing various lending, overhead and support groups,
and obtaining working capital funding. No assurance can be given that we will be
able to successfully implement the contingent financial restructuring plan, if
necessary, and repay our outstanding debt which would negatively impact the
value of our capital stock.
39
IF WE ARE UNABLE TO OBTAIN ADDITIONAL FINANCING, WE MAY NOT BE ABLE TO
RESTRUCTURE OUR BUSINESS TO PERMIT PROFITABLE OPERATIONS OR REPAY OUR
OUTSTANDING DEBT AND THE VALUE OF OUR CAPITAL STOCK WILL BE NEGATIVELY IMPACTED.
Our inability to complete publicly underwritten securitizations during
the fourth quarter of fiscal 2003 and all of fiscal 2004 (we completed a
privately-placed securitization in the second quarter of fiscal 2004), our
inability to draw down upon and the expiration of several of our credit
facilities, and our temporary discontinuation of sales of new subordinated
debentures for approximately a six-week period during the first quarter of
fiscal 2004 adversely impacted our short-term liquidity position and resulted in
our inability to comply with financial covenants contained in our credit
facilities. The expiration of our $300.0 million mortgage conduit facility in
July 2003 and the temporary discontinuation of the sale of new subordinated
debentures for approximately a six-week period during the first quarter of
fiscal 2004 also adversely impacted our short-term liquidity position.
We have entered into a commitment letter and anticipate entering into
definitive agreements for a $100.0 million credit facility to replace our
expiring $200.0 million (now $100.0 million) credit facility. However, we cannot
give any assurances that we will execute definitive agreements for this facility
on or before November 5, 2004 or that the definitive agreements offered to us
will contain terms acceptable to us, although preliminary discussions indicate
the replacement facility will be structured similarly to our $250.0 million
credit facility.
Although we obtained two warehouse credit facilities totaling $450.0
million in fiscal 2004, and after November 5, 2004 we expect to have at least
two warehouse credit facilities totaling at a minimum $500.0 million, the
proceeds of these credit facilities could only be used to fund loan originations
and could not be used for any other purpose. Consequently, we need to generate
cash to fund the balance of our business operations from other sources, such as
whole loan sales, additional financings and sales of subordinated debentures.
Additionally, our warehouse credit facilities have been obtained at high costs,
which have a significant impact on our liquidity. We are currently negotiating
additional credit facilities to provide additional borrowing capacity to fund
the increased level of loan originations expected under our adjusted business
strategy, however, no assurances can be given that we will succeed in obtaining
new credit facilities or that these facilities will contain terms and conditions
acceptable to us.
Our ability to obtain alternative sources of financing may be limited
to the extent we have pledged our interest-only strips and residual interests,
which represent a significant amount of our assets, to secure our obligations in
an amount not to exceed 10% of the outstanding principal balance of, and the
payment of fees on, the $250.0 million credit facility and a portion of the cash
flows from our interest-only strips to secure the senior collateralized
subordinated notes, and by our current financial situation. To the extent that
we are not successful in maintaining, replacing or obtaining alternative
financing sources on acceptable terms, we may have to limit our loan
originations, sell loans earlier than intended and further restructure our
operations under our adjusted business strategy. Limiting our originations or
earlier sales of our loans would prevent us from operating profitably and
restrict our ability to repay our outstanding debt and could negatively impact
the value of our capital stock. Likewise, there can be no assurance that we can
successfully implement our adjusted business strategy, if necessary, or that the
assumptions underlying the adjusted business strategy can be achieved. Our
failure to successfully implement our adjusted business strategy, if necessary,
would impair our ability to operate profitably and repay our outstanding debt
and would negatively impact the value of our capital stock. If we fail to
successfully implement our adjusted business strategy, we will be required to
consider other alternatives, including raising equity, seeking to convert a
portion of our subordinated debentures to equity, seeking protection under
federal bankruptcy laws, seeking a strategic investor, or exploring a sale of
the company or some or all of its assets.
EVEN IF WE ARE ABLE TO OBTAIN ADEQUATE FINANCING, OUR INABILITY TO SECURITIZE
OUR LOANS COULD HINDER OUR ABILITY TO OPERATE PROFITABLY IN THE FUTURE AND REPAY
OUR OUTSTANDING DEBT WHICH COULD NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL
STOCK.
Since 1995, we have relied on the quarterly securitization of our loans
to generate cash for the repayment of our credit facilities and the origination
of additional loans. Our inability to complete our typical publicly underwritten
quarterly securitization during the fourth quarter of 2003 and during fiscal
2004 and the significant net pre-tax valuation adjustments to our securitization
assets resulted in a net loss attributable to common stock of $29.9 million for
fiscal 2003 and $115.1 million for fiscal 2004, and contributed to our shift in
focus to less profitable whole loan sales. The losses resulted in our inability
to comply with certain financial covenants contained in our credit facilities.
The losses and the expiration of our mortgage conduit facility adversely
impacted our short-term liquidity position. The temporary discontinuation of
sales of subordinated debentures further impaired our liquidity.
40
Depending on our ability to recognize gains on our future
securitizations, we anticipate incurring losses at least through the first
quarter of fiscal 2005 causing us to fail to comply with the financial covenants
in our credit facilities, increase our reliance on less profitable whole loan
sales which will require us to originate more loans to reach the same level of
profitability as we experienced in securitization transactions, and increase our
need for additional financing to fund our loan originations. Our continued
inability to securitize our loans could result in us reaching our capacity under
our existing credit facilities or require us to sell our loans when market
conditions are less favorable and could cause us to incur a loss on the sale
transaction. See "-- An interruption or reduction in the whole loan sale or
securitization markets would hinder our ability to operate profitably and repay
our outstanding debt which would negatively impact the value of our capital
stock."
BASED UPON OUR LOSS FOR THE QUARTER ENDED JUNE 30, 2004 AND OUR ANTICIPATED LOSS
FOR THE QUARTER ENDED SEPTEMBER 30, 2004, WE WILL BE OUT OF COMPLIANCE WITH
FINANCIAL COVENANTS CONTAINED IN ONE OF OUR CREDIT FACILITIES AND WE WILL
CONTINUE TO NEED WAIVERS FROM OUR LENDER.
At various times since June 30, 2003, including at June 30, 2004, July
31, 2004, August 31, 2004 and September 30, 2004, we have been out of compliance
with one or more financial covenants contained in our $200.0 million credit
facility. We have continued to operate on the basis of waivers granted by the
lender under this facility. We currently anticipate that we will be out of
compliance with one or more of these financial covenants at October 31, 2004 and
will need a waiver from this lender for this noncompliance to continue to
operate. The expiration date of this facility was originally September 21, 2004,
but the lender agreed to extend the expiration date until November 5, 2004 in
consideration for, among other things, a reduction in the amount that could be
borrowed under this facility to $100.0 million.
A provision in our $250.0 million credit facility required us to
maintain another credit facility for $200.0 million with a $40.0 million
sublimit of such facility available for funding loans between the time they are
closed by a title agency or closing attorney and the time documentation for the
loans is received by the collateral agent. As a result of the reduction of our
$200.0 million facility to $100.0 million, as described above, we entered into
an amendment to the master loan and security agreement governing our $250.0
million facility which reduced the required amount for another facility to
$100.0 million. In the event we do not extend the $200.0 million (now $100.0
million) facility beyond its November 5, 2004 expiration date, or in the event
we do not otherwise enter into definitive agreements with other lenders by
November 5, 2004 which satisfy the above-described requirements in our $250.0
million facility for $100.0 million in additional credit facilities and a $40.0
million sublimit, we will need an additional amendment to the $250.0 million
facility or a waiver from the lender to continue to operate.
We cannot assure you that we will continue to receive the waivers that
we need to operate or that they will not contain conditions that are
unacceptable to us. Because we anticipate incurring losses through at least the
first quarter of fiscal 2005, we anticipate that we will need to obtain
additional waivers from our lenders and bond insurers as a result of our
non-compliance with financial covenants contained in our credit facilities and
servicing agreements. See "-- We depend upon the availability of financing to
fund our operations. Any failure to obtain adequate funding could hurt our
ability to operate profitably, restrict our ability to repay our outstanding
debt and negatively impact the value of our capital stock," and "-- Restrictive
covenants in the agreements governing our indebtedness may reduce our operating
flexibility and limit our ability to operate profitably, and our ability to
repay our outstanding debt may be impaired and the value of our capital stock
could be negatively impacted."
41
IN THE EVENT OUR COMMON STOCK IS DELISTED FROM TRADING ON THE NASDAQ NATIONAL
MARKET SYSTEM, THE VALUE OF OUR CAPITAL STOCK AND OUR ABILITY TO CONTINUE TO
SELL SUBORDINATED DEBENTURES WOULD BE NEGATIVELY IMPACTED.
Since our common stock is listed on the NASDAQ National Market System,
we are required to meet certain requirements established by the NASDAQ Stock
Market in order to maintain this listing. These requirements include, among
other things, maintenance of stockholders' equity of $10.0 million, a minimum
bid price of $1.00 and a market value of publicly held shares of $5.0 million.
On April 1, 2004, we received a notice from the NASDAQ Stock Market
that we were not in compliance with the requirement for continued listing of our
common stock on the NASDAQ National Market System on the basis that we have not
met the requirement that the minimum market value of our publicly held shares
equal at least $5.0 million. Under NASDAQ Marketplace Rules, we had 90 days, or
until June 28, 2004, to become compliant with this requirement for a period of
10 consecutive trading days. On June 15, 2004, we advised the NASDAQ Stock
Market that we had been in compliance with this requirement for 10 consecutive
trading days and we withdrew our application to list our common stock on the
American Stock Exchange, referred to as AMEX in this document, which application
we filed with AMEX upon our receipt of the letter from the NASDAQ Stock Market
described above. On June 24, 2004, we received a letter from the staff of the
NASDAQ Stock Market confirming that we had regained compliance with the NASDAQ
continued listing requirement related to the market value of our publicly held
shares and were not subject to delisting.
There can be no assurance that we will be in compliance with the
$10.0 million stockholders' equity requirement on September 30, 2004. We are
considering a new exchange offer in order to maintain compliance with this
listing requirement.
If we are unable to maintain our listing on the NASDAQ National Market
System, the value of our capital stock and our ability to continue to sell
subordinated debentures would be negatively impacted by making the process of
complying with the state securities laws more difficult, costly and time
consuming. As a result, we may be unable to continue to sell subordinated
debentures in certain states, which would have a material adverse effect on our
liquidity and our ability to repay maturing debt when due.
OUR ESTIMATES OF THE VALUE OF INTEREST-ONLY STRIPS AND SERVICING RIGHTS WE
RETAIN WHEN WE SECURITIZE LOANS COULD BE INACCURATE AND COULD LIMIT OUR ABILITY
TO OPERATE PROFITABLY, IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND
NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
We generally retain interest-only strips and may retain servicing
rights in the securitization transactions we complete. We estimate the fair
value of the interest-only strips and servicing rights based upon discount
rates, prepayment and credit loss rate assumptions established by the management
of our company. The value of our interest-only strips totaled $459.1 million and
the value of our servicing rights totaled $73.7 million at June 30, 2004.
Together, these two assets represented 51.1% of our total assets at June 30,
2004. Although we believe that these amounts represent the fair value of these
assets, the amounts were estimated based on discounting the expected cash flows
to be received in connection with our securitizations using discount rate,
prepayment rate and credit loss rate assumptions established by us. Changes in
market interest rates may impact our discount rate assumptions and our actual
prepayment and default experience may vary materially from these estimates. Even
a small unfavorable change in these assumptions could have a significant adverse
impact on the value of these assets. In the event of an unfavorable change in
these assumptions, the fair value of these assets would be overstated, requiring
an accounting adjustment, consisting of a corresponding reduction in pre-tax
income or stockholders' equity or both in the period of adjustment. Adjustments
to income could impair our ability to repay our outstanding debt and negatively
impact the value of our capital stock.
42
During fiscal 2004, we recorded a write down of $63.8 million on our
securitization assets. The write down consisted of a $46.4 million reduction of
pre-tax income and a $17.4 million pre-tax reduction of other comprehensive
income, a component of stockholders' equity. The write down was mainly due to
actual prepayment experience that was higher than anticipated. During fiscal
2003, we recorded a write down of $63.3 million on our securitization assets.
The write down consisted of a $45.2 million reduction of pre-tax income and an
$18.1 million pre-tax reduction of stockholders' equity. The write down was
mainly due to actual prepayment experience that was higher than our assumptions,
but was reduced by the favorable valuation impact of reducing the discount rates
used to value our securitization assets at June 30, 2003. We cannot predict with
certainty what our future prepayment experience will be. Any unfavorable
difference between the assumptions used to value our securitization assets and
our actual experience may have a significant adverse impact on the value of
these assets. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Impact of Changes in Critical Accounting Estimates
in Prior Fiscal Years" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Securitizations" for information on the
sensitivities of interest-only strips and servicing rights to changes in
assumptions. In addition, our servicing rights (and the related fees) can be
terminated under certain circumstances, such as failure to make required
servicer payments, defined changes in control and reaching certain loss and
delinquency levels on the underlying pool. See "-- Our servicing rights may be
terminated if we fail to satisfactorily perform our servicing obligations, or
fail to meet minimum net worth requirements or financial covenants which could
hinder our ability to operate profitably, impair our ability to repay our
outstanding debt and negatively impact the value of our capital stock."
LENDING TO CREDIT-IMPAIRED BORROWERS MAY RESULT IN HIGHER DELINQUENCIES IN OUR
TOTAL PORTFOLIO, WHICH COULD HINDER OUR ABILITY TO OPERATE PROFITABLY, IMPAIR
OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE OF OUR
CAPITAL STOCK.
We market a significant portion of our loans to borrowers who are
either unable or unwilling to obtain financing from traditional sources, such as
commercial banks. This type of borrower is commonly referred to as a subprime
borrower. Loans made to subprime borrowers, which are commonly referred to as
subprime loans, may entail a higher risk of delinquency and loss than loans made
to borrowers who use traditional financing sources. Financial institutions
utilize a credit rating system referred to as a FICO score to evaluate the
creditworthiness of borrowers and as a means to establish the risk associated
with lending to a particular borrower. The higher the FICO score, which can
range from 300 to 850, the more creditworthy the borrower is. Generally,
borrowers with FICO scores of 720 to 850 would receive the most favorable
interest rates. During fiscal 2004, the average FICO score of our subprime home
mortgage borrowers was 623. According to Standard & Poor's, subprime lenders
issued securitized transactions with mixed collateral (fixed and adjustable rate
mortgage loans) with a range of average FICO scores between 584 and 642 during
the second quarter of calendar 2004. Historically, we have experienced higher
rates of delinquency on these subprime loans as compared to delinquency rates
experienced by banks on loans to borrowers who are not credit-impaired. While we
use underwriting standards and collection procedures designed to mitigate the
higher credit risk associated with subprime loans, our standards and procedures
may not offer adequate protection against risks of default. When we securitize
loans we continue to bear some exposure to delinquencies and losses through our
securitization assets, which are accounted for through our credit loss
assumptions. Higher than anticipated delinquencies, foreclosures or losses in
our total portfolio could reduce the cash flow we receive from our
securitization assets which would hinder our ability to operate profitably,
restrict our ability to repay our outstanding debt and negatively impact the
value of our capital stock. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Total Portfolio Quality" and
"Business -- Lending Activities."
43
DELINQUENCIES AND PREPAYMENTS IN THE POOLS OF SECURITIZED LOANS COULD ADVERSELY
AFFECT THE CASH FLOW WE RECEIVE FROM OUR INTEREST-ONLY STRIPS, IMPAIR OUR
ABILITY TO SELL OR SECURITIZE LOANS IN THE FUTURE, IMPAIR OUR ABILITY TO REPAY
OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
We re-acquire the risks of delinquency and default for non-performing
loans that we determine to repurchase from the securitization trusts. Levels of
delinquencies or losses in a particular securitized pool of loans, which exceed
maximum percentage limits, or "triggers," set in the securitization agreement
governing that pool, impact some or all of the cash that we would otherwise
receive from our interest-only strips. If delinquencies or losses exceed maximum
limits, the securitization trust withholds cash from our interest-only strips.
The trust then uses the cash to repay outside investors, which reduces the
proportionate interest of outside investors in the pool and results in
additional overcollateralization. Additionally, for losses, the securitization
trust utilizes cash from our interest-only strips to pay off investors. Our
receipt of cash payments on the interest-only strip resumes when the additional
overcollateralization created for outside investors meets specified targets or
delinquency and loss rates for the pool of loans no longer exceed trigger
levels. However, to adequately fund our ongoing operations during a period of
suspended cash flow, we may need to borrow funds to replace the cash being
withheld. The additional interest expense would hinder our ability to operate
profitably, could impair our ability to repay our outstanding debt and
negatively impact the value of our capital stock. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Securitizations
-- Trigger Management."
We have the ability to repurchase a limited number of delinquent loans
from securitized pools. This ability to repurchase loans enables us to avoid
disruptions in securitization cash flows by repurchasing delinquent loans before
trigger limits are reached, or to restore suspended cash flows by repurchasing
sufficient delinquent loans to lower delinquency and loss rates below trigger
limits. However, the repurchase of loans for this purpose, called "trigger
management," would require funding from the same sources we rely on for our
other cash needs and could require us to borrow additional funds. If funds were
not available to permit us to repurchase these loans, our cash flow from the
interest-only strips would be reduced, our ability to repay our outstanding debt
could be impaired and the value of our capital stock could be negatively
impacted. Lack of liquidity in these circumstances could result in more pools
reaching trigger levels, which, in turn, would further tighten liquidity.
At June 30, 2004, four of our twenty-six mortgage securitization trusts
were under a triggering event as a result of delinquencies exceeding specified
levels. There were no securitization trusts exceeding specified loss levels at
June 30, 2004. At June 30, 2003, none of our mortgage securitization trusts were
under a triggering event. Approximately $8.0 million of excess
overcollateralization is being held by the four trusts as of June 30, 2004. For
the fiscal years ended June 30, 2004 and 2003, we repurchased delinquent loans
and real estate owned with an aggregate unpaid principal balance of $54.0
million and $55.0 million, respectively, from securitization trusts primarily
for trigger management. We cannot predict when the four trusts currently
exceeding triggers will be below trigger limits and release the excess
overcollateralization. In order for these trusts to release the excess
overcollateralization, delinquent loans would need to decline, or we would need
to repurchase delinquent loans of up to $10.4 million as of June 30, 2004. We
received $40.9 million and $37.6 million of proceeds from the liquidation of
repurchased loans and real estate owned in fiscal 2004 and fiscal 2003,
respectively.
44
While our managed portfolio has significantly decreased and we
anticipate that the amount of loans repurchased from securitization trust will
decline, if delinquencies increase and we cannot cure the delinquency or
liquidate the loans in the mortgage securitization trusts without exceeding loss
triggers, the levels of repurchases required to manage triggers may increase.
Our ability to continue to manage triggers in our securitization trusts in the
future is affected by our availability of cash from operations or through the
sale of subordinated debentures to fund these repurchases.
Prepayments by borrowers also make it more difficult for us to maintain
delinquencies below trigger limits set in securitization agreements. During
fiscal 2004 and fiscal 2003, $1.3 billion and $1.0 billion, respectively, of our
loans were prepaid by the borrowers prior to maturity. By reducing current loans
in a securitized pool, prepayments mathematically increase the percentage of
delinquent loans remaining in the pool. The consequences resulting from either a
suspension of cash flow or our repurchase of delinquent loans from the
securitized pool could impair our ability to repay our outstanding debt and
negatively impact the value of our capital stock. We currently anticipate that
the level of prepayments and prepayment speeds will decline based on current
economic conditions and published mortgage industry surveys including the
Mortgage Bankers Association's Refinance Indexes available at the time of our
quarterly revaluation of our interest-only strips and servicing rights, and our
own prepayment experience. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Securitizations -- Trigger
Management," "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Total Portfolio Quality," "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Securitizations"
and "Business -- Lending Activities."
AN INTERRUPTION OR REDUCTION IN THE WHOLE LOAN SALE OR SECURITIZATION MARKETS
WOULD HINDER OUR ABILITY TO OPERATE PROFITABLY AND REPAY OUR OUTSTANDING DEBT
WHICH WOULD NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
A significant portion of our revenue and net income represents gain on
the sale of loans. Our strategy is to sell substantially all of the loans we
originate at least quarterly. Operating results for a given period can fluctuate
significantly as a result of the timing and size of whole loan sales or
securitizations. If we do not close whole loan sales or securitizations on a
quarterly basis, we could experience a loss for that quarter. In addition, we
rely on the quarterly sale of our loans to generate cash proceeds for the
repayment of our warehouse credit facilities and origination of additional
loans.
Our ability to complete securitizations depends on several factors,
including:
o conditions in the securities markets generally, including
market interest rates;
o conditions in the asset-backed securities markets
specifically;
o general economic conditions, including conditions in the
subprime industry;
o our financial condition;
o the performance of our previously securitized loans;
o the credit quality of our total portfolio; and
o changes in federal tax laws.
If we are not able to sell substantially all of the loans that we
originate during the quarter in which the loans are made, we would likely not be
profitable for the quarter. Any substantial impairment in the size or
availability of the market for our loans could result in our inability to
continue to originate loans, repay our outstanding debt which would have a
material adverse effect on our results of operations, financial condition and
business prospects and would negatively impact the value of our capital stock.
If it is not possible or economical for us to complete a whole loan sale or
securitization within favorable timeframes, we may exceed our capacity under our
warehouse financing and lines of credit. We may be required to sell the
accumulated loans at a time when market conditions for our loans are less
favorable, and potentially to incur a loss on the sale transaction. If we cannot
generate sufficient liquidity upon any such loan sale or through the sale of
additional subordinated debentures, we will be required to restrict or
restructure our operations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources" and "Business -- Securitizations."
45
IF WE ARE UNABLE TO SUCCESSFULLY IMPLEMENT OUR ADJUSTED BUSINESS STRATEGY WHICH
FOCUSES ON WHOLE LOAN SALES, WE MAY BE UNABLE TO ATTAIN PROFITABLE OPERATIONS
WHICH COULD IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND COULD
NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
Our adjusted business strategy seeks to increase our loan volume by
broadening our loan product line, offering more competitive interest rates and
through further development of existing markets while maintaining our
origination fees, underwriting criteria and the interest rate spread between
loan interest rates and the interest rates we pay for capital. Implementation of
this strategy will depend in large part on our ability to:
o broaden our mortgage loan product line and increase
originations of loans;
o obtain additional financing to fund our operations;
o manage the mix of loans originated in order to maximize the
timing and levels of advances under our credit facilities and
to appeal to a broader group of borrowers;
o expand in markets with a sufficient concentration of borrowers
who meet our underwriting criteria;
o maintain adequate financing on reasonable terms to fund our
loan origination;
o profitably sell our loans through whole loan sales on a
regular basis;
o hire, train and retain skilled employees; and
o successfully implement our marketing campaigns.
Our inability to achieve any or all of these factors could impair our
ability to successfully implement our adjusted business strategy and
successfully leverage our fixed costs which could hinder our ability to operate
profitably, result in continued losses and impair our ability to repay our
outstanding debt and could negatively impact the value of our capital stock. If
we fail to successfully implement our adjusted business strategy, we will be
required to consider other alternatives, including raising equity, seeking to
convert a portion of our subordinated debentures to equity, seeking protection
under federal bankruptcy laws, seeking a strategic investor, or exploring a sale
of the company or some or all of its assets.
CHANGES IN INTEREST RATES COULD NEGATIVELY IMPACT OUR ABILITY TO OPERATE
PROFITABLY, IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND COULD
NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
Rising interest rates could reduce our overall profitability in one or more of
the following ways:
o reducing the demand for our loan products, which could reduce
our profitability;
o causing investors in asset-backed securities to increase the
interest rate spread requirements and overcollateralization
requirements for our future securitizations, which could
reduce the profitability of our securitizations;
o increasing interest rates required by purchasers of our loans
in whole loan sales;
o reducing the spread between the interest rates we receive on
loans we originate and the interest rates we pay to fund the
originations, which among other effects, increases our
carrying costs for these loans during the period they are
being pooled for securitization;
46
o increasing the interest rates we must pay on our subordinated
debentures to attract investors at the levels we require to
fund our operations;
o increasing our interest expense on all sources of borrowed
funds, such as subordinated debentures, credit facilities and
lines of credit, and could restrict our access to the capital
markets;
o negatively impacting the value and profitability of loans from
the date of origination until the date we sell the loans;
o reducing the spread between the average interest rate on the
loans in a securitization pool and the pass-through interest
rate to investors issued in connection with the securitization
(This reduction in the spread occurs because interest rates on
loans in a securitization pool are typically set over the
three months preceding a securitization while the pass-through
rate on securities issued in the securitization is based on
market rates at the time a securitization is priced.
Therefore, if market interest rates required by investors
increase prior to securitization of the loans, the interest
rate spread between the average interest rate on the loans and
the pass-through interest rate to investors may be reduced or
eliminated. This factor would reduce our profit on the sale of
the loans. Any reduction in our profitability could impair our
ability to repay our outstanding debt and could negatively
impact the value of our capital stock); and
o increasing the cost of floating rate certificates issued in
certain securitizations without a corresponding increase in
the interest income of the underlying fixed rate loan
collateral (This situation would reduce the cash flow we
receive from the interest-only strips related to those
securitizations and reduce the fair value or expected future
cash flow of that asset as well. At June 30, 2004, floating
interest rate certificates represented 12.6% of total debt
issued by loan securitization trusts. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Interest Rate Risk Management" for further
discussion of the impact on our interest-only strips of
interest rate changes in floating interest rate certificates
issued by securitization trusts and outstanding debt issued by
the securitization trusts).
Declining interest rates could reduce our profitability in one or more of the
following ways:
o subordinated debentures with terms of one year or more which
are not redeemable at our option represent an unfavorable
source of borrowing in an environment where market rates fall
below those paid on the subordinated debentures (At June 30,
2004, $15.3 million in non-redeemable subordinated debentures
with maturities of greater than one year was outstanding.);
and
o a decline in market interest rates generally induces borrowers
to refinance their loans, which are held in the securitization
trusts, and could reduce our profitability; prepayment levels
in excess of our assumptions reduce the value of our
securitization assets. A significant decline in market
interest rates would increase the level of loan prepayments,
which would decrease the size of the total managed loan
portfolio and the related projected cash flows. Higher than
anticipated rates of loan prepayments could require a write
down of the fair value of the related interest-only strips and
servicing rights, adversely impacting earnings during the
period of adjustment which would result in a reduction in our
profitability, could impair our ability to repay our
outstanding debt and could negatively impact the value of our
capital stock (See " -- Our estimates of the value of
interest-only strips and servicing rights we retain when we
securitize loans could be inaccurate and could limit our
ability to operate profitably, impair our ability to repay our
outstanding debt and negatively impact the value of our
capital stock.").
47
Although both rising and falling interest rates negatively impact our
business and profitability, the speed at which rates fluctuate, the duration of
high or low interest rate environments and the nature and magnitude of any
favorable interest rate consequences, as well as economic events and business
conditions outside of our control, affect the overall manner in which interest
rate changes impact our operations and the magnitude of such impact. In
addition, because of the volatile and unpredictable manner in which these
factors interact, we may experience interest rate risks in the future that we
have not previously experienced or identified. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Interest Rate Risk
Management."
OUR SECURITIZATION AGREEMENTS IMPOSE OBLIGATIONS ON US TO MAKE CASH OUTLAYS
WHICH COULD IMPAIR OUR ABILITY TO OPERATE PROFITABLY AND OUR ABILITY TO REPAY
OUR OUTSTANDING DEBT AND COULD NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
Our securitization agreements require us to replace or repurchase loans
which do not conform to representations and warranties we made in the
agreements. Additionally, as servicer, we are required to:
o compensate investors for interest shortfalls on loan
prepayments (up to the amount of the related servicing fee);
and
o advance interest payments for delinquent loans if we believe
in good faith the advances will ultimately be recoverable by
the securitization trust. These advances can first be made out
of funds available in the trusts' collection accounts. If the
funds available from the trusts' collection accounts are
insufficient to make the required advances, then we are
required to make the advances from our operating cash. The
advances made from the trusts' collection accounts, if not
recovered from the borrowers or proceeds from the liquidation
of the loans, require reimbursement from us. These advances,
if ultimately not recoverable by us, require funding from our
capital resources and may create greater demands on our cash
flow, which could limit our ability to repay our outstanding
debt and could negatively impact the value of our capital
stock. See "Business -- Securitizations."
In fiscal 2004, our cash expenditures related to our securitization
agreements constituted less than $100,000. We do not anticipate that these cash
outlays will increase significantly in the foreseeable future.
OUR SERVICING RIGHTS MAY BE TERMINATED IF WE FAIL TO SATISFACTORILY PERFORM OUR
SERVICING OBLIGATIONS, OR FAIL TO MEET MINIMUM NET WORTH REQUIREMENTS OR
FINANCIAL COVENANTS WHICH COULD HINDER OUR ABILITY TO OPERATE PROFITABLY, IMPAIR
OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE OF OUR
CAPITAL STOCK.
As part of the securitization of our loans, we may retain the servicing
rights, which is the right to service the loans for a fee. At June 30, 2004,
85.5% of the total portfolio we serviced was owned by third parties. The value
of servicing rights related to our total portfolio is an asset on our balance
sheet called servicing rights. We enter into agreements in connection with the
securitizations that allow bond insurers to terminate us as the servicer if we
breach our servicing obligations, fail to perform satisfactorily or fail to meet
a minimum net worth requirement or other financial covenants. For example, our
servicing rights may be terminated if losses on the pool of loans in a
particular securitization exceed prescribed levels for specified periods of
time. Since October 2003 we have been out of compliance with the net worth
covenant in the servicing agreements associated with one bond insurer and we
have obtained a waiver from this bond insurer for this noncompliance on a
monthly basis in order to continue as servicer under these servicing agreements.
We anticipate having to obtain this waiver on a monthly basis for the
foreseeable future. There can be no assurances that we will continue to receive
the waivers necessary to operate or that such waivers will not contain
conditions that are unacceptable to us.
48
As a result of recent amendments to our servicing agreements, all of
our servicing agreements associated with the bond insurers now provide for
term-to-term servicing and, in the case of our servicing agreements with two
bond insurers, our rights as a servicer may be terminated at the expiration of a
servicing term in the sole discretion of the bond insurer. During fiscal 2004,
we did not experience any termination of servicing rights pursuant to existing
term-to-term servicing agreements. There can be no assurances that we will
continue to receive the servicing agreement extensions we need to operate or
that they will not contain conditions that are unacceptable to us. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
If we lose the right to service some or all of the loans in our total
portfolio, the servicing fees will no longer be paid to us and we would be
required to write down or write off this asset, which would decrease our
earnings and our net worth, impair our ability to repay our outstanding debt and
negatively impact the value of our capital stock. In addition, if we do not meet
eligibility criteria to act as servicer in future securitizations, we would not
receive income from these future servicing rights.
IF WE ARE NOT ABLE TO EXCEED THE LEVELS OF LOAN ORIGINATIONS THAT WE EXPERIENCED
IN THE PAST, WE MAY BE UNABLE TO ATTAIN PROFITABLE OPERATIONS AND OUR ABILITY TO
REPAY OUR OUTSTANDING DEBT MAY BE IMPAIRED AND THE VALUE OF OUR CAPITAL STOCK
WOULD BE NEGATIVELY IMPACTED.
During fiscal 2003 and 2002, we experienced record levels of loan
originations. As a result of our liquidity issues, our loan volume for fiscal
2004 decreased substantially. During fiscal 2004, we originated $982.7 million
of loans as compared to originations of $1.67 billion of loans in fiscal 2003.
We anticipate that depending upon the size of our future quarterly
securitizations, if any, we will need to increase our loan originations to
approximately $400.0 million to $500.0 million per month to return to profitable
operations. If we are unable to complete quarterly securitizations, we will need
to increase our loan originations to approximately $500.0 million to $600.0
million per month to return to profitability. Our ability to achieve the level
of loan originations necessary to obtain profitable operations depends upon a
variety of factors, some of which are outside our control, including:
o interest rates;
o our ability to manage the mix of loans originated in order to
maximize the timing and levels of advances under our credit
facilities and to appeal to a broader group of borrowers;
o our ability to broaden our mortgage loan product line;
o our ability to originate loans, which have the characteristics
that qualify for us to obtain advances under our new credit
facilities (including higher loan-to-value ratios than those
originated in the past);
o our ability to obtain additional financing on reasonable
terms;
o conditions in the asset-backed securities markets;
o our ability to attract and retain qualified personnel;
o economic conditions in our primary market area;
o competition; and
o regulatory restrictions.
49
To the extent that we are not successful in maintaining or replacing
outstanding debt upon maturity, increasing and maintaining adequate warehouse
credit facilities or lines of credit to fund increasing loan originations, or
securitizing and selling our loans, we may have to limit future loan
originations and further restructure our operations. If we are unable to attain
the level of loan originations of approximately $400.0 to $500.0 million per
month with a securitization or approximately $500.0 million to $600.0 million
per month without a securitization, we may be unable to attain profitable
operations, our ability to repay our outstanding debt may be impaired and the
value of our capital stock would be negatively impacted. See "-- Changes in
interest rates could negatively impact our ability to operate profitably, impair
our ability to repay our outstanding debt and could negatively impact the value
of our capital stock."
THE LOANS WE RECENTLY ORIGINATED ARE UNSEASONED AND MAY HAVE HIGHER DELINQUENCY
AND DEFAULT RATES THAN MORE SEASONED LOAN PORTFOLIOS, WHICH COULD RESULT IN
LOSSES ON LOANS THAT ARE REQUIRED TO BE REPURCHASED BY US UNDER RECOURSE
PROVISIONS AND WHICH MAY IMPACT OUR ABILITY TO SELL LOANS IN THE SECONDARY
MARKET WHICH WOULD NEGATIVELY IMPAIR OUR ABILITY TO REPAY OUTSTANDING DEBT AND
IMPACT THE VALUE OF OUR CAPITAL STOCK.
The mortgage loans which we recently originated are unseasoned and may
have higher delinquency and default rates than seasoned mortgage loans.
Delinquency interrupts the flow of projected interest income from a mortgage
loan, and default can ultimately lead to a loss if the net realizable value of
the real property securing the mortgage loan is insufficient to cover the
principal and interest due on the loan. We start bearing the risk of delinquency
and default on loans when we originate them. Some whole loan sale agreements we
enter into with purchasers may include limited recourse provisions obligating us
to repurchase loans at the sale price in the event of unfavorable delinquency
performance of the loans sold or to refund premiums if a sold loan prepays
within a specified period. The duration of these obligations typically ranges
from 60 days to one year from the date of the loan sale. We reserve for these
premium obligations at the time of sale through an expense charge against the
gain on sale. In fiscal 2004, we had sold approximately $803.7 million of loans
under agreements containing recourse provisions, of which $624.0 million of
loans were still subject to recourse provisions at June 30, 2004. The remaining
$4.7 million of whole loan sales during fiscal 2004 were without recourse.
We attempt to manage these risks with risk-based loan pricing and
appropriate underwriting policies and loan collection methods. However, if such
policies and methods are insufficient to control our delinquency and default
risks and do not result in appropriate loan pricing and appropriate loss
reserves, our ability to repay our outstanding debt will be negatively impaired
and the value of our capital stock will be negatively impacted.
A DECLINE IN REAL ESTATE VALUES COULD RESULT IN A REDUCTION IN OUR LOAN
ORIGINATIONS, WHICH COULD HINDER OUR ABILITY TO ATTAIN PROFITABLE OPERATIONS,
IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE
OF OUR CAPITAL STOCK.
Our business may be adversely affected by declining real estate values.
Any significant decline in real estate values reduces the ability of borrowers
to use home equity as collateral for borrowings. This reduction in real estate
values may reduce the number of loans we are able to make, which will reduce the
gain on sale of loans and servicing and origination fees we will collect, which
could hinder our ability to attain profitable operations, limit our ability to
repay our outstanding debt and negatively impact the value of our capital stock.
See "Business -- Lending Activities."
50
A DECLINE IN VALUE OF THE COLLATERAL SECURING OUR LOANS COULD RESULT IN AN
INCREASE IN LOSSES ON FORECLOSURE, WHICH COULD HINDER OUR ABILITY TO ATTAIN
PROFITABLE OPERATIONS, LIMIT OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND
NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
Declining real estate values will increase the loan-to-value ratios of
loans we previously made, which in turn, increases the probability of a loss in
the event the borrower defaults and we have to sell the mortgaged property. In
addition, delinquencies, foreclosures on loans and losses from delinquent and
foreclosed loans generally increase during economic slowdowns or recessions, and
the increase in delinquencies, foreclosures on loans and losses from delinquent
and foreclosed loans we experience may be particularly pronounced because we
lend to credit-impaired borrowers. As a result, the market value of the real
estate or other collateral underlying our loans may not, at any given time, be
sufficient to satisfy the outstanding principal amount of the loans which could
hinder our ability to attain profitable operations, limit our ability to repay
our outstanding debt and negatively impact the value of our capital stock. In
addition, 89.9% of our loans originated during fiscal 2004 were secured by first
mortgages and 10.1% of our loans originated during fiscal 2004 were secured by
second mortgages. Our loans secured by second mortgages are more frequently
subject to delinquencies and losses on foreclosure than the loans secured by
first mortgages. Any sustained period of increased delinquencies, foreclosures
or losses from delinquent and foreclosed loans could adversely affect our
ability to sell loans, the prices we receive for our loans or the value of our
interest-only strips which could have a material adverse effect on our results
of operations, financial condition and business prospects. See "Business --
Lending Activities."
THE AMOUNT OF OUR OUTSTANDING DEBT COULD IMPAIR OUR FINANCIAL CONDITION, OUR
ABILITY TO FULFILL OUR DEBT AND DIVIDEND OBLIGATIONS AND COULD NEGATIVELY IMPACT
THE VALUE OF OUR CAPITAL STOCK.
As of June 30, 2004, we had total indebtedness of approximately $847.4
million, comprised of amounts outstanding under our warehouse lines,
subordinated debentures, senior collateralized subordinated notes issued in the
exchange offers through June 30, 2004, convertible promissory notes and
capitalized lease obligations. At June 30, 2004, our ratio of total debt and
liabilities to equity was approximately 86.5 to 1. At June 30, 2004, we also had
availability to incur additional indebtedness of approximately $210.4 million
under our revolving warehouse and credit facilities. In fiscal 2005, we will be
obligated to pay $615.9 million of interest and principal on maturing debt
outstanding at June 30, 2004 and $10.9 million of dividends on Series A
preferred stock outstanding at June 30, 2004. If we issue $275.0 million of
additional subordinated debentures during fiscal 2005, we would expect to
increase the amount of interest payable in the next twelve months by
approximately $14.0 million. In addition, during fiscal 2004, we were required
to pay fees and expenses of lenders of $23.3 million in order to maintain
existing and obtain new credit facilities. During fiscal 2005, these fees and
expenses are estimated to be approximately $30.0 million.
The amount of our outstanding indebtedness could:
o require us to dedicate a substantial portion of our cash flow
to the payment of interest, principal and fees on our
indebtedness, thereby reducing the availability of our cash
flow to fund working capital, capital expenditures and other
general corporate requirements, including the payment of
dividends on our capital stock;
o limit our flexibility in planning for, or reacting to, changes
in operations and the subprime industry in which we operate;
and
o place us at a competitive disadvantage compared to our
competitors that have proportionately less debt.
51
In addition, the interest expense resulting from additional outstanding
debt and fees and expenses of lenders payable in order to maintain our credit
facilities would reduce our profitability and could impair our ability to repay
our outstanding debt as it matures. If we are unable to meet our debt service
obligations, we could be forced to restructure or refinance our indebtedness,
seek additional equity capital or sell assets. Our ability to obtain additional
financing could be limited to the extent that our interest-only strips, which
represent a significant portion of our assets, are pledged to secure our
obligation in an amount not to exceed 10% of the outstanding principal balance
of, and the payment of fees on, our $250.0 million credit facility and a portion
of the cash flows from our interest-only strips is pledged to secure the senior
collateralized subordinated notes issued in the exchange offers. Our inability
to obtain financing or sell assets on satisfactory terms could impair our
ability to operate profitably and our ability to repay our outstanding debt and
could negatively impact the value of our capital stock. See "-- We depend upon
the availability of financing to fund our continuing operations. Any failure to
obtain adequate funding could hurt our ability to operate profitably, restrict
our ability to repay our outstanding debt and negatively impact the value of our
capital stock."
WE DO NOT CURRENTLY PAY CASH DIVIDENDS ON OUR COMMON STOCK AND DO NOT ANTICIPATE
DOING SO IN THE FORESEEABLE FUTURE.
During the first quarter of fiscal 2004, we suspended paying cash
dividends on our common stock and we do not anticipate paying any cash dividends
on the common stock in the foreseeable future. As a Delaware corporation, we may
not declare and pay dividends on our capital stock if the amount paid exceeds an
amount equal to the surplus which represents the excess of our net assets over
paid-in-capital or, if there is no surplus, our net profits for the current
and/or immediately preceding fiscal year. Under applicable Delaware case law,
dividends may not be paid on our common stock if we become insolvent or the
payment of dividends will render us insolvent. As a result, to the extent that
we continue to experience losses, we may be prohibited from paying dividends on
our common stock under applicable Delaware law. In addition, the terms of Series
A preferred stock issued by us in the exchange offers may restrict the payment
of dividends on our common stock. See "-- We have issued 109.4 million shares of
the Series A preferred stock in the exchange offers, which have dividend rights
and rights upon liquidation which rank senior to our common stock."
WE HAVE ISSUED 109.4 MILLION SHARES OF THE SERIES A PREFERRED STOCK IN THE
EXCHANGE OFFERS, WHICH HAVE DIVIDEND RIGHTS AND RIGHTS UPON LIQUIDATION WHICH
RANK SENIOR TO OUR COMMON STOCK.
Our board of directors has designated 200,000,000 shares of preferred
stock as Series A preferred stock. As of August 23, 2004, 109.4 million shares
of the Series A preferred stock were outstanding as a result of the exchange
offers. Upon any voluntary or involuntary liquidation, dissolution or winding up
of our affairs, before any payment to holders of common stock, the holders of
the Series A preferred stock will be entitled to receive a liquidation
preference of $1.00 per share, plus accrued and unpaid dividends, if any, to the
date of final distribution to such holders.
We pay monthly cash dividend payments to the Series A preferred
stockholders of $0.008334 per share of the Series A preferred stock, subject to
compliance with applicable Delaware law. We are required to pay the cumulative
amount of any unpaid dividends upon liquidation of the Series A preferred stock,
or the appropriate adjustment, which takes into account unpaid dividends, will
be made upon the redemption or conversion of the Series A preferred stock. As
long as shares of the Series A preferred stock are outstanding, no dividends
will be declared or paid on our common stock unless all monthly dividends
accrued and unpaid on outstanding shares of the Series A preferred stock have
been paid in full.
52
ISSUANCE OF SHARES OF OUR COMMON STOCK UPON THE CONVERSION OF THE SERIES A
PREFERRED STOCK WILL RESULT IN SIGNIFICANT DILUTION OF EQUITY INTERESTS OF
EXISTING HOLDERS OF OUR COMMON STOCK, REDUCE THE PROPORTIONATE VOTING POWER OF
EXISTING HOLDERS OF OUR COMMON STOCK AND MAY DECREASE THE MARKET VALUE PER SHARE
OF OUR COMMON STOCK.
On or after the second anniversary of the issuance date (or on or after
the one year anniversary of the issuance date if no dividends are paid on the
Series A preferred stock outstanding on such date), the holder of shares of the
Series A preferred stock has an option to convert each share of the Series A
preferred stock into a number of shares of common stock determined by dividing:
(A) $1.00 plus an amount equal to accrued but unpaid dividends (if the
conversion date is prior to the second anniversary of the issuance date because
the Series A preferred stock has become convertible due to failure to pay
dividends), $1.20 plus an amount equal to accrued but unpaid dividends (if the
conversion date is prior to the third anniversary of the issuance date but on or
after the second anniversary of the issuance date) or $1.30 plus an amount equal
to accrued but unpaid dividends (if the conversion date is on or after the third
anniversary of the issuance date) by (B) the market price of a share of our
common stock (which figure shall not be less than $5.00 per share regardless of
the actual market price, such $5.00 minimum figure to be subject to adjustments
for stock splits, including reverse stock splits) on the conversion date.
To the extent that holders of the Series A preferred stock issued in
the exchange offers exercise their conversion rights described above, the
maximum number of shares into which 109.4 million shares of the Series A
preferred stock issued in the exchange offers may be converted is 28.5 million
shares of common stock based upon the conversion price of $1.30 per share, a
market price of $5.00 per share and assuming the payment of all dividends on the
shares of the Series A preferred stock currently outstanding. The issuance of
28.5 million shares of common stock will result in significant dilution of
equity interests of existing holders of our common stock, reduce the
proportionate voting power of existing holders of our common stock and may
decrease the market value per share of our common stock.
If we are unable to continue paying dividends on the Series A preferred
stock outstanding, this could result in the Series A preferred stock outstanding
being converted into shares of our common stock prior to the second anniversary
of the issuance date of the Series A preferred stock.
WE MAY ISSUE ADDITIONAL PREFERRED STOCK WHICH COULD BE ENTITLED TO DIVIDENDS,
LIQUIDATION PREFERENCES AND OTHER SPECIAL RIGHTS AND PREFERENCES NOT SHARED BY
HOLDERS OF OUR COMMON STOCK OR WHICH COULD HAVE ANTI-TAKEOVER EFFECTS.
We are authorized to issue up to 3,000,000 shares of blank check
preferred stock, in addition to 200,000,000 shares of preferred stock designated
as Series A preferred stock. See "-- We have issued 109.4 million shares of the
Series A preferred stock in the exchange offers, which have dividend rights and
rights upon liquidation which rank senior to our common stock." We may issue
shares of preferred stock in one or more series as our board of directors may
from time to time determine without stockholder approval. The voting powers,
preferences and other special rights and the qualifications, limitations or
restrictions of each such series of preferred stock may differ from those of the
Series A preferred stock and all other series of preferred stock at any time
outstanding. The issuance of any such preferred stock could materially adversely
affect the rights of holders of our common stock and could reduce the value of
our capital stock.
Depending on market conditions and our financial condition, we may
engage in additional exchange offers in the future and we are considering
another exchange offer in the fall of 2004, as a result of which we may issue
additional shares of preferred stock.
In addition, specific rights granted to future holders of preferred
stock could be used to restrict our ability to merge with, or sell our assets
to, a third party. The ability of the board of directors to issue preferred
stock could discourage, delay or prevent a takeover of our company, thereby
preserving control of our company by the current stockholders. See "--
Beneficial ownership of 49.7% of our common stock (excluding options) by our
executive officers and directors may limit or preclude a change in control of
our company."
53
THE VALUE OF OUR COMMON STOCK COULD BE ADVERSELY IMPACTED BY THE MARKET
PERCEPTION OF OUR COMPANY.
The market value of our common stock has decreased and may continue to
decrease based on our performance and market perception and conditions. The
market value of our common stock may be based primarily upon the market's
perception of the future viability of our company, our ability to implement our
adjusted business strategy and our ability to reduce our outstanding debt, and
may be secondarily based upon the perceived value of our interest-only strips
which constitute a substantial portion of our assets.
IF WE ARE UNABLE TO IMPLEMENT AN EFFECTIVE HEDGING STRATEGY, WE MAY BE UNABLE TO
ATTAIN PROFITABLE OPERATIONS WHICH WOULD REDUCE THE FUNDS WE HAVE AVAILABLE TO
REPAY OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
IN A DECLINING INTEREST RATE ENVIRONMENT, EVEN AN EFFECTIVE HEDGING STRATEGY
COULD RESULT IN LOSSES IN THE CURRENT PERIOD WHICH COULD IMPAIR OUR ABILITY TO
REPAY OUR OUTSTANDING DEBT AND NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
From time to time we use hedging strategies in an attempt to mitigate
the effect of changes in interest rates on our fixed interest rate mortgage
loans prior to securitization. These strategies may involve the use of, among
other things, derivative financial instruments including futures, interest rate
swaps and forward pricing of securitizations. An effective hedging strategy is
complex and no strategy can completely insulate us from interest rate risk. In
fact, poorly designed strategies or improperly executed transactions may
increase rather than mitigate interest rate risk. Hedging involves transaction
and other costs, and these costs could increase as the period covered by the
hedging protection increases or in periods of rising and fluctuating interest
rates. During fiscal 2004, we recorded gains on the fair value of derivative
financial instruments of $2.5 million and paid $0.8 million of cash in
settlement of derivative financial instruments. We recorded losses on the fair
value of derivative financial instruments of $14.2 million during fiscal 2003
and $9.4 million in fiscal 2002. The amount of losses settled in cash was $7.7
million in fiscal 2003 and $9.4 million in fiscal 2002. In addition, an interest
rate hedging strategy may not be effective against the risk that the interest
rate spread needed to attract potential buyers of asset-backed securities may
widen. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Interest Rate Risk Management."
COMPETITION FROM OTHER LENDERS COULD ADVERSELY AFFECT OUR ABILITY TO ATTAIN
PROFITABLE OPERATIONS AND OUR ABILITY TO REPAY OUR OUTSTANDING DEBT MAY BE
IMPAIRED AND THE VALUE OF OUR CAPITAL STOCK COULD BE NEGATIVELY IMPACTED.
The lending markets in which we compete are evolving. Some competitors
have been acquired by companies with substantially greater resources, lower cost
of funds, and a more established market presence than we have. Government
sponsored entities are expanding their participation in our market. In addition,
we have experienced increased competition over the Internet, where barriers to
entry are relatively low. If these companies or entities increase their
marketing efforts to include our market niche of borrowers, we may be forced to
reduce the interest rates and fees we currently charge in order to maintain and
expand our market share. Any reduction in our interest rates or fees could have
an adverse impact on our profitability and our ability to repay our outstanding
debt may be impaired and the value of our capital stock could be negatively
impacted. As we expand our business further, we will face a significant number
of new competitors, many of whom are well established in the markets we seek to
penetrate. The profitability of other similar lenders may attract additional
competitors into this market.
54
The competition in the subprime lending industry has also led to rapid
technological developments, evolving industry standards, and frequent releases
of new products and enhancements. As loan products are offered more widely
through alternative distribution channels, such as the Internet, we may be
required to make significant changes to our current retail structure, broker
structure and information systems to compete effectively. Our ability to adapt
to other technological changes in the industry could have a material adverse
effect on our business.
The need to increase our loan volume to implement our adjusted business
strategy in this competitive environment creates a risk of price competition in
the subprime lending industry. Competition in the industry can take many forms,
including interest rates and costs of a loan, convenience in obtaining a loan,
customer service, amount and term of a loan, marketing and distribution
channels, and competition in attracting and retaining qualified employees. Price
competition would lower the interest rates that we are able to charge borrowers,
which would lower our interest income. Price-cutting or discounting reduces
profits and will depress earnings if sustained for any length of time. Increased
competition may also reduce the volume of our loan originations and result in a
decrease in gain on sale from the securitization or sale of such loans which
would decrease our income. As a result, any increase in these pricing pressures
could have a material adverse effect on our business. See "Business --
Competition."
AN ECONOMIC DOWNTURN OR RECESSION IN A SMALL NUMBER OF STATES COULD HINDER OUR
ABILITY TO OPERATE PROFITABLY AND REDUCE THE FUNDS AVAILABLE TO REPAY OUR
OUTSTANDING DEBT WHICH COULD NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
In fiscal 2004, we originated 54.5% of our mortgage loans in
California, New York, Pennsylvania, Massachusetts and Florida. The concentration
of loans in these states subjects us to the risk that a downturn in the economy
or recession in these states would more greatly affect us than if our lending
business were more geographically diversified. As a result, an economic downturn
or recession in these states could result in decreases in loan originations and
increases in delinquencies and foreclosures in our total portfolio which could
negatively impair our ability to sell or securitize loans, hinder our ability to
operate profitably, limit the funds available to repay our outstanding debt and
could negatively impact the value of our capital stock. See "Business -- Lending
Activities."
55
OUR OPERATIONS IN A SMALL NUMBER OF STATES COULD BE IMPACTED BY THE OCCURRENCE
OF A NATURAL DISASTER, WHICH COULD HINDER OUR ABILITY TO OBTAIN PROFITABLE
OPERATIONS, IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY
IMPACT THE VALUE OF OUR CAPITAL STOCK.
In fiscal 2004, we originated approximately 37.6% of our mortgage loans
in California, Florida, New Jersey, Texas, and Georgia. The occurrence of a
natural disaster, such as an earthquake or hurricane, in one or more of these
states could result in a decline in loan originations, the declining value or
destruction of the mortgaged properties in these states and an increase in the
risk of delinquency, foreclosure or loss for the loans originated by us, which
could have a material adverse effect on our business, financial conditions and
results of operations. See "Business -- Lending Activities" and "-- A decline in
value of the collateral securing our loans could result in an increase in losses
on foreclosure, which could hinder our ability to attain profitable operations,
limit our ability to repay our outstanding debt and negatively impact the value
of our capital stock."
OUR RESIDENTIAL LENDING BUSINESS IS SUBJECT TO GOVERNMENT REGULATION AND
LICENSING REQUIREMENTS, WHICH MAY HINDER OUR ABILITY TO OPERATE PROFITABLY,
NEGATIVELY IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND NEGATIVELY
IMPACT THE VALUE OF OUR CAPITAL STOCK.
Our residential lending business is subject to extensive regulation,
supervision and licensing by various state departments of banking and other
state, local and federal agencies. Our lending business is also subject to
various laws and judicial and administrative decisions imposing requirements and
restrictions on all or part of our home equity lending activities.
We are also subject to examinations by state departments of banking or
similar agencies in the 46 states where we are licensed or otherwise qualified
with respect to originating, processing, underwriting, selling and servicing
home mortgage loans. We are also subject to Federal Reserve Board, Federal Trade
Commission, Department of Housing and Urban Development and other federal and
state agency regulations related to residential mortgage lending, servicing and
reporting. Failure to comply with these requirements can lead to, among other
remedies, termination or suspension of licenses, rights of rescission for
mortgage loans, class action lawsuits and administrative enforcement actions. In
addition, we are subject to review by state attorneys general and the U.S.
Department of Justice and recently entered into a joint agreement with the Civil
Division of the U.S. Attorney's Office for the Eastern District of Pennsylvania
which ended the inquiry by the U.S. Attorney focused on our forbearance policy
initiated pursuant to the civil subpoena dated May 14, 2003. See "Legal
Proceedings."
State and federal banking regulatory agencies, state attorneys' general
offices, the Federal Trade Commission, the U.S. Department of Justice, the U.S.
Department of Housing and Urban Development and state and local governmental
authorities have increased their focus on lending practices by some companies in
the subprime lending industry, more commonly referred to as "predatory lending"
practices. State, local and federal governmental agencies have imposed sanctions
for practices, including, but not limited to, charging borrowers excessive fees,
imposing higher interest rates than the borrower's credit risk warrants, and
failing to adequately disclose the material terms of loans to the borrowers. For
example, the Pennsylvania Attorney General reviewed fees our subsidiary,
HomeAmerican Credit, Inc., charged Pennsylvania customers. Although we believe
that these fees were fair and in compliance with applicable federal and state
laws, in April 2002, we agreed to reimburse borrowers approximately $221,000
with respect to a particular fee paid by borrowers from January 1, 1999 to
mid-February 2001 and to reimburse the Commonwealth of Pennsylvania $50,000 for
its costs of investigation and for future public protection purposes. We
discontinued charging this particular fee in mid-February 2001. As a result of
these initiatives, we are unable to predict whether state, local or federal
authorities will require changes in our lending practices in the future,
including reimbursement of fees charged to borrowers, or will impose fines on
us. These changes, if required, could impact our profitability. These laws and
regulations may limit our ability to securitize loans originated in some states
or localities due to rating agency, investor or market restrictions. As a
result, we have limited the types of loans we offer in some states and may
discontinue originating loans in other states or localities.
56
Additionally, the United States Congress is currently considering a
number of proposed bills or proposed amendments to existing laws, such as the
"Ney - Lucas Responsible Lending Act of 2003" introduced on February 13, 2003
into the U.S. House of Representatives, which could affect our lending
activities and make our business less profitable. These bills and amendments, if
adopted as proposed, could reduce our profitability by limiting the fees we are
permitted to charge, including prepayment fees, restricting the terms we are
permitted to include in our loan agreements and increasing the amount of
disclosure we are required to give to potential borrowers. See "Business --
Lending Activities" and "Business -- Regulation."
In addition to new regulatory initiatives with respect to so-called
"predatory lending" practices, current laws or regulations in some states
restrict our ability to charge prepayment penalties and late fees. Prior to its
preclusion in July 2003, we had used the Federal Alternative Mortgage
Transactions Parity Act of 1982, which we refer to as the Parity Act, to preempt
these state laws for loans which meet the definition of alternative mortgage
transactions under the Parity Act. However, the Office of Thrift Supervision has
adopted a rule effective in July 2003, which precludes us and other non-bank,
non-thrift creditors from using the Parity Act to preempt state prepayment
penalty and late fee laws on new loan originations. Under the provisions of this
rule, we are required to modify or eliminate the practice of charging prepayment
and other fees on new loans in some of the states where we originate loans.
Prior to this rule becoming effective, 80% to 85% of the home mortgage loans we
originated contained prepayment fees. The origination of a high percentage of
loans with prepayment fees impacts our securitization gains and securitization
assets by helping to reduce the likelihood of a borrower prepaying their loan,
thereby prolonging the life of a securitization, and increasing the amounts of
residual cash flow, servicing fees and prepayment fees we can expect to collect
over the life of a securitization. We currently expect that the percentage of
loans that we will originate in the future containing prepayment fees will
decrease to approximately 65% to 70%. During fiscal 2004, approximately 72% of
the loans we originated contained prepayment fees. This decrease in prepayment
fee penetration will potentially reduce the amount of gains and securitization
assets we will record on any future securitizations. Because there are many
other variables including market conditions, which will also impact
securitizations, we are unable to quantify the impact of this rule on any future
securitization assets and related gains until we complete a publicly-placed
securitization of loans which we originated since this rule became effective.
We have procedures and controls to monitor compliance with numerous
federal, state and local laws and regulations. However, because these laws and
regulations are complex and often subject to interpretation, or as a result of
inadvertent errors, we may, from time to time, inadvertently violate these laws
and regulations.
More restrictive laws, rules and regulations may be adopted in the
future that could make compliance more difficult or expensive or we may be
subject to additional governmental reviews of our lending practices which could
hinder our ability to operate profitably and repay our debt which could
negatively impact the value of our capital stock. See "Business -- Regulation."
57
WE ARE SUBJECT TO PRIVATE LITIGATION, INCLUDING LAWSUITS RESULTING FROM THE
ALLEGED "PREDATORY" LENDING PRACTICES, AS WELL AS SECURITIES CLASS ACTION AND
DERIVATIVE LAWSUITS, THE IMPACT OF WHICH ON OUR FINANCIAL POSITION IS UNCERTAIN.
THE INHERENT UNCERTAINTY RELATED TO LITIGATION OF THIS TYPE AND THE PRELIMINARY
STAGE OF THESE SUITS MAKES IT DIFFICULT TO PREDICT THE ULTIMATE OUTCOME OR
POTENTIAL LIABILITY THAT WE MAY INCUR AS A RESULT OF THESE MATTERS.
We are subject, from time to time, to private litigation resulting from
alleged "predatory lending" practices. Our lending subsidiaries, including
HomeAmerican Credit, Inc., which does business as Upland Mortgage, are involved
in class action lawsuits, other litigation, claims, investigations by
governmental authorities, and legal proceedings arising out of their lending and
servicing activities. For example, in the purported class action entitled,
Calvin Hale v. HomeAmerican Credit, Inc., d/b/a Upland Mortgage, borrowers in
several states alleged that the charging of, and failure to properly disclose
the nature of, a document preparation fee were improper under applicable state
law. The case was ultimately settled without class certification. In addition,
on May 20, 2004, the purported consumer class action lawsuit captioned Moore v.
American Business Financial Services, Inc. et al, No. 003237 was filed against
us, our lending subsidiaries and an unrelated party in the Philadelphia Court of
Common Pleas. The lawsuit was brought on behalf of residential mortgage
consumers and challenges the validity of our deed in lieu of foreclosure and
force-placed insurance practices as well as certain mortgage service fees
charged by us. This lawsuit appears to relate, in part, to the same subject
matter as the U.S. Attorney's inquiry concluded in December 2003 with no
findings of wrongdoing as discussed in "Legal Proceedings." The lawsuit seeks
actual and treble damages, statutory damages, punitive damages, costs and
expenses of the litigation and injunctive relief. We believe the complaint
contains fundamental factual inaccuracies and that we have numerous defenses to
these allegations. We expect, that as a result of the publicity surrounding
"predatory lending" practices, we may be subject to other class action suits in
the future. See "Legal Proceedings."
In January and February of 2004, four class action lawsuits were filed
against us and certain of our officers and directors in the United States
District Court for the Eastern District of Pennsylvania. The consolidated
amended class action complaint that supersedes complaints filed in those four
lawsuits brings claims on behalf of a class of all purchasers of our common
stock for a proposed class period of January 27, 2000 through June 26, 2003. The
consolidated complaint alleges that, among other things, we and the named
directors and officers violated Sections 10(b) and 20(a) of the Exchange Act.
The consolidated complaint alleges that, during the applicable class period, our
forbearance and deferment practices enabled us to, among other things, lower our
delinquency rates to facilitate the securitization of our loans which
purportedly allowed us to collect interest income from our securitized loans and
inflate our financial results and market price of our common stock. The
consolidated amended class action complaint seeks unspecified compensatory
damages, costs and expenses related to bringing the action, and other
unspecified relief.
In addition, a shareholder derivative action was filed against us, as a
nominal defendant, and our directors and certain officers in the United States
District Court for the Eastern District of Pennsylvania, alleging that the named
directors and officers breached their fiduciary duties to us, engaged in the
abuse of control, gross mismanagement and other violations of law during the
period from January 27, 2000 through June 25, 2003.
Procedurally, these lawsuits are in a very preliminary stage. We
believe that we have several defenses to the claims raised by these lawsuits and
intend to vigorously defend the lawsuits. Due to the inherent uncertainties in
litigation and because the ultimate resolution of these proceedings is
influenced by factors outside of our control, we are currently unable to predict
the ultimate outcome of this litigation or its impact on our financial position
or results of operations. However, to the extent that our management will be
required to participate in or otherwise devote substantial amounts of time to
the defense of these lawsuits, such activities would result in the diversion of
our management resources from our business operations and the implementation of
our adjusted business strategy, which may negatively impact our results of
operations. See "Legal Proceedings."
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CLAIMS BY BORROWERS OR INVESTORS IN LOANS COULD HINDER OUR ABILITY TO OPERATE
PROFITABLY, WHICH WOULD REDUCE THE FUNDS WE HAVE AVAILABLE TO REPAY OUR
OUTSTANDING DEBT AND WOULD NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
In the ordinary course of our business, we are subject to claims made
against us by borrowers and investors in loans arising from, among other things:
o losses that are claimed to have been incurred as a result of
alleged breaches of fiduciary obligations, misrepresentation,
error and omission by our employees, officers and agents
(including our appraisers);
o incomplete documentation; and
o failure to comply with various laws and regulations applicable
to our business.
If claims asserted, pending legal actions or judgments against us
result in legal expenses or liability, these expenses could hinder our ability
to operate profitably, which would reduce funds available to repay our
outstanding debt and negatively impact the value of our capital stock. See
"Legal Proceedings."
IF WE ARE UNABLE TO REALIZE CASH PROCEEDS FROM THE SALE OF LOANS IN EXCESS OF
THE COST TO ORIGINATE THE LOANS, OUR FINANCIAL POSITION AND OUR ABILITY TO REPAY
OUR OUTSTANDING DEBT COULD BE ADVERSELY AFFECTED AND THE VALUE OF OUR CAPITAL
STOCK COULD BE NEGATIVELY IMPACTED.
The net cash proceeds received from loan sales consist of the premiums
we receive on sales of loans in excess of the outstanding principal balance,
plus the cash proceeds we receive from securitizations, minus the discounts on
loans that we have to sell for less than the outstanding principal balance. If
we are unable to originate loans at a cost lower than the cash proceeds realized
from loan sales, our results of operations, financial condition, business
prospects and ability to repay our outstanding debt could be adversely affected
and the value of our capital stock could be negatively impacted.
RESTRICTIVE COVENANTS IN THE AGREEMENTS GOVERNING OUR INDEBTEDNESS MAY REDUCE
OUR OPERATING FLEXIBILITY AND LIMIT OUR ABILITY TO OPERATE PROFITABLY, AND OUR
ABILITY TO REPAY OUR OUTSTANDING DEBT MAY BE IMPAIRED AND THE VALUE OF OUR
CAPITAL STOCK COULD BE NEGATIVELY IMPACTED.
The agreements governing our credit facilities and warehouse lines of
credit contain various covenants that may restrict our ability to:
o incur other senior indebtedness;
o engage in transactions with affiliates;
o incur liens;
o make certain restricted payments;
o enter into certain business combinations and asset sale transactions;
o engage in new lines of business; and
o make certain investments.
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These restrictions may limit our ability to obtain future financings,
make needed capital expenditures, withstand a future downturn in our business or
the economy in general, conduct operations or otherwise take advantage of
business opportunities that may arise. Our credit facilities and warehouse lines
of credit also require us to maintain specified financial ratio covenants and
satisfy other financial conditions. Our ability to meet those ratio covenants
and conditions can be affected by events beyond our control, such as interest
rates and general economic conditions.
Pursuant to the terms of these credit facilities, the failure to comply
with the financial covenants constitutes an event of default and at the option
of the lender, entitles the lender to, among other things, terminate commitments
to make future advances to us, declare all or a portion of the loan due and
payable, foreclose on the collateral securing the loan, require servicing
payments be made to the lender or other third party or assume the servicing of
the loans securing the credit facility. In the past, we did not meet certain
financial covenants contained in our credit facilities and we requested and
obtained waivers or amendments to our credit facilities to address our
non-compliance with these financial covenants.
The terms of our $200.0 million credit facility, as amended, required,
among other things, that we have a minimum net worth of $25.0 million at October
31, 2003 and November 30, 2003, $30.0 million at December 31, 2003, $32.0
million at March 31, 2004 and $34.0 million at June 30, 2004. An identical
minimum net worth requirement applied to an $8.0 million letter of credit
facility with the same lender through December 22, 2003, the date this facility
expired according to its terms. We obtained waivers from these net worth
requirements from the lender under these two facilities. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources -- Credit Facilities." As a result of our future
anticipated losses, we anticipate that we will also need to obtain additional
waivers in future periods from our lenders for our non-compliance with any
financial covenants but we cannot give you any assurances as to whether or in
what form these waivers will be granted.
Our breach of our financial covenants under our revolving credit
facilities could result in a default under the terms of those facilities, which
could cause that indebtedness and other senior indebtedness, by reason of
cross-default provisions in such indebtedness, to become immediately due and
payable. Our failure to repay those amounts could result in a bankruptcy
proceeding or liquidation proceeding or our lenders could proceed against the
collateral granted to them to secure that indebtedness. If the lenders under the
credit facilities and warehouse lines of credit accelerate the repayment of
borrowings, we may not have sufficient cash to repay our indebtedness and may be
forced to sell assets on less than optimal terms and conditions.
WE DEPENDED ON MORTGAGE BROKERS FOR APPROXIMATELY 39% OF OUR LOAN PRODUCTION IN
FISCAL 2004 AND, IF WE ARE UNABLE TO MAINTAIN RELATIONSHIPS WITH THESE BROKERS,
IT COULD NEGATIVELY IMPACT THE VOLUME AND PRICING OF OUR LOANS, ADVERSELY AFFECT
OUR RESULTS OF OPERATIONS AND ABILITY TO REPAY OUR OUTSTANDING DEBT AND COULD
NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
We depended on brokers for approximately 39% of our loan originations
in fiscal 2004. In addition, our adjusted business strategy to increase loan
originations requires creating an expanded broker network, which will increase
the percentage of our loan production that will be dependent on broker
relationships. Further, our competitors also have relationships with our brokers
and other lenders, and actively compete with us in our efforts to expand our
broker network. Accordingly, we cannot assure you that we will be successful in
maintaining our existing relationships or expanding our broker network which
could negatively impact the volume and pricing of our loans, which could have a
material adverse effect on our results of operations and our ability to repay
our outstanding debt and could negatively impact the value of our capital stock.
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SOME OF OUR WAREHOUSE FINANCING AGREEMENTS INCLUDE PROVISION FOR MARGIN CALLS
BASED ON THE LENDER'S OPINION OF THE VALUE OF OUR LOAN COLLATERAL. AN
UNANTICIPATED LARGE MARGIN CALL COULD ADVERSELY AFFECT OUR LIQUIDITY, OUR
ABILITY TO REPAY OUR OUTSTANDING DEBT AND THE VALUE OF OUR CAPITAL STOCK.
The amount of financing we receive under our warehouse agreements
depends in large part on the lender's valuation of the mortgage loans that
secure the financings. Each warehouse line provides the lender the right, under
certain circumstances, to reevaluate the loan collateral that secures our
outstanding borrowings at any time. In the event the lender determines that the
value of the loan collateral has decreased, it has the right to initiate a
margin call. A margin call would require us to provide the lender with
additional collateral or to repay a portion of the outstanding borrowing. We
have not experienced margin calls on these agreements related to the value of
loan collateral. However, during the first four months of fiscal 2004, we did
have one previous warehouse lender and the sponsor of a previous mortgage
conduit facility request that we use up to 100% of the proceeds received from
the sale of loans funded by their facilities to pay down their facilities from
their scheduled 97% advance rates to advance rates of 83% and 92%, respectively.
The requests from these facility providers were made primarily in response to
our liquidity issues and in exchange for waivers and amendments to the credit
facility. See "Management's Discussion and Analysis of Financial Position and
Results of Operations -- Liquidity and Capital Resources." These facilities were
fully paid off in October 2003.
We are unable to predict whether we will be subject to margin calls in
the foreseeable future. Any such margin call could have a material adverse
effect on our results of operations, financial condition and business prospects,
our ability to repay our outstanding debt and the value of our capital stock.
PROVISIONS IN OUR CERTIFICATE OF INCORPORATION AND DELAWARE LAW MAY HAVE THE
EFFECT OF IMPEDING A CHANGE OF CONTROL WHICH COULD NEGATIVELY IMPACT THE VALUE
OF OUR CAPITAL STOCK.
We are subject to restrictions that may impede our ability to effect a
change in control. Certain provisions contained in our certificate of
incorporation and bylaws and certain provisions of Delaware law may have the
effect of discouraging a third party from making an acquisition proposal for us
and thereby inhibit a change in control, which could negatively impact the value
of our capital stock.
BENEFICIAL OWNERSHIP OF 49.7% OF OUR COMMON STOCK (EXCLUDING OPTIONS) BY OUR
EXECUTIVE OFFICERS AND DIRECTORS MAY LIMIT OR PRECLUDE A CHANGE IN CONTROL OF
OUR COMPANY.
As of September 30, 2004, our executive officers and directors, in the
aggregate, beneficially owned approximately 49.7% of our outstanding common
stock (excluding options to purchase shares of our common stock). As a result,
these stockholders acting together are able to control most matters requiring
approval by our stockholders, including the election of directors. Such
concentration of ownership may have the effect of delaying or preventing a
change in control of our company, including transactions in which stockholders
might otherwise receive a premium for their shares over then current market
prices.
ENVIRONMENTAL LAWS AND REGULATIONS AND OTHER ENVIRONMENTAL CONSIDERATIONS MAY
RESTRICT OUR ABILITY TO FORECLOSE ON LOANS SECURED BY REAL ESTATE OR INCREASE
COSTS ASSOCIATED WITH THOSE LOANS WHICH COULD HINDER OUR ABILITY TO OPERATE
PROFITABLY, LIMIT THE FUNDS AVAILABLE TO REPAY OUR OUTSTANDING DEBT AND
NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
Our ability to foreclose on the real estate collateralizing our loans
may be limited by environmental laws which pertain primarily to commercial
properties that require a current or previous owner or operator of real property
to investigate and clean up hazardous or toxic substances or chemical releases
on the property. In addition, the owner or operator may be held liable to a
governmental entity or to third parties for property damage, personal injury,
investigation and cleanup costs relating to the contaminated property. While we
would not knowingly make a loan collateralized by real property that was
contaminated, we may not discover the environmental contamination until after we
had made the loan or after we had foreclosed on a loan. If we foreclosed upon a
property and environmental liabilities subsequently arose, we could face
significant liability.
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Since the commencement of our operations, there have been approximately
ten instances where we have determined not to foreclose on the real estate
collateralizing a delinquent loan because of environmental considerations. Two
are currently under administration. Any losses we sustained on these loans did
not have a material adverse effect on our profitability and we believe any
losses we may sustain in the future will not be material. We may face
environmental clean up costs with respect to one of the loans under
administration which we do not believe will have a material adverse effect on
our financial results.
In addition to federal or state laws, owners or former owners of a
contaminated site may be subject to common law claims, including tort claims, by
third parties based on damages and costs resulting from environmental
contamination migrating from the property. Other environmental considerations,
such as pervasive mold infestation of real estate securing our loans, may also
restrict our ability to foreclose on delinquent loans. See "Business -- Loan
Servicing and Administrative Procedures."
TERRORIST ATTACKS IN THE UNITED STATES MAY CAUSE DISRUPTION IN OUR BUSINESS AND
OPERATIONS AND OTHER ATTACKS OR ACTS OF WAR MAY ADVERSELY AFFECT THE MARKETS IN
WHICH OUR COMMON STOCK TRADES, THE MARKETS IN WHICH WE OPERATE, OUR ABILITY TO
OPERATE PROFITABLY AND OUR ABILITY TO REPAY OUR OUTSTANDING DEBT MAY BE IMPAIRED
AND THE VALUE OF OUR CAPITAL STOCK COULD BE NEGATIVELY IMPACTED.
Terrorists' attacks in the United States in September 2001 caused major
instability in the United States financial markets. These attacks or new events
and responses on behalf of the U.S. government may lead to further armed
hostilities or to further acts of terrorism in the U.S. which may cause a
further decline in the financial market and may contribute to a further decline
in economic conditions. These events may cause disruption in our business and
operations including reductions in demand for our loan products and our
subordinated debentures, increases in delinquencies and credit losses in our
managed loan portfolio, changes in historical prepayment patterns and declines
in real estate collateral values. To the extent we experience an economic
downturn, unusual economic patterns and unprecedented behaviors in financial
markets, these developments may affect our ability to originate loans at
profitable interest rates, to price future loan securitizations profitably, to
effect whole loan sales and to effectively hedge our loan portfolio against
market interest rate changes. Should these disruptions and unusual activities
occur, our ability to operate profitably and cash flow could be reduced and our
ability to make principal and interest payments on our outstanding debt could be
impaired and the value of our capital stock could be negatively impacted.
IF MANY OF OUR BORROWERS BECOME SUBJECT TO THE SERVICEMEMBERS CIVIL RELIEF ACT,
OUR CASH FLOWS AND INTEREST INCOME MAY BE ADVERSELY AFFECTED WHICH WOULD
NEGATIVELY IMPAIR OUR ABILITY TO REPAY OUR OUTSTANDING DEBT AND WOULD NEGATIVELY
IMPACT THE VALUE OF OUR CAPITAL STOCK.
Under the Servicemembers Civil Relief Act (formerly known as the
Soldiers' and Sailors' Civil Relief Act of 1940), a borrower who enters military
service after the origination of his or her loan generally may not be charged
interest above an annual rate of six percent. Additionally, this Relief Act may
restrict or delay our ability to foreclose on an affected loan during the
borrower's active duty status. The Relief Act also applies to a borrower who was
on reserve status and is called to active duty after origination of the loan. A
significant mobilization by the U.S. Armed Forces could increase the number of
our borrowers who are the subject of this Relief Act, thereby reducing our cash
flow and the interest payments we collect from those borrowers, and in the event
of default, delaying or preventing us from exercising the remedies for default
that otherwise would be available to us.
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WE ARE SUBJECT TO LOSSES DUE TO FRAUDULENT AND NEGLIGENT ACTS ON THE PART OF
LOAN APPLICANTS, MORTGAGE BROKERS, OTHER VENDORS AND OUR EMPLOYEES WHICH COULD
HINDER OUR ABILITY TO OPERATE PROFITABLY AND IMPAIR OUR ABILITY TO REPAY OUR
OUTSTANDING DEBT AND COULD NEGATIVELY IMPACT THE VALUE OF OUR CAPITAL STOCK.
When we originate mortgage loans, we rely heavily upon information
supplied by third parties including the information contained in the loan
application, property appraisal, title information and employment and income
documentation. If any of this information is intentionally or negligently
misrepresented and such misrepresentation is not detected prior to loan funding,
the value of the loan may be significantly lower than expected. Whether a
misrepresentation or fraudulent act is made by the loan applicant, the mortgage
broker, another third party or one of our employees, we generally bear the risk
of loss. A loan subject to a material misrepresentation or fraudulent act is
typically unsaleable or subject to repurchase if it is sold prior to detection,
such persons and entities are often difficult to locate and it is often
difficult to collect any monetary losses we have suffered from them.
We have controls and processes designed to help us identify
misrepresented or fraudulent information in our loan origination operations. We
cannot assure you, however, that we have detected or will detect all
misrepresented or fraudulent information in our loan originations.
EMPLOYEES
At June 30, 2004, we employed 931 people on a full-time basis and 38
employees on a part-time basis. None of our employees are covered by a
collective bargaining agreement. We consider our employee relations to be good.
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EXECUTIVE OFFICERS WHO ARE NOT ALSO DIRECTORS(1)
BARRY EPSTEIN, age 65, is our Managing Director of the National
Wholesale Residential Mortgage Division, a position he has held since December
2003. Mr. Epstein is responsible for the sales, marketing and day-to-day
management of our broker origination channel. From October 2003 to December
2003, Mr. Epstein was Chief Operating Officer of Rekaren, Incorporated, a
mortgage loan broker. Mr. Epstein was Managing Director and a director of
Approved FSB, a federally chartered savings bank, from 2000 to 2002. From 1998
through 2000, he was a consultant with Lincolnshire Management, Inc., an equity
fund manager. Mr. Epstein was Senior Vice President of Ocwen Financial Services,
a subsidiary of Ocwen Federal Bank of West Palm Beach, Florida, from 1996 to
1998.
STEPHEN M. GIROUX, age 56, is our Executive Vice President, General
Counsel and Secretary. Mr. Giroux is also an Executive Vice President and the
General Counsel and Secretary of all of our subsidiaries. Mr. Giroux was
promoted to Executive Vice President and Secretary in November 2003. Mr. Giroux
was our Senior Vice President and General Counsel from April 2001 to November
2003. Mr. Giroux joined us in September 1999 as Senior Vice President and Deputy
General Counsel. Prior to such time, he was a partner with the law firm of Weir
& Partners, LLC, Philadelphia, Pennsylvania from 1998 to 1999. From 1977 to
1998, Mr. Giroux was Senior Vice President and Lead Counsel for CoreStates
Financial Corp., Philadelphia, Pennsylvania, and its predecessors.
ALBERT W. MANDIA, age 57, is our Executive Vice President and Chief
Financial Officer, positions he has held since June 1998 and October 1998,
respectively. Mr. Mandia is responsible for all financial, treasury, information
systems, facilities and investor relations functions. Mr. Mandia also is an
Executive Vice President and the Chief Financial Officer of all of our
subsidiaries. From 1974 to 1998, Mr. Mandia was associated with CoreStates
Financial Corp. where he last held the position of Chief Financial Officer from
February 1997 to April 1998.
MILTON RISEMAN, age 68, is our Chairman of our Consumer Mortgage Group.
Mr. Riseman has held that position from the time he joined us in June 1999. Mr.
Riseman resigned and served as our consultant from July 2, 2003 until November
24, 2003. On November 24, 2003, Mr. Riseman rejoined us as Chairman of our
Consumer Mortgage Group. As Chairman of the Consumer Mortgage Group, Mr. Riseman
is responsible for the sales, marketing and day-to-day management of Upland
Mortgage's retail operation and he held supervisory responsibility for the Bank
Alliance Services program. From February 1994 until October 1998, Mr. Riseman
served as President of Advanta Mortgage. Mr. Riseman joined Advanta in 1992 as
Senior Vice President, Administration. From 1965 until 1992, Mr. Riseman served
in various capacities at Citicorp, including serving as President of Citicorp
Acceptance Corp. from 1986 to 1992.
JEFFREY M. RUBEN, age 41, is our Executive Vice President, a position
he has held since September 1998. Mr. Ruben was our general counsel from April
1992 to April 2001. He is also Executive Vice President of some of our
subsidiaries, positions he has held since April 1992. Mr. Ruben is responsible
for the loan servicing and collections departments, the asset allocation unit
and the legal department. Mr. Ruben served as Vice President from April 1992 to
1995 and Senior Vice President from 1995 to 1998. From June 1990 until he joined
us in April 1992, Mr. Ruben was an attorney with the law firm of Klehr,
Harrison, Harvey, Branzburg & Ellers in Philadelphia, Pennsylvania. From
December 1987 until June 1990, Mr. Ruben was employed as a credit analyst with
the CIT Group Equipment Financing, Inc. Mr. Ruben is a member of the
Pennsylvania and New Jersey Bar Associations. Mr. Ruben holds a New Jersey
Mortgage Banker License and a New Jersey Secondary Mortgage Banker License.
BEVERLY SANTILLI, age 45, is the President of American Business Credit,
Inc. and an Executive Vice President of HomeAmerican Credit, Inc., a position
she was appointed to on June 1, 2004. Mrs. Santilli is also responsible for our
human resources and those of our subsidiaries. Mrs. Santilli was our First
Executive Vice President, from September 1998 through May 2004. Prior to
September 1998 Mrs. Santilli held a variety of positions including Executive
Vice President, Vice President and Secretary. Prior to joining American Business
Credit, Inc. and from September 1984 to November 1987, Mrs. Santilli was
affiliated with PSFS initially as an Account Executive and later as a Commercial
Lending Officer with that bank's Private Banking Group. Mrs. Santilli is the
wife of Anthony J. Santilli.
(1) Ages are as of October 1, 2004.
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ITEM 2. PROPERTIES
Except for real estate acquired in foreclosure in the normal course of
our business, we do not presently hold title to any real estate for operating
purposes. The interests which we presently hold in real estate are in the form
of mortgages against parcels of real estate owned by our borrowers or their
affiliates and real estate acquired through foreclosure.
We presently lease office space for our corporate headquarters in
Philadelphia, Pennsylvania. The current lease term for the Philadelphia facility
expires in June 2014. The terms of the rental agreement require increased
payments annually for the term of the lease with average minimum annual rental
payments of $4.2 million. We have entered into contracts, or may engage parties
in the future, related to the relocation of our corporate headquarters such as
contracts for building improvements to the leased space, office furniture and
equipment and moving services. The provisions of the lease and local and state
grants provided us with reimbursement of a substantial amount of our costs
related to the relocation, subject to certain conditions and limitations. We do
not believe our unreimbursed expenses or unreimbursed cash outlay related to the
relocation will be material to our operations.
The lease requires us to maintain a letter of credit in favor of the
landlord to secure our obligations to the landlord throughout the term of the
lease. The amount of the letter of credit is currently $8.0 million. The letter
of credit is currently issued by JPMorgan Chase Bank.
We continue to lease some office space in Bala Cynwyd under a five-year
lease expiring in November 2004 at an annual rental of approximately $0.7
million. We performed loan servicing and collection activities at this office,
but these activities were relocated to our Philadelphia office on July 12, 2004.
The expenses and cash outlay related to the relocation were not material to our
operations.
We also lease the office space in Roseland, New Jersey and the
nine-year lease expires in January 2012. The terms of the rental agreement
require increased payments periodically for the term of the lease with average
minimum annual rental payments of $0.8 million.
In connection with the acquisition of the California mortgage broker
operation in December 2003, we assumed the obligations under a lease for
approximately 3,700 square feet of space in West Hills, California. The
remaining term of the lease is 2 years, expiring September 30, 2006 at an annual
rental of approximately $0.1 million.
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In connection with the opening of the Irvine, California mortgage
broker operation, we entered into a sublease on March 4, 2004 for approximately
6,400 square feet of space. The term of the sublease is 1 2/3 years and expires
November 30, 2005. The terms of the sublease require average minimum annual
rental payments of $0.1 million.
In connection with the opening of the Maryland mortgage broker
operation, we entered into a sublease on March 15, 2004 for approximately 10,300
square feet of space in Edgewater, Maryland. The term of the sublease is 3 years
and expires March 15, 2007. The terms of the sublease require increased payments
annually for the term of the lease with average minimum annual rental payments
of $0.2 million.
In connection with the acquisition of the Texas broker operation, we
entered into a sublease on June 11, 2004 for approximately 6,000 square feet of
space in Austin, Texas. The term of the sublease is 10 1/2 months, expiring
April 28, 2005 at an annual rental of approximately $0.1 million.
ITEM 3. LEGAL PROCEEDINGS
On February 26, 2002, a purported class action titled Calvin Hale v.
HomeAmerican Credit, Inc., No. 02 C 1606, United States District Court for the
Northern District of Illinois, was filed in the Circuit Court of Cook County,
Illinois (subsequently removed by Upland Mortgage to the captioned federal
court) against our subsidiary, HomeAmerican Credit, Inc., which does business as
Upland Mortgage, on behalf of borrowers in Illinois, Indiana, Michigan and
Wisconsin who paid a document preparation fee on loans originated since February
4, 1997. The case consisted of three purported class action counts and two
individual counts. The plaintiff alleged that the charging of, and the failure
to properly disclose the nature of, a document preparation fee were improper
under applicable state law. In November 2002 the Illinois Federal District Court
dismissed the three class action counts and an agreement in principle was
reached in August 2003 to settle the matter. The terms of the settlement were
finalized and the action was dismissed on September 23, 2003. The matter did not
have a material effect on our consolidated financial position or results of
operations.
On May 20, 2004, the purported consumer class action lawsuit captioned
Moore v. American Business Financial Services, Inc. et al, No. 003237 was filed
against us, our lending subsidiaries and an unrelated party in the Philadelphia
Court of Common Pleas. The lawsuit was brought on behalf of residential mortgage
consumers and challenges the validity of our deed in lieu of foreclosure and
force-placed insurance practices as well as certain mortgage service fees
charged by us. This lawsuit relates, in part, to the same subject matter as the
U.S. Attorney's inquiry concluded in December 2003 with no findings of
wrongdoing as discussed below. The lawsuit seeks actual and treble damages,
statutory damages, punitive damages, costs and expenses of the litigation and
injunctive relief. Procedurally, this lawsuit is in a very preliminary stage. We
believe the complaint contains fundamental factual inaccuracies and that we have
numerous defenses to these allegations. We intend to vigorously defend this
lawsuit. Due to the inherent uncertainties in litigation and because the
ultimate resolution of this proceeding is influenced by factors outside of our
control, we are currently unable to predict the ultimate outcome of this
litigation or its impact on our financial position or results of operations.
In addition, our lending subsidiaries, including HomeAmerican Credit,
Inc., which does business as Upland Mortgage, and American Business Mortgage
Services, Inc., are involved, from time to time, in class action lawsuits, other
litigation, claims, investigations by governmental authorities, and legal
proceedings arising out of their lending and servicing activities. For example,
in July 2004, we received a document request in the form of an administrative
subpoena from the New Jersey Attorney General's Office, acting as counsel for
the Office of Consumer Protection, in connection with American Business Mortgage
Services, Inc. It seeks the loan files of two borrowers and includes a broader
request for a list of loans solicited or closed by a former loan officer from
January 1, 1999 to the present. The loan officer's employment was terminated in
2001. While it would appear that the request does not raise material issues,
since this matter is in the preliminary stages, communications from the Attorney
General's Office have not been sufficient to confirm the extent of their
interest. Due to our current expectation regarding the ultimate resolution of
these actions, management believes that the liabilities resulting from these
actions will not have a material adverse effect on our consolidated financial
position or results of operations. However due to the inherent uncertainty in
litigation and because the ultimate resolution of these proceedings is
influenced by factors outside of our control, our estimated liability under
these proceedings may change or actual results may differ from our estimates.
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Additionally, court decisions in litigation to which we are not a party
may also affect our lending activities and could subject us to litigation in the
future. For example, in Glukowsky v. Equity One, Inc., (Docket No. A-3202 -
01T3), dated April 24, 2003, to which we are not a party, the Appellate Division
of the Superior Court of New Jersey determined that the Parity Act's preemption
of state law was invalid and that the state laws precluding some lenders from
imposing prepayment fees are applicable to loans made in New Jersey. On May 26,
2004, the New Jersey Supreme Court reversed the decision of the Appellate
Division of the Superior Court of New Jersey and held that the Parity Act had
preempted the New Jersey Prepayment Law, which prohibited housing lenders from
imposing prepayment penalties. However, the plaintiff has petitioned the United
States Supreme Court for certiorari in this matter.
We expect that, as a result of the publicity surrounding predatory
lending practices, we may be subject to other class action suits in the future.
In addition, from time to time, we are involved as plaintiff or defendant in
various other legal proceedings arising in the normal course of our business.
While we cannot predict the ultimate outcome of these various legal proceedings,
management believes that the resolution of these legal actions should not have a
material effect on our financial position, results of operations or liquidity.
We received a civil subpoena, dated May 14, 2003, from the Civil
Division of the U.S. Attorney for the Eastern District of Pennsylvania. The
subpoena requested that we provide certain documents and information with
respect to us and our lending subsidiaries for the period from May 1, 2000 to
May 1, 2003, including: (i) all loan files in which we entered into a
forbearance agreement with a borrower who is in default; (ii) the servicing,
processing, foreclosing, and handling of delinquent loans and non-performing
loans, the carrying, processing and sale of real estate owned, and forbearance
agreements; and (iii) agreements to sell or otherwise transfer mortgage loans
(including, but not limited to, any pooling or securitization agreements) or to
obtain funds to finance the underwriting, origination or provision of mortgage
loans, any transaction in which we sold or transferred mortgage loans, any
instance in which we did not service or act as custodian for a mortgage loan,
representations and warranties made in connection with mortgage loans, secondary
market loan sale schedules, and credit loss, delinquency, default, and
foreclosure rates of mortgage loans. On December 22, 2003, we entered into a
Joint Agreement with the Civil Division of the U. S. Attorney's Office for the
Eastern District of Pennsylvania which ends this inquiry. We do not believe that
the Joint Agreement with the U.S. Attorney's Office has had a significant impact
on our operations.
In response to the inquiry and as part of the Joint Agreement, we have
adopted a revised forbearance policy, which became effective on November 19,
2003. Under this policy, we no longer require a borrower to execute a deed in
lieu of foreclosure as a condition to entering into a forbearance agreement with
us where the real estate securing the loan is the borrower's primary residence.
Under the Joint Agreement, we also agreed to return to existing borrowers any
executed but unrecorded deeds in lieu of foreclosure obtained under our former
forbearance policy.
We also agreed to contribute a total of $80 thousand, and made this
contribution as required, to a U.S. Department of Housing and Urban Development
(HUD) approved housing counseling organization providing housing counseling in
states in which we originate mortgage loans. Under our revised forbearance
policy, eligible borrowers are sent a letter, along with our standard form
forbearance agreement encouraging them to: read the forbearance agreement; seek
the advice of an attorney or other advisor prior to signing the forbearance
agreement; and contact our consumer advocate by calling a toll-free number with
questions. The Joint Agreement requires that for 18 months following its
execution, we will notify the U.S. Attorney's Office of any material changes we
propose to make to our forbearance policy and form of forbearance agreement (or
cover letter) and that no changes to these documents shall be effective until at
least 30 days after this notification. The U.S. Attorney reserves the right to
reinstitute its inquiry if we do not comply with our revised forbearance policy,
fail to provide the 30 days notice described above, or disregard the concerns of
the U.S. Attorney's Office after providing such notice. The Joint Agreement also
requires that we provide the U.S. Attorney with two independently prepared
reports confirming our compliance with our revised forbearance policy (including
the standard form of forbearance agreement and cover letter) and internal
company training for collections department employees described below. These
reports are to be submitted to the U.S. Attorney's Office at 9 and 18 months
after the execution of the Joint Agreement. KPMG LLP, which we engaged to
perform an independent compliance audit required at the end of the 9-month
period, determined that we had complied with our policy requirements entered
into as a result of the Joint Agreement with the U.S. Attorney's Office.
67
We also agreed to implement a formal training session regarding our
revised forbearance policy for all of our collections department employees, at
which such employees are directed to inform borrowers that they can obtain
assistance from housing and credit counseling organizations and how to find such
organizations in their area. We agreed to monitor compliance with our
forbearance policy and take appropriate disciplinary action against those
employees who do not comply with this policy.
In January and February of 2004, four class action lawsuits were filed
against us and certain of our officers and directors. Lead plaintiffs and
counsel were appointed on June 3, 2004. A consolidated amended class action
complaint that supersedes these four complaints was filed on August 19, 2004 in
the United States District Court for the Eastern District of Pennsylvania. The
consolidated class action case is American Business Financial Services, Inc.
Securities Litigation, Civil Action No. 04-0265.
The consolidated amended class action complaint brings claims on behalf
of a class of all purchasers of our common stock for a proposed class period of
January 27, 2000 through June 26, 2003. The consolidated complaint names us, our
director and Chief Executive Officer, Anthony Santilli, our Chief Financial
Officer, Albert Mandia, and former director, Richard Kaufman, as defendants and
alleges that, among other things, we and the named directors and officers
violated Sections 10(b) and 20(a) of the Exchange Act. The consolidated
complaint alleges that, during the applicable class period, our forbearance and
deferment practices enabled us to, among other things, lower our delinquency
rates to facilitate the securitization of our loans which purportedly allowed us
to collect interest income from our securitized loans and inflate our financial
results and market price of our common stock. The consolidated amended class
action complaint seeks unspecified compensatory damages, costs and expenses
related to bringing the action, and other unspecified relief.
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania. The complaint is captioned: Osterbauer v. Santilli, Kaufman,
Mandia, Becker, DeLuca and Sussman, Civil Action No. 04-1105. The lawsuit was
brought nominally on behalf of the Company, as a shareholder derivative action,
alleging that the named directors and officers breached their fiduciary duties
to the Company, engaged in the abuse of control, gross mismanagement and other
violations of law during the period from January 27, 2000 through June 25, 2003.
The lawsuit seeks unspecified compensatory damages, equitable or injunctive
relief and costs and expenses related to bringing the action, and other
unspecified relief. The parties have agreed to stay this case pending
disposition of any motion to dismiss the consolidated amended complaint filed in
the putative consolidated securities class action.
Procedurally, these lawsuits are in a very preliminary stage. We
believe that we have several defenses to the claims raised by these lawsuits and
intend to vigorously defend the lawsuits. Due to the inherent uncertainties in
litigation and because the ultimate resolution of these proceedings is
influenced by factors outside of our control, we are currently unable to predict
the ultimate outcome of this litigation or its impact on our financial position
or results of operations. See "Risk Factors -- We are subject to private
litigation, including lawsuits resulting from the alleged "predatory" lending
practices, as well as securities class action and derivative lawsuits, the
impact of which on our financial position is uncertain. The inherent uncertainty
related to litigation of this type and the preliminary stage of these suits
makes it difficult to predict the ultimate outcome or potential liability that
we may incur as a result of these matters."
68
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Special Meeting of Stockholders of the Company was held on June 29,
2004. The following proposal was presented to stockholders and voted on at the
Special Meeting:
To approve a proposal to issue shares of the Series A preferred stock
in connection with the second exchange offer and shares of common stock issuable
upon the conversion of Series A Preferred Stock (the "Proposal").
The results of the voting on the Proposal at the Special Meeting were
as follows:
Shares For Shares Against Shares Abstaining Broker Non-votes
2,102,819 27,877 3,372 0
69
PART II
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASE OF SECURITIES
Our common stock is currently traded on the NASDAQ National Market System under
the symbol "ABFI." Our common stock began trading on the NASDAQ National Market
System on February 14, 1997. The following table sets forth the high and low
sales prices of our common stock for the periods indicated.
QUARTER ENDED HIGH LOW
-------------------------------------------------------------------
September 30, 2002............................ 14.42 5.78
December 31, 2002............................. 11.52 8.81
March 31, 2003................................ 13.56 9.14
June 30, 2003................................. 11.55 5.77
September 30, 2003............................ 7.25 4.00
December 31, 2003............................. 6.62 2.83
March 31, 2004................................ 4.09 2.73
June 30, 2004................................. 5.60 2.97
September 30, 2004............................ 5.75 3.54
On September 30, 2004, the closing price of the common stock on the
NASDAQ National Market System was $4.00.
On April 1, 2004, we received a notice from the NASDAQ Stock Market
that we were not in compliance with the requirement for continued listing of our
common stock on the NASDAQ National Market System on the basis that we have not
met the requirement that the minimum market value of our publicly held shares
equals at least $5.0 million. Under NASDAQ Marketplace Rules, we had 90 days, or
until June 28, 2004, to become compliant with this requirement for a period of
10 consecutive trading days. On June 15, 2004, we advised the NASDAQ Stock
Market that we had been in compliance with this requirement for 10 consecutive
trading days and we withdrew our application to list our common stock on the
American Stock Exchange, referred to as AMEX in this document, which application
we filed with AMEX upon our receipt of the letter from the NASDAQ Stock Market
described above. On June 24, 2004, we received a letter from the staff of the
NASDAQ Stock Market confirming that we had regained compliance with the NASDAQ
continued listing requirement related to the market value of our publicly held
shares and were not subject to delisting. There can be no assurance that we will
be in compliance with the $10.0 million stockholders' equity requirement on
September 30, 2004. We are considering a new exchange offer in order to maintain
compliance with this listing requirement. If we are unable to maintain our
listing on the NASDAQ National Market System, the value of our capital stock and
our ability to continue to sell subordinated debentures would be negatively
impacted by making the process of complying with the state securities laws more
difficult, costly and time consuming. As a result, we may be unable to continue
to sell subordinated debentures in certain states, which would have a material
adverse effect on our liquidity and our ability to repay maturing debt when due.
As of October 5, 2004, there were 1,131 record holders and
approximately 1,470 beneficial holders of our common stock.
On May 13, 2004, our board of directors declared a 10% common stock
dividend, which was paid on June 8, 2004 to common stockholders of record as of
May 25, 2004. Stock price and related information contained in this document
have been adjusted to reflect this stock dividend.
70
During the first quarter of fiscal 2004, we suspended paying quarterly
cash dividends on our common stock. During the fiscal year ended June 30, 2003,
we paid dividends of $0.291 per share on our common stock for an aggregate
dividend payment of $0.9 million.
On August 21, 2002, the Board of Directors declared a 10% stock
dividend on our common stock which was paid on September 13, 2002 to
shareholders of record as of September 3, 2002. All cash dividends on our common
stock reported above have been adjusted to reflect all stock dividends.
The payment of dividends on our common stock in the future is at the
sole discretion of our Board of Directors and will depend upon, among other
things, our earnings, capital requirements and financial condition, as well as
other relevant factors.
During fiscal 2004, we declared the following dividends on our Series A
preferred stock (in thousands, except per share):
PREFERRED TOTAL
DIVIDEND PER PREFERRED
FOR THE MONTH ENDED SHARE DIVIDENDS
-------------------------------------------- ------------ ---------
January 31, 2004............................ $ 0.008334 $ 323
February 29, 2004........................... 0.008334 514
March 31, 2004.............................. 0.008334 515
April 30, 2004.............................. 0.008334 515
May 31, 2004................................ 0.008334 515
June 30, 2004............................... 0.008334 515
---------
$2,897
=========
As a Delaware corporation, we may not declare and pay dividends on
capital stock if the amount paid exceeds an amount equal to the surplus which
represents the excess of our net assets over paid-in-capital or, if there is no
surplus, our net profits for the current and/or immediately preceding fiscal
year. Dividends cannot be paid from our net profits unless the paid-in-capital
represented by the issued and outstanding stock having a preference upon the
distribution of our assets at the market value is intact. Under applicable
Delaware case law, dividends may not be paid on our Series A preferred stock or
common stock if we become insolvent or the payment of the dividend will render
us insolvent. To the extent we pay dividends and we are deemed to be insolvent
or inadequately capitalized, a bankruptcy court could direct the return of any
dividends. In addition, pursuant to the terms of the Series A preferred stock,
no dividends may be paid on shares of Series A preferred stock or set apart for
payment by us if the terms of any of our agreements prohibit such declaration,
payment or setting apart for payment or provide that such declaration, payment
or setting apart for payment would constitute a breach thereof or a default
thereunder, or if such declaration or payment shall be restricted by agreement
or law, would be unlawful, or would cause us to become insolvent as contemplated
by the Delaware law.
See "Part III - Item 12. Security Ownership of Certain Beneficial
Owners and Management and Related Stockholder Matters" for the information
regarding our equity compensation plans.
On February 11, 2003, the Board of Directors issued 2,000 shares (2,200
shares after the effect of subsequent stock dividends) of common stock to each
of Warren E. Palitz, a current director, and Jeffrey S. Steinberg, a former
director, in consideration for their board service. This issuance was exempt
from registration under Section 4(2) of the Securities Act of 1933, as amended,
referred to as the Securities Act, based upon a determination that the investors
were sophisticated, had access to, and were provided with, information that
would otherwise be contained in a registration statement and there was no
general solicitation.
71
As of December 24, 2003, we issued a convertible non-negotiable
promissory note; referred to as the note in this document, in the principal
amount of $475,000 to Rekaren, Incorporated, a California corporation referred
to as Rekaren, as partial consideration for the purchase of certain assets of
Rekaren. At any time on or after December 24, 2004 and before January 31, 2005,
the outstanding principal balance of, and accrued interest under, the note is
convertible, at the holder's option, into the number of shares of our common
stock determined by dividing the aggregate principal amount of the note by the
conversion price of $5.00 per share (the conversion price is subject to
adjustments in case of a stock split, combination, reclassification or other
similar event effected by us with respect to the common stock). We issued the
note in reliance on the exemption from registration under Section 4(2) of the
Securities Act based upon a determination that the investor was sophisticated,
had access to, and was provided with, information that would otherwise be
contained in a registration statement and there was no general solicitation.
As of December 24, 2003, we issued 200,000 shares (220,000 after the
effect of subsequent stock dividends) of common stock to Barry Epstein, the
newly hired experienced industry professional to head the National Wholesale
Residential Mortgage Division, as an inducement material to his employment with
us pursuant to the employment agreement and restricted stock agreement by and
between us and Mr. Epstein, dated December 24, 2003. We issued the foregoing
shares in reliance on the exemption from registration under Section 4(2) of the
Securities Act based upon a determination that the security was issued to a
sophisticated investor who had access to, and was provided with, information
that would otherwise be contained in a registration statement and there was no
general solicitation.
As of February 6, 2004, in connection with the first exchange offer, we
issued $55.4 million in the aggregate principal amount of senior collateralized
subordinated notes and 61.8 million shares of Series A preferred stock in
exchange for $117.2 million in the aggregate principal amount of subordinated
debentures issued prior to April 1, 2003. As of June 30, 2004, in connection
with the second exchange offer, we issued $28.6 million in the aggregate
principal amount of senior collateralized subordinated notes and 32.0 million
shares of Series A preferred stock in exchange for $60.6 million in the
aggregate principal amount of subordinated debentures. We issued the foregoing
senior collateralized subordinated notes and shares of the Series A preferred
stock in reliance on the exemption from the registration under Section 3(a)(9)
of the Securities Act.
We believe that the exchange offers met all of the requirements of the
exemption provided by Section 3(a)(9) of the Securities Act because (i) we were
the issuer of both (a) the senior collateralized subordinated notes and the
Series A preferred stock issued in the exchange offers and (b) the subordinated
debentures exchanged; (ii) the exchange offers involved an exchange exclusively
with our existing security holders and did not involve any new consideration
being paid by security holders; and (iii) we did not pay, and do not intend to
pay, any compensation for soliciting holders of subordinated debentures to
participate in the exchange offers.
As of June 11, 2004, we issued a convertible non-negotiable promissory
note, referred to as the ESI note in this document, in the principal amount of
$650,000 to ESI Mortgage, LP, a Texas limited partnership referred to as ESI, as
partial consideration for the purchase of certain assets of ESI. At any
principal payment date (based on an installment schedule), the principal balance
due under the ESI note is convertible, at the holder's option, into the number
of shares of our common stock determined by dividing the aggregate principal
amount then due under the ESI note by the closing sales price per share of our
common stock on the immediately preceding principal due date, except for the
principal amount due on December 31, 2004, which is based on the closing sales
price per share of our common stock on June 11, 2004. However, the ESI note may
not be converted by the holder as of the December 31, 2004 principal payment
date if such conversion would negatively impact the securities law exemptions
available with respect to our unregistered securities offerings occurring during
the period from June 11, 2004 through the first principal payment date, in which
case the principal amount which would have been convertible as of such date will
be convertible on March 31, 2005, at the same exchange ratio that would have
applied to a December 31, 2004 conversion. We issued the ESI note in reliance on
the exemption from registration under Section 4(2) of the Securities Act based
upon a determination that the investor was sophisticated, had access to, and was
provided with, information that would otherwise be contained in a registration
statement and there was no general solicitation.
72
ITEM 6. SELECTED FINANCIAL DATA
You should consider our selected consolidated financial information set
forth below together with the more detailed consolidated financial statements,
including the related notes, and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included elsewhere in this
document.
YEAR ENDED JUNE 30,
-----------------------------------------------------
2004 2003 2002 2001 2000
--------- -------- --------- --------- --------
STATEMENT OF INCOME DATA: (In thousands, except per share data)
Revenues:
Gain on sale of loans and leases:
Securitizations.................... $ 15,107 $170,950 $185,580 $128,978 $ 90,380
Whole loan sales................... 18,725 655 2,448 2,742 1,717
Interest and fees.................... 17,732 19,395 18,890 19,840 17,683
Interest accretion on interest-only
strips............................. 40,176 47,347 35,386 26,069 16,616
Other................................ 5,332 3,059 5,597 5,707 4,250
--------- -------- -------- -------- --------
Total revenues.......................... 97,072 241,406 247,901 183,336 130,646
Total expenses(a)....................... 276,794 290,426 234,351 170,151 120,284
--------- -------- -------- -------- --------
Income (loss) before provision for income
taxes (benefit)...................... (179,722) (49,020) 13,550 13,185 10,362
Provision for income taxes (benefit).... (68,294) (19,118) 5,691 5,274 3,938
--------- -------- -------- -------- --------
Income (loss) before cumulative effect of
a change in accounting principle..... (111,428) (29,902) 7,859 7,911 6,424
Cumulative effect of a change in
accounting principle................. -- -- -- 174 --
--------- -------- -------- -------- --------
Income (loss) before dividends on
preferred stock....................... (111,428) (29,902) 7,859 8,085 6,424
Dividends on preferred stock............ 3,718 -- -- -- --
--------- -------- -------- -------- --------
Net income (loss) attributable to common
stock................................ $(115,146) $(29,902) $ 7,859 $ 8,085 $ 6,424
========= ======== ======== ======== ========
Per Common Share Data:
Income (loss) before cumulative effect of
a change in accounting principle (b):
Basic earnings (loss) per common share $ (34.07) $ (9.32) $ 2.44 $ 1.89 $ 1.41
Diluted earnings (loss) per common share (34.07) (9.32) 2.26 1.85 1.37
Net income (loss):
Basic earnings (loss) per common share $ (34.07) $ (9.32) $ 2.44 $ 1.94 $ 1.41
Diluted earnings (loss) per common share (34.07) (9.32) 2.26 1.89 1.37
Cash dividends declared per common share. -- 0.291 0.255 0.236 0.227
(a) Includes securitization assets fair value adjustments of $41.2 million
for the fiscal year ended June 30, 2004, $45.2 million for the fiscal
year ended June 30, 2003, $22.1 million for the fiscal year ended June
30, 2002 and $12.6 million for the fiscal year ended June 30, 2000.
(b) Amounts for the years ended June 30, 2003 and prior have been
retroactively adjusted to reflect the effect of a 10% common stock
dividend declared May 13, 2004 as if the additional shares had been
outstanding for each period presented. Amounts for the years ended June
30, 2002 and prior have been retroactively adjusted to reflect the
effect of a 10% stock dividend declared August 21, 2002. Amounts for
the years ended June 30, 2001 and prior have been retroactively
adjusted to reflect the effect of a 10% stock dividend declared October
1, 2001.
73
JUNE 30,
--------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
BALANCE SHEET DATA:
Cash and cash equivalents ... $ 910 $ 36,590 $ 99,599 $ 84,667 $ 66,507
Restricted cash ............. 13,307 10,885 9,000 6,425 3,244
Loan and lease receivables:
Loans available for sale . 304,275 263,419 45,919 78,060 29,699
Non-accrual loans ........ 1,993 3,999 3,868 2,831 3,474
Lease receivables ........ -- 3,984 7,891 14,030 18,629
Interest and fees receivable 18,089 10,838 9,595 14,582 11,071
Deferment and forbearance
advances receivable ....... 6,249 4,341 2,697 1,967 1,931
Loans subject to repurchase
rights..................... 38,984 23,761 9,028 2,428 --
Interest-only strips ........ 459,086 598,278 512,611 398,519 277,872
Servicing rights ............ 73,738 119,291 125,288 102,437 74,919
Receivable for sold loans and
leases..................... -- 26,734 -- -- 46,333
Total assets ................ 1,042,870 1,159,351 876,375 766,487 594,282
Subordinated debentures ..... 522,609 719,540 655,720 537,950 390,676
Senior collateralized
subordinated notes......... 83,639 -- -- -- --
Total liabilities ........... 1,030,955 1,117,282 806,997 699,625 532,167
Stockholders' equity ........ 11,915 42,069 69,378 66,862 62,115
YEAR ENDED JUNE 30,
--------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
OTHER DATA:
Total loans and leases on
balance sheet................. $ 303,603 $ 267,325 $ 59,386 $ 91,615 $ 48,580
Originations(a):
Business purpose loans........ 587 122,790 133,352 120,537 106,187
Home mortgage loans........... 982,093 1,543,730 1,246,505 1,096,440 949,014
Average loan size of loans
originated(a):
Business purpose loans........ 293 92 97 91 89
Home mortgage loans........... 119 91 89 82 70
Weighted average interest rate
of loans originated(a):
Business purpose loans........ 14.62% 15.76% 15.75% 15.99% 15.99%
Home mortgage loans........... 7.86 9.99 10.91 11.46 11.28
Combined...................... 7.86 10.42 11.38 11.91 11.64
Loans and leases sold:
Securitizations............... $ 141,407 $1,423,764 $1,351,135 $1,102,066 $1,001,702
Whole loan sales.............. 808,378 28,013 57,679 76,333 102,670
(a) Conventional first mortgages and leases originated in fiscal 2000 have
been excluded because we no longer originate these types of loans and
leases.
74
YEAR ENDED JUNE 30,
-------------------------------------------------------------
FINANCIAL RATIOS: 2004 2003 2002 2001 2000
-------- -------- -------- -------- --------
Return on average assets....... (11.60)% (3.07)% 0.94% 1.22% 1.31%
Return on average equity....... (566.80) (44.20) 11.75 12.22 10.29
Total delinquencies as a
percentage of total on
balance sheet portfolio at
end of period(a)............ 1.19 1.97 11.72 3.87 6.08
Real estate owned as a
percentage of total on
balance sheet portfolio at
end of period............... 0.63 1.79 6.37 2.53 3.41
Loan and lease losses as a
percentage of the average
total on balance sheet
portfolio during the
period (b).................. 8.93 5.17 4.23 3.31 1.09
Pre-tax income (loss) as a
percentage of total
revenues.................... (1.11) (20.00) 5.47 7.19 7.93
Ratio of earnings to fixed
charges(c).................. (1.42)x 0.31x 1.19x 1.23x 1.26x
(a) Includes loans delinquent 31 days or more and excludes real estate
owned and previously delinquent loans subject to deferment and
forbearance agreements if the borrower with this arrangement is current
on principal and interest payments as required under the terms of the
original note (exclusive of delinquent payments advanced or fees paid
by us on the borrower's behalf as part of the deferment or forbearance
arrangement).
(b) Percentage based on annualized losses and average total portfolio.
(c) Earnings (loss) before income taxes and fixed charges were insufficient
to cover fixed charges by $183.4 million and $49.0 million for the
years ended June 30, 2004 and 2003, respectively.
The following table presents financial ratios and measures for our
total portfolio and total real estate owned, referred to as REO. The total
portfolio measure includes loans and leases recorded on our balance sheet and
securitized loans and leases both managed by us and serviced by others.
Management believes these measures enhance the users' overall understanding of
our current financial performance and prospects for the future because the
volume and credit characteristics of off-balance sheet securitized loan and
lease receivables have a significant effect on our financial performance as a
result of our retained interests in the securitized loans. Retained interests
include interest-only strips and servicing rights. In addition, because the
servicing and collection of our off-balance sheet securitized loan and lease
receivables are performed in the same manner and according to the same standards
as the servicing and collection of our on-balance sheet loan and lease
receivables, certain of our resources, such as personnel and technology, are
allocated based on their pro rata relationship to the total portfolio and total
REO. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Reconciliation of Non-GAAP Financial Measures" for a
reconciliation of total portfolio and managed real estate owned to our balance
sheet.
YEAR ENDED JUNE 30,
---------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
Total Portfolio - Loans and
Leases..................... $2,231,689 $3,651,074 $3,066,189 $2,589,395 $1,918,540
FINANCIAL RATIOS:
Total delinquencies as a
percentage of total
portfolio at end of period.. 10.67% 6.27% 5.59% 4.13% 2.91%
Real estate owned as a
percentage of total
portfolio at end of period.. 1.54 0.77 1.11 1.10 0.68
Loan and lease losses as a
percentage of the average
total portfolio during the
period...................... 1.02 0.36 0.28 0.53 0.31
75
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following financial review and analysis of the financial condition
and results of operations for the fiscal years ended June 30, 2004, 2003 and
2002 should be read in conjunction with the consolidated financial statements
and the accompanying notes to the consolidated financial statements, and other
detailed information appearing in this document.
OVERVIEW
GENERAL. We are a financial services organization operating mainly in
the eastern and central portions of the United States. Recent expansion has
positioned us to increase our operations in the western portion of the United
States, especially California. See "-- Business Strategy Adjustments" for
details of our acquisition of a broker operation located in California. Through
our principal direct and indirect subsidiaries, we originate, sell and service
home mortgage loans. We also process and purchase home mortgage loans through
our Bank Alliance Services program. See "Business -- Lending Activities -- Home
Mortgage Loans" for a description of this program and the amount of loans we
purchased under this program. Additionally, we service business purpose loans,
which we had originated and sold in prior periods. To the extent we obtain a
credit facility to fund business purpose loans, we may originate and sell
business purpose loans in future periods.
In addition, we offer subordinated debentures to the public, the
proceeds of which are used for repayment of existing debt, loan originations,
our operations (including repurchases of delinquent assets from securitization
trusts and funding our loan overcollateralization requirements under our credit
facilities), investments in systems and technology and for general corporate
purposes.
Historically, our loans primarily consisted of fixed interest rate
loans secured by first or second mortgages on one-to-four family residences. Our
business strategy adjustments include increasing loan originations by offering
adjustable rate loans and purchase money mortgage loans. During the fourth
quarter of fiscal 2004, 46.7% of loans we originated were adjustable rate and
53.3% were fixed rate. During fiscal 2004, 18.0% of the loans we originated were
purchase money mortgage loans. During fiscal 2004, 89.9% of the loans we
originated were secured by first mortgages and 10.1% were secured by second
mortgages.
Our customers are primarily credit-impaired borrowers who are generally
unable to obtain financing from banks or savings and loan associations and who
are attracted to our products and services. This type of borrower is commonly
referred to as a subprime borrower. Loans made to subprime borrowers are
frequently referred to as subprime loans.
We originate loans through a combination of channels including a
national processing center located at our centralized operating office in
Philadelphia, Pennsylvania and a network of mortgage brokers. Our loan servicing
and collection activities are performed at our Philadelphia office.
76
Our loan origination volumes, and accordingly our financial results,
are affected by the economic environment, including interest rates, consumer
spending and debt levels, real estate values and employment rates. Additionally,
our loan originations are affected by competitive conditions and regulatory
influences.
Our principal revenues are derived from gains on the sale of loans in
either whole loan sales or securitizations, interest accretion on our
interest-only strips, interest income earned on loans while they are carried on
our balance sheet and income from servicing loans.
Our principal expenses include interest expense incurred on our
subordinated debentures and senior collateralized subordinated notes, interest
expense incurred to fund loans while they are carried on our balance sheet, the
provision for credit losses recognized on loans carried on our balance sheet and
loans repurchased from securitization trusts, employee related costs, marketing
costs, costs to service and collect loans and other administrative expenses.
Our critical success factors include our ability to originate loans,
our ability to sell loans in whole loan sales or into securitizations, our
ability to maintain credit and warehouse facilities to fund loan originations,
and our ability to raise capital through the sale of subordinated debentures.
OUR RECENT FINANCIAL DIFFICULTIES AND LIQUIDITY CONCERNS. Several
events and issues, which occurred beginning in the fourth quarter of fiscal
2003, have negatively impacted our short-term liquidity and contributed to our
losses for fiscal 2003 and fiscal 2004. These events included our inability to
complete publicly underwritten securitizations during the fourth quarter of
fiscal 2003 and all of fiscal 2004 (we completed a privately-placed
securitization in the second quarter of fiscal 2004), our inability to draw down
upon and the expiration of several of our credit facilities, and our temporary
discontinuation of sales of new subordinated debentures for approximately a
six-week period during the first quarter of fiscal 2004.
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Our inability to complete a publicly underwritten securitization during
the fourth quarter of fiscal 2003 was the result of our investment bankers'
decision in late June 2003 not to underwrite the contemplated June 2003
securitization transaction. Management believes that a number of factors
contributed to this decision, including a highly publicized lawsuit finding
liability of an underwriter in connection with the securitizations of loans for
another unaffiliated subprime leader, an inquiry by the Civil Division of the
U.S. Attorney's Office in Philadelphia regarding our forbearance practices, an
anonymous letter regarding us received by our investment bankers, the SEC's
enforcement action against another unaffiliated subprime lender related to its
loan restructuring practices and related disclosure, a federal regulatory agency
investigation of practices by another subprime servicer and our investment
bankers' prior experience with securitizations transactions with non-affiliated
originators.
We were unable to complete a publicly underwritten securitization
during fiscal 2004 due to our diminished capacity to originate loans, our
commitment to whole loan sales under our adjusted business strategy, our
financial condition and liquidity issues, and an absence of market demand for
our securitizations. We completed a privately-placed securitization during the
second quarter of fiscal 2004.
As a result of these liquidity issues our loan origination volume
during fiscal 2004 was substantially reduced. From July 1, 2003 through June 30,
2004, we originated $982.7 million of loans, as compared to originations of
$1.67 billion of loans for the same period in fiscal 2003. We anticipate that
depending upon the size of our future quarterly securitizations, if any, we will
need to increase our loan originations to approximately $400.0 million to $500.0
million per month to return to profitable operations. If we are unable to
complete quarterly securitizations, we will need to increase our loan
originations to approximately $500.0 million to $600.0 million per month to
return to profitability. Our ability to achieve the levels of loan originations
necessary to achieve profitable operations could be hampered by our failure to
continue to successfully implement our adjusted business strategy, funding
limitations under existing credit facilities and our ability to obtain new
credit facilities and renew existing facilities. Our plan is to increase loan
originations through the continued application of our business strategy
adjustments, particularly as related to building our expanded broker channel and
offering adjustable rate mortgages and more competitively priced fixed rate
mortgages. See "Business -- Business Strategy" for a discussion of our plans to
achieve this level of originations. For a detailed discussion of our losses,
capital resources and commitments, see "-- Liquidity and Capital Resources."
We have entered into a commitment letter and anticipate entering into a
definitive agreement regarding a $100.0 million credit facility to replace our
$200.0 million facility (reduced to $100.0 million on September 30, 2004) that
expires on November 5, 2004. However, we cannot assure you that we will enter
into a definitive agreement regarding the $100.0 million credit facility or that
this agreement will contain terms and conditions acceptable to us.
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We are currently negotiating additional credit facilities to provide
additional borrowing capacity to fund the increased level of loan originations
expected under our adjusted business strategy, however, no assurances can be
given that we will succeed in obtaining new credit facilities or that these
facilities will contain terms and conditions acceptable to us. See "-- Liquidity
and Capital Resources" for a discussion of these facilities.
On June 30, 2004, we had unrestricted cash of approximately $0.9
million and up to $210.4 million available under our warehouse credit
facilities. We can only use advances under these credit facilities to fund loan
originations and not for any other purposes. The combination of our current cash
position and expected sources of operating cash may not be sufficient to cover
our operating cash requirements.
For the next six to twelve months, we intend to augment our sources of
operating cash with proceeds from the issuance of subordinated debentures. In
addition to repaying maturing subordinated debentures, proceeds from the
issuance of subordinated debentures may be used to fund overcollateralization
requirements, as defined below, in connection with our loan originations and to
fund our operating losses. Under the terms of our credit facilities, our credit
facilities will advance us 75% to 97% of the value of loans we originate. See
"-- Liquidity and Capital Resources" for a discussion of advance rates under the
terms of our credit facilities." As a result of this limitation, we must fund
the difference between the loan value and the advances, which we refer to as the
overcollateralization requirement, from our operating cash. We can provide no
assurances that we will be able to continue issuing subordinated debentures.
See "-- Liquidity and Capital Resources -- Remedial Steps Taken to
Address Liquidity Issues" for a discussion of the specific actions we undertook
to address liquidity concerns.
RECENT OPERATING LOSSES AND SALE OF ASSETS. We incurred a net loss
attributable to common stock of $115.1 million and $29.9 million for the fiscal
years ended June 30, 2004 and 2003, respectively. In addition, depending on our
ability to recognize gains on our future securitizations, we anticipate
incurring operating losses at least through the first quarter of fiscal 2005.
The loss for fiscal 2004 primarily resulted from liquidity issues we
have experienced since the fourth quarter of fiscal 2003, including the absence
of credit facilities until the second quarter of fiscal 2004, which
substantially reduced our loan origination volume and our ability to generate
revenues, our inability to complete a publicly underwritten securitization
during fiscal 2004, our shift in business strategy to focus on whole loan sales,
and charges to the income statement of $46.4 million for pre-tax valuation
adjustments on our securitization assets. Additionally, operating expense levels
that would support greater loan origination volume also contributed to the loss
for fiscal 2004.
During fiscal 2004, we recorded total pre-tax valuation adjustments on
our interest-only strips and servicing rights of $63.8 million, of which $46.4
million was charged as expense to the income statement and $17.4 million was
charged to other comprehensive income, a component of stockholders' equity.
These adjustments primarily reflect the impact of higher than anticipated
prepayments on securitized loans experienced in fiscal 2004 due to the low
interest rate environment experienced during fiscal 2004. Additionally, the
fiscal 2004 valuation adjustment also includes a write down of $5.4 million of
the carrying value of our interest-only strips and servicing rights related to
five of our mortgage securitization trusts to reflect their values under the
terms of a September 27, 2004 sale agreement. The sale of these assets was
undertaken as part of our negotiations to obtain the new $100.0 million
warehouse credit facility described in "-- Liquidity and Capital Resources" and
to raise cash to pay fees on new warehouse credit facilities and as a result, we
did not realize their full value as reflected on our books. This compares to
total pre-tax valuation adjustments on our securitization assets of $63.3
million during the year ended June 30, 2003, of which $45.2 million was charged
as expense to the income statement and $18.1 million was reflected as an
adjustment to other comprehensive income. See "- Application of Critical
Accounting Estimates - Interest-Only Strips" for a discussion of how valuation
adjustments are recorded.
EXCHANGE OFFERS. On December 1, 2003, we mailed an offer to exchange,
which we refer to as the first exchange offer, to holders of our subordinated
debentures issued prior to April 1, 2003. On May 14, 2004, we mailed a second
offer to exchange, which we refer to as the second exchange offer, to holders of
our subordinated debentures issued prior to November 1, 2003. See "-- Liquidity
and Capital Resources -- Subordinated Debentures" for more detail on the terms
of the exchange offers, senior collateralized subordinated notes and Series A
preferred stock issued and the results of the exchange offers.
Depending on market conditions and our financial condition, we may
engage in additional exchange offers in the future and we are considering
another exchange offer in our second quarter of fiscal 2005.
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AMOUNT OF OUR INDEBTEDNESS. At June 30, 2004, we had total
indebtedness of approximately $847.4 million, comprised of amounts outstanding
under our credit facilities, senior collateralized subordinated notes issued in
the exchange offers, capitalized leases and subordinated debentures. See "--
Liquidity and Capital Resources -- Secured and Unsecured Indebtedness " for a
comparison at June 30, 2004 of our secured and senior debt obligations and
unsecured subordinated debenture obligations to assets which are available to
repay those obligations.
BUSINESS STRATEGY ADJUSTMENTS. In response to our inability to
securitize our loans and the liquidity concerns described above, we adjusted our
business strategy at the beginning of fiscal 2004. Our adjusted business
strategy focuses on shifting from gain-on-sale accounting and the use of
securitization transactions as our primary method of selling loans to a more
diversified strategy which utilizes a combination of whole loan sales and
securitizations, while protecting revenues, controlling costs and improving
liquidity. See "Business -- Business Strategy" for information regarding our
adjusted business strategy.
Our business strategy is dependent on our ability to emphasize lending
related activities that provide us with the most economic value. The
implementation of this strategy will depend in large part on a variety of
factors outside of our control, including, but not limited to, our ability to
obtain adequate financing on reasonable terms and to profitably sell or
securitize our loans on a regular basis. Our failure with respect to any of
these factors could impair our ability to successfully implement our strategy,
which could adversely affect our results of operations and financial condition.
See "Risk Factors -- If we are unable to successfully implement our adjusted
business strategy which focuses on whole loan sales, we may be unable to attain
profitable operations which could impair our ability to repay our outstanding
debt and could negatively impact the value of our capital stock."
If we fail to generate sufficient liquidity through the sales of our
loans, the sale of our subordinated debentures, the maintenance of credit
facilities or a combination of the foregoing, we will have to restrict loan
originations and make additional changes to our business strategy, including
restricting or restructuring our operations which could result in losses and
impair our ability to repay our subordinated debentures and other outstanding
debt. While we currently believe that we will be able to restructure our
operations, if necessary, we cannot assure you that such restructuring will
enable us to attain profitable operations or repay the subordinated debentures
when due. If we fail to successfully implement our adjusted business strategy,
we will be required to consider other alternatives, including raising additional
equity, seeking to convert an additional portion of our subordinated debentures
to equity, seeking protection under federal bankruptcy laws, seeking a strategic
investor, or exploring a sale of the company or some or all of its assets. See
"Risk Factors -- We depend upon the availability of financing to fund our
continuing operations. Any failure to obtain adequate funding could hurt our
ability to operate profitably, restrict our ability to repay our outstanding
debt and negatively impact the value of our capital stock" and "-- If we are
unable to obtain additional financing, we may be not be able to restructure our
business to permit profitable operations or repay our outstanding debt and the
value of our capital stock will be negatively impacted."
In addition to the above potential restrictions and changes to our
business strategy, in the event we are unable to offer additional subordinated
debentures for any reason, we have developed a contingent financial
restructuring plan including cash flow projections for the next twelve-month
period. Based on our current cash flow projections, we anticipate being able to
make all scheduled subordinated debenture maturities and vendor payments.
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The contingent financial restructuring plan is based on actions that we
would take, in addition to those indicated in our adjusted business strategy, to
reduce our operating expenses and conserve cash. These actions would include
reducing capital expenditures, selling all loans originated on a whole loan
basis, eliminating or downsizing various lending, overhead and support groups
and obtaining working capital funding. No assurance can be given that we will be
able to successfully implement the contingent financial restructuring plan, if
necessary, and repay the subordinated debentures when due.
CREDIT FACILITIES, SERVICING AGREEMENTS AND WAIVERS RELATED TO
FINANCIAL COVENANTS. At various times since June 30, 2003, including at June 30,
2004, July 31, 2004, August 31, 2004 and September 30, 2004, we have been out of
compliance with one or more financial covenants contained in our $200.0 million
credit facility (reduced to $100.0 million). We have continued to operate on the
basis of waivers granted by the lender under this facility. We currently
anticipate that we will be out of compliance with one or more of these financial
covenants at October 31, 2004 and will need a waiver from this lender for this
noncompliance to continue to operate. The expiration date of this facility was
originally September 21, 2004, but the lender agreed to extend the expiration
date until November 5, 2004 in consideration for, among other things, a
reduction in the amount that could be borrowed under this facility to $100.0
million.
A provision in our $250.0 million credit facility required us to
maintain another credit facility for $200.0 million with a $40.0 million
sublimit of such facility available for funding loans between the time they are
closed by a title agency or closing attorney and the time documentation for the
loans is received by the collateral agent. As a result of the reduction of our
$200.0 million facility to $100.0 million, as described above, we entered into
an amendment to the master loan and security agreement governing our $250.0
million facility which reduced the required amount for another facility to
$100.0 million. In the event we do not extend the $200.0 million (now $100.0
million) facility beyond its November 5, 2004 expiration date, or in the event
we do not otherwise enter into definitive agreements with other lenders by
November 5, 2004 which satisfy the above-described requirements in our $250.0
million facility for $100.0 million in additional credit facilities and a $40.0
million sublimit, we will need an additional amendment to the $250.0 million
facility or a waiver from the lender to continue to operate.
At various times since June 30, 2003 we have also been out of
compliance with the net worth requirement in several of our pooling and
servicing agreements and sale and servicing agreements (collectively referred to
in this document as the servicing agreements). Two of the financial insurers who
provide financial guaranty insurance to certain bond holders and certificate
holders under these servicing agreements (collectively referred to in this
document as bond insurers) required us to amend the servicing agreements in
consideration for granting us waivers from this noncompliance. One bond insurer
granted us a permanent waiver from this noncompliance in consideration for a
term-to-term servicing arrangement. The other bond insurer granted us a one-time
waiver in consideration for a term-to-term servicing arrangement. Since then, we
have had to obtain a waiver of net worth requirements from this bond insurer on
a monthly basis and we currently anticipate that we will need to do so for the
foreseeable future.
Due to our financial results during fiscal 2004, two other bond
insurers required us to amend the servicing agreements related to the
securitizations these bond insurers insured. As a result of the amendments to
our servicing agreements, all of our servicing agreements associated with bond
insurers now provide for term-to-term servicing and, in the case of our
servicing agreements with two bond insurers, our rights as servicer may be
terminated at the expiration of a servicing term in the sole discretion of the
bond insurer.
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We cannot assure you that we will continue to receive the waivers and
servicing agreement extensions that we need to operate or that they will not
contain conditions that are unacceptable to us. Because we anticipate incurring
losses through at least the first quarter of fiscal 2005, we anticipate that we
will need to obtain additional waivers from our lenders and bond insurers as a
result of our non-compliance with financial covenants contained in our credit
facilities and servicing agreements. To the extent we are not able to obtain
waivers under our credit facilities, we may be unable to pay dividends on the
Series A preferred stock. See "-- Liquidity and Capital Resources" for
additional information regarding the waivers obtained. See also "Risk Factors --
Restrictive covenants in the agreements governing our indebtedness may reduce
our operating flexibility and limit our ability to operate profitability, and
our ability to repay our outstanding debt may be impaired and the value of our
capital stock could be negatively impacted" and " -- Our servicing rights may be
terminated if we fail to satisfactorily perform our servicing obligations, or
fail to meet minimum net worth requirements or financial covenants which could
hinder our ability to operate profitably, impair our ability to repay our
outstanding debt and negatively impact the value of our capital stock."
DELINQUENCIES; FORBEARANCE AND DEFERMENT ARRANGEMENTS. We had total
delinquencies in our managed portfolio of $219.4 million at June 30, 2004,
$228.9 million at June 30, 2003 and $171.6 million at June 30, 2002. The managed
total portfolio includes loans on our balance sheet and loans serviced for
others. At June 30, 2004, the total managed portfolio was $2.1 billion, compared
to $3.7 billion at June 30, 2003 and $3.1 billion at June 30, 2002. Total
delinquencies (loans and leases, excluding real estate owned, with payments past
due for more than 30 days) as a percentage of the total managed portfolio were
10.49% at June 30, 2004 compared to 6.27% at June 30, 2003 and 5.59% at June 30,
2002.
As the managed portfolio continues to season and if the economy does
not continue to improve, the delinquency rate may continue to increase, which
could negatively impact our ability to sell or securitize loans and reduce our
profitability and the funds available to repay our subordinated debentures. As
the portfolio seasons, or ages, the likelihood that borrowers will incur credit
problems increases. Additionally, continuing low market interest rates could
continue to encourage borrowers to refinance their loans and increase the levels
of loan prepayments we experience which would negatively impact our delinquency
rate.
Delinquencies in our total managed portfolio do not include $216.3
million of previously delinquent loans at June 30, 2004, which are subject to
deferment and forbearance arrangements. Generally, a loan remains current after
we enter into a deferment or forbearance arrangement with the borrower only if
the borrower makes the principal and interest payments as required under the
terms of the original note (exclusive of the delinquent payments advanced or
fees paid by us on borrower's behalf as part of the deferment or forbearance
arrangement) and we do not reflect it as a delinquent loan in our delinquency
statistics. However, if the borrower fails to make principal and interest
payments, we will generally declare the account in default, reflect it as a
delinquent loan in our delinquency statistics and resume collection actions.
During the final six months of fiscal 2003 and the first six months of
fiscal 2004, we experienced a pronounced increase in the number of borrowers
under deferment arrangements and in light of the weakened economic environment
during that twelve-month period we made use of deferment arrangements to a
greater degree than in prior periods. Since December 2003, we have experienced a
reduction in new deferment arrangements and if the improving economic
environment continues, we expect to continue to experience a reduction in new
deferment arrangements.
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There was approximately $216.3 million of cumulative unpaid principal
balance of loans under deferment and forbearance arrangements at June 30, 2004,
as compared to approximately $197.7 million and $138.7 million of cumulative
unpaid principal balance at June 30, 2003 and 2002, respectively. Total
cumulative unpaid principal balances under deferment or forbearance arrangements
as a percentage of the total managed portfolio were 10.34% at June 30, 2004,
compared to 5.41% and 4.52% at June 30, 2003 and 2002, respectively.
Additionally, there are loans under deferment and forbearance arrangements which
have returned to delinquent status. At June 30, 2004, there was $29.9 million of
cumulative unpaid principal balance under deferment arrangements and $31.8
million of cumulative unpaid principal balance under forbearance arrangements
that are now reported as delinquent 31 days or more. See "-- On Balance Sheet
Portfolio Quality -- Deferment and Forbearance Arrangements," "-- Total
Portfolio Quality -- Deferment and Forbearance Arrangements" and "Risk Factors
-- Restrictive covenants in the agreements governing our indebtedness may reduce
our operating flexibility and limit our ability to operate profitably, and our
ability to repay our outstanding debt may be impaired and the value of our
capital stock could be negatively impacted."
LISTING ON THE NASDAQ NATIONAL MARKET SYSTEM. Since our common stock is
listed on the NASDAQ National Market System, we are required to meet certain
requirements established by the NASDAQ Stock Market in order to maintain this
listing. These requirements include, among other things, maintenance of
stockholders' equity of $10.0 million, a minimum bid price of $1.00 and a market
value of publicly held shares of $5.0 million. If we are unable to maintain our
listing on the NASDAQ National Market System, the value of our capital stock and
our ability to continue to sell subordinated debentures would be negatively
impacted by making the process of complying with the state securities laws more
difficult, costly and time consuming. As a result, we may be unable to continue
to sell subordinated debentures in certain states, which would have a material
adverse effect on our liquidity and our ability to repay maturing debt when due.
There can be no assurance that we will be in compliance with the $10.0 million
stockholders' equity requirement on September 30, 2004. We are considering a new
exchange offer in order to maintain compliance with this listing requirement.
See "Risk Factors -- In the event our common stock is delisted from trading on
the NASDAQ National Market System, the value of our capital stock and our
ability to continue to sell subordinated debentures would be negatively
impacted."
LIQUIDITY AND CAPITAL RESOURCES
GENERAL. Liquidity and capital resource management is a process focused
on providing the funding to meet our short and long-term cash needs. We have
used a substantial portion of our funding sources to build our serviced
portfolio and investments in securitization assets with the expectation that
they will generate sufficient cash flows in the future to cover our operating
requirements, including repayment of maturing subordinated debentures and senior
collateralized subordinated notes outstanding. Our cash needs change as the mix
of loan sales through securitization shifts to more whole loan sales, as the
serviced portfolio changes, as our interest-only strips mature and release cash,
as subordinated debentures and senior collateralized subordinated notes
outstanding mature, as operating expenses change and as revenues change. Because
we have historically experienced negative cash flows from operations under our
prior business strategy and, more recently, have been impacted by short-term
liquidity issues, our business requires continual access to short and long-term
sources of debt to generate the cash required to fund our operations.
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Our cash requirements include funding loan originations, repaying
existing subordinated debentures and senior collateralized subordinated notes
outstanding, paying interest expense, preferred dividends and operating
expenses, funding capital expenditures, and in connection with our
securitizations, funding overcollateralization requirements, costs of
repurchasing delinquent loans for trigger management and servicer obligations.
When loans are sold through a securitization, we may retain the rights to
service the loans. Servicing loans obligates us to advance interest payments for
delinquent loans under certain circumstances and allows us to repurchase a
limited amount of delinquent loans from securitization trusts. See "--
Securitizations" and "-- Securitizations -- Trigger Management" and "--
Securitizations -- Repurchase Rights" for more information on how the servicing
of securitized loans affects requirements on our capital resources and cash
flow. At times, we have used cash to repurchase our common stock and could in
the future use cash for unspecified acquisitions of related businesses or assets
(although no acquisitions are currently contemplated).
Under our business strategy, we initially finance our loans under
secured credit facilities. These credit facilities are generally revolving lines
of credit that enable us to borrow on a short-term basis against our loans. We
then sell our loans to unrelated third parties on a whole loan basis or
securitize our loans to generate the cash to pay off these revolving credit
facilities.
LIQUIDITY CONCERNS. Several events and issues have negatively impacted
our short-term liquidity. First, our inability to complete a publicly
underwritten securitization during the fourth quarter of fiscal 2003 adversely
impacted our short-term liquidity position and contributed to our loss for
fiscal 2003. Because there was no securitization, $453.4 million of the $516.1
million in revolving credit and conduit facilities available to us at June 30,
2003 was drawn upon. Our revolving credit facilities and mortgage conduit
facility had only $62.7 million of unused capacity available at June 30, 2003,
which significantly reduced our ability to fund loan originations in fiscal 2004
until we sold existing loans, extended existing credit facilities, or added new
credit facilities.
Second, our ability to borrow under credit facilities to fund new loan
originations in the first three months of fiscal 2004 using borrowings under
certain of our credit facilities which carried over into fiscal 2004 was
limited, terminated or expired by October 31, 2003. Further advances under a
non-committed portion of one of these credit facilities were subject to the
discretion of the lender and subsequent to June 30, 2003, there were no new
advances under the non-committed portion. Additionally, on August 20, 2003, this
credit facility was amended to, among other things, eliminate the non-committed
portion, reduce the amount available to $50.0 million and accelerate the
expiration date from November 2003 to September 30, 2003. We entered into a
subsequent amendment to this facility, which extended its maturity date to
October 17, 2003. We also had a $300.0 million mortgage conduit facility with a
financial institution that enabled us to sell our loans into an off-balance
sheet facility, which expired pursuant to its terms on July 5, 2003. In
addition, we were unable to borrow under a $25.0 million warehouse facility
after September 30, 2003, and this $25.0 million facility expired on October 31,
2003.
Third, even though we were successful in obtaining one new credit
facility in September 2003 and a second new credit facility in October 2003, our
ability to finance new loan originations in the second and third quarters of
fiscal 2004 with borrowings under these new facilities was limited. The
limitations resulted from requirements to fund overcollateralization, which is
discussed below, in connection with new loan originations.
Fourth, our temporary discontinuation of sales of new subordinated
debentures for approximately a six-week period during the first quarter of
fiscal 2004 further impaired our liquidity.
As a result of these liquidity issues, our loan origination volume was
substantially reduced. In fiscal 2004, we originated $982.7 million of loans,
compared to originations of $1.67 billion of loans in fiscal 2003. As a result
of the decrease in loan originations and liquidity issues described above, we
incurred losses in fiscal 2003 and 2004 and depending on our ability to complete
securitizations and recognize gains in the future, we anticipate incurring
losses at least through the first quarter of fiscal 2005.
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For the next six to twelve months, we intend to augment our sources of
operating cash with proceeds from the issuance of subordinated debentures. In
addition to repaying maturing subordinated debentures, proceeds from the
issuance of subordinated debentures may be used to fund overcollateralization
requirements in connection with our loan originations and fund our operating
losses. Under the terms of our credit facilities, our credit facilities will
advance us 75% to 97% of the value of loans we originate. As a result of this
limitation, we must fund the difference between the loan value and the advances,
which we refer to as the overcollateralization requirement, from our operating
cash. We can provide no assurances that we will be able to continue issuing
subordinated debentures.
There can be no assurance that we will be in compliance with the
$10.0 million stockholders' equity requirement on September 30, 2004. We are
considering a new exchange offer in order to maintain compliance with this
listing requirement. If we are unable to maintain our listing on the NASDAQ
National Market System, our ability to continue to sell subordinated debentures
would be negatively impacted by making the process of complying with the state
securities laws more difficult, costly and time consuming. As a result, we may
be unable to continue to sell subordinated debentures in certain states, which
would have a material adverse effect on our liquidity and our ability to repay
maturing debt when due.
SECURED AND UNSECURED INDEBTEDNESS. At June 30, 2004, we had total
indebtedness of approximately $847.4 million, comprised of amounts outstanding
under our credit facilities, senior collateralized subordinated notes issued in
the exchange offers, capitalized leases and subordinated debentures. The
following table compares our secured and senior debt obligations and unsecured
subordinated debenture obligations at June 30, 2004 to assets which were
available to repay those obligations. We anticipate that any shortfall in assets
available to repay obligations will be funded through cash received on the sale
of future loan originations:
(a) Includes the impact of the exchange of $177.8 million of subordinated
debentures (unsecured subordinated debentures) for $84.0 million of senior
collateralized subordinated notes (secured and senior debt obligations) and
93.8 million shares of Series A preferred stock in the first exchange offer
and first closing of the second exchange offer. At June 30, 2004, our
interest in the cash flows from the interest-only strips held in the trust,
which secure the senior collateralized subordinated notes totaled $411.9
million, of which approximately $125.5 million represents 150% of the
principal balance of the senior collateralized subordinated notes
outstanding at June 30, 2004. For presentation purposes, $125.5 million is
included in the column entitled "secured and senior debt obligations" in the
table above.
(b) Security interests under the terms of the $250.0 million credit facility are
included in this table. This $250.0 million credit facility is secured by
loans when funded under this facility. In addition, interest-only strips
secure, as a first priority, obligations in an amount not to exceed 10% of
the outstanding principal balance under this facility and the obligations
due under the fee letter related to this facility. Assuming the entire
$250.0 million available under this credit facility were utilized, the
maximum amount secured by the interest-only strips would be approximately
$53.7 million. This amount is included as an allocation of our interest-only
strips to the secured and senior debt obligations column.
(c) Reflects the amount of loans specifically pledged as collateral against our
advances under our credit facilities.
(d) Reflects the fair value of our interest-only strips and servicing rights at
June 30, 2004.
(e) The grant of a lien on the collateral to secure the senior collateralized
subordinated notes issued upon the completion of the first exchange offer
and the senior collateralized subordinated notes to be issued in this
exchange offer is not a direct lien on any interest-only strips, but is,
rather, a lien on the right of certain of our subsidiaries to receive
certain cash flows from ABFS Warehouse Trust 2003-1 which is a special
purpose entity which holds the majority of, but not all of, the
interest-only strips directly or indirectly held by us. The interest-only
strips in this trust also secure, as a first priority, obligations in an
amount not to exceed 10% of the outstanding principal balance under our
$250.0 million credit facility and the obligations due under the fee letter
related to this facility. Assuming the entire $250.0 million available under
this credit facility were utilized, the maximum amount secured by the
interest-only strips would be approximately $53.7 million.
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(f) The second exchange offer was extended through August 23, 2004 with closings
on July 31, 2004 and August 23, 2004. The pro forma effects on the above
table of the two closings of an additional $30.8 million of subordinated
debentures (unsecured subordinated debentures) for $15.2 million of senior
collateralized subordinated notes (secured obligations) and 15.6 million
shares of Series A Preferred Stock are summarized below. At August 23, 2004,
$22.8 million of our interest-only strips were collateralizing these new
senior collateralized subordinated notes. Including the senior
collateralized subordinated notes issued as of June 30, 2004, $148.2 million
of our interest-only strips are collateralizing senior collateralized
subordinated notes. The table below summarizes the pro forma impact of the
two closings of our second exchange offer subsequent to June 30, 2004 on the
historical comparison of our secured and senior debt obligations and
unsecured subordinated debenture obligations at June 30, 2004 to assets
which are available to repay those obligations (in thousands):
SECURED AND UNSECURED
SENIOR DEBT SUBORDINATED TOTAL
(in thousands) OBLIGATIONS DEBENTURES DEBT/ASSETS
----------- ------------ -----------
Outstanding debt obligations -
historical............................... $ 324,839 $ 522,609 $ 847,448
Pro forma effect of the second exchange
offer extension to August 23, 2004....... 15,173 (30,811) (15,638)
----------- ------------ -----------
Pro forma outstanding debt
obligations.............................. $ 340,012 $ 491,798 $ 831,810
=========== ============ ===========
Total assets available to repay debt -
historical............................... $ 431,533 $ 406,476 $ 838,009
Pro forma effect of the second exchange
offer extension to August 23, 2004....... 22,760 (22,760) --
----------- ------------ -----------
Pro forma assets available................... $ 454,293 $ 383,716 $ 838,009
=========== ============ ===========
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REMEDIAL STEPS TAKEN TO ADDRESS LIQUIDITY ISSUES. Since June 30, 2003,
we undertook specific remedial actions to address liquidity concerns including:
o We adjusted our business strategy beginning in early fiscal 2004.
Our adjusted business strategy focuses on shifting from gain-on-sale
accounting and the use of securitization transactions as our primary
method of selling loans to a more diversified strategy which
utilizes a combination of whole loan sales and securitizations,
while protecting revenues, controlling costs and improving
liquidity. See "-- Overview -- Business Strategy Adjustments" and
"Business -- Business Strategy" for more information.
o We solicited bids and commitments from participants in the whole
loan sale market and entered into forward sale agreements and
individual sale transactions. In total, from June 30, 2003 through
June 30, 2004, we sold approximately $1.1 billion (which includes
$222.3 million of loans sold by the expired mortgage conduit
facility described under "-- Credit Facilities") of loans through
whole loan sales. From July 1, 2004 through September 30, 2004, we
sold an additional $586.5 million of loans through whole loan sales.
88
o We have entered into an informal arrangement with one recurring
purchaser of our loans whereby the purchaser maintains members of
its loan underwriting staff on our premises to facilitate its
purchase of our loans promptly after we originate them. This
arrangement accelerates our receipt of cash proceeds from the sale
of loans, accelerates the pay down of our advances under our
warehouse credit facilities and adds to our liquidity. This quicker
turnaround time is expected to enable us to operate with smaller
committed warehouse credit facilities than would otherwise be
necessary.
o On October 31, 2003, we completed a privately-placed securitization,
with servicing released, of $173.5 million of loans.
o We entered into two definitive loan agreements during fiscal 2004
for the purpose of funding our loan originations. These two
agreements replaced those credit facilities, which carried over into
fiscal 2004 but were limited, terminated or expired by October 31,
2003. We entered into the first agreement on September 22, 2003 with
a financial institution for a one-year $200.0 million credit
facility. We entered into the second agreement on October 14, 2003
with a warehouse lender for a three-year revolving mortgage loan
warehouse credit facility of up to $250.0 million. The $200.0
million facility was extended to November 5, 2004 and reduced to
$100.0 million. The three-year $250.0 million warehouse credit
facility continues to be available. See "-- Credit Facilities" for
information regarding the terms of these facilities.
o We have recently entered into a commitment letter and anticipate
entering into a definitive agreement with a warehouse lender for a
one-year $100.0 million credit facility to replace the maturing
$200.0 million credit facility (reduced to $100.0 million). However,
we cannot assure you that we will enter into a definitive agreement
regarding the $100.0 million credit facility or that this agreement
will contain the terms and conditions acceptable to us. We also sold
the interest-only strips and servicing rights related to five of our
mortgage securitization trusts to an affiliate of this facility
provider under the terms of a September 27, 2004 sale agreement. The
sale of these assets was undertaken as part of our negotiations to
obtain the new $100.0 million warehouse credit facility and to raise
cash to pay fees on new warehouse credit facilities and as a result,
we did not realize their full value as reflected on our books. We
wrote down the carrying value of these interest-only strips and
servicing rights by $5.4 million at June 30, 2004 to reflect their
values under the terms of the sale agreement.
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o We are currently negotiating additional credit facilities to provide
additional borrowing capacity to fund the increased level of loan
originations expected under our adjusted business strategy, however,
no assurances can be given that we will succeed in obtaining new
credit facilities or that these facilities will contain terms and
conditions acceptable to us. See "-- Credit Facilities" for
information regarding the terms of these facilities and "Risk
Factors -- If we are unable to obtain additional financing, we may
not be able to restructure our business to permit profitable
operations or repay our outstanding debt and the value of our
capital stock will be negatively impacted."
o We mailed exchange offers on December 1, 2003 and May 14, 2004 to
holders of our subordinated debentures in order to increase our
stockholders' equity and reduce the amount of our outstanding debt.
These exchange offers resulted in the exchange of $208.6 million of
our subordinated debentures for 109.4 million shares of Series A
preferred stock and $99.2 million of senior collateralized
subordinated notes. The issuance of 109.4 million shares of Series A
preferred stock results in an annual cash preferred dividend
obligation of $10.9 million. See "-- Subordinated Debentures" for
more detail on the terms of the exchange offers, senior
collateralized subordinated notes and preferred stock issued.
o On January 22, 2004, we executed an agreement to sell our interests
in the remaining leases in our portfolio. The terms of the agreement
included a cash sale price of approximately $4.8 million in exchange
for our lease portfolio balance as of December 31, 2003. We received
the cash from this sale in January 2004 and recognized a net gain of
$0.5 million.
o We suspended the payment of quarterly dividends on our common stock
beginning in the first quarter of fiscal 2004.
Although we obtained two warehouse credit facilities totaling $450.0
million in fiscal 2004, and after November 5, 2004 we expect to have at least
two warehouse credit facilities totaling at a minimum $500.0 million, the
proceeds of these credit facilities could only be used to fund loan originations
and could not be used for any other purpose. Consequently, we need to generate
cash to fund the balance of our business operations from other sources, such as
whole loan sales, additional financings and sales of subordinated debentures.
Additionally, our warehouse credit facilities have been obtained at high costs,
which have a significant impact on our liquidity. See "-- Credit Facilities" for
detail on the amount of fees we are required to pay under these facilities.
We can provide no assurances that we will be able to sell our loans,
maintain existing credit facilities or expand or obtain new credit facilities,
if necessary. If we are unable to maintain existing financing, we may not be
able to restructure our business to permit profitable operations or repay our
subordinated debentures and senior collateralized subordinated notes when due.
Even if we are able to maintain adequate financing, our inability to originate
and sell our loans could hinder our ability to operate profitably in the future
and repay our subordinated debentures and senior collateralized subordinated
notes when due.
SHORT AND LONG TERM CAPITAL RESOURCES AND CONTRACTUAL OBLIGATIONS. The
following table summarizes our short and long-term capital resources and
contractual obligations as of June 30, 2004. For capital resources, the table
presents projected and scheduled principal cash flows expected to be available
to meet our contractual obligations. For those timeframes where a shortfall in
capital resources exists, we anticipate that these shortfalls will be funded
through a combination of cash from whole loan sales of future loan originations
and the issuance of subordinated debentures. We can provide no assurances that
we will be able to continue issuing subordinated debentures. In the event that
we are unable to offer additional subordinated debentures for any reason, we
have developed a contingent financial restructuring plan. See "-- Overview --
Business Strategy Adjustments" for a discussion of this plan. The terms of our
credit facilities provide that we may only use the funds available under the
credit facilities to originate home mortgage loans.
(a) Reflects projected cash flows utilizing assumptions including prepayment and
credit loss rates. See "-- Application of Critical Accounting Estimates --
Interest-Only Strips" and "Application of Critical Accounting Estimates -
Servicing Rights."
(b) See "-- Contractual Obligations."
(c) This table reflects interest payment terms elected by subordinated debenture
holders as of June 30, 2004. In accordance with the terms of the
subordinated debenture offering, subordinated debenture holders have the
right to change the timing of the interest payment on their notes once
during the term of their investment.
(d) This table reflects interest payment terms elected by senior collateralized
subordinated note holders as of June 30, 2004.
(e) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(f) Amount includes principal and accrued interest at June 30, 2004.
(g) Amounts include principal and interest.
(h) Amounts include lease for office space.
Cash flow from operations, the issuance of subordinated debentures and
lines of credit fund our operating cash needs. We expect these sources of funds
to be sufficient to meet our cash needs. Loan originations are funded through
borrowings against warehouse credit facilities. Each funding source is described
in more detail below.
CASH FLOW FROM OPERATIONS. One of our corporate goals is to achieve
sustainable positive cash flow from operations. However, we cannot be certain
that we will achieve our projections regarding positive cash flow from
operations. Our achieving this goal is dependent on our ability to successfully
implement our business strategy and on the following items:
o manage the mixture of whole loan sales and securitization
transactions to maximize cash flow and economic value;
o manage levels of securitizations to maximize cash flows received at
closing and subsequently from interest-only strips and servicing
rights;
o maintain a portfolio of mortgage loans which will generate income
and cash flows through our servicing activities and the residual
interests we hold in the securitized loans;
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o build on our established approaches to underwriting loans, servicing
and collecting loans and managing credit risks in order to control
delinquency and losses;
o continue to identify and invest in technology and other efficiencies
to reduce per unit costs in our loan origination and servicing
process; and
o control overall expense levels.
Historically, our cash flow from operations had been negative because
we incur the cash expenses as we originate loans, but generally do not recover
the cash outflow from these origination expenses until we securitize or sell the
underlying loans. With respect to loans securitized, we may be required to wait
more than one year to begin recovering the cash outflow from loan origination
expenses through cash inflows from our residual assets retained in
securitization. However, during the year ended June 30, 2004, we experienced
positive cash flow from operations, primarily due to whole loan sales of loans
we originated in prior periods that were carried on our balance sheet at June
30, 2003.
Additionally, increasing market interest rates could negatively impact
our cash flows. If market interest rates increase, the premiums we would be paid
on whole loan sales could be reduced and the interest rates that investors will
demand on the certificates issued in future securitizations will increase. The
increase in interest rates paid to investors reduces the cash we will receive
from interest-only strips created in future securitizations. Although we may
have the ability in a rising interest rate market to charge higher loan interest
rates to our borrowers, competition, laws and regulations and other factors may
limit or delay our ability to do so. Increasing market interest rates would also
result in higher interest expense incurred on future issuances of subordinated
debentures and interest expense incurred to fund loans while they are carried on
our balance sheet.
Cash flow from operations for the year ended June 30, 2004 was a
positive $6.8 million compared to a negative $285.4 million for the year ended
June 30, 2003. The positive cash flow from operations for the year ended June
30, 2004 was due to our sales during fiscal 2004 of loans originated in the
prior fiscal year that were carried on our balance sheet at June 30, 2003.
During the year ended June 30, 2004, we received cash on whole loan sales of
$835.5 million and $26.7 million during the year ended June 30, 2003 from a
whole loan sale transaction, which closed on June 30, 2003, but settled in cash
on July 1, 2003. Additionally, cash flow from our interest-only strips in fiscal
2004 increased $18.0 million, compared to fiscal 2003. The following table
compares the principal amount of loans sold in whole loan sales during the year
ended June 30, 2004, to the amount of loans originated during the same period
(in thousands).
Whole Loan Loans
Quarter Ended Sales Originated
--------------------------------------------- ----------- ----------
September 30, 2003........................... $ 245,203 $ 124,052
December 31, 2003............................ 7,975 (a) 103,084
March 31, 2004............................... 228,629 241,449
June 30, 2004................................ 326,571 514,095
---------- ----------
Total for the year ended June 30, 2004....... $ 808,378 $ 982,680
========== ==========
(a) During the quarter ended December 31, 2003, we completed a securitization of
$173.5 million of mortgage loans.
The amount of cash we receive as gains on whole loan sales, and the
amount of cash we receive and the amount of overcollateralization we are
required to fund at the closing of our securitizations are dependent upon a
number of factors including market factors over which we have no control.
Although we expect cash flow from operations to continue to fluctuate in the
foreseeable future, our goal is to improve upon our historical levels of
negative cash flow from operations. We believe that if our projections based on
our business strategy prove accurate, our cash flow from operations will
continue to be positive. However, negative cash flow from operations may occur
in any future quarter depending on the size and frequency of our whole loan
sales, the size and frequency of our future securitizations and due to the
nature of our operations and the time required to implement our business
strategy adjustments. We generally expect the level of cash flow from operations
to fluctuate.
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Other factors could negatively affect our cash flow and liquidity such
as increases in mortgage interest rates, legislation or other economic
conditions, which may make our ability to originate loans more difficult. As a
result, our costs to originate loans could increase or our volume of loan
originations could decrease.
CONTRACTUAL OBLIGATIONS. Following is a summary of future payments
required on our contractual obligations as of June 30, 2004 (in thousands):
PAYMENTS DUE BY PERIOD
----------------------------------------------------------------------
LESS THAN 1 TO 3 3 TO 5 MORE THAN
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS 5 YEARS
----------------------------------------- ----------- ----------- ----------- ---------- ----------
Subordinated debentures................. $ 522,609 $ 326,152 $ 170,452 $ 14,036 $ 11,969
Accrued interest - subordinated
debentures (a)........................ 34,327 20,033 11,332 1,312 1,650
Senior collateralized subordinated notes 83,639 28,094 50,701 2,516 2,328
Accrued interest - senior
collateralized subordinated notes (b) 2,975 1,002 1,738 126 109
Warehouse lines of credit (c)........... 239,587 239,587 -- -- --
Convertible promissory notes (d)........ 1,130 697 433 -- --
Capitalized lease (e)................... 519 377 142 -- --
Operating leases (f).................... 56,601 5,940 11,217 11,561 27,883
Services and equipment.................. 1,464 1,464 -- -- --
--------- ---------- ---------- --------- ---------
Total obligations....................... $ 942,851 $ 623,346 $ 246,015 $ 29,551 $ 43,939
========= ========== ========== ========= =========
(a) This table reflects interest payment terms elected by subordinated debenture
holders as of June 30, 2004. In accordance with the terms of the
subordinated debenture offering, subordinated debenture holders have the
right to change the timing of the interest payment on their notes once
during the term of their investment.
(b) This table reflects interest payment terms elected by senior collateralized
subordinated note holders as of June 30, 2004.
(c) See the table provided under "-- Credit Facilities" for additional
information about our credit facilities.
(d) Amount includes principal and accrued interest at June 30, 2004.
(e) Amounts include principal and interest.
(f) Amounts include lease for office space.
CREDIT FACILITIES. Borrowings against warehouse credit facilities
represent cash advanced to us for a limited duration, generally no more than 270
days, and are secured by the loans we pledge to the lender. These credit
facilities provide the primary funding source for loan originations. Under the
terms of these facilities, approximately 75% to 97% of our loan originations may
be funded with borrowings under the credit facilities and the remaining amounts,
our overcollateralization requirements, must come from our operating capital.
The ultimate sale of the loans through whole loan sale or securitization
generates the cash proceeds necessary to repay the borrowings under the
warehouse facilities. We periodically review our expected future credit needs
and attempt to negotiate credit commitments for those needs as well as excess
capacity in order to allow us flexibility in implementing our adjusted business
strategy.
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The following is a description of the warehouse and operating lines of
credit facilities, which were available to us at June 30, 2004 (in thousands):
FACILITY AMOUNT AMOUNT
AMOUNT UTILIZED AVAILABLE
-------- -------- ---------
REVOLVING CREDIT FACILITIES:
Warehouse revolving line of credit, expiring September 2004 (a)...... $ 200,000 $ 53,223 $ 146,777
Warehouse revolving line of credit, expiring October 2006 (b)........ 250,000 186,364 63,636
---------- --------- ---------
Total revolving credit facilities.................................... 450,000 239,587 210,413
OTHER FACILITIES:
Capitalized leases, maturing January 2006 (c)..................... 488 488 --
---------- --------- ---------
Total credit facilities.............................................. $ 450,488 $ 240,075 $ 210,413
========== ========= =========
(a) $200.0 million warehouse revolving line of credit with JP Morgan Chase Bank
entered into on September 22, 2003 and expiring September 2004. The maturity
date of this facility was extended to November 5, 2004 and the facility was
reduced to $100.0 million. Interest rates on the advances under this
facility are based upon one-month LIBOR plus a margin. Obligations under the
facility are collateralized by pledged loans. Further detail and provisions
of this facility are described below.
Additionally, we have a stand alone letter of credit with JP Morgan Chase
Bank to secure lease obligations for corporate office space. The amount of
the letter of credit was $8.0 million at June 30, 2004. The letter of credit
was collateralized by cash.
(b) $250.0 million warehouse revolving line of credit with Chrysalis Warehouse
Funding, LLC, entered into on October 14, 2003 and expiring October 2006.
Interest rates on the advances under this facility are based upon one-month
LIBOR plus a margin. Obligations under the facility are collateralized by
pledged loans. Further detail and provisions of this facility are described
below.
(c) Capitalized leases, imputed interest rate of 8.0%, collateralized by
computer equipment.
Until their expiration, two other facilities were utilized for portions
of fiscal 2004 including:
o A warehouse line of credit with Credit Suisse First Boston Mortgage
Capital, LLC originally for $200.0 million. $100.0 million of this
facility was continuously committed for the term of the facility
while the remaining $100.0 million of the facility was available at
Credit Suisse's discretion. Subsequent to June 30, 2003, there were
no new advances under the non-committed portion. On August 20, 2003,
this credit facility was amended to reduce the committed portion to
$50.0 million (from $100.0 million), eliminate the non-committed
portion and accelerate its expiration date from November 2003 to
September 30, 2003. The expiration date was subsequently extended to
October 17, 2003, but no new advances were permitted under this
facility subsequent to September 30, 2003. This facility was paid
down in full on October 16, 2003. The interest rate on the facility
was based on one-month LIBOR plus a margin. Advances under this
facility were collateralized by pledged loans.
o A $25.0 million warehouse line of credit facility from Residential
Funding Corporation. Under this warehouse facility, advances could
be obtained, subject to specific conditions described in the
agreements. In connection with our receipt of a waiver of our
non-compliance with financial covenants at September 30, 2003, we
agreed not to make further advances under this line. Interest rates
on the advances were based on one-month LIBOR plus a margin. The
obligations under this agreement were collateralized by pledged
loans. This facility was paid down in full on October 16, 2003 and
it expired pursuant to its terms on October 31, 2003.
Until its expiration, we also had available to us a $300.0 million
mortgage conduit facility. This facility expired pursuant to its terms on July
5, 2003. The facility provided for the sale of loans into an off-balance sheet
facility. See "-- Application of Critical Accounting Estimates" for further
discussion of the off-balance sheet features of this facility. On October 16,
2003, we refinanced through another mortgage warehouse conduit facility $40.0
million of loans that were previously held in the above off-balance sheet
mortgage conduit facility. We also refinanced an additional $133.5 million of
mortgage loans in the new conduit facility, which were previously held in other
warehouse facilities, including the $50.0 million warehouse facility, which
expired on October 17, 2003. On October 31, 2003, we completed a
privately-placed securitization, with servicing released, of the $173.5 million
of loans that had been transferred to this conduit facility. This conduit
facility terminated upon the disposition of the loans held by it.
94
On September 22, 2003, we entered into definitive agreements with JP
Morgan Chase Bank for a $200.0 million credit facility for the purpose of
funding our loan originations. Pursuant to the terms of this facility, we are
required to, among other things: (i) have a net worth of at least $28.0 million
by September 30, 2003; with quarterly increases of $2.0 million thereafter; (ii)
apply 60% of our net cash flow from operations each quarter to reduce the
outstanding amount of subordinated debentures commencing with the quarter ending
March 31, 2004; (iii) as of the end of any month, commencing January 31, 2004,
the aggregate outstanding balance of subordinated debentures must be less than
the aggregate outstanding balance as of the end of the prior month; and (iv)
provide a parent company guaranty of 10% of the outstanding principal amount of
loans under the facility. This facility had a term of 364 days and by its
original terms would have expired September 21, 2004. This facility is secured
by the mortgage loans, which are funded by advances under the facility with
interest equal to LIBOR plus a margin. This facility is subject to
representations and warranties and covenants, which are customary for a facility
of this type, as well as amortization events and events of default related to
our financial condition. These provisions require, among other things, our
maintenance of a delinquency ratio for the managed portfolio (which represents
the portfolio of securitized loans and leases we service for others) at the end
of each fiscal quarter of less than 12.0%, our subordinated debentures not to
exceed $705.0 million at any time, and our ownership of an amount of repurchased
loans not to exceed 1.5% of the managed portfolio.
On September 20, 2004, we entered into an amendment to our $200.0
million credit facility which extended the scheduled expiration date of this
credit facility from September 21, 2004 to September 30, 2004.
On September 30, 2004, we entered into an amendment to our $200.0
million credit facility which extends the expiration date of this credit
facility from September 30, 2004 to November 5, 2004, subject to earlier
termination upon the occurrence of any of the specified events or conditions
described in the facility documents, and decreases this facility from $200.0
million to $100.0 million. Since entering into this facility on September 22,
2003, the amount outstanding under this facility at any given time has not
exceeded $100.0 million. In addition, the amendment includes changes which
reduce the advance rate if the amount outstanding under the facility exceeds
$75.0 million. The amendment also changes the portfolio composition requirements
to accommodate fluctuations in the pledged loans at the beginning and end of
each month, providing greater flexibility to us. The purpose of the amendment is
to allow us to continue to borrow under this facility, subject to its terms as
described above, while we finalize the definitive agreement for a new credit
facility. In light of this amendment, on October 1, 2004, we entered into an
amendment to the $250.0 million credit facility described below which decreased
the amount of the additional credit facilities that we must maintain from $200.0
million to $100.0 million, provided that there continues to be at least $40.0
million available for funding loans between the time they are closed by a title
agency or closing attorney and the time documentation for the loans is received
by the collateral agent, as originally required by the facility agreements.
On September 17, 2004, we executed a commitment letter dated as of
September 16, 2004 for a mortgage warehouse credit facility with a warehouse
lender for the purpose of funding our home mortgage loan originations. The
commitment letter provides for a facility that will consist of a $100.0 million
senior secured revolving warehouse line of credit, which may be increased prior
to closing to $150.0 million at the option of the warehouse lender. The
commitment letter provides for a facility that will have a term of one year from
closing with the right to extend for up to two additional one-year terms upon
mutual agreement of the parties, with interest equal to LIBOR plus a margin. The
facility will be secured by the mortgage loans which are funded by advances
under the facility, as well as all assets, accounts receivable and all related
proceeds held by the special purpose entity organized to facilitate this
transaction referred to as the borrower. The stock of the borrower will also be
pledged to the warehouse lender. We paid a due diligence fee and also agreed to
pay fees of $1.3 million upon commitment, $1.0 million at closing and
approximately $3.8 million over the next twelve months plus a non-usage fee
based on the difference between the average daily outstanding balance for the
current month and the maximum credit amount under the facility, as well as the
lender's out-of-pocket expenses. The commitment letter and the closing of the
facility will be subject to such customary and commercially reasonable terms,
covenants, events of default and conditions as the warehouse lender deems
appropriate. It is anticipated that this $100.0 million facility will contain
representations and warranties, events of default and covenants which are
customary for facilities of this type and will be structured similarly to our
$250.0 million credit facility.
The warehouse lender may terminate the commitment at any time prior
to entering into a definitive agreement if we fail to fulfill our obligations
under the commitment letter, the warehouse lender determines that it is likely
that the borrower is not capable of entering into a definitive agreement prior
to October 20, 2004 or there is a material adverse change in the business,
assets, liabilities, operations or condition of the borrower. The commitment
letter expires upon the earlier to occur of: the execution of a definitive
agreement, October 20, 2004 and our closing of another similar credit facility
with a lender other than this warehouse lender. While we anticipate that we will
close on the facility with this warehouse lender, there can be no assurance that
these negotiations will result in a definitive agreement or that this agreement
will contain terms and conditions acceptable to us.
95
We also sold the interest-only strips and servicing rights related to
five of our mortgage securitization trusts to an affiliate of this facility
provider under the terms of a September 27, 2004 sale agreement. The sale of
these assets was undertaken as part of our negotiations to obtain the new $100.0
million warehouse credit facility and to raise cash to pay fees on new warehouse
credit facilities and as a result, we did not realize their full value as
reflected on our books. We wrote down the carrying value of these interest-only
strips and servicing rights by $5.4 million at June 30, 2004 to reflect their
values under the terms of the sale agreement.
On October 14, 2003, we entered into definitive agreements with
Chrysalis Warehouse Funding, LLC for a revolving mortgage loan warehouse credit
facility of up to $250.0 million to fund loan originations. The $250.0 million
facility has a term of three years with an interest rate on amounts outstanding
equal to the one-month LIBOR plus a margin and the yield maintenance fees (as
defined in the agreements). We also agreed to pay an affiliate of the lender
fees of $8.9 million upon closing and approximately $10.3 million annually plus
a non-usage fee based on the difference between the average daily outstanding
balance for the current month and the maximum credit amount under the facility,
as well as the lender's out-of-pocket expenses. Advances under this facility are
collateralized by specified pledged loans. Additional credit support for a
portion of the facility was created by granting a security interest in
substantially all of our interest-only strips and residual interests which we
contributed to a special purpose entity organized to facilitate this
transaction. The interest-only strips and residual interests contributed to this
special purpose entity also secured our fee obligations under this facility to
an affiliate of the lender, as described above. The interest-only strips sold
pursuant to the previously described sale agreement of September 27, 2004 were
part of the interest-only strips contributed to this special purpose entity for
the purpose of securing our fee obligations to this lender affiliate. In
consideration for the release by this lender affiliate of its lien on the
interest-only strips involved in the September 27, 2004 sale, we prepaid $3.5
million of fees owed or to be owed to the lender affiliate.
This $250.0 million facility contains representations and warranties,
events of default and covenants which are customary for facilities of this type,
as well as our agreement to: (i) restrict the total amount of indebtedness
outstanding under the indenture related to our subordinated debentures to $750.0
million or less; (ii) make quarterly reductions commencing in April 2004 of an
amount of subordinated debentures pursuant to the formulas set forth in the loan
agreement; (iii) maintain maximum interest rates offered on subordinated
debentures not to exceed 10 percentage points above comparable rates for FDIC
insured products; and (iv) maintain minimum cash and cash equivalents of not
less than $10.0 million. In addition to events of default which are typical for
this type of facility, an event of default would occur if: (1) we are unable to
sell subordinated debentures for more than three consecutive weeks or on more
than two occasions in a 12 month period; and (2) certain members of management
are not executive officers and a satisfactory replacement is not found within 60
days.
The definitive agreements for this $250.0 million facility granted the
lender an option for a period of 90 days commencing on the first anniversary of
entering into the definitive agreements to increase the credit amount to $400.0
million with additional fees and interest payable by us.
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We intend to amend the security agreements related to the senior
collateralized subordinated notes to accommodate a request from the lender on
our $250.0 million credit facility, and its affiliate, dated September 30, 2004,
to clarify an inconsistency between these agreements and the $250.0 million
credit facility documents related to liens on certain assets previously pledged
by ABFS Warehouse Trust 2003-1 to Clearwing, the affiliate of the lender.
Although after November 5, 2004 we expect to have mortgage loan
warehouse credit facilities available totaling at a minimum $500.0 million, the
proceeds of these credit facilities may only be used to fund loan originations
and may not be used for any other purpose. Consequently, we will have to
generate cash to fund the balance of our business operations from other sources,
such as whole loan sales, additional financings and sales of subordinated
debentures. We are currently negotiating additional credit facilities to provide
additional borrowing capacity to fund the increased level of loan originations
expected under our adjusted business strategy, however, assurances can be given
that we will succeed in obtaining new credit facilities or that these facilities
will contain terms and conditions acceptable to us.
WAIVERS AND AMENDMENTS OF FINANCIAL COVENANTS RELATED TO OUR CREDIT
AGREEMENTS AND SERVICING AGREEMENTS. Our warehouse credit agreements require
that we comply with one or more financial covenants regarding, for example, net
worth, leverage, net income, liquidity, total debt and debt to equity and other
debt ratios. Each agreement has multiple individualized financial covenant
thresholds and ratio limits that we must meet as a condition to drawing on a
particular line of credit. Pursuant to the terms of these credit facilities, the
failure to comply with the financial covenants constitutes an event of default
and at the option of the lender, entitles the lender to, among other things,
terminate commitments to make future advances to us, declare all or a portion of
the loan due and payable, foreclose on the collateral securing the loan, require
servicing payments be made to the lender or other third party or assume the
servicing of the loans securing the credit facility. An event of default under
these credit facilities would result in defaults pursuant to cross-default
provisions of our other agreements, including but not limited to, other loan
agreements, lease agreements and other agreements. The failure to comply with
the terms of these credit facilities or to obtain the necessary waivers would
have a material adverse effect on our liquidity and capital resources.
As a result of the loss experienced during fiscal 2003, we were not in
compliance with the terms of certain financial covenants related to net worth,
consolidated stockholders' equity and the ratio of total liabilities to
consolidated stockholders' equity under two of our principal credit facilities
existing at June 30, 2003 (one for $50.0 million and the other for $200.0
million, which was reduced to $50.0 million as described below). We obtained
waivers from these covenant provisions from both lenders. Commencing August 21,
2003, the lender under the $50.0 million warehouse credit facility (which had
been amended in December 2002 to add a letter of credit facility) granted us a
series of waivers for our non-compliance with a financial covenant in that
credit facility through November 30, 2003 and on September 22, 2003, in
connection with the creation of a $200.0 million credit facility on the same
date, reduced this facility to an $8.0 million letter of credit facility, which
secured the lease on our principal executive office. This letter of credit
facility expired according to its terms on December 22, 2003, but the underlying
letter of credit was renewed for a one year term on December 18, 2003. We also
entered into an amendment to the $200.0 million credit facility which provided
for the waiver of our non-compliance with the financial covenants in that
facility, the reduction of the committed portion of this facility from $100.0
million to $50.0 million, the elimination of the $100.0 million non-committed
portion of this credit facility and the acceleration of the expiration date of
this facility from November 2003 to September 30, 2003. We entered into
subsequent amendments to this credit facility, which extended the expiration
date until October 17, 2003. This facility was paid down in full on October 16,
2003 and expired on October 17, 2003.
In addition, in light of the losses experienced during fiscal 2004, we
requested and obtained waivers or amendments to several credit facilities to
address our non-compliance with certain financial covenants.
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The lender under a $25.0 million credit facility agreed to amend such
facility in light of our non-compliance at September 30, 2003 with the
requirement that our net income not be less than zero for two consecutive
quarters. Pursuant to the revised terms of our agreement with this lender, no
additional advances were made under this facility after September 30, 2003. This
facility was paid down in full on October 16, 2003 and expired pursuant to its
terms on October 31, 2003.
On September 22, 2003, the lender under the $200.0 million facility
agreed to extend the deadline for our registration statement to be declared
effective by the SEC to November 10, 2003. Our registration statement was
declared effective on November 7, 2003. The lender on the $200.0 million credit
facility agreed to extend the date by which we were required to close an
additional credit facility of at least $200.0 million from October 3, 2003 to
October 8, 2003. We subsequently obtained an additional waiver from this lender,
which extended this required closing date for obtaining the additional credit
facility to October 14, 2003 (this condition was satisfied by the closing of the
$250.0 million facility described above). Prior to the closing of the second
credit facility, our borrowing capacity on the $200.0 million facility was
limited to $80.0 million. We entered into two amendments to the sale and
servicing agreement with the lender under our $200.0 million facility which
clarified the scope of particular financial covenants: one amendment dated as of
May 12, 2004 clarified the scope of the financial covenant regarding the
maintenance of minimum adjusted tangible net worth; and one amendment dated as
of June 30, 2004 clarified the scope of the financial covenant regarding the
maintenance of minimum cash and cash equivalents. This lender waived our
noncompliance with the minimum net worth requirements at September 30, 2003,
October 31, 2003, November 30, 2003, December 31, 2003, March 31, 2004, June 30,
2004, July 31, 2004, August 31, 2004 and September 30, 2004. This lender also
waived our noncompliance with: the minimum adjusted tangible net worth
requirement for all monthly compliance periods commencing with the month ending
April 30, 2004 and continuing through the month ending September 30, 2004; our
noncompliance with the minimum cash and cash equivalents requirement on December
31, 2003, April 30, 2004 and May 31, 2004; and our noncompliance on September
30, 2004 with requirements regarding the aggregate cash flow from all
securitization trusts and the ratio of debt to adjust tangible net worth.
We have continued to operate on the basis of waivers granted by the
lender under this facility to each of these events of noncompliance. The
expiration date of this facility was originally September 21, 2004, but the
lender agreed to extend the expiration date until November 5, 2004 in
consideration for, among other things, a reduction in the amount that could be
borrowed under this facility to $100.0 million. Consequently, we currently
anticipate that we will be out of compliance with one or more of the financial
covenants contained in this facility at October 31, 2004 and will need an
additional waiver for this noncompliance from this lender to continue to
operate.
A provision in our $250.0 million credit facility required us to
maintain another credit facility for $200.0 million with a $40.0 million
sublimit of such facility available for funding loans between the time they are
closed by a title agency or closing attorney and the time documentation for the
loans is received by the collateral agent. As a result of the reduction of our
$200.0 million facility to $100.0 million, as described above, we entered into
an amendment to the master loan and security agreement governing our $250.0
million facility which reduced the required amount for another facility to
$100.0 million. In the event we do not extend the $200.0 million (now $100.0
million) facility beyond its November 5, 2004 expiration date, or in the event
we do not otherwise enter into definitive agreements with other lenders by
November 5, 2004 which satisfy the above-described requirements in our $250.0
million facility for $100.0 million in additional credit facilities and a $40.0
million sublimit, we will need an additional amendment to the $250.0 million
facility or a waiver from the lender to continue to operate.
Additionally, as a result of being out of compliance at various times
since June 30, 2003 with the net worth requirement in several of our servicing
agreements, we requested and obtained waivers of this non-compliance from the
bond insurers associated with each of two separable groups of these servicing
agreements. In connection with the waiver of the net worth covenant granted by
one of these bond insurers, for the remaining term of the related servicing
agreements, we amended the servicing agreements on September 30, 2003
principally to provide for 120-day term-to-term servicing and for our
appointment as servicer for an initial 120-day period commencing as of October
1, 2003. The bond insurer re-appointed us as servicer under these amended
servicing agreements for additional 120-day terms commencing, respectively, on
January 29, 2004, May 27, 2004 and September 23, 2004. The second of these bond
insurers waived our non-compliance with net worth requirements on an oral basis
from September 30, 2003 through March 9, 2004, at which time it executed a
written waiver document which confirmed its prior oral waivers and extended
these waivers through March 14, 2004. Additionally, we entered into an agreement
with this second bond insurer on February 20, 2004 which amended the related
servicing agreements principally to provide for 30-day term-to-term servicing
and which re-appointed us as servicer for an initial term through March 15,
2004. Subsequently, this bond insurer, on a monthly basis, has given us a waiver
of the net worth covenant and re-appointed us as servicer for an additional
one-month term under these amended servicing agreements for all relevant periods
since the execution of the amended servicing agreements. Our reappointment as
servicer under these amended servicing agreements occurs in the sole discretion
of the associated bond insurer.
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Separately, one bond insurer, as a condition to its participation in
our October 31, 2003 privately-placed securitization, required that we amend the
servicing agreement related to a previous public securitization in which the
bond insurer had provided financial guarantee insurance to the Class M
certificate. The resulting amendment to this servicing agreement, dated October
31, 2003, provided, among other things, for a specifically designated back-up
servicer, for 90-day term-to-term servicing and for our re-appointment as
servicer for an initial 90-day term commencing October 31, 2003. This bond
insurer subsequently re-appointed us as servicer under the amended servicing
agreement for an additional term through April 30, 2004. On April 30, 2004 this
amended servicing agreement was amended again principally to provide for 30-day
term-to-term servicing and for our reappointment as servicer for a 30-day term
expiring May 31, 2004. On May 24, 2004 this amended servicing agreement was
further amended principally to provide for minor administrative changes to the
agreement and to reappoint us as servicer for an additional term expiring June
30, 2004. This bond insurer has re-appointed us as servicer under this amended
servicing agreement for successive additional terms expiring on, respectively,
July 31, 2004, August 31, 2004, September 30, 2004 and October 31, 2004. Our
re-appointment as servicer under this amended servicing agreement is determined
by reference to our compliance with its provisions.
Also separately, on March 5, 2004, we entered into agreements with
another bond insurer which amended the servicing agreements related to all
securitizations insured by this bond insurer. These amendments principally
provided for a specifically designated back-up servicer. The original provisions
of these servicing agreements providing for 3-month term-to-term servicing were
not altered by these amendments. We were continuously re-appointed as servicer
under these servicing agreements prior to the described amendments and we have
continuously been re-appointed as servicer for all relevant periods subsequent
to the described amendments. Our re-appointment as servicer under these amended
servicing agreements is determined by reference to our compliance with their
provisions.
As a result of the foregoing amendments to our servicing agreements,
all of our servicing agreements associated with bond insurers now provide for
term-to-term servicing. See "Risk Factors -- Our servicing rights may be
terminated if we fail to satisfactorily perform our servicing obligations, or
fail to meet minimum net worth requirements or financial covenants which could
hinder our ability to operate profitably, impair our ability to repay our
outstanding debt and negatively impact the value of our capital stock" for
information regarding the impact of these amendments to servicing agreements.
We intend to amend the security agreements related to the senior
collateralized subordinated notes to accommodate a request from the lender on
our $250.0 million credit facility, and its affiliate, dated September 30, 2004,
to clarify an inconsistency between these agreements and the $250.0 million
credit facility documents related to liens on certain assets previously pledged
by ABFS Warehouse Trust 2003-1 to Clearwing, the affiliate of the lender. See
"-- Liquidity and Capital Resources" for additional information regarding these
amendments.
Because we anticipate incurring losses at least through the first
quarter of fiscal 2005 and as a result of any non-compliance with other
financial covenants, we anticipate that we will need to obtain additional
waivers. We cannot assure you as to whether or in what form a waiver or
modification of these agreements would be granted to us.
SUBORDINATED DEBENTURES. The issuance of subordinated debentures funds
the majority of our remaining operating cash requirements. We rely significantly
on our ability to issue subordinated debentures since our cash flow from
operations is not sufficient to meet these requirements. In order to expand our
businesses we have issued subordinated debentures to partially fund growth and
to partially fund maturities of subordinated debentures. In addition, we utilize
proceeds from the issuance of subordinated debentures to fund
overcollateralization. During the fiscal year ended June 30, 2004, subordinated
debentures decreased by $196.7 million compared to an increase of $63.8 million
in fiscal 2003. The reduction in subordinated debentures outstanding at June 30,
2004 was primarily due to the exchange offers and the resulting conversion of
$177.8 million of subordinated debentures through June 30, 2004 into 93.8
million of shares of Series A preferred stock and $84.0 million of senior
collateralized subordinated notes. The decrease also resulted from our temporary
discontinuation of sales of new subordinated debentures for a portion of the
first quarter of fiscal 2004. In July 2004 and August 2004, we converted an
additional $30.8 million of subordinated debentures into 15.6 million shares of
Series A preferred stock and $15.2 million of senior collateralized subordinated
notes.
On December 1, 2003, we mailed the first exchange offer to holders of
our subordinated debentures issued prior to April 1, 2003. Holders of such
subordinated debentures had the ability to exchange their debentures for (i)
equal amounts of senior collateralized subordinated notes and shares of Series A
preferred stock; and/or (ii) dollar-for-dollar for shares of Series A preferred
stock. Senior collateralized subordinated notes issued in the exchange have
interest rates equal to 10 basis points above the subordinated debentures
tendered. Senior collateralized subordinated notes with maturities of 12 months
were issued in exchange for subordinated debentures tendered with maturities of
less than 12 months, while subordinated debentures with maturities greater than
36 months were exchanged for senior collateralized subordinated notes with the
same maturity or a maturity of 36 months. All other senior collateralized
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subordinated notes issued in the exchange have maturities equal to the
subordinated debentures tendered. The senior collateralized subordinated notes
outstanding are secured by a security interest in certain cash flows originating
from interest-only strips of certain of our subsidiaries held by ABFS Warehouse
Trust 2003-1 with an aggregate value of at least an amount equal to 150% of the
principal balance of the senior collateralized subordinated notes issued in the
first exchange offer plus priority lien obligations secured by interest-only
strips and/or the cash flows from the interest-only strips; provided that, such
collateral coverage may not fall below 100% of the principal balance of the
senior collateralized subordinated notes issued in the first exchange offer, as
determined by us on any quarterly balance sheet date. In the event of
liquidation, to the extent the collateral securing the senior collateralized
subordinated notes is not sufficient to repay these notes, the deficiency
portion of the senior collateralized subordinated notes will rank junior in
right of payment behind our senior indebtedness and all of our other existing
and future senior debt and behind the existing and future debt of our
subsidiaries and equally in right of payment with the deficiency portion of the
senior collateralized subordinated notes, and any future subordinated debentures
issued by us and other unsecured debt.
On May 14, 2004, we mailed the second exchange offer to holders of up
to $120,000,000 of investment notes issued prior to November 1, 2003, which
offered holders of such notes the ability to exchange their investment notes on
substantially the same terms described above.
Under the terms of the exchange offers, the following amounts of
subordinated dentures were exchanged for shares of Series A preferred stock and
senior collateralized subordinated notes (in thousands):
Shares of Senior
Subordinated Series A Collateralized
Debentures Preferred Subordinated
By Closing Dates Exchanged Stock Issued Notes Issued
---------------- ------------ ------------ ---------------
First exchange offer:
December 31, 2003................................ $ 73,554 39,095 $ 34,459
February 6, 2004................................. 43,673 22,712 20,961
--------- ------- ---------
Results of first exchange offer............... 117,227 61,807 55,420
--------- ------- ---------
Second exchange offer:
June 30, 2004.................................... 60,589 31,980 28,609
July 31, 2004.................................... 25,414 12,908 12,506
August 23, 2004.................................. 5,397 2,730 2,667
--------- ------- ---------
Results of second exchange offer.............. 91,400 47,618 43,782
--------- ------- ---------
Cumulative results of exchange offers............... $ 208,627 109,425 $ 99,202
========= ======= =========
Note: results as of June 30, 2004, which include the
first exchange offer and the June 30, 2004 closing
of the second exchange offer....................... $ 177,816 93,787 $ 84,029
========= ======= =========
At June 30, 2004, our interest in the cash flows from the interest-only
strips held in the trust which secure the senior collateralized subordinated
notes totaled $411.9 million of which approximately $125.5 million represented
150% of the outstanding principal balance of senior collateralized subordinated
notes. After the August 23, 2004 closing of the exchange offer, the
interest-only strips securing the senior collateralized subordinated notes
totaled $148.2 million.
Anthony J. Santilli, our Chairman, Chief Executive Officer and
President, Beverly Santilli, formerly our First Executive Vice President, and
Dr. Jerome Miller, our director, each held subordinated debentures eligible to
participate in the first exchange offer. Each named individual tendered all such
eligible subordinated debentures in the first exchange offer and as of February
6, 2004, the expiration date of the first exchange offer, pursuant to the terms
of the first exchange offer, were holders of the following number of shares of
Series A preferred stock (SAPS) and aggregate amount of senior collateralized
subordinated notes (SCSN) outstanding: Mr. Santilli: SAPS - 4,691, SCSN -
$4,691; Mrs. Santilli: SAPS - 4,691, SCSN - $4,691; Dr. Miller: SAPS - 30,164,
SCSN - $30,164.
Under a registration statement declared effective by the SEC on
November 7, 2003, we registered $295.0 million of subordinated debentures. Of
the $295.0 million, $134.7 million of debt from this registration statement was
available for future issuance as of June 30, 2004.
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In the event we are unable to offer additional subordinated debentures
for any reason, we have developed a contingent financial restructuring plan
including cash flow projections for the next twelve-month period. Based on our
current cash flow projections, we anticipate being able to make all scheduled
subordinated debenture maturities and vendor payments.
The contingent financial restructuring plan is based on actions that we
would take, in addition to those indicated in our adjusted business strategy, to
reduce our operating expenses and conserve cash. These actions would include
reducing capital expenditures, selling all loans originated on a whole loan
basis, eliminating or downsizing various lending, overhead and support groups,
and obtaining working capital funding. No assurance can be given that we will be
able to successfully implement the contingent financial restructuring plan, if
necessary, and repay our outstanding debt when due.
We intend to meet our obligation to repay such debt and interest as it
matures with cash flow from operations, cash flows from interest-only strips and
cash generated from additional debt financing. To the extent that we fail to
maintain our credit facilities or obtain alternative financing on acceptable
terms and increase our loan originations, we may have to sell loans earlier than
intended and further restructure our operations which could further hinder our
ability to repay the subordinated debentures when due.
The weighted-average interest rate of our subordinated debentures
issued in the month of June 2004 was 11.09%, compared to a weighted-average
interest rate of 7.49% for subordinated debentures issued in the month of June
2003. We had reduced the interest rates offered on subordinated debentures
beginning in the fourth quarter of fiscal 2001 and had continued reducing rates
through the fourth quarter of fiscal 2003 in response to decreases in market
interest rates as well as declining cash needs during that period. However,
during fiscal 2004, the weighted-average interest rate on subordinated
debentures we issued had steadily increased, reflecting our financial condition.
Subordinated debentures issued at our peak rate, which was in February 2001, was
at a rate of 11.85%. We expect to reduce the interest rates offered on
subordinated debentures over time as our business and cash needs, our financial
condition, liquidity, future results of operations, market interest rates and
competitive factors permit. The weighted average remaining maturity of our
subordinated debentures at June 2004 was 13.5 months compared to 19.5 months at
June 2003.
TERMS OF THE SERIES A PREFERRED STOCK. The Series A preferred stock has
a par value of $0.001 per share and may be redeemed at our option at a price
equal to the liquidation value plus accrued and unpaid dividends after the
second anniversary of the issuance date. At June 30, 2004, 93,787,111 shares of
the Series A preferred stock were issued and outstanding.
Upon any voluntary or involuntary liquidation, the holders of the
Series A preferred stock will be entitled to receive a liquidation preference of
$1.00 per share, plus accrued and unpaid dividends to the date of liquidation.
Based on the shares of Series A preferred stock outstanding on June 30, 2004,
the liquidation value equals $93.8 million. After completion of all closings
under the second exchange offer, the liquidation value increased to $109.4
million.
Monthly cash dividend payments are $0.008334 per share of Series A
preferred stock (equivalent to $0.10 per share annually or 10% annually of the
liquidation value). Payment of cash dividends on the Series A preferred stock is
subject to compliance with applicable Delaware state law. Based on the shares of
Series A preferred stock outstanding on June 30, 2004, the annual cash dividend
requirement equals $9.4 million. After completion of all closings under the
second exchange offer, the annual cash dividend requirement increased to $10.9
million.
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On or after the second anniversary of the issuance date (or on or after
the one year anniversary of the issuance date if no dividends are paid on the
Series A preferred stock), each share of the Series A preferred stock is
convertible at the option of the holder into a number of shares of the our
common stock determined by dividing: (A) $1.00 plus an amount equal to accrued
but unpaid dividends (if the conversion date is prior to the second anniversary
of the issuance date because the Series A preferred stock has become convertible
due to a failure to pay dividends), $1.20 plus an amount equal to accrued but
unpaid dividends (if the conversion date is prior to the third anniversary of
the issuance date but on or after the second anniversary of the issuance date)
or $1.30 plus an amount equal to accrued but unpaid dividends (if the conversion
date is on or after the third anniversary of the issuance date) by (B) the
market value of a share of our common stock (which figure shall not be less than
$5.00 per share regardless of the actual market value on the conversion date).
Based on the $5.00 per share market value floor and if each share of
Series A preferred stock issued in the first exchange offer and the second
exchange offer converted on the anniversary dates listed below, the number of
shares of the our common stock which would be issued upon conversion follows
(shares in thousands):
As of June 30, 2004 As of August 23, 2004
----------------------------- -----------------------------
Convertible Convertible
Number of into Number Number of into Number
Preferred of Common Preferred of Common
Shares Shares Shares Shares
--------- ----------- --------- -----------
Second anniversary date.... 93,787 22,509 109,425 26,262
Third anniversary date..... 93,787 24,384 109,425 28,451
As described above, the conversion ratio of the Series A preferred
stock increases during the first three years following its issuance, which
provides the holders of the Series A preferred stock with a discount on the
shares of common stock that will be issued upon conversion. Under guidance
issued by the EITF in issue 98-5, "Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,"
this discount, or beneficial conversion feature, must be valued and amortized to
the income statement as additional non-cash preferred dividends over the
three-year period that the holders of the Series A preferred stock earn the
discount.
We computed the value of the beneficial conversion feature using the
conversion ratio of $1.30 to $5.00, which is the conversion term that is most
beneficial to the investor, and would result in the issuance of 24.5 million
shares of common stock based on the shares of Series A preferred stock that were
issued through June 30, 2004. The value of the beneficial conversion feature
equals the excess of the intrinsic value of those 24.5 million shares of common
stock at their closing prices on the dates the preferred stock was issued, over
the value of the Series A preferred stock on the same dates. The value of the
Series A preferred stock was equal to the carrying value of the subordinated
debentures exchanged. For closings under the exchange offers through June 30,
2004, the value of the beneficial conversion feature was $10.7 million. During
fiscal 2004, amortization of $0.8 million was added to the $2.9 million of cash
dividends declared resulting in a total charge to the income statement of $3.7
million. The offset to the charge to the income statement for the amortization
of the beneficial conversion feature is recorded to additional paid in capital.
For closings under the exchange offers through August 23, 2004, the value of the
beneficial conversion feature was $11.3 million. Amortization of the total value
of the beneficial conversion feature will be $3.6 million in fiscal 2005, $3.8
million in fiscal 2006 and $3.0 million for fiscal 2007.
SALES INTO SPECIAL PURPOSE ENTITIES AND OFF-BALANCE SHEET FACILITIES.
In the past, we have relied significantly on access to the asset-backed
securities market through securitizations to provide permanent funding of our
loan production. Our adjusted business strategy will continue to rely on access
to this market, although to a lesser extent. We also may retain the right to
service the loans. Residual cash from the loans after required principal and
interest payments are made to the investors provides us with cash flows from our
interest-only strips. It is our expectation that future cash flows from our
interest-only strips and servicing rights will generate more of the cash flows
required to meet maturities of our subordinated debentures and our operating
cash needs. See "-- Off-Balance Sheet Arrangements" for further detail of our
securitization activity and effect of securitizations on our liquidity and
capital resources.
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OTHER LIQUIDITY CONSIDERATIONS. At our annual meeting of shareholders
held on December 31, 2003, our shareholders approved three proposals to enable
us to consummate the first exchange offer: a proposal to increase the number of
authorized shares of common stock from 9.0 million to 209.0 million, a proposal
to increase the number of authorized shares of preferred stock from 3.0 million
to 203.0 million, and a proposal to authorize us to issue Series A preferred
stock in connection with our first exchange offer and the common stock issuable
upon the conversion of the Series A preferred stock.
At a special meeting of stockholders held on June 29, 2004, our
shareholders approved a proposal to authorize the issuance of shares of Series A
preferred stock in connection with our second exchange offer and the common
stock issuable upon the conversion of the Series A preferred stock.
Shareholder approval of these issuances of securities was required
pursuant to the NASDAQ Corporate Governance Rules as the issuance of such shares
could result in a change in control of our company. In addition to meeting the
requirements of the exchange offers, the preferred shares may be used to raise
equity capital, redeem outstanding debt or acquire other companies, although no
such acquisitions are currently contemplated. The Board of Directors has
discretion with respect to designating and establishing the terms of each series
of preferred stock prior to issuance.
In fiscal 1999, the Board of Directors initiated a stock repurchase
program in view of the price level of our common stock, which at the time traded
and has continued to trade at below book value. In addition, our consistent
earnings growth at that time did not result in a corresponding increase in the
market value of our common stock. The repurchase program was extended in fiscal
2000, 2001 and 2002. The total number of shares repurchased under the stock
repurchase program was: 117,000 shares in fiscal 1999; 327,000 shares in fiscal
2000; 627,000 shares in fiscal 2001; and 352,000 shares in fiscal 2002. The
cumulative effect of the stock repurchase program was an increase in diluted net
earnings per share of $0.41 and $0.32 for the years ended 2002 and 2001,
respectively. We currently have no plans to continue to repurchase additional
shares or extend the repurchase program.
A further decline in economic conditions, continued instability in
financial markets or further acts of terrorism in the United States may cause
disruption in our business and operations including reductions in demand for our
loan products and our subordinated debentures, increases in delinquencies and
credit losses in our total loan portfolio, changes in historical prepayment
patterns and declines in real estate collateral values. To the extent the United
States experiences an economic downturn, unusual economic patterns and
unprecedented behaviors in financial markets, these developments may affect our
ability to originate loans at profitable interest rates, to price future loan
securitizations profitably and to hedge our loan portfolio effectively against
market interest rate changes which could cause reduced profitability. Should
these disruptions and unusual activities occur, our profitability and cash flow
could be reduced and our ability to make principal and interest payments on our
subordinated debentures could be impaired. Additionally, under the
Servicemembers Civil Relief Act, members of all branches of the military on
active duty, including draftees and reservists in military service and state
national guard called to federal duty are entitled to have interest rates
reduced and capped at 6% per annum, on obligations (including mortgage loans)
incurred prior to the commencement of military service for the duration of
military service and may be entitled to other forms of relief from mortgage
obligations. To date, compliance with the Act has not had a material effect on
our business.
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LEGAL AND REGULATORY CONSIDERATIONS
Local, state and federal legislatures, state and federal banking
regulatory agencies, state attorneys general offices, the Federal Trade
Commission, the U.S. Department of Justice, the U.S. Department of Housing and
Urban Development and state and local governmental authorities have increased
their focus on lending practices by companies in the subprime lending industry,
more commonly referred to as "predatory lending" practices. State, local and
federal governmental agencies have imposed sanctions for practices including,
but not limited to, charging borrowers excessive fees, imposing higher interest
rates than the borrower's credit risk warrants, failing to adequately disclose
the material terms of loans to the borrowers and abusive servicing and
collections practices. As a result of initiatives such as these, we are unable
to predict whether state, local or federal authorities will require changes in
our lending practices in the future, including reimbursement of fees charged to
borrowers, or will impose fines on us. These changes, if required, could impact
our profitability. These laws and regulations may limit our ability to
securitize loans originated in some states or localities due to rating agency,
investor or market restrictions. As a result, we have limited the types of loans
we offer in some states and may discontinue originating loans in other states or
localities.
Additionally, the United States Congress is currently considering a
number of proposed bills or proposed amendments to existing laws, such as the
"Ney - Lucas Responsible Lending Act of 2003" introduced on February 13, 2003
into the U.S. House of Representatives, which could affect our lending
activities and make our business less profitable. These bills and amendments, if
adopted as proposed, could reduce our profitability by limiting the fees we are
permitted to charge, including prepayment fees, restricting the terms we are
permitted to include in our loan agreements and increasing the amount of
disclosure we are required to give to potential borrowers. While we cannot
predict whether or in what form Congress may enact legislation, we are currently
evaluating the potential impact of these legislative initiatives, if adopted, on
our lending practices and results of operations.
In addition to new regulatory initiatives with respect to so-called
"predatory lending" practices, current laws or regulations in some states
restrict our ability to charge prepayment penalties and late fees. Prior to its
preclusion in July 2003, we used the Federal Alternative Mortgage Transactions
Parity Act of 1982, which we refer to as the Parity Act, to preempt these state
laws for loans which meet the definition of alternative mortgage transactions
under the Parity Act. However, the Office of Thrift Supervision has adopted a
rule effective in July 2003, which precludes us and other non-bank, non-thrift
creditors from using the Parity Act to preempt state prepayment penalty and late
fee laws on new loan originations. Under the provisions of this rule, we are
required to modify or eliminate the practice of charging prepayment and other
fees on new loans in some of the states where we originate loans. Prior to this
rule becoming effective, 80% to 85% of the home mortgage loans we originated
contained prepayment fees. The origination of a high percentage of loans with
prepayment fees impacts our securitization gains and securitization assets by
helping to reduce the likelihood of a borrower prepaying their loan, thereby
prolonging the life of a securitization, and increasing the amounts of residual
cash flow, servicing fees and prepayment fees we can expect to collect over the
life of a securitization. We currently expect that the percentage of loans that
we will originate in the future containing prepayment fees will decrease to
approximately 65% to 70%. During fiscal 2004, approximately 72% of the loans we
originated contained prepayment fees. This decrease in prepayment fee
penetration will potentially reduce the amount of gains and securitization
assets we will record on any future securitizations. Because there are many
other variables including market conditions, which will also impact
securitizations, we are unable to quantify the impact of this rule on any future
securitization assets and related gains until we complete a publicly-placed
securitization of loans which we originated since this rule became effective.
Additionally, in a recent decision, the Appellate Division of the Superior Court
of New Jersey determined that the Parity Act's preemption of state law was
invalid and that the state laws precluding some lenders from imposing prepayment
fees are applicable to loans made in New Jersey, including alternative mortgage
transactions. On May 26, 2004, the New Jersey Supreme Court reversed the
decision of the Appellate Division of the Superior Court of New Jersey and held
that the Parity Act had preempted the New Jersey Prepayment Law, which
prohibited housing lenders from imposing prepayment penalties. However, the
plaintiff has petitioned the United States Supreme Court for certiorari in this
matter.
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Although we are licensed or otherwise qualified to originate loans in
46 states, our loan originations are concentrated mainly in the eastern half of
the United States. Recent expansion has positioned us to increase originations
in the western portion of the United States, especially California. The
concentration of loans in a specific geographic region subjects us to the risk
that a downturn in the economy or recession in the eastern half of the country
would more greatly affect us than if our lending business were more
geographically diversified. As a result, an economic downturn or recession in
this region could result in reduced profitability. See "Risk Factors -- An
economic downturn or recession in a small number of states could hinder our
ability to operate profitably and reduce the funds available to repay our
outstanding debt which could negatively impact the value of our capital stock."
We are also subject, from time to time, to private litigation resulting
from alleged "predatory lending" practices. We expect that as a result of the
publicity surrounding predatory lending practices and the recent New Jersey
court decision regarding the Parity Act, we may be subject to other class action
suits in the future. See "Risk Factors -- Our residential lending business is
subject to government regulation and licensing requirements, which may hinder
our ability to operate profitably, negatively impair our ability to repay our
outstanding debt and negatively impact the value of our capital stock."
On May 20, 2004, the purported consumer class action lawsuit captioned
Moore v. American Business Financial Services, Inc. et al, No. 003237 was filed
against us, our lending subsidiaries and an unrelated party in the Philadelphia
Court of Common Pleas. The lawsuit was brought on behalf of residential mortgage
consumers and challenges the validity of our deed in lieu of foreclosure and
force-placed insurance practices as well as certain mortgage service fees
charged by us. This lawsuit relates, in part, to the same subject matter as the
U.S. Attorney's inquiry concluded in December 2003 with no findings of
wrongdoing as discussed below. The lawsuit seeks actual and treble damages,
statutory damages, punitive damages, costs and expenses of the litigation and
injunctive relief. Procedurally, this lawsuit is in a very preliminary stage. We
believe the complaint contains fundamental factual inaccuracies and that we have
numerous defenses to these allegations. We intend to vigorously defend this
lawsuit. Due to the inherent uncertainties in litigation and because the
ultimate resolution of this proceeding is influenced by factors outside of our
control, we are currently unable to predict the ultimate outcome of this
litigation or its impact on our financial position or results of operations.
SECURITIES CLASS ACTION LAWSUITS AND SHAREHOLDER DERIVATIVE ACTION. In
January and February of 2004, four class action lawsuits were filed against us
and certain of our officers and directors. Lead plaintiffs and counsel were
appointed on June 3, 2004. A consolidated amended class action complaint that
supersedes these four complaints was filed on August 19, 2004 in the United
States District Court for the Eastern District of Pennsylvania.
The consolidated amended class action complaint brings claims on behalf
of a class of all purchasers of our common stock for a proposed class period of
January 27, 2000 through June 26, 2003. The consolidated complaint names us, our
director and Chief Executive Officer, Anthony Santilli, our Chief Financial
Officer, Albert Mandia, and former director, Richard Kaufman, as defendants and
alleges that we and the named directors and officers violated Sections 10(b) and
20(a) of the Exchange Act. The consolidated complaint alleges that, during the
applicable class period, our forbearance and deferment practices enabled us to,
among other things, lower our delinquency rates to facilitate the securitization
of our loans which purportedly allowed us to collect interest income from our
securitized loans and inflate our financial results and market price of our
common stock. The consolidated amended class action complaint seeks unspecified
compensatory damages, costs and expenses related to bringing the action, and
other unspecified relief.
105
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania. The lawsuit was brought nominally on behalf of the Company, as a
shareholder derivative action, alleging that the named directors and officers
breached their fiduciary duties to the Company, engaged in the abuse of control,
gross mismanagement and other violations of law during the period from January
27, 2000 through June 25, 2003. The lawsuit seeks unspecified compensatory
damages, equitable or injunctive relief and costs and expenses related to
bringing the action, and other unspecified relief. The parties have agreed to
stay this case pending disposition of any motion to dismiss the consolidated
amended complaint filed in the putative consolidated securities class action.
Procedurally, these lawsuits are in a very preliminary stage. We
believe that we have several defenses to the claims raised by these lawsuits and
intend to vigorously defend the lawsuits. Due to the inherent uncertainties in
litigation and because the ultimate resolution of these proceedings is
influenced by factors outside of our control, we are currently unable to predict
the ultimate outcome of this litigation or its impact on our financial position,
results of operations or cash flows. See "Risk Factors -- We are subject to
private litigation, including lawsuits resulting from the alleged "predatory"
lending practices, as well as securities class action and derivative lawsuits,
the impact of which on our financial position is uncertain. The inherent
uncertainty related to litigation of this type and the preliminary stage of
these suits makes it difficult to predict the ultimate outcome or potential
liability that we may incur as a result of these matters."
JOINT AGREEMENT WITH THE U.S. ATTORNEY'S OFFICE. On December 22, 2003,
we entered into a Joint Agreement with the Civil Division of the U.S. Attorney's
Office for the Eastern District of Pennsylvania which ended the inquiry by the
U.S. Attorney initiated pursuant to the civil subpoena dated May 14, 2003. The
U.S. Attorney's inquiry focused on our forbearance policies, primarily on our
practice of requesting a borrower who entered into forbearance agreement to
execute a deed in lieu of foreclosure. In response to the inquiry and as part of
the Joint Agreement, we, among other things, have adopted a revised forbearance
policy, which became effective on November 19, 2003 and will make an $80
thousand contribution to a housing counseling organizations approved by the U.S.
Department of Housing and Urban Development. We do not believe that the Joint
Agreement with the U.S. Attorney has had a significant impact on our operations.
See "Legal Proceedings."
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
Our consolidated financial statements are prepared in accordance with
GAAP. The accounting policies discussed below are considered by management to be
critical to understanding our financial condition and results of operations. The
application of these accounting policies requires significant judgment and
assumptions by management, which are based upon historical experience and future
expectations. The nature of our business and our accounting methods make our
financial condition, changes in financial condition and results of operations
highly dependent on management's estimates. The line items on our income
statement and balance sheet impacted by management's estimates are described
below.
106
REVENUE RECOGNITION. Revenue recognition is highly dependent on the
application of Statement of Financial Accounting Standards, referred to as SFAS
in this document, No. 140 "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities," referred to as SFAS No. 140 in this
document, and "gain-on-sale" accounting to our loan securitizations. Gains on
sales of loans through securitizations for the fiscal year ended June 30, 2004
were 15.6% of total revenues compared to 70.8% for the fiscal year ended June
30, 2003. The decline in the percentage of total revenues comprised of
securitization gains resulted from our inability to complete securitizations in
the first, third and fourth quarters of fiscal 2004 and the reduction in loans
originated during fiscal 2004. Securitization gains represent the difference
between the net proceeds to us, including retained interests in the
securitization, and the allocated cost of loans securitized. The allocated cost
of loans securitized is determined by allocating their net carrying value
between the loans, the interest-only strips and the servicing rights we may
retain based upon their relative fair values. Estimates of the fair values of
the interest-only strips and the servicing rights we may retain are discussed
below. We believe the accounting estimates related to gain on sale are critical
accounting estimates because more than 80% of the securitization gains in fiscal
2003 were based on estimates of the fair value of retained interests. The amount
recognized as gain on sale for the retained interests we receive as proceeds in
a securitization, in accordance with accounting principles generally accepted in
the United States of America, is highly dependent on management's estimates.
INTEREST-ONLY STRIPS. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 44.0% of our
total assets at June 30, 2004 and 51.6% of our total assets at June 30, 2003 and
are carried at their fair values. Interest-only strips are initially recorded at
their allocated cost basis at the time of recording a securitization gain and in
accordance with SFAS No. 115 "Accounting for Certain Investments in Debt and
Equity Securities," referred to as SFAS No. 115 in this document, are then
written up to their fair value through other comprehensive income, a component
of stockholders' equity.
Fair value is based on a discounted cash flow analysis which estimates
the present value of the future expected residual cash flows and
overcollateralization cash flows utilizing assumptions made by management. These
assumptions include the rates used to calculate the present value of expected
future residual cash flows and overcollateralization cash flows, referred to as
the discount rates, and expected prepayment and credit loss rates on pools of
loans sold through securitizations. We believe the accounting estimates used in
determining the fair value of interest-only strips are critical accounting
estimates because estimates of prepayment and credit loss rates are made based
on management's expectation of future experience, which is based in part, on
historical experience, current and expected economic conditions and in the case
of prepayment rate assumptions, consideration of the impact of changes in market
interest rates. The actual loan prepayment rate may be affected by a variety of
economic and other factors, including prevailing interest rates, the
availability of alternative financing to borrowers and the type of loan.
We re-evaluate expected future cash flows from our interest-only strips
on a quarterly basis. We monitor the current assumptions for prepayment and
credit loss rates against actual experience and other economic and market
conditions and we adjust assumptions if deemed appropriate. Even a small
unfavorable change in our assumptions made as a result of unfavorable actual
experience or other considerations could have a significant adverse impact on
our estimate of residual cash flows and on the value of these assets. In the
event of an unfavorable change in these assumptions, the fair value of these
assets would be overstated, requiring an accounting adjustment for impairment.
In accordance with the provisions of Emerging Issues Task Force guidance on
issue 99-20, "Recognition of Interest Income and Impairment on Purchased and
Retained Beneficial Interests in Securitized Financial Assets," referred to as
EITF 99-20 in this document, and SFAS No. 115, decreases in the fair value of
interest-only strips that are deemed to be other than temporary adjustments to
fair value are recorded through the income statement, which would adversely
affect our income in the period of adjustment. Additionally, to the extent any
individual interest-only strip has a portion of its initial write up to fair
value still remaining in other comprehensive income, other than temporary
decreases in its fair value would first be recorded as a reduction to other
comprehensive income, which would adversely affect our stockholders' equity in
the period of adjustment.
107
During fiscal 2004, we recorded total pre-tax other than temporary
valuation adjustments on our interest only-strips of $57.0 million, of which, in
accordance with EITF 99-20, $39.6 million was charged as expense to the income
statement and $17.4 million was charged to other comprehensive income. During
fiscal 2003, we recorded total pre-tax other than temporary valuation
adjustments on our interest-only strips of $58.0 million, of which $39.9 million
was charged as expense to the income statement and $18.1 million was charged to
other comprehensive income. The valuation adjustments primarily reflect the
impact of higher than anticipated prepayments on securitized loans experienced
during fiscal 2004 and fiscal 2003 due to the continuing low interest rate
environment. Additionally, on June 30, 2004, we wrote down the carrying value of
our interest-only strips related to five of our mortgage securitization trusts
by $4.1 million to reflect their values under the terms of a September 27, 2004
sale agreement. The sale of these assets was undertaken as part of our
negotiations to obtain the new $100.0 million warehouse credit facility
described in "-- Liquidity and Capital Resources" and to raise cash to pay fees
on new warehouse credit facilities and as a result, we did not realize their
full value as reflected on our books. See "-- Securitizations" for more detail
on the estimation of the fair value of interest-only strips and the
sensitivities of these balances to changes in assumptions and the impact on our
financial statements of changes in assumptions. See "Risk Factors -- Our
estimates of the value of interest-only strips and servicing rights we retain
when we securitize loans could be inaccurate and could limit our ability to
operate profitably, impair our ability to repay our outstanding debt and
negatively impact the value of our capital stock."
Interest accretion income represents the yield component of cash flows
received on interest-only strips. We use a prospective approach to estimate
interest accretion. As previously discussed, we update estimates of residual
cash flow from our securitizations on a quarterly basis. Under the prospective
approach, when it is probable that there is a favorable or unfavorable change in
estimated residual cash flow from the cash flow previously projected, we
recognize a larger or smaller percentage of the cash flow as interest accretion.
Any change in value of the underlying interest-only strip could impact our
current estimate of residual cash flow earned from the securitizations. For
example, a significant change in market interest rates could increase or
decrease the level of prepayments, thereby changing the size of the total
managed loan portfolio and related projected cash flows. The managed portfolio
includes loans held as available for sale on our balance sheet and loans
serviced for others.
SERVICING RIGHTS. Servicing rights, which represent the rights to
receive contractual servicing fees from securitization trusts and ancillary fees
from borrowers, net of adequate compensation that would be required by a
substitute servicer, represented 7.1% of our total assets at June 30, 2004 and
10.3% of our total assets at June 30, 2003. Servicing rights are carried at the
lower of cost or fair value. The fair value of servicing rights is determined by
computing the benefits of servicing in excess of adequate compensation, which
would be required by a substitute servicer. The benefits of servicing are the
present value of projected net cash flows from contractual servicing fees and
ancillary servicing fees. We believe the accounting estimates used in
determining the fair value of servicing rights are critical accounting estimates
because the projected cash flows from servicing fees incorporate assumptions
made by management, including prepayment rates and discount rates. These
assumptions are similar to those used to value the interest-only strips retained
in a securitization. We monitor the current assumptions for prepayment rates
against actual experience and other economic and market conditions and we adjust
assumptions if deemed appropriate. Even a small unfavorable change in our
assumptions, made as a result of unfavorable actual experience or other
considerations could have a significant adverse impact on the value of these
assets. In the event of an unfavorable change in these assumptions, the fair
value of these assets would be overstated, requiring an adjustment, which would
adversely affect our income in the period of adjustment.
108
A review for impairment is performed on a quarterly basis by
stratifying the serviced loans by loan type, home mortgage or business purpose
loans, which we consider to be the predominant risk characteristic in the
portfolio of loans we service. In establishing loan type as the predominant risk
characteristic, we considered the following additional loan characteristics and
determined these characteristics as mostly uniform within our two types of
serviced loans and not predominant for risk stratification:
o Fixed versus floating rate loans - All loans we service in our
securitizations are fixed-rate loans.
o Conforming versus non-conforming loans - All loans we service are
sub-prime (non-conforming) loans, with over 80% of the loans serviced
having credit grades of A or B.
o Interest rate on serviced loans - The serviced loan portfolio has a
high penetration rate of prepayment fees. Sub-prime borrowers, in
general, are not as influenced by movement in market interest rates as
conforming borrowers. A sub-prime borrower's ability to `rate shop' is
generally limited due to personal credit circumstances that are not
market driven.
o Loan collateral - All loans we service are secured by real estate, with
approximately 85% secured with first liens on residential property.
o Individual loan size - The average loan size in our serviced portfolio
is $75 thousand. The serviced portfolio is approximately $2.1 billion
at June 30, 2004 with approximately 25 thousand loans. There are no
significant defining groupings with respect to loan size. No loans are
greater than $1.0 million, only $10.8 million of loans have principal
balances greater than $500 thousand, and only $34.5 million of loans
have principal balances greater than $350 thousand.
o Geographic location of loans - The largest percentage of loans we
service are geographically located in the mid-Atlantic and northeast
sections of the United States.
o Original loan term - Home equity loan terms are primarily 180, 240 or
360 months. Business purpose loan terms are primarily 120 or 180
months.
If our quarterly analysis indicates the carrying value of servicing
rights is not recoverable through future cash flows from contractual servicing
and other ancillary fees, a valuation allowance or write down would be required.
Our valuation analyses indicated that valuation adjustments of $5.5 million and
$5.3 million were required during fiscal 2004 and 2003, respectively, for
impairment of servicing rights due to higher than expected prepayment
experience. Additionally, on June 30, 2004, we wrote down the carrying value of
our servicing rights related to five of our mortgage securitization trusts by
$1.3 million to reflect their values under the terms of a September 27, 2004
sale agreement. The sale of these assets was undertaken as part of our
negotiations to obtain the new $100.0 million warehouse credit facility
described in "-- Liquidity and Capital Resources" and to raise cash to pay fees
on new warehouse credit facilities and as a result, we did not realize their
full value as reflected on our books. In accordance with SFAS No. 140, the write
downs were recorded as a charge to the income statement. Impairment is measured
as the excess of carrying value over fair value. See "-- Securitizations" for
more detail on the estimation of the fair value of servicing rights and the
sensitivities of these balances to changes in assumptions and the estimated
impact on our financial statements of changes in assumptions.
Amortization of the servicing rights asset for securitized loans is
calculated individually for each securitized loan pool and is recognized in
proportion to, and over the period of, estimated future servicing income on that
particular pool of loans.
DEFERRED TAX ASSET. Estimates of deferred tax assets and deferred tax
liabilities make up the deferred income tax asset on our balance sheet. These
estimates involve significant judgments and estimates by management, which may
have a material impact on the carrying value of the deferred income tax asset.
We periodically review the deferred income tax asset to determine if it is more
likely than not that we will realize this deferred tax asset.
109
Our net deferred income tax position changed from a liability of $17.0
million at June 30, 2003 to an asset of $59.1 million at June 30, 2004. For more
detail on this net deferred income tax asset, see Note 14 of the June 30, 2004
Consolidated Financial Statements. This change from a liability position is the
result of recording $68.3 million of federal and state income tax benefits on
our pre-tax loss for the fiscal year ended June 30, 2004. These federal and
state income tax benefits will be realized against anticipated future years'
state and federal taxable income. Factors we considered in determining that it
is more likely than not we will realize this deferred tax asset included: (i)
the circumstances producing the losses for the fourth quarter of fiscal 2003 and
the fiscal year ended June 30, 2004; (ii) our historical profitability prior to
the fourth quarter of fiscal 2003; (iii) the anticipated impact that our
adjusted business strategy will have on producing more currently taxable income
than our previous business strategy produced due to higher loan originations and
shifting from securitizations to whole loan sales; (iv) the achievability of
anticipated levels of future taxable income under our adjusted business
strategy; and (v) the likely utilization of our net operating loss
carryforwards. Additionally, we consider tax-planning strategies we can use to
increase the likelihood that the deferred income tax asset will be realized.
Our adjusted business strategy, as described in "Business -- Business
Strategy," will more likely than not produce the level of loan originations that
we need to achieve taxable income. For the month of May 2003, we originated
$169.0 million of loans, an historical monthly high under our previous business
strategy. In the month of September 2004 under our adjusted business strategy,
we originated $234.0 million of loans and management believes that amount would
have been higher if not for the impact of hurricanes in some of the states in
which we originate loans. Once our adjusted business strategy is fully
implemented, we anticipate increasing our loan originations to approximately
$400.0 million to $600.0 million per month, which will return us to profitable
operations. We have significantly expanded our geographic reach and established
a strong presence on the west coast in fiscal 2004, and are continuing to apply
our adjusted business strategy, particularly as it relates to expanding our
broker channel and offering adjustable rate mortgages, purchase money mortgages
and more competitively priced fixed rate mortgages. Additionally, economic
conditions are favorable for loan originations with growing GDP and employment,
high real estate values and moderate increases in interest rates.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is maintained
on non-accrual loans to account for delinquent loans and leases and delinquent
loans that have been repurchased from securitization trusts. The allowance is
maintained at a level that management determines is adequate to absorb estimated
probable losses. The allowance is calculated based upon management's estimate of
our ability to collect on outstanding loans based upon a variety of factors,
including, periodic analysis of the loans, economic conditions and trends,
historical credit loss experience, borrowers' ability to repay, and collateral
considerations. Additions to the allowance arise from the provision for credit
losses charged to operations or from the recovery of amounts previously
charged-off. Loan charge-offs reduce the allowance. Delinquent loans are charged
off against the allowance in the period in which a loan is deemed fully
uncollectable or when liquidated in a payoff or sale. If the actual collection
of outstanding loans is less than we anticipate, further write downs would be
required which would reduce our net income in the period the write down was
required.
DERIVATIVE FINANCIAL INSTRUMENTS. We utilize derivative financial
instruments to manage the effect of changes in interest rates on the fair value
of our loans between the date loans are originated at fixed interest rates and
the date the terms and pricing for a whole loan sale are fixed or the date the
fixed interest rate pass-through certificates to be issued by a securitization
trust are priced. See "-- Interest Rate Risk Management -- Strategies for Use of
Derivative Financial Instruments" for more detail.
Derivative contracts receive hedge accounting only if they are
designated as a hedge and are expected to be, and are, highly effective in
substantially reducing interest rate risk arising from the pools of mortgage
loans exposing us to risk. Under hedge accounting, the gain or loss derived from
these derivative financial instruments, which are designated as fair value
hedges, is reported in the Statement of Income (included in the caption "gains
and losses on derivative financial instruments") as it occurs with an offsetting
adjustment to the hedged loans attributable to the risk being hedged also
reported in the Statement of Income. The fair value of derivative financial
instruments is determined based on quoted market prices. The fair value of the
hedged loans is determined based on current pricing of these assets in a whole
loan sale or securitization. Cash flows resulting from fair value hedges are
reported in the period they occur.
Assuming a hedge relationship continues to be highly effective,
determined as described below, the relationship continues until the mortgage
loan pool is sold in a whole loan sale, is committed to a forward sale agreement
or is sold in a securitization. When a hedge relationship is terminated, the
derivative financial instrument may be re-designated as a hedge of a new
mortgage pool.
110
The effectiveness of our fair value hedges is periodically assessed.
Fair value hedges must meet specific effectiveness tests to be considered highly
effective. Over time the change in the fair values of the derivative financial
instrument must be within 80 to 120 percent of the change in the fair value of
the hedged loans due to the designated risk. If highly effective correlation
does not exist, we discontinue hedge accounting prospectively.
DEVELOPMENT OF CRITICAL ACCOUNTING ESTIMATES. On a quarterly basis,
senior management reviews the estimates used in our critical accounting
policies. As a group, senior management discusses the development and selection
of the assumptions used to perform its estimates described above. Management has
discussed the development and selection of the estimates used in our critical
accounting policies as of June 30, 2004 and June 30, 2003 with the Audit
Committee of our Board of Directors. In addition, management has reviewed its
disclosure of the estimates discussed in "Management's Discussion and Analysis
of Financial Condition and Results of Operations" with the Audit Committee.
IMPACT OF CHANGES IN CRITICAL ACCOUNTING ESTIMATES. For a description
of the impact of changes in critical accounting estimates related to
interest-only strips and servicing rights in the fiscal year ended June 30,
2004, see "-- Securitizations."
INITIAL ADOPTION OF ACCOUNTING POLICIES. In conjunction with the
relocation of our corporate headquarters to new leased office space, we entered
into a lease agreement and certain governmental grant agreements, which provided
us with reimbursement for certain expenditures related to our office relocation.
The reimbursable expenditures included both capitalizable items for leasehold
improvements, furniture and equipment and expense items such as legal costs,
moving costs and employee communication programs. Amounts reimbursed to us in
accordance with our lease agreement are initially recorded as a liability on our
balance sheet and will be amortized in the income statement on a straight-line
basis over the term of the lease as a reduction of rent expense. Amounts
received from government grants were initially recorded as a liability. Grant
funds received to offset expenditures for capitalizable items are classified as
a reduction of the related fixed asset and amortized to income over the
depreciation period of the related asset as an offset to depreciation expense.
Amounts received to offset expense items were recognized in the income statement
as an offset to the expense item.
IMPACT OF CHANGES IN CRITICAL ACCOUNTING ESTIMATES IN PRIOR FISCAL YEARS
DISCOUNT RATES. During fiscal 2003, we recorded total pre-tax valuation
adjustments on our securitization assets of $63.3 million, of which $45.2
million was charged as expense to the income statement and $18.1 million was
charged to other comprehensive income. The breakout of the total adjustments in
fiscal 2003 between interest-only strips and servicing rights and the amount of
the adjustments related to changes in discount rates were as follows:
o We recorded total pre-tax valuation adjustments on our interest
only-strips of $58.0 million, of which $39.9 million was charged to
the income statement and $18.1 million was charged to other
comprehensive income. The valuation adjustment reflects the impact
of higher than anticipated prepayments on securitized loans
experienced in fiscal 2003 due to the low interest rate environment
experienced during fiscal 2003, which has impacted the entire
mortgage industry. The valuation adjustment on interest-only strips
for fiscal 2003 was reduced by a $20.9 million favorable valuation
impact as a result of reducing the discount rates applied in valuing
the interest-only strips at June 30, 2003. The amount of the
valuation adjustment charged to the income statement was reduced by
a $10.8 million favorable valuation impact as a result of reducing
the discount rates and the charge to other comprehensive income was
reduced by $10.1 million for the favorable impact of reducing
discount rates. The discount rates were reduced at June 30, 2003
primarily to reflect the impact of the sustained decline in market
interest rates. The reductions in discount rates are discussed in
more detail below.
111
o We recorded total pre-tax valuation adjustments on our servicing
rights of $5.3 million, which was charged to the income statement.
The valuation adjustment reflects the impact of higher than
anticipated prepayments on securitized loans experienced in fiscal
2003 due to the low interest rate environment experienced during
fiscal 2003. The valuation adjustment on servicing rights for fiscal
2003 was reduced by a $7.1 million favorable valuation impact as a
result of reducing the discount rate applied in valuing the
servicing rights at June 30, 2003. The discount rate was reduced at
June 30, 2003 primarily to reflect the impact of the sustained
decline in market interest rates. The discount rate on our servicing
rights was reduced from 11% to 9% at June 30, 2003.
See "- Application of Critical Accounting Estimates - Interest-Only
Strips" for a discussion of how valuation adjustments are recorded.
From June 30, 2000 through March 31, 2003, we had applied a discount
rate of 13% to residual cash flows. On June 30, 2003, we reduced that discount
rate to 11% based on the following factors:
o We had experienced a period of sustained decreases in market
interest rates. Interest rates on three and five-year term US
Treasury securities have been on the decline since mid-2000.
Three-year rates had declined approximately 475 basis points and
five-year rates have declined approximately 375 basis points over
that period.
o The interest rates on the bonds issued in our securitizations over
that same timeframe also had experienced a sustained period of
decline. The trust certificate pass-through interest rate had
declined 426 basis points, from 8.04% in the 2000-2 securitization
to 3.78% in the 2003-1 securitization.
o The weighted average interest rate on loans securitized had declined
from a high of 12.01% in the 2000-3 securitization to 10.23% in the
2003-1 securitization.
o Market factors and the economy favored the continuation of low
interest rates for the foreseeable future.
o Economic analysis of interest rates and data released at the time of
the June 30, 2003 evaluation supported declining mortgage
refinancings even though predicting the continuation of low interest
rates for the foreseeable future.
o The interest rates paid on subordinated debentures issued, which is
used to fund our interest-only strips, had declined from a high of
11.85% in February 2001 to a rate of 7.49% in June 2003.
However, because the discount rate is applied to projected cash flows,
which consider expected prepayments and losses, the discount rate assumption was
not evaluated in isolation. These risks involved in our securitization assets
were considered in establishing a discount rate. The impact of this reduction in
discount rate from 13% to 11% was to increase the valuation of our interest-only
strips by $17.6 million at June 30, 2003.
112
We apply a second discount rate to projected cash flows from the
overcollateralization portion of our interest-only strips. The discount rate
applied to projected overcollateralization cash flows in each mortgage
securitization is based on the highest trust certificate pass-through interest
rate in the mortgage securitization. In fiscal 2001, we instituted the use of a
minimum discount rate of 6.5% on overcollateralization cash flows. At June 30,
2003 we reduced the minimum discount rate to 5.0% to reflect the sustained
decline in interest rates. This reduction in the minimum discount rate impacted
the valuation of three securitizations and increased the June 30, 2003 valuation
of our interest-only strips by $3.3 million.
The blended rate used to value our interest-only strips at June 30,
2003 was 9%.
From June 2000 to March 2003, the discount rate applied in determining
the fair value of servicing rights was 11%, which was 200 basis points lower
than the 13% discount rate applied to value residual cash flows from
interest-only strips during that period. On June 30, 2003, we reduced the
discount rate on servicing rights cash flows to 9%. The impact of the June 30,
2003 reduction in discount rate from 11% to 9% was to increase the valuation of
our servicing rights by $7.1 million at June 30, 2003. This favorable impact was
offset by a decrease of $12.4 million mainly due to prepayment experience in
fiscal 2003.
PREPAYMENT RATES. From the second quarter of fiscal 2002 through the
fourth quarter of fiscal 2004, we revised the prepayment rate assumptions used
to value our securitization assets, thereby decreasing the fair value of these
assets. See "-- Securitizations" for discussion of the impacts of these
revisions in prepayment rate assumptions.
OFF-BALANCE SHEET ARRANGEMENTS
We use off-balance sheet arrangements extensively in our business
activities. The types of off-balance sheet arrangements we use include special
purpose entities for the securitization of loans, obligations we incur as the
servicer of securitized loans and other contractual obligations such as
operating leases for corporate office space. See "-- Liquidity and Capital
Resources" for additional information regarding our off-balance sheet
contractual obligations.
We have used special purpose entities and off-balance sheet facilities
in our mortgage loan securitizations. Asset securitizations are one of the most
common off-balance sheet arrangements in which a company transfers assets off of
its balance sheet by selling them to a special purpose entity. We sell our loans
into off-balance sheet facilities to generate the cash to pay off revolving
credit facilities and to generate revenue through securitization gains. The
special purpose entities described below meet our objectives for mortgage loan
securitization structures and comply with accounting principles generally
accepted in the United States of America. We expect to use off-balance sheet
facilities in any future securitizations.
Our securitizations involve a two-step transfer that qualifies for sale
accounting under SFAS No. 140. First, we sell the loans to a special purpose
entity, which has been established for the limited purpose of buying and
reselling the loans and establishing a true sale under legal standards. Next,
the special purpose entity sells the loans to a qualified special purpose
entity, which we refer to as the trust. The trust is a distinct legal entity,
independent from us. By transferring title of the loans to the trust, we isolate
those assets from our assets. Finally, the trust issues certificates to
investors to raise the cash purchase price for the loans we have sold. Cash from
the sale of certificates to third party investors is returned to us in exchange
for our loan receivables and we use this cash, in part, to repay any borrowings
under warehouse and credit facilities. The off-balance sheet trusts' activities
are restricted to holding title to the loan collateral, issuing certificates to
investors and distributing loan payments to the investors and us in accordance
with the relevant agreement.
113
When we securitize loans, we also may retain the right to service the
loans. We do not service the loans in the 2003-2 securitization, our most recent
securitization, which closed in October 2003. We have no additional obligations
to the off-balance sheet facilities other than those required as servicer of the
loans and for breach of covenants or warranty obligations. We are not required
to make any additional investments in the trusts. Under current accounting
rules, the trusts do not qualify for consolidation in our financial statements.
The trusts carry the loan collateral as assets and the certificates issued to
investors as liabilities. Residual cash from the loans after required principal
and interest payments are made to the investors and after payment of certain
fees and expenses provides us with cash flows from our interest-only strips. We
expect that future cash flows from our interest-only strips and servicing rights
will generate more of the cash flows required to meet maturities of our
subordinated debentures and our operating cash needs.
We may retain the rights to service the loans we sell through
securitizations. If we retain the servicing rights, as the servicer of
securitized loans, we are obligated to advance interest payments for delinquent
loans if we deem that the advances will ultimately be recoverable. These
advances can first be made out of funds available in a trust's collection
account. If the funds available from the collection account are insufficient to
make the required interest advances, then we are required to make the advance
from our operating cash. The advances made from a trust's collection account, if
not recovered from the borrower or proceeds from the liquidation of the loan,
require reimbursement from us. These advances may require funding from our
capital resources and may create greater demands on our cash flow than either
selling loans with servicing released or maintaining a portfolio of loans on our
balance sheet. However, any advances we make on a mortgage loan from our
operating cash can be recovered from the subsequent mortgage loan payments to
the applicable trust prior to any distributions to the certificate holders.
At June 30, 2004 and 2003, the mortgage securitization trusts held
loans with an aggregate principal balance due of $1.9 billion and $3.4 billion
as assets and owed $1.7 billion and $3.2 billion to third party investors,
respectively. Revenues from the sale of loans to securitization trusts were
$15.1 million, or 15.6% of total revenues for the fiscal year ended June 30,
2004 and $171.0 million, or 70.8% of total revenues for the fiscal year ended
June 30, 2003. The revenues for fiscal 2004 and 2003 are net of $2.9 million and
$5.1 million, respectively, of expenses for underwriting fees, legal fees and
other expenses associated with securitization transactions during that period.
We have interest-only strips and servicing rights with fair values of $459.1
million and $73.7 million, respectively at June 30, 2004, which combined
represent 51% of our total assets. Net cash flows received from interest-only
strips and servicing rights were $194.7 million for fiscal 2004 and $132.1
million for fiscal 2003. These amounts are included in our operating cash flows.
We also used special purpose entities in our sales of loans to a $300.0
million off-balance sheet mortgage conduit facility that was available to us
until July 5, 2003. Sales into the off-balance sheet facility involved a
two-step transfer that qualified for sale accounting under SFAS No. 140, similar
to the process described above. This facility had a revolving feature and could
be directed by the third party sponsor to dispose of the loans. Typically, the
loans were disposed of by securitizing the loans in a term securitization. The
third party note purchaser also has the right to have the loans sold in whole
loan sale transactions. Under this off-balance sheet facility arrangement, the
loans have been isolated from us and our subsidiaries and as a result, transfers
to the facility were treated as sales for financial reporting purposes. When
loans were sold to this facility, we assessed the likelihood that the sponsor
would transfer the loans into a term securitization. As the sponsor had
typically transferred the loans to a term securitization prior to the fourth
quarter of fiscal 2003, the amount of gain on sale we had recognized for loans
sold to this facility was estimated based on the terms we would obtain in a term
securitization rather than the terms of this facility. For the fourth quarter of
fiscal 2003, the likelihood that the facility sponsor would ultimately transfer
the underlying loans to a term securitization was significantly reduced and the
amount of gain recognized for loans sold to this facility was based on terms
expected in a whole loan sale transaction. Our ability to sell loans into this
facility expired pursuant to its terms on July 5, 2003. At June 30, 2003, the
off-balance sheet mortgage conduit facility held loans with principal balances
due of $275.6 million as assets and owed $267.5 million to third parties.
Through September 30, 2003, $222.3 million of the loans which were in the
facility at June 30, 2003 were sold in whole loan sales as directed by the
facility sponsor. At September 30, 2003, the off-balance sheet mortgage conduit
facility held loans with principal balances due of $40.5 million as assets and
owed $36.0 million to third parties. This conduit facility was refinanced in the
October 16, 2003 refinancing described under "-- Liquidity and Capital Resources
-- Credit Facilities."
114
SECURITIZATIONS
In our mortgage loan securitizations, pools of mortgage loans are sold
to a trust. The trust then issues certificates or notes, which we refer to as
certificates in this document, to third-party investors, representing the right
to receive a pass-through interest rate and principal collected on the mortgage
loans each month. These certificates, which are senior in right to our
interest-only strips in the trusts, are sold in public or private offerings. The
difference between the weighted-average interest rate that is charged to
borrowers on the fixed interest rate pools of mortgage loans and the
weighted-average pass-through interest rate paid to investors is referred to as
the interest rate spread. The interest rate spread after payment of certain fees
and expenses and subject to certain conditions is distributed from the trust to
us and is the basis of the value of our interest-only strips. In addition, when
we securitize our loans we may retain the right to service the loans for a fee,
which is the basis for our servicing rights. Servicing includes processing of
mortgage payments, processing of disbursements for tax and insurance payments,
maintenance of mortgage loan records, performance of collection efforts,
including disposition of delinquent loans, foreclosure activities and
disposition of real estate owned, referred to as REO, and performance of
investor accounting and reporting processes.
In a declining interest rate environment, such as experienced during
fiscal 2003, securitization pass-through interest rates generally decline, which
can lead to higher interest rate spreads. Increased interest rate spreads result
in increases in the residual cash flow we expect to receive on securitized
loans, the amount of cash we receive at the closing of a securitization from the
sale of notional bonds or premiums on investor certificates and corresponding
increases in the gains we recognize on the sale of loans in a securitization. In
our fiscal 2003 securitizations, we experienced improved interest rate spreads.
However, in a rising interest rate environment and under our business strategy
we would expect our ability to originate loans at interest rates that will
maintain our most recent level of securitization gain profitability to become
more difficult than during a stable or falling interest rate environment. No
assurances can be made that market interest rates will remain at current levels
or that we can complete securitizations in the future. We would seek to address
the challenge presented by a rising interest rate environment by carefully
monitoring our product pricing, the actions of our competition, market trends
and the use of hedging strategies in order to continue to originate loans in as
profitable a manner as possible. See "-- Interest Rate Risk Management --
Strategies for Use of Derivative Financial Instruments" for a discussion of our
hedging strategies.
While a declining interest rate environment can lead to higher interest
rate spreads, a declining interest rate environment could also unfavorably
impact the valuation of our interest-only strips. In a declining interest rate
environment the level of mortgage refinancing activity tends to increase, which
could result in an increase in loan prepayment experience and may require
increases in assumptions for prepayments for future periods. This has been our
experience since fiscal 2002.
115
Declining interest rates and resulting high prepayment rates over the
last eleven quarters have required revisions to our estimates of the value of
our securitization assets. Beginning in the second quarter of fiscal 2002 and on
a quarterly basis thereafter, our prepayment rates, as well as those throughout
the mortgage industry, remained at higher than expected levels due to continuing
low interest rates during this period. As a result, over the last eleven
quarters we have recorded cumulative pre-tax write downs to our interest-only
strips in the aggregate amount of $175.8 million and pre-tax adjustments to the
value of servicing rights of $17.9 million, for total adjustments of $193.7
million, mainly due to the higher than expected prepayment experience. During
the same period, we reduced the discount rates we apply to value our
securitization assets, resulting in net favorable pre-tax valuation impacts of
$20.9 million on interest-only strips and $7.1 million on servicing rights. The
discount rates were reduced primarily to reflect the impact of the sustained
decline in market interest rates. Additionally, on June 30, 2004, we wrote down
the carrying value of our interest-only strips and servicing rights related to
five of our mortgage securitization trusts by $5.4 million to reflect their
values under the terms of a September 27, 2004 sale agreement. The sale of these
assets was undertaken as part of our negotiations to obtain the new $100.0
million warehouse credit facility described in "-- Liquidity and Capital
Resources" and to raise cash to pay fees on new warehouse credit facilities and
as a result, we did not realize their full value as reflected on our books. The
following table summarizes the net cumulative write downs recorded on our
securitization assets over the last eleven quarters (in thousands):
TOTAL INCOME OTHER
WRITE DOWN STATEMENT COMPREHENSIVE
(WRITE UP) IMPACT INCOME IMPACT
---------- --------- -------------
PRE-TAX ADJUSTMENT RESULTING FROM:
Prepayments.............................. $ 193,743 $ 128,667 $ 65,076
Discount rate............................ (28,038) (18,427) (9,611)
Loss on sale............................. 5,452 3,446 2,006
---------- ---------- ----------
Net cumulative write down................ $ 171,157 $ 113,686 $ 57,471
========== ========== ==========
See "- Application of Critical Accounting Estimates - Interest-Only
Strips" for a discussion of how valuation adjustments are recorded in the income
statement or other comprehensive income.
During fiscal 2004, we recorded total pre-tax valuation adjustments on
our interest-only strips and servicing rights of $63.8 million, of which $46.4
million was charged as expense to the income statement and $17.4 million was
charged to other comprehensive income. These adjustments primarily reflect the
impact of higher than anticipated prepayments on securitized loans experienced
in fiscal 2004 due to the low interest rate environment experienced during
fiscal 2004. The fiscal 2004 valuation adjustment also includes a write down of
the carrying value of our interest-only strips and servicing rights related to
five of our mortgage securitization trusts of $5.4 million to reflect their
values under the terms of a September 27, 2004 sale agreement. This compares to
total pre-tax valuation adjustments on our securitization assets of $63.3
million during the fiscal year ended June 30, 2003, of which $45.2 million was
charged as expense to the income statement and $18.1 million was reflected as an
adjustment to other comprehensive income. The breakout of the total adjustments
in fiscal 2004 and 2003 between interest-only strips and servicing rights was as
follows (in thousands):
116
YEAR ENDED JUNE 30, 2004 YEAR ENDED JUNE 30, 2003
-------------------------------------- ----------------------------------------
INCOME OTHER INCOME OTHER
TOTAL STATEMENT COMPREHENSIVE TOTAL STATEMENT COMPREHENSIVE
WRITE DOWN IMPACT INCOME IMPACT WRITE DOWN IMPACT INCOME IMPACT
---------- --------- ------------- ---------- --------- -------------
Interest-only strips.......... $ 57,031 $ 39,659 $ 17,372 $ 57,973 $ 39,900 $ 18,073
Servicing rights.............. 6,791 6,791 -- 5,282 5,282 --
------------------------------------- ---------------------------------------
Total securitization assets... $ 63,822 $ 46,450 $ 17,372 $ 63,255 $ 45,182 $ 18,073
===================================== =======================================
The valuation adjustment on interest-only strips for fiscal 2004
included the net impact of a December 31, 2003 reduction in the discount rate
applied to value the residual cash flows from interest-only strips from 11% to
10%, and a subsequent increase in that discount rate at June 30, 2004 back to
11%. The discount rate was reduced to 10% on December 31, 2003 from 11% on
September 30, 2003 and June 30, 2003 primarily to reflect the impact of the
sustained decline in market interest rates. The increase back to 11% at June 30,
2004 was made to reflect an increase in market interest rates that had occurred
since the end of the March 2004 quarter. The December 31, 2004 reduction in
discount rate had a favorable impact of $8.4 million on that quarter's valuation
adjustment. The June 30, 2004 increase in discount rate had an unfavorable
impact of $8.4 million on that quarter's valuation adjustment.
The long duration of historically low interest rates, combined with
increasing home values and high consumer debt levels has given borrowers an
extended opportunity to engage in mortgage refinancing activities, which
resulted in elevated prepayment experience. Low interest rates and increasing
home values provide incentive to borrowers to convert high cost consumer debt
into lower rate tax deductible loans. As home values have increased, lenders
have been highly successful in educating borrowers that they have the ability to
access the cash value in their homes.
The persistence of historically low interest rate levels, unprecedented
in the last 40 years, has made the forecasting of prepayment levels difficult.
We assumed for each quarter end valuation that the decline in interest rates had
stopped and a rise in interest rates would occur in the near term. This
assumption was supported by published data. Consistent with this view that
interest rates would rise, we had utilized derivative financial instruments to
manage interest rate risk exposure on our loan production and loan pipeline to
protect the fair value of these fixed rate items against potential increases in
market interest rates. We believe that once we are beyond the low interest rate
environment and its impact on prepayments, the long recurring and highly
unfavorable prepayment experience over the last eleven quarters will subside.
Also, the rate of increase in home values has slowed considerably, which we
expect will mean that fewer borrowers will have excess value in their homes to
access. The Mortgage Bankers Association of America has forecast as of September
17, 2004 that mortgage refinancings as a percentage share of total mortgage
originations will decline from 49% in the second quarter of calendar 2004 to 24%
in the second quarter of calendar 2005. The Mortgage Bankers Association of
America has also projected in its September 2004 economic forecast that the
10-year treasury rate (which generally affects mortgage rates) will increase
steadily each quarter in their forecast. As a result of our analysis of these
factors, we believe prepayments will continue to remain at higher t
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