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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report under Section 13 or 15(d) of the Securities and
Exchange Act of 1934
For the quarterly period ended September 30, 2002
[ ] Transition report under Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _______________ to ________________
Commission File No. 000-22474
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
------------------------------------------
(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.)
111 Presidential Boulevard, Bala Cynwyd, PA 19004
-------------------------------------------------
(Address of principal executive offices) (zip code)
(610) 668-2440
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) filed all reports
required to be filed by Section 13 or 15(d) of the 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 whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X] NO
The number of shares outstanding of the Registrant's sole class of
common stock as of November 1, 2002 was 2,938,764 shares.
American Business Financial Services, Inc. and Subsidiaries
INDEX
Page
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PART I FINANCIAL INFORMATION
Item 1. Financial Information
Consolidated Balance Sheets as of September 30, 2002 and June 30, 2002............................................1
Consolidated Statements of Income for the three months ended September 30, 2002 and 2001 .........................2
Consolidated Statement of Stockholders' Equity for the three months ended September 30, 2002 .....................3
Consolidated Statements of Cash Flow for the three months ended September 30, 2002 and 2001 ......................4
Notes to Consolidated Financial Statements........................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................18
Item 3. Quantitative and Qualitative Disclosure about Market Risk................................................65
Item 4. Controls and Procedures..................................................................................65
PART II OTHER INFORMATION
Item 1. Legal Proceedings........................................................................................66
Item 2. Changes in Securities....................................................................................66
Item 3. Defaults Upon Senior Securities..........................................................................66
Item 4. Submission of Matters to a Vote of Security Holders......................................................66
Item 5. Other Information........................................................................................67
Item 6. Exhibits and Reports on Form 8-K.........................................................................67
Part I FINANCIAL INFORMATION
Item 1. Financial Information
American Business Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollars in thousands)
September 30, June 30,
2002 2002
----------- --------
(Unaudited) (Note)
Assets
Cash and cash equivalents $106,923 $108,599
Loan and lease receivables, net
Available for sale 67,843 61,650
Interest and fees 11,568 12,292
Interest-only strips (includes the fair value of
overcollateralization related cash flows of $251,014 and
$236,629 at September 30, 2002 and June 30, 2002) 543,862 512,611
Servicing rights 128,856 125,288
Receivable for sold loans 7,396 5,055
Prepaid expenses 3,441 3,640
Property and equipment, net 18,823 18,446
Other assets 29,998 28,794
-------- --------
Total assets $918,710 $876,375
======== ========
Liabilities
Subordinated debt $669,691 $655,720
Warehouse lines and other notes payable 11,687 8,486
Accrued interest payable 45,496 43,069
Accounts payable and accrued expenses 19,619 13,690
Deferred income taxes 37,169 35,124
Other liabilities 61,878 50,908
-------- --------
Total liabilities 845,540 806,997
-------- --------
Stockholders' equity
Preferred stock, par value $.001, authorized, 1,000,000 shares,
issued and outstanding, none - -
Common stock, par value $.001, authorized, 9,000,000 shares,
issued: 3,653,037 shares at September 30, 2002 and 3,645,192
shares at June 30, 2002 (including Treasury shares of 753,048
at September 30, 2002 and 801,823 at June 30, 2002) 4 4
Additional paid-in capital 23,985 23,985
Accumulated other comprehensive income 13,629 11,479
Retained earnings 45,710 47,968
Treasury stock, at cost (9,558) (13,458)
-------- --------
73,770 69,978
Note receivable (600) (600)
-------- --------
Total stockholders' equity 73,170 69,378
-------- --------
Total liabilities and stockholders' equity $918,710 $876,375
======== ========
Note: The balance sheet at June 30, 2002 has been derived from the audited
financial statements at that date.
See accompanying notes to consolidated financial statements.
1
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Income
(amounts in thousands except per share data)
(unaudited)
Three Months Ended
September 30,
---------------------
2002 2001
------- -------
Revenues
Gain on sale of loans $58,011 $35,356
Interest and fees 4,168 5,941
Interest accretion on interest-only strips 10,747 7,736
Servicing income 1,537 1,636
Other income 4 3
------- -------
Total revenues 74,467 50,672
------- -------
Expenses
Interest 17,083 16,983
Provision for credit losses 1,538 1,436
Employee related costs 9,575 7,824
Sales and marketing 6,688 6,064
General and administrative 24,365 16,017
Interest-only strips valuation adjustment 12,078 -
------- -------
Total expenses 71,327 48,324
------- -------
Income before provision for income taxes 3,140 2,348
Provision for income taxes 1,319 986
------- -------
Net income $ 1,821 $ 1,362
======= =======
Earnings per common share:
Basic $ 0.64 $ 0.43
======= =======
Diluted $ 0.61 $ 0.40
======= =======
Average common shares:
Basic 2,856 3,198
======= =======
Diluted 2,985 3,402
======= =======
See accompanying notes to consolidated financial statements.
2
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity
(amounts in thousands, except per share data)
(unaudited)
Common Stock
------------------- Accumulated
Number of Additional Other Total
For the three months ended Shares Paid-In Comprehensive Retained Treasury Note Stockholders'
September 30, 2002: Outstanding Amount Capital Income Earnings Stock Receivable Equity
----------- ------ --------- ------------- -------- -------- ---------- -------------
Balance June 30, 2002 2,843 $ 4 $23,985 $11,479 $47,968 $(13,458) $(600) $69,378
Comprehensive income:
Net income -- -- -- -- 1,821 -- -- 1,821
Net unrealized gain on interest-only
strips -- -- -- 2,150 -- -- -- 2,150
----- ------ ------- ------- ------- -------- ------ -------
Total comprehensive income -- -- -- 2,150 1,821 -- -- 3,971
Exercise of non-employee stock options 57 -- -- -- (569) 619 -- 50
Stock dividend (10% of outstanding shares) -- -- -- -- (3,281) 3,281 -- --
Cash dividends ($0.08 per share) -- -- -- -- (229) -- -- (229)
----- ------ ------- ------- ------- -------- ------ -------
Balance September 30, 2002 2,900 $ 4 $23,985 $13,629 $45,710 $ (9,558) $ (600) $73,170
===== ====== ======= ======= ======= ======== ====== =======
See accompanying notes to consolidated financial statements.
3
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow
(in thousands)
(unaudited)
Three Months Ended
September 30,
-----------------------
2002 2001
--------- ---------
Cash flows from operating activities
Net income $ 1,821 $ 1,362
Adjustments to reconcile net income to net cash used in
operating activities:
Gain on sales of loans (58,011) (35,356)
Depreciation and amortization 11,163 9,346
Interest accretion on interest-only strips (10,747) (7,736)
Interest-only strips fair value adjustment 12,078 -
Provision for credit losses 1,538 1,436
Loans originated for sale (386,390) (328,269)
Proceeds from sale of loans 382,181 318,891
Principal payments on loans and leases 4,382 2,266
Decrease in accrued interest and fees on loan and lease
receivables 724 1,464
Required purchase of additional overcollateralization
on securitized loans (17,128) (13,508)
Cash flow from interest-only strips 33,464 23,987
Decrease in prepaid expenses 199 666
Increase in accrued interest payable 2,427 5,532
Increase in accounts payable and accrued expenses 5,929 1,617
Accrued interest payable reinvested in subordinated debt 7,863 5,366
(Decrease) increase in deferred income taxes (598) 469
(Decrease) increase in loans in process (529) 2,123
Other, net 1,106 (9,051)
--------- ---------
Net cash used in operating activities (8,528) (19,395)
--------- ---------
Cash flows from investing activities
Purchase of property and equipment, net (1,031) (1,305)
Principal receipts and maturity of investments 8 7
--------- ---------
Net cash used in investing activities (1,023) (1,298)
--------- ---------
4
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow (continued)
(in thousands)
(unaudited)
Three Months Ended
September 30,
-------------------------
2002 2001
-------- --------
Cash flows from financing activities
Proceeds from issuance of subordinated debt $ 40,006 $ 67,467
Redemptions of subordinated debt (33,898) (28,058)
Net borrowings on revolving lines of credit 3,110 1,064
Principal payments on lease funding facility (931) (867)
Net repayments of other notes payable - (80)
Financing costs incurred (233) (777)
Exercise of non-employee stock options 50 -
Cash dividends paid (229) (210)
Repurchase of treasury stock - (3,344)
-------- --------
Net cash provided by financing activities 7,875 35,195
-------- --------
Net (decrease) increase in cash and cash equivalents (1,676) 14,502
Cash and cash equivalents at beginning of year 108,599 91,092
-------- --------
Cash and cash equivalents at end of year $106,923 $105,594
======== ========
Supplemental disclosures:
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ (1,022) $ -
Increase in warehouse lines and other notes payable $ 1,022 $ -
Cash paid during the period for:
Interest $ 6,793 $ 6,721
Income taxes $ 700 $ 200
See accompanying notes to consolidated financial statements.
5
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 2002
1. Basis of Financial Statement Presentation
American Business Financial Services, Inc. ("ABFS"), together with its
subsidiaries (the "Company"), is a diversified financial services organization
operating predominantly in the eastern and central portions of the United
States. The Company originates, sells and services business purpose loans and
home equity loans, through its principal direct and indirect subsidiaries. The
Company also processes and purchases home equity loans from other financial
institutions through the Bank Alliance Program.
The Company's loans primarily consist of fixed interest rate loans
secured by first or second mortgages on single family residences. The Company's
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 its products and services. The Company originates loans through a
combination of channels including a national processing center located at a
centralized operating office in Bala Cynwyd, Pennsylvania, a regional processing
center in Roseland, New Jersey and several retail branch offices. In addition,
the Company offers subordinated debt securities to the public, the proceeds of
which are used for repayment of existing debt, loan originations, operations,
investments in systems and technology and for general corporate purposes.
Effective December 31, 1999 the Company de-emphasized and subsequent to that
date, discontinued the equipment leasing origination business but continues to
service the remaining portfolio of leases.
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
of America for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. Accordingly, they do not
include all the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals and the elimination of intercompany balances) considered
necessary for a fair presentation have been included. Operating results for the
three-month period ended September 30, 2002 are not necessarily indicative of
financial results that may be expected for the full year ended June 30, 2003.
These unaudited consolidated financial statements should be read in conjunction
with the audited consolidated financial statements and notes thereto included in
the Company's Annual Report on Form 10-K for the fiscal year ended June 30,
2002.
On August 21, 2002, the Company's Board of Directors declared a 10% stock
dividend, which was paid on September 13, 2002 to shareholders of record on
September 3, 2002. As a result of the stock dividend, all outstanding stock
options and the related exercise prices were adjusted. Accordingly, all
outstanding common shares, earnings per common share, dividends per share,
average common shares and stock option amounts for all periods presented have
been retroactively adjusted to reflect the effect of this stock dividend.
6
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
1. Basis of Financial Statement Presentation (continued)
Certain prior period financial statement balances have been reclassified to
conform to current period presentation.
Recent Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board issued a proposed
interpretation of Accounting Research Bulletin No. 51 "Consolidated Financial
Statements." The proposal provides guidance on consolidation by a business
enterprise of special purpose entities ("SPEs"). The proposal defines the
primary beneficiary of an SPE as a business enterprise that has a controlling
financial interest in the SPE. The proposal requires that the primary
beneficiary of an SPE consolidate an SPE's assets, liabilities and results of
the activities of the SPE in their financial statements and provide certain
disclosures regarding both consolidated and unconsolidated SPEs. SPEs whose
structures effectively disburse risk would not be required to be consolidated by
any party. Although the Company uses SPEs extensively in their loan
securitization activities, the proposal, if adopted as proposed, will not affect
the Company's current consolidation policies for SPEs. The proposed
interpretation does not change the guidance incorporated in Statement of
Financial Accounting Standards (SFAS) No. 140 which precludes consolidation of a
qualifying SPE by a transferor of assets to that SPE. The proposal as currently
contemplated will therefore have no effect on the Company's financial condition
or results of operations and would not be expected to affect it in the future.
Restricted Cash Balances
The Company held restricted cash balances of $9.4 million and $9.0 million
related to borrower escrow accounts at September 30, 2002 and June 30, 2003,
respectively, and $4.2 million at September 30, 2002 related to deposits for
future settlement of interest rate swap contracts.
7
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
2. Loan and Lease Receivables
Loan and lease receivables - available for sale were comprised of the following
(in thousands):
September 30, June 30,
2002 2002
------- -------
Real estate secured loans $48,725 $48,116
Leases, net of unearned income of $494 and $668 7,052 8,211
------- -------
55,777 56,327
Less: allowance for credit losses on loan and lease
receivables available for sale 3,184 3,705
------- -------
52,593 52,622
Receivable for securitized loans 15,250 9,028
------- -------
$67,843 $61,650
======= =======
In accordance with the Company's securitization trust agreements, the Company
has the right, but not the obligation, to repurchase a limited amount of
delinquent loans from securitization trusts. In accordance with the provisions
of SFAS No. 140, the Company has recorded an obligation for the repurchase of
loans subject to these removal of accounts provisions, whether or not the
Company plans to repurchase the loans. The obligation for the loans' purchase
price is recorded in Other liabilities. A corresponding receivable is recorded
at the lower of the loans' cost basis or fair value.
Real estate secured loans have contractual maturities of up to 30 years.
At September 30, 2002 and June 30, 2002, the accrual of interest income was
suspended on real estate secured loans of $7.1 million and $7.0 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $2.4 million and $2.9 million at
September 30, 2002 and June 30, 2002, respectively.
Substantially all leases are direct finance-type leases whereby the lessee has
the right to purchase the leased equipment at the lease expiration for a nominal
amount.
8
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
3. Interest-Only Strips
Activity for interest-only strip receivables for the three months ended
September 30, 2002 and 2001 were as follows (in thousands):
September 30,
2002 2001
-------- --------
Balance at beginning of period $512,611 $398,519
Initial recognition of interest-only strips 44,126 33,636
Cash flow from interest-only strips (33,464) (23,987)
Required purchases of additional
overcollateralization 17,128 13,508
Interest accretion 10,747 7,736
Net adjustments to fair value (a) 4,792 776
Other than temporary fair value adjustment (a) (12,078) -
-------- --------
Balance at end of period $543,862 $430,188
======== ========
(a) Net temporary adjustments to fair value are recorded through
other comprehensive income, which is a component of equity. Other
than temporary adjustments to decrease the fair value of
interest-only strips are recorded through the income statement.
Interest-only strips include overcollateralization balances that represent
undivided interests in securitizations maintained to provide credit enhancement
to investors in securitization trusts. At September 30, 2002 and 2001, the fair
value of overcollateralization related cash flows were $251.0 million and $195.7
million, respectively.
During the first three months of fiscal 2003, write downs of $16.7 million were
recorded on interest-only strips due to increases in prepayment experience. The
income statement impact for the first quarter of fiscal 2003 was a write down of
$12.1 million while the remaining $4.7 million was written down through other
comprehensive income in accordance with the provisions of SFAS No. 115
"Accounting for Certain Investments in Debt and Equity Securities" and Emerging
Issues Task Force guidance, referred to as EITF in this document, 99-20. The
following table details the pre-tax write downs of the interest-only strips (in
thousands):
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- ----------------------------------------- ---------- --------- --------------
September 30, 2002....................... $16,739 $12,078 $4,661
9
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
3. Interest-Only Strips (continued)
Beginning in the second quarter of fiscal 2002 and on a quarterly basis
thereafter the Company increased the prepayment rate assumptions used to value
interest-only strips. However, because prepayment rates throughout the mortgage
industry continued to remain at higher than expected levels, prepayment
experience exceeded even the revised assumptions. Based on current economic
conditions, published mortgage industry surveys and the Company's own prepayment
experience, the Company expects that prepayments will continue to remain at
higher than normal levels for the near term before returning to average
historical levels. As a result, the Company has increased our prepayment rate
assumptions for home equity loans for the near term, but at a declining rate,
before returning to historical levels. However, the Company cannot predict with
certainty what its prepayment experience will be in the future. Any unfavorable
difference between the assumptions used to value interest-only strips and actual
experience may have a significant adverse impact on the value of these assets.
4. Servicing Rights
Activity for the loan and lease servicing rights asset for the three months
ended September 30, 2002 and 2001 were as follows (in thousands):
September 30,
2002 2001
-------- --------
Balance at beginning of period $125,288 $102,437
Initial recognition of servicing rights 12,193 9,471
Amortization (8,625) (6,596)
-------- --------
Balance at end of period $128,856 $105,312
======== ========
5. Other Assets and Other Liabilities
Other assets were comprised of the following (in thousands):
September 30, June 30,
2002 2002
------- -------
Goodwill $15,121 $15,121
Financing costs, debt offerings 5,322 5,849
Real estate owned 4,508 3,784
Investments held to maturity 909 917
Due from securitization trusts for
servicing related activities 1,333 1,616
Other 2,805 1,507
------- -------
$29,998 $28,794
======= =======
10
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
5. Other Assets and Other Liabilities (continued)
Other liabilities were comprised of the following (in thousands):
September 30 June 30,
2002 2002
------- -------
Commitments to fund closed loans $29,337 $29,866
Obligation for repurchase of securitized
loans 17,941 10,621
Escrow deposits held 9,448 9,011
Trading liabilities, at fair value 4,364 461
Other 788 949
------- -------
$61,878 $50,908
======= =======
See Note 2 for an explanation of the obligation for repurchase of securitized
loans.
6. Subordinated Debt and Warehouse Lines and Other Notes Payable
Subordinated debt was comprised of the following (in thousands):
September 30, June 30,
2002 2002
-------- --------
Subordinated debt (a) $654,451 $640,411
Subordinated debt - money market notes (b) 15,240 15,309
-------- --------
Total subordinated debt $669,691 $655,720
======== ========
Warehouse lines and other notes payable were comprised of the following (in
thousands):
September 30, June 30,
2002 2002
------- ------
Warehouse and operating revolving line of credit (c) $ 8,203 $6,171
Lease funding facility (d) 1,198 2,128
Warehouse revolving line of credit (e) 1,060 187
Warehouse revolving line of credit (f) 204 -
Capitalized leases (g) 1,022 -
------- ------
Total warehouse lines and other notes payable $11,687 $8,486
======= ======
11
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
(a) Subordinated debt due October 2002 through September 2012, interest rates
ranging from 5.0% to 13.00%; average rate at September 30, 2002 was 9.62%,
average remaining maturity was 17 months, subordinated to all of the
Company's senior indebtedness.
(b) Subordinated debt-money market notes due upon demand, interest rate at
4.88%; subordinated to all of the Company's senior indebtedness.
(c) $50 million warehouse and operating revolving line of credit expiring
December 2002, collateralized by certain pledged loans, advances to
securitization trusts, real estate owned and certain interest-only strips.
The Company is currently renegotiating the terms of this facility. The
Company can make no assurances that the facility will be extended, or if
extended, will be on the same terms as described above.
(d) Lease funding facility matures through December 2004, collateralized by
certain lease receivables.
(e) $25 million warehouse revolving line of credit expiring October 2003,
collateralized by certain pledged loans.
(f) $200 million warehouse revolving line of credit expiring November 2002,
collateralized by certain pledged loans. The Company is currently
renegotiating the terms of this facility. The Company can make no
assurances that the facility will be extended, or if extended, will be on
the same terms as described above.
(g) Capitalized leases, maturing through January 2006, imputed interest rate of
8.0%, collateralized by computer equipment.
At September 30, 2002, warehouse lines and other notes payable were
collateralized by $13.1 million of loan and lease receivables and $1.0 million
of computer equipment.
In addition to the above the Company had available to it the following credit
facilities:
o $1.2 million operating line of credit expiring January 2003, fundings to be
collateralized by an investment in the 99-A lease securitization trust.
This line was unused at September 30, 2002.
o $100.0 million revolving line of credit expiring March 2003, fundings to be
collateralized by certain pledged loans. This line was unused at September
30, 2002.
o $300.0 million facility, expiring July 2003, which provides for the sale of
mortgage loans into an off-balance sheet funding facility. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Critical Accounting Policies -- Special Purpose Entities and
Off-Balance Sheet Facilities" for further discussion of the off-balance
sheet features of this facility. At September 30, 2002, $51.2 million of
this facility was utilized.
12
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
Interest rates on the revolving credit facilities range from London Inter-Bank
Offered Rate ("LIBOR") plus 1.25% to LIBOR plus 2.50% or the commercial paper
rate plus 0.99%. The weighted-average interest rate paid on the revolving credit
facilities was 3.34% and 3.35% at September 30, 2002 and June 30, 2002,
respectively.
The terms of the warehouse lines and operating lines of credit require the
Company to meet specific financial covenants and other standards. Each agreement
has multiple individualized financial covenant thresholds and ratio limits that
the Company must meet as a condition to drawing on that particular line of
credit. At September 30, 2002, the Company was in compliance with the terms of
all debt agreements.
Under a registration statement declared effective by the Securities and Exchange
Commission on October 16, 2001, the Company registered $325.0 million of
subordinated debt. Of the $325.0 million, $24.1 million of debt from this
registration statement was available for future issuance as of September 30,
2002. Subsequent to September 30, 2002, an additional $8.6 million of debt was
issued. The Company registered an additional $315.0 million of subordinated debt
under a registration statement declared effective by the Securities and Exchange
Commission on October 3, 2002.
The Company's subordinated debt securities are subordinated in right of payment
to, or subordinate to, the payment in full of all senior debt as defined in the
indentures related to such debt, whether outstanding on the date of the
applicable indenture or incurred following the date of the indenture. The
Company's assets, including the stock it holds in its subsidiaries, are
available to repay the subordinated debt in the event of default following
payment to holders of the senior debt. In the event of the Company's default and
liquidation of its subsidiaries to repay the debt holders, creditors of the
subsidiaries must be paid or provision made for their payment from the assets of
the subsidiaries before the remaining assets of the subsidiaries can be used to
repay the holders of the subordinated debt securities.
13
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
7. 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 the Company's 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 plaintiff alleges that the charging of, and the
failure to properly disclose the nature of, a document preparation fee were
improper under applicable state law. The plaintiff seeks restitution,
compensatory and punitive damages and attorney's fees and costs, in unspecified
amounts. The Company believes that its imposition of this fee is permissible
under applicable law and is vigorously defending the case.
The Company's lending subsidiaries, including HomeAmerican Credit, Inc. which
does business as Upland Mortgage, 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 activities from
time to time including the purported class action entitled, Calvin Hale v.
HomeAmerican Credit, Inc., d/b/a Upland Mortgage, described above. Due to the
Company's 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 the Company's consolidated financial
position or results of operations. The Company maintains a reserve which
management believes is sufficient to cover these matters. However, due to the
inherent uncertainty in litigation and since the ultimate resolutions of these
proceedings are influenced by factors outside of the Company's control, it is
possible that the Company's estimated liability under these proceedings may
change or that actual results will differ from its estimates.
In addition, from time to time, the Company is involved as plaintiff or
defendant in various legal proceedings arising in the normal course of business.
While the Company cannot predict the ultimate outcome of these various legal
proceedings, it is management's opinion that the resolution of these legal
actions should not have a material effect on the Company's financial position,
results of operations or liquidity.
14
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
8. Derivative Financial Instruments
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Interest Rate Risk Management" for a detailed discussion of the
Company's use of derivative financial instruments.
Hedging activity
A primary market risk exposure that the Company faces is interest rate risk.
Interest rate risk occurs due to potential changes in interest rates between the
date fixed rate loans are originated and the date of securitization. The Company
may, from time to time, utilize hedging strategies to mitigate the effect of
changes in interest rates between the date loans are originated and the date the
fixed rate pass-through certificates to be issued by a securitization trust are
priced, a period typically less than 90 days.
The Company recorded losses on the fair value of interest rate swap contracts
accounted for as hedges of $2.9 million and $2.6 million on futures contracts
during the three months ended September 30, 2002 and 2001, respectively, which
were offset by securitization gains during the periods. An additional $1.0
million of unrealized losses on interest rate swap contracts in the first
quarter of fiscal 2003 were offset by unrealized increases in the fair value of
items hedged. The losses in the first quarter of fiscal 2003 were recorded as
liabilities on the balance sheet as of September 30, 2002 and the losses
recorded in the first quarter of fiscal 2002 were settled in cash during the
period. Any ineffectiveness related to hedging transactions during the period
was immaterial. Ineffectiveness is a measure of the difference in the change in
fair value of the derivative financial instrument as compared to the change in
the fair value of the item hedged.
Trading activity
An additional $2.5 million in losses on interest rate swap contracts which were
used to protect the future securitization spreads on loans in our pipeline and
were therefore classified as trading. These losses were also recorded as
liabilities on the balance sheet at September 30, 2002.
In addition, for the three months ended September 30, 2002, the Company recorded
$0.7 million in losses on an interest rate swap contract, which is not
designated as an accounting hedge. This contract was designed to reduce the
exposure to changes in the fair value of certain interest-only strips due to
changes in one-month LIBOR. The loss on the swap contract was due to decreases
in the interest rate swap yield curve during the period the contract was in
place. Of the total losses recognized during the period, $0.4 million were
unrealized losses representing the net change in the fair value of the contract
during the quarter and $0.3 were cash losses. The cumulative net unrealized loss
of $0.9 million is included as a trading liability in Other liabilities at
September 30, 2002.
15
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
9. Earnings Per Share
Following is a reconciliation of the Company's basic and diluted earnings per
share calculations (in thousands, except per share data):
Three Months Ended
September 30,
------------------
2002 2001
------ ------
Earnings
(a) Net Income $1,821 $1,362
====== ======
Average Common Shares
(b) Average common shares outstanding 2,856 3,198
Average potentially dilutive shares 129 204
------ ------
(c) Average common and potentially dilutive
shares 2,985 3,402
====== ======
Earnings Per Common Share
Basic (a/b) $ 0.64 $ 0.43
Diluted (a/c) $ 0.61 $ 0.40
10. Segment Information
The Company has three operating segments: Loan Origination, Servicing and
Treasury and Funding.
The Loan Origination segment originates business purpose loans secured by real
estate and other business assets, home equity loans typically to credit-impaired
borrowers and loans secured by one to four family residential real estate.
The Servicing segment services the loans and leases originated by the Company
both while held as available for sale by the Company and subsequent to
securitization. Servicing activities include billing and collecting payments
from borrowers, transmitting payments to securitization trust investors,
accounting for principal and interest, collections and foreclosure activities
and disposing of real estate owned.
The Treasury and Funding segment offers the Company's subordinated debt
securities pursuant to a registered public offering and obtains other sources of
funding for the Company's general operating and lending activities.
All Other mainly represents segments that do not meet the SFAS No. 131 defined
thresholds for determining reportable segments, financial assets not related to
operating segments, mainly comprised of interest-only strips, unallocated
overhead and other expenses of the Company unrelated to the reportable segments
identified.
16
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
September 30, 2002
10. Segment Information (continued)
The reporting segments follow the same accounting policies used for the
Company's consolidated financial statements as described in the summary of
significant accounting policies. Management evaluates a segment's performance
based upon profit or loss from operations before income taxes.
Reconciling items represent elimination of inter-segment income and expense
items, and are included to reconcile segment data to the consolidated financial
statements (in thousands).
Treasury
Three months ended Loan and Reconciling
September 30, 2002: Origination Funding Servicing All Other Items Consolidated
----------- -------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 58,011 $ - $ - $ - $ - $ 58,011
Interest income................. 1,459 169 217 10,747 - 12,592
Non-interest income............. 2,178 1 10,277 - (8,592) 3,864
Inter-segment revenues - 18,314 - 18,192 (36,506) -
Operating expenses:
Interest expense................ 5,721 16,819 (36) 12,893 (18,314) 17,083
Non-interest expense............ 12,289 2,836 9,809 15,521 - 40,455
Depreciation and amortization .. 848 31 307 525 - 1,711
Interest-only strips valuation
adjustment................... - - - 12,078 - 12,078
Inter-segment expense........... 26,784 - - - (26,784) -
Income tax expense................. 6,723 (505) 174 (5,073) - 1,319
-------- -------- -------- -------- -------- --------
Net income (loss).................. $ 9,283 $ (697) $ 240 $ (7,005) $ - $ 1,821
======== ======== ======== ======== ======== ========
Segment assets..................... $100,400 $204,732 $126,823 $577,653 $(90,898) $918,710
======== ======== ======== ======== ======== ========
Treasury
Three months ended Loan and Reconciling
September 30, 2001: Origination Funding Servicing All Other Items Consolidated
----------- -------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 35,356 $ - $ - $ - $ - $ 35,356
Interest income................. 1,752 276 514 7,736 - 10,278
Non-interest income............. 3,449 - 8,137 - (6,548) 5,038
Inter-segment revenues - 17,225 - 16,202 (33,427) -
Operating expenses:
Interest expense................ 4,971 16,588 144 12,505 (17,225) 16,983
Non-interest expense............ 9,390 2,638 6,772 10,805 - 29,605
Depreciation and amortization .. 819 33 256 628 - 1,736
Inter-segment expense........... 22,750 - - - (22,750) -
Income tax expense................. 1,104 (739) 621 - - 986
-------- -------- -------- -------- -------- --------
Net income (loss).................. $ 1,523 $ (1,019) $ 858 $ - $ - $ 1,362
======== ======== ======== ======== ======== ========
Segment assets..................... $107,871 $180,371 $109,382 $494,308 $(73,402) $818,530
======== ======== ======== ======== ======== ========
17
American Business Financial Services, Inc. and Subsidiaries
PART I FINANCIAL INFORMATION (Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Our consolidated financial information set forth below should be read
in conjunction with the consolidated financial statements and the accompanying
notes to consolidated financial statements included in Item 1 of this Quarterly
Report on Form 10-Q, and the consolidated financial statements, notes to
consolidated financial statements and Management's Discussion and Analysis of
Financial Condition and Results of Operations and the risk factors contained in
our Annual Report on Form 10-K for the year ended June 30, 2002.
Forward Looking Statements
Some of the information in this Quarterly Report on Form 10-Q 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 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 document. You should
not place undue reliance on any forward-looking statement.
General
We are a diversified financial services organization operating
predominantly in the eastern and central portions of the United States. We
originate, sell and service business purpose loans and home equity loans,
through our principal direct and indirect subsidiaries. We also process and
purchase home equity loans from other financial institutions through the Bank
Alliance Program.
Our loans primarily consist of fixed interest rate loans secured by
first or second mortgages on single family residences. 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. We originate loans through a combination of channels
including a national processing center located at our centralized operating
office in Bala Cynwyd, Pennsylvania, a regional processing center in Roseland,
New Jersey and several retail branch offices. In addition, we offer subordinated
debt securities to the public, the proceeds of which are used for repayment of
existing debt, loan originations, our operations, investments in systems and
technology and for general corporate purposes.
18
Initially, we finance our loans under several secured and committed
credit facilities. These credit facilities are generally revolving lines of
credit, which we have with several financial institutions that enable us to
borrow on a short-term basis against our loans. We then securitize or sell our
loans to unrelated third parties on a whole loan basis to generate the cash to
pay off these revolving credit facilities. We also have a committed mortgage
conduit facility with a financial institution that enables us to sell our loans
into an off-balance sheet facility. Additionally, we rely upon funds generated
by the sale of subordinated debt and other borrowings to fund our operations and
to repay our debt as it matures. At September 30, 2002, $669.7 million of
subordinated debt was outstanding and revolving credit and conduit facilities
totaling $676.2 million were available, of which $60.6 million was drawn upon on
that date. We expect to continue to rely on the borrowings to fund our
operations and to repay maturing subordinated debt. For a description of our
credit facilities, subordinated debt and off-balance sheet facilities, see "--
Liquidity and Capital Resources."
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. The difference between the 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.
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 favorable terms and to profitably 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.
Since fiscal 2000, declines in securitization pass-through interest
rates resulted in interest rate spreads improving by approximately 282 basis
points at September 30, 2002 compared to the fourth quarter of fiscal 2000.
Increased interest rate spreads result in increases in the residual cash flow we
will receive on securitized loans, the amount we received at the closing of a
securitization from the sale of notional bonds or premiums on bonds and
corresponding increases in the gains we recognized on the sale of loans in a
securitization. See "-- Securitizations" for further details. No assurances can
be made that market interest rates will continue to decline or remain at current
levels. However, in a rising interest rate environment we would expect our
ability to originate loans at interest rates that will maintain our current
level of securitization gain profitability to become more difficult than during
a stable or falling interest rate environment. This situation occurred from our
September 1998 mortgage loan securitization through the June 2000 mortgage loan
securitization when the pass-through interest rates on the asset-backed
securities issued in our securitizations had increased by approximately 155
basis points. During the same period, the average interest rate on our loans
securitized increased only 71 basis points. We would 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.
19
A rising interest rate environment could also unfavorably impact our
liquidity and capital resources. Rising interest rates could impact our
short-term liquidity by widening investor interest rate spread requirements in
pricing future securitizations as described above, increasing the levels of
overcollateralization required in future securitizations, limiting our access to
borrowings in the capital markets and limiting our ability to sell our
subordinated debt securities at favorable interest rates. See "-- Liquidity and
Capital Resources" for a discussion of both long and short-term liquidity.
A declining interest rate environment could unfavorably impact the
valuations 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. See -- "Application of Critical
Accounting Policies -- Interest-Only Strips" and "Securitizations" for a
discussion of the impact of prepayment experience exceeding prepayment
assumptions.
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 and
failing to adequately disclose the material terms of loans to the borrowers. 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 the reimbursement of borrowers as a result of fees charged or the
imposition of fines, or the impact of those changes on our profitability.
The Office of Thrift Supervision has recently adopted a rule effective
in January 2003, which will preclude us and other non-bank, non-thrift creditors
from using the Parity Act to preempt state prepayment penalty and late fee laws
and regulations on new loan originations. Under the provisions of this rule we
will be required to modify or eliminate the practice of charging a prepayment
fee in some of the states where we originate loans and other fees we normally
charge will also be modified or eliminated. We are currently evaluating the
impact of the adoption of this rule on our future lending activities and results
of operations.
In addition to the regulatory initiatives with respect to so-called
"predatory lending" practices, we are also subject, from time to time, to
private litigation, including actual and purported class action suits. See Note
7 of the Consolidated Financial Statements for a description of one purported
class action suit currently pending. 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.
Although we are licensed to originate loans in 44 states, our loan
originations are concentrated in the eastern half of the United States. 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.
Effective December 31, 1999, we de-emphasized and subsequent to that
date, discontinued the origination of business equipment leases but continue to
service the remaining portfolio of leases.
20
Application of Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America. 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.
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" and "gain-on-sale" accounting to our
quarterly loan securitizations. Gains on sales of loans through securitizations
for the three months ended September 30, 2002 were 77.9% of total revenues.
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 retain based upon their relative fair values.
Estimates of the fair values of the interest-only strips and the servicing
rights we retain are discussed below. We believe the accounting estimates
related to gain on sale are critical accounting estimates because more than 75%
in the first quarter of fiscal 2003 and 80% in fiscal 2002, of the
securitization gains 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 59.2% of our
total assets at September 30, 2002 and are carried at their fair values. 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 at the time the loans are sold.
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. Our expected future cash flows from our interest-only strips are
periodically re-evaluated. The current assumptions for prepayment and credit
loss rates are monitored against actual experience and other economic and market
conditions and are changed if deemed necessary. 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, which would adversely affect our
income in the period of adjustment. 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.
21
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 periodically update estimates of
residual cash flow from our securitizations. 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 estimated compensation that would be required by a
substitute servicer represented 14.0% of our total assets at September 30, 2002.
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, credit loss rates and discount rates. These assumptions are similar to
those used to value the interest-only strips retained in a securitization. The
current assumptions for prepayment and credit loss rates are monitored against
actual experience and other economic and market conditions and are changed if
deemed necessary. 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. 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 impact on our financial statements of
changes in assumptions.
22
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. A review for impairment is periodically performed by
stratifying the serviced loans by loan type, which is considered to be the
predominant risk characteristic. If our 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 would be required. As
of September 30, 2002, our valuation analysis has not indicated any impairment.
Impairment is measured as the excess of carrying value over fair value.
Special Purpose Entities and Off-Balance Sheet Facilities. Special
purpose entities and off-balance sheet facilities are used in our mortgage loan
securitizations. Asset securitizations are one of the most common off-balance
sheet arrangements in which a company transfers assets off its balance sheet by
selling them to a special purpose entity. 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.
Accounting for special purpose entities is under review by the Financial
Accounting Standards Board, referred to as FASB in this document. In June 2002,
the FASB issued a proposed interpretation of Accounting Research Bulletin No. 51
"Consolidated Financial Statements." The proposal provides guidance on
consolidation by a business enterprise of special purpose entities. The
proposal, if adopted as proposed, will not affect our current consolidation
policies for special purpose entities or recognition of gains for the sale of
loans. In the event that the proposal is not adopted as proposed or accounting
rules are changed in the future, our use of special purpose entities, our
revenue recognition for securitization gains for securitized loans and our
off-balance sheet accounting treatment for securitized loans could be materially
impacted.
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, transferring title of the loans and
isolating those assets from our assets. Finally, the trust issues certificates
to investors to raise the cash purchase price for the loans being sold, collects
proceeds on behalf of the certificate holders, distributes proceeds and is a
distinct legal entity, independent from us. Under current accounting rules, the
trusts do not qualify for consolidation in our financial statements and carry
the loan collateral as assets and the certificates issued to investors as
liabilities. At September 30, 2002 and June 30, 2002, the mortgage
securitization trusts held loans with an aggregate principal balance due of $3.1
billion and $2.9 billion as assets and owed $2.9 billion and $2.8 billion of
investor certificates to third parties, respectively.
We also use special purpose entities in our sales of loans to a $300
million off-balance sheet mortgage conduit facility. Sales into the off-balance
sheet facility involve a two-step transfer that qualifies for sale accounting
under SFAS No. 140, similar to the process described above. This facility has a
revolving feature and can be directed by the sponsor to dispose of the loans.
Typically this has been accomplished by securitizing them in a term
securitization. The third party note purchaser also has the right to sell the
loans. Under this arrangement, the loans have been isolated from us and our
subsidiaries and as a result, transfers to the facility are treated as sales for
financial reporting purposes. When loans are sold to this facility, we perform a
probability assessment of the likelihood that the sponsor will transfer the
loans into a term securitization. As the sponsor has typically transferred the
loans to a term securitization in the past, the amount of gain on sale we have
recognized for loans sold to this facility is estimated based on the terms we
would obtain in a term securitization rather than the terms of this facility. At
September 30, 2002, the off-balance sheet mortgage conduit facility held loans
with principal balance due of $52.7 million as assets and owed $51.2 million to
third parties.
23
Allowance for Loan and Lease Losses. The allowance for loan and lease
losses is maintained primarily to account for loans and leases that are
delinquent and are expected to be ineligible for sale into a future
securitization and for delinquent loans that have been repurchased from
securitization trusts. The allowance is calculated based upon management's
estimate of our ability to collect on outstanding loans and leases based upon a
variety of factors, including, periodic analysis of the available for sale loans
and leases, 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 and lease charge-offs
reduce the allowance. If the actual collection of outstanding loans and leases
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.
Development of Critical Accounting Estimates. On a periodic 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 September 30, 2002 with the Audit Committee of our
Board of Directors. In addition, management has reviewed its disclosure of the
estimates 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 impacts of changes in critical accounting estimates in the three months
ended September 30, 2002, see "-- Securitizations."
Securitizations
During the first three months of fiscal 2003, write downs of $16.7
million were recorded on our interest-only strips due to increases in prepayment
experience. The income statement impact for the first quarter of fiscal 2003 was
a write down of $12.1 million while the remaining $4.7 million was written down
through other comprehensive income in accordance with the provisions of SFAS No.
115 "Accounting for Certain Investments in Debt and Equity Securities" and
Emerging Issues Task Force guidance, referred to as EITF in this document,
99-20. The following table details the pre-tax write downs of the interest-only
strips (in thousands):
Other
Total Income Comprehensive
Quarter Ended Write down Statement Impact Income Impact
- ------------------------------------------- ---------- ---------------- -------------
September 30, 2002......................... $16,739 $12,078 $4,661
24
Beginning in the second quarter of fiscal 2002 and on a quarterly basis
thereafter we increased the prepayment rate assumptions used to value our
interest-only strips. However, because prepayment rates throughout the mortgage
industry continued to remain at higher than expected levels our prepayment
experience exceeded even our revised assumptions. Based on current economic
conditions, published mortgage industry surveys and our own prepayment
experience, we believe prepayments will continue to remain at higher than normal
levels for the near term before returning to average historical levels. As a
result, we have increased our prepayment rate assumptions for home equity loans
for the near term, but at a declining rate, before returning to our historical
levels. However, we cannot predict with certainty what our prepayment experience
will be in the future. Any unfavorable difference between the assumptions used
to value our interest-only strips and our actual experience may have a
significant adverse impact on the value of these assets.
In fiscal 2002, write downs of $44.1 million were recorded on our
interest-only strips due to increases in prepayment experience. The income
statement impact for fiscal 2002 was a write down of $22.1 million while the
remaining $22.0 million was written down through other comprehensive income in
accordance with the provisions of SFAS No. 115 and EITF 99-20. The following
table details the pre-tax write downs of the interest-only strips by quarter (in
thousands):
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
---------------------------- ------- ------- -------
December 31, 2001 $11,322 $ 4,462 $ 6,860
March 31, 2002 15,513 8,691 6,822
June 30, 2002 17,244 8,900 8,344
------- ------- -------
Total fiscal 2002 $44,079 $22,053 $22,026
======= ======= =======
The following table summarizes the volume of loan securitizations and
whole loan sales for the three months ended September 30, 2002 and 2001 (dollars
in thousands):
Three months ended
September 30,
---------------------
2002 2001
-------- --------
Securitizations:
Business loans....................................... $ 29,998 $ 29,949
Home equity loans.................................... 336,410 259,856
-------- --------
Total............................................. $366,408 $289,805
======== ========
Gain on sale of loans through securitization....... $ 58,011 $ 35,356
Securitization gains as a percentage of total revenue 77.9% 69.8%
Whole loan sales..................................... $ 1,537 $ 28,901
Premiums on whole loan sales......................... $ 34 $ 1,193
Our quarterly revenues and net income may fluctuate in the future
principally as a result of the timing, size and profitability of our
securitizations. The strategy of selling loans through securitizations requires
building an inventory of loans over time, during which time we incur costs and
expenses. Since a gain on sale is not recognized until a securitization is
closed, which may not occur until a subsequent quarter, operating results for a
given quarter can fluctuate significantly. If securitizations do not close when
expected, we could experience a materially adverse effect on our results of
operations for a quarter. See "-- Liquidity and Capital Resources" for a
discussion of the impact of securitizations on our cash flow.
Several factors affect our ability to complete securitizations on a
profitable basis. These factors include conditions in the securities markets,
such as fluctuations in interest rates described below, conditions in the
asset-backed securities markets relating to the loans we originate and credit
quality of the managed portfolio of loans. Any substantial reduction in the size
or availability of the securitization market for loans could have a material
adverse effect on our results of operations and financial condition.
When we securitize our loans by selling them to trusts, we receive cash
and an interest-only strip, which represents our retained interest in
securitized loans. The trust issues multi-class securities, which derive their
cash flows from the pool of securitized loans. These securities, which are
senior in right to our interest-only strips in the trusts, are sold to public or
private investors. In addition, when we securitize our loans we retain the right
to service the loans for a fee, which creates an asset that we refer to as 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.
25
Interest-Only Strips. As the holder of the interest-only strips, we are
entitled to receive excess (or residual) cash flows and cash flows from
overcollateralization. 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.
Generally, all residual cash flows are initially retained by the trust
to establish required overcollateralization levels in the trust.
Overcollateralization is the excess of the aggregate principal balances of loans
in a securitized pool over the investor interests. Overcollateralization
requirements are established to provide credit enhancement for the trust
investors.
The overcollateralization requirements for a mortgage loan
securitization, which are different for each securitization, include:
(1) The initial requirement, if any, is a percentage of the
original balance of loans securitized and is paid in cash at
the time of sale;
(2) The final target is a percentage of the original balance of
loans securitized and is funded from the monthly excess cash
flow. Specific securitizations contain provisions requiring an
increase above the final target overcollateralizaton levels
during periods in which delinquencies exceed specified limits.
The overcollateralization levels return to the target levels
when delinquencies fall below the specified limits; and
(3) The stepdown overcollateralization requirement is a percentage
of the remaining balance of securitized loans. During the
stepdown period, the overcollateralization amount is gradually
reduced through cash payments to us until the
overcollateralization balance declines to a specific floor.
The stepdown period generally begins at the later of 30 to 36
months after the initial securitization of the loans or when
the remaining balance of securitized loans is less than 50% of
the original balance of securitized loans.
The fair value of our interest-only strips is a combination of the fair
values of our residual cash flows and our overcollateralization cash flows. At
September 30, 2002, investments in interest-only strips totaled $543.9 million,
including the fair value of overcollateralization related cash flows of $251.0
million.
26
The following tables provide information regarding the nature and
principal balances of mortgage loans securitized in each trust, the securities
issued by each trust, and the overcollateralization requirements of each trust.
Summary of Selected Mortgage Loan Securitization Trust Information
Current Balances as of September 30, 2002
(dollars in millions)
2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 2000-3
------- ------ ------ ------ ------- ------- ------- ------ -------
Original balance of loans securitized:
- --------------------------------------
Business loans..............................$ 34 $ 34 $ 32 $ 29 $ 31 $ 35 $ 29 $ 27 $ 16
Home equity loans........................... 336 346 288 287 269 320 246 248 134
------- ------ ------ ------ ------- ------- ------- ------ -------
Total.......................................$ 370 $ 380 $ 320 $ 316 $ 300 $ 355 $ 275 $ 275 $ 150
======= ====== ====== ====== ======= ======= ======= ====== =======
Current balance of loans securitized:
- -------------------------------------
Business loans..............................$ 34 $ 33 $ 30 $ 27 $ 26 $ 29 $ 23 $ 20 $ 11
Home equity loans........................... 335 338 266 245 206 213 144 130 67
------- ------ ------ ------ ------- ------- ------- ------ -------
Total.......................................$ 369 $ 371 $ 296 $ 272 $ 232 $ 242 $ 167 $ 150 $ 78
======= ====== ====== ====== ======= ======= ======= ====== =======
Weighted-average interest rate on loans
- ---------------------------------------
securitized:
------------
Business loans.............................. 15.89% 16.00% 15.82% 15.78% 15.93% 15.93% 16.06% 16.09% 16.10%
Home equity loans........................... 10.89% 10.97% 10.86% 10.71% 11.13% 11.21% 11.45% 11.60% 11.46%
Total....................................... 11.35% 11.43% 11.37% 11.22% 11.67% 11.78% 12.09% 12.19% 12.11%
Percentage of first mortgage loans............. 85% 85% 90% 89% 87% 89% 88% 85% 86%
Weighted-average loan-to-value................. 77% 76% 76% 77% 76% 76% 76% 76% 77%
Weighted-average remaining term (months) on
loans securitized.......................... 262 251 248 248 237 236 228 218 215
Original balance of Trust Certificates.........$ 370 $ 380 $ 320 $ 322 $ 306 $ 355 $ 275 $ 275 $ 150
Current balance of Trust Certificates..........$ 369 $ 368 $ 288 $ 267 $ 224 $ 227 $ 155 $ 138 $ 71
Weighted-average pass-through interest rate
to Trust Certificate holders(a)............ 6.73% 7.04% 5.46% 5.35% 5.72% 6.55% 7.31% 7.05% 7.61%
Highest Trust Certificate pass-through
interest rate.............................. 6.86% 7.39% 6.51% 5.35% 6.14% 6.99% 6.28% 7.05% 7.61%
Overcollateralization requirements:
- -----------------------------------
Required percentages:
Initial.................................... -- -- -- -- -- -- -- -- --
Final target............................... 3.50% 3.50% 4.50% 4.25% 4.00% 4.40% 4.10% 4.50% 4.75%
Stepdown overcollateralization............. 7.00% 7.00% 9.00% 8.50% 8.00% 8.80% 8.20% 9.00% 9.50%
Required dollar amounts:
Initial.................................... -- -- -- -- -- -- -- -- --
Final target...............................$ 13 $ 13 $ 14 $ 13 $ 12 $ 16 $ 11 $ 12 $ 7
Current status:
Overcollateralization amount............... -- $ 3 $ 8 $ 5 $ 8 $ 15 $ 12 $ 12 $ 7
Final target reached or anticipated date
to reach.................................10/2003 8/2003 5/2003 7/2003 3/2003 12/2002 Yes Yes Yes
Stepdown reached or anticipated date to
reach.................................... 5/2006 1/2006 7/2005 2/2005 11/2004 5/2004 10/2003 1/2004 10/2003
Annual surety wrap fee......................... (b) (b) 0.21% 0.20% 0.20% 0.20% 0.20% 0.21% 0.21%
Servicing rights:
- -----------------
Original balance............................$ 13 $ 15 $ 13 $ 13 $ 12 $ 15 $ 11 $ 14 $ 7
Current balance.............................$ 13 $ 15 $ 12 $ 11 $ 9 $ 10 $ 7 $ 8 $ 4
- ----------------------------
(a) Rates for securitizations 2001-1 and forward include rates on notional
bonds, or the impact of premiums received on certificates, included in
securitization structure. The sale of notional bonds allows us to receive
more cash at the closing of a securitization. See "-- Three Months Ended
September 30, 2002 Compared to Three Months Ended September 30, 2001 -- Gain
on Sale of Loans" for further description of the notional bonds.
(b) Credit enhancement was provided through a senior / subordinated certificate
structure.
27
Summary of Selected Mortgage Loan Securitization Trust Information (Continued)
Current Balances as of September 30, 2002
(dollars in millions)
2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998(a) 1997(a) 1996(a)
------ ------ ------- ------- ------- ------- ------- ------- -------
Original balance of loans securitized:
- --------------------------------------
Business loans..............................$ 28 $ 25 $ 25 $ 28 $ 30 $ 16 $ 57 $ 45 $ 29
Home equity loans........................... 275 212 197 194 190 169 448 130 33
------- ------ ------- ------- ------- ------- ------- ------- -------
Total.......................................$ 303 $ 237 $ 222 $ 222 $ 220 $ 185 $ 505 $ 175 $ 62
======= ====== ======= ======= ======= ======= ======= ======= =======
Current balance of loans securitized:
- -------------------------------------
Business loans..............................$ 18 $ 15 $ 16 $ 15 $ 16 $ 8 $ 19 $ 13 $ 6
Home equity loans........................... 134 100 95 90 94 71 152 26 5
------- ------ ------- ------- ------- ------- ------- ------- -------
Total.......................................$ 152 $ 115 $ 111 $ 105 $ 110 $ 79 $ 171 $ 39 $ 11
======= ====== ======= ======= ======= ======= ======= ======= =======
Weighted-average interest rate on loans
- ---------------------------------------
securitized:
------------
Business loans.............................. 16.07% 16.00% 16.11% 15.87% 15.74% 15.96% 15.95% 15.91% 15.91%
Home equity loans........................... 11.44% 11.33% 11.06% 10.87% 10.44% 10.67% 10.77% 11.52% 11.00%
Total....................................... 11.99% 11.92% 11.77% 11.57% 11.19% 11.19% 11.35% 12.92% 13.66%
Percentage of first mortgage loans............. 80% 80% 82% 85% 88% 91% 89% 75% 74%
Weighted-average loan-to-value................. 77% 78% 76% 77% 76% 77% 77% 74% 66%
Weighted-average remaining term (months) on
loans securitized........................... 227 216 209 214 220 216 199 158 118
Original balance of Trust Certificates.........$ 300 $ 235 $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61
Current balance of Trust Certificates..........$ 134 $ 101 $ 99 $ 94 $ 99 $ 70 $ 154 $ 33 $ 8
Weighted-average pass-through interest rate to
Trust Certificate holders................... 7.15% 7.14% 6.84% 6.81% 6.63% 6.56% 6.28% 7.19% 7.68%
Highest Trust Certificate pass-through interest
rate........................................ 8.04% 7.93% 7.68% 7.49% 7.13% 6.58% 7.15% 7.29% 7.67%
Overcollateralization requirements:
- -----------------------------------
Required percentages:
Initial..................................... 0.90% 0.75% 1.00% 1.00% 0.50% 0.50% 1.50% 2.43% 1.94%
Final target................................ 5.95% 5.95% 5.50% 5.00% 5.00% 5.00% 5.10% 7.43% 8.94%
Stepdown overcollateralization.............. 11.90% 11.90% 11.00% 10.00% 10.00% 10.00% 10.21% 14.86% 12.90%
Required dollar amounts:
Initial.....................................$ 3 $ 2 $ 2 $ 2 $ 1 $ 1 $ 7 $ 4 $ 1
Final target................................$ 18 $ 14 $ 12 $ 11 $ 11 $ 9 $ 26 $ 13 $ 6
Current status:
Overcollateralization amount................$ 18 $ 14 $ 12 $ 11 $ 11 $ 9 $ 17 $ 6 $ 3
Final target reached or anticipated date to
reach .................................... Yes Yes Yes Yes Yes Yes Yes Yes Yes
Stepdown reached or anticipated date to
reach..................................... 7/2003 4/2003 12/2002 10/2002 10/2002 12/2002 Yes Yes Yes
Annual surety wrap fee......................... 0.21% 0.19% 0.21% 0.21% 0.19% 0.19% 0.22% 0.26% 0.18%
Servicing rights:
- -----------------
Original balance............................$ 14 $ 10 $ 10 $ 10 $ 10 $ 8 $ 18 $ 7 $ 4
Current balance.............................$ 8 $ 5 $ 5 $ 5 $ 4 $ 3 $ 6 $ 3 $ 1
- ----------------------------
(a) Amounts represent combined balances and weighted-average percentages for
four 1998 securitization pools, two 1997 securitization pools and two 1996
securitization pools.
28
The estimation of the fair value of interest-only strips is based upon
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 at the time loans are sold. 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, prepayment rates and credit loss rates on the pool of loans.
These assumptions are monitored against actual experience and other economic and
market conditions and are changed if deemed necessary. Our methodology for
determining the discount rates, prepayment rates and credit loss rates used to
calculate the fair value of our interest-only strips is described below.
Discount rates. We use discount rates, which we believe are
commensurate with the risks involved in our securitization assets. While quoted
market prices on comparable interest-only strips are not available, we have
performed comparisons of our valuation assumptions and performance experience to
others in the non-conforming mortgage industry. We quantify the risks in our
securitization assets by comparing the asset quality and performance experience
of the underlying securitized mortgage pools to comparable industry performance.
In determining the discount rate applied to residual cash flows, we
believe that the practice of many companies in the non-conforming mortgage
industry has been to add an interest rate spread for risk to the all-in cost of
securitizations to determine their discount rates. The all-in cost of the
securitization trusts' investor certificates includes the highest trust
certificate pass-through interest rate in each mortgage securitization, trustee
fees, and surety fees, which generally range from 19 to 22 basis points
combined. From industry experience comparisons, we have determined an interest
rate spread, which is added to the all-in cost of our mortgage loan
securitization trusts' investor certificates. The 13% discount rate that we
apply to our residual cash flow portion of our interest-only strips compared to
rates used by others in the industry reflects our higher asset quality and
performance of our securitized assets compared to industry asset quality and
performance and the other characteristics of our securitized loans described
below:
o Underlying loan collateral with fixed yields, which are higher
than others in the non-conforming mortgage industry. Average
interest rate of securitized loans exceeds the industry average by
100 basis points or more. All of the securitized loans have fixed
interest rates, which are more predictable than adjustable rate
loans.
o Approximately 90% to 95% of securitized business purpose loans
have prepayment fees. Approximately 85% to 90% of securitized home
equity loans have prepayment fees. Our historical experience
indicates that prepayment fees lengthen the prepayment ramp
periods and slow annual prepayment speeds, which have the effect
of increasing the life of the securitized loans.
o A portfolio mix of first and second mortgage loans of 80-85% and
15-20%, respectively. Historically, the high proportion of first
mortgages has resulted in lower delinquencies and losses.
o A portfolio credit grade mix comprised of 60% A credits, 24% B
credits, 14% C credits, and 2% D credits. In addition, our
historical loss experience is below what is experienced by others
in the non-conforming mortgage industry.
29
Although market interest rates have declined from fiscal years 2001
through the first quarter of fiscal 2003, no reduction to the discount rate used
to value the residual portion of our interest-only strips has been made. We do
not believe a decrease in the discount rate is warranted as the current market
interest rate decline was mainly due to actions taken by the Federal Reserve
Board in an attempt to prevent the potential adverse effect of uncertain
economic conditions and to stimulate economic growth. Additionally, the
non-conforming mortgage lending industry generally has taken no actions to
reduce discount rates.
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%. At September 30, 2002, the average discount rate
applied to projected overcollateralization cash flows was 7%. The risk
characteristics of the projected overcollateralization cash flows do not include
prepayment risk and have minimal credit risk. For example, if the entire
collateral balance in a securitized pool of loans was prepaid by borrowers, we
would fully recover the overcollateralization portion of the interest-only
strips. In addition, historically, these overcollateralization balances have not
been impacted by credit losses as the residual cash flow portion of our
interest-only strips has always been sufficient to absorb credit losses and
stepdowns of overcollateralization have generally occurred as scheduled.
Overcollateralization represents our investment in the excess collateral in a
securitized pool of mortgage loans.
The blended discount rate used to value the interest-only strips,
including the overcollateralization cash flows, was 10% at September 30, 2002.
Prepayment rates. The assumptions we use to estimate future prepayment
rates are periodically compared to actual prepayment experience of the
individual securitization pool of mortgage loans and an average of the actual
experience of other similar pools of mortgage loans at the same number of months
after their inception. It is our practice to use an average historical
prepayment rate of similar pools for the expected constant prepayment rate
assumption while a pool of mortgage loans is less than a year old even though
actual experience may be different. During this period, before a pool of
mortgage loans reaches its expected constant prepayment rate, actual experience
both quantitatively and qualitatively is generally not sufficient to conclude
that final actual experience for an individual pool of mortgage loans would be
materially different from the average. For pools of mortgage loans greater than
one year old, prepayment experience trends for an individual pool is considered
to be more significant. For these pools, adjustments to prepayment assumptions
may be made to more closely conform the assumptions to actual experience if the
variance from average experience is significant and is expected to continue.
Current economic conditions, current interest rates and other factors are also
considered in our analysis.
As was previously discussed, during the three months ended September
30, 2002, our actual prepayment experience was generally higher, most
significantly on home equity loans, than our historical averages for
prepayments. The mortgage industry in general has had this experience. Our
recent increase in prepayment experience has been mainly due to loan
refinancings. We do not believe that the current growth in the rate of
refinancings is indicative of a long-term trend in the non-conforming mortgage
market. We believe this recent activity was due to significant decreases in
market interest rates which have occurred over a short period of time which have
generated a larger than normal volume of refinancing activity during this
period. Based on current economic conditions, published mortgage industry
surveys and our own prepayment experience, we believe prepayments will continue
to remain at higher than normal levels for the near term before returning to
average historical levels.
30
In addition to the use of prepayment fees on our loans, we have
implemented programs and strategies in an attempt to reduce loan prepayments in
the future. These programs and strategies may include providing information to a
borrower regarding costs and benefits of refinancing, which at times may
demonstrate a refinancing option is not in the best economic interest of the
borrower. Other strategies include offering second mortgages to existing
qualified borrowers or offering financial incentives to qualified borrowers to
deter prepayment of their loan. We cannot predict with certainty what our
prepayment experience will be in the future and any unfavorable difference
between the assumptions used to value our interest-only strips and our actual
experience may have a significant adverse impact on the value of these assets.
Credit loss rates. Credit loss rates are analyzed in a similar manner
to prepayment rates. Credit loss assumptions are compared to actual loss
experience averages for similar mortgage loan pools and for individual mortgage
loan pools. Delinquency trends and economic conditions are also considered. If
our periodic analysis indicates that loss experience may be different from our
assumptions, we would adjust our assumptions as necessary.
Floating interest rate certificates. Some of the securitization trusts
have issued floating interest rate certificates supported by fixed interest rate
mortgages. The fair value of the excess cash flow we will receive may be
affected by any changes in the interest rates paid on the floating interest rate
certificates. The interest rates paid on the floating interest rate certificates
are based on one-month LIBOR. The assumption used to estimate the fair value of
the excess cash flows received from these securitization trusts is based on a
forward yield curve.
31
Sensitivity analysis. The table below outlines the sensitivity of the
current fair value of our interest-only strips and servicing rights to 10% and
20% adverse changes in the key assumptions used in determining the fair value of
those assets. Our base prepayment, loss and discount rates are described in the
table "Summary of Material Mortgage Loan Securitization Valuation Assumptions
and Actual Experience." (dollars in millions):
Securitized collateral balance..................................... $3,136.7
Balance sheet carrying value of retained interests................. $ 672.7
Weighted-average collateral life (in years)........................ 4.1
Sensitivity of assumptions used to value retained interests:
Prepayment speed:
Impact on fair value for 10% adverse change........................ $27.5
Impact on fair value for 20% adverse change........................ $53.2
Credit loss rate:
Impact on fair value for 10% adverse change........................ $ 4.4
Impact on fair value for 20% adverse change........................ $ 8.9
Floating interest rate certificates (a):
Impact on fair value for 10% adverse change........................ $ 0.7
Impact on fair value for 20% adverse change........................ $ 1.4
Discount rate:
Impact on fair value for 10% adverse change........................ $22.1
Impact on fair value for 20% adverse change........................ $42.8
- ----------------------------
(a) The floating interest rate certificates are indexed to one-month LIBOR plus
a trust specific interest rate spread. The base one-month LIBOR assumption
used in this sensitivity analysis was derived from a forward yield curve.
The sensitivity analysis in the table above is hypothetical and should
be used with caution. As the figures indicate, changes in fair value based on a
10% or 20% variation in management's assumptions generally cannot easily be
extrapolated because the relationship of the change in the assumptions to the
change in fair value may not be linear. Also, in this table, the effect that a
change in a particular assumption may have on the fair value is calculated
without changing any other assumption. Changes in one assumption may result in
changes in other assumptions, which might magnify or counteract the impact of
the intended change.
These sensitivities reflect the approximate amount of the fair values
that our interest-only strips and servicing rights would be reduced for the
indicated adverse changes. These reductions would result in a charge to expense
in the income statement in the period incurred and a resulting reduction of
stockholders' equity, net of income taxes. The effect on our liquidity of
changes in the fair values of our interest-only strips and servicing rights are
discussed in "-- Liquidity and Capital Resources."
32
The following tables provide information regarding the initial and