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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 March 31, 2003
[ ] 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 May 12, 2003 was 2,942,764 shares.
American Business Financial Services, Inc. and Subsidiaries
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2003 and June 30, 2002...............................................1
Consolidated Statements of Income for the three and nine months ended March 31, 2003 and 2002....................2
Consolidated Statement of Stockholders' Equity for the nine months ended March 31, 2003..........................3
Consolidated Statements of Cash Flow for the nine months ended March 31, 2003 and 2002...........................4
Notes to Consolidated Financial Statements.......................................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................23
Item 3. Quantitative and Qualitative Disclosure about Market Risk..............................................80
Item 4. Controls and Procedures................................................................................80
PART II OTHER INFORMATION
Item 1. Legal Proceedings......................................................................................81
Item 2. Changes in Securities..................................................................................82
Item 3. Defaults Upon Senior Securities........................................................................82
Item 4. Submission of Matters to a Vote of Security Holders....................................................82
Item 5. Other Information......................................................................................82
Item 6. Exhibits and Reports on Form 8-K.......................................................................82
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
American Business Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollars in thousands)
March 31, June 30,
2003 2002
----------- -----------
(Unaudited) (Note)
Assets
Cash and cash equivalents $ 87,232 $ 108,599
Loan and lease receivables, net
Available for sale 52,651 52,622
Interest and fees 14,154 12,292
Other 21,254 9,028
Interest-only strips (includes the fair value of
overcollateralization related cash flows of $290,650 and
$236,629 at March 31, 2003 and June 30, 2002) 609,891 512,611
Servicing rights 132,925 125,288
Prepaid expenses 3,584 3,640
Receivable for sold loans - 5,055
Property and equipment, net 18,092 18,446
Other assets 33,156 28,794
----------- -----------
Total assets $ 972,939 $ 876,375
=========== ===========
Liabilities
Subordinated debt $ 710,218 $ 655,720
Warehouse lines and other notes payable 6,782 8,486
Accrued interest payable 45,513 43,069
Accounts payable and accrued expenses 21,268 13,690
Deferred income taxes 38,898 35,124
Other liabilities 73,033 50,908
----------- -----------
Total liabilities 895,712 806,997
----------- -----------
Stockholders' equity
Preferred stock, par value $.001, authorized, 3,000,000 shares
at March 31, 2003 and 1,000,000 shares at June 30, 2002,
issued and outstanding, none - -
Common stock, par value $.001, authorized, 9,000,000 shares,
issued: 3,653,037 shares at March 31, 2003 and 3,645,192 shares
at June 30, 2002 (including Treasury shares of 710,273 at March
31, 2003 and 801,823 at June 30, 2002) 4 4
Additional paid-in capital 23,985 23,985
Accumulated other comprehensive income 15,442 11,479
Retained earnings 47,411 47,968
Treasury stock, at cost (9,015) (13,458)
----------- -----------
77,827 69,978
Note receivable (600) (600)
----------- -----------
Total stockholders' equity 77,227 69,378
----------- -----------
Total liabilities and stockholders' equity $ 972,939 $ 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 Nine Months Ended
March 31, March 31,
---------------------------- -----------------------------
2003 2002 2003 2002
----------- ------------ ------------ ----------
Revenues
Gain on sale of loans $ 54,504 $ 49,220 $ 170,394 $ 129,139
Interest and fees 4,661 5,292 13,422 16,759
Interest accretion on interest-only strips 12,114 9,538 34,361 25,920
Servicing income 486 1,282 2,667 4,216
Other income 1 103 7 107
----------- ------------ ------------ ----------
Total revenues 71,766 65,435 220,851 176,141
----------- ------------ ------------ ----------
Expenses
Interest 16,824 17,191 51,057 51,467
Provision for credit losses 1,718 1,728 4,692 4,434
Employee related costs 9,418 9,467 29,965 25,953
Sales and marketing 6,963 6,498 20,136 18,937
General and administrative 26,157 18,824 74,890 52,589
Securitization assets valuation adjustment 10,657 8,691 33,303 13,153
----------- ------------ ------------ ----------
Total expenses 71,737 62,399 214,043 166,533
----------- ------------ ------------ ----------
Income before provision for income taxes 29 3,036 6,808 9,608
Provision (benefit) for income taxes (192) 1,275 2,655 4,035
----------- ------------ ------------ ----------
Net Income $ 221 $ 1,761 $ 4,153 $ 5,573
=========== ============ ============ ==========
Earnings per common share:
Basic $ 0.07 $ 0.58 $ 1.43 $ 1.88
=========== ============ ============ ==========
Diluted $ 0.06 $ 0.55 $ 1.36 $ 1.74
=========== ============ ============ ==========
Average common shares:
Basic 2,941 2,844 2,909 2,963
=========== ============ ============ ==========
Diluted 3,103 3,034 3,043 3,202
=========== ============ ============ ==========
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 nine months ended Shares Paid-In Comprehensive Retained Treasury Note Stockholders'
March 31, 2003: Outstanding Amount Capital Income Earnings Stock Receivable Equity
----------- ------ ---------- ------------- -------- -------- ---------- -------------
Balance June 30, 2002 2,844 $ 4 $ 23,985 $ 11,479 $ 47,968 $ (13,458) $ (600) $ 69,378
Comprehensive income:
Net income -- -- -- -- 4,153 -- -- 4,153
Net unrealized gain on
interest-only strips -- -- -- 3,963 -- -- -- 3,963
----- ----- --------- --------- -------- --------- ------- ---------
Total comprehensive income -- -- -- 3,963 4,153 -- -- 8,116
Exercise of non-employee stock
options 57 -- -- -- (569) 619 -- 50
Shares issued to employees 38 -- -- -- (119) 492 -- 373
Shares issued to directors 4 -- -- -- (42) 51 -- 9
Stock dividend (10% of
outstanding shares) -- -- -- -- (3,281) 3,281 -- --
Cash dividends ($0.24 per
share) -- -- -- -- (699) -- -- (699)
----- ----- --------- --------- -------- --------- ------- ---------
Balance March 31, 2003 2,943 $ 4 $ 23,985 $ 15,442 $ 47,411 $ (9,015) $ (600) $ 77,227
===== ===== ========= ========= ======== ========= ======= =========
See accompanying notes to consolidated financial statements.
3
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow
(dollars in thousands)
(unaudited)
Nine Months Ended
March 31,
-----------------------------------
2003 2002
------------- ------------
Cash flows from operating activities
Net income $ 4,153 $ 5,573
Adjustments to reconcile net income to net cash used in operating
activities:
Gain on sales of loans (170,394) (129,139)
Depreciation and amortization 38,085 29,806
Interest accretion on interest-only strips (34,361) (25,920)
Securitization assets valuation adjustment 33,303 13,153
Provision for credit losses 4,692 4,434
Loans originated for sale (1,226,712) (1,048,706)
Proceeds from sale of loans 1,208,940 1,049,999
Principal payments on loans and leases 14,626 8,098
(Increase) decrease in accrued interest and fees on loan and lease
receivables (1,862) 3,216
Purchase of initial overcollateralization on securitized loans (3,800) -
Required purchase of additional overcollateralization on securitized
loans (53,496) (35,468)
Cash flow from interest-only strips 109,849 70,729
Decrease in prepaid expenses 56 50
Increase in accrued interest payable 2,444 11,589
Increase in accounts payable and accrued expenses 7,953 2,254
Accrued interest payable reinvested in subordinated debt 28,174 20,545
(Decrease) increase in deferred income taxes (549) 2,738
Increase in loans in process 1,884 762
Other, net (4,493) (4,697)
------------- ------------
Net cash used in operating activities (41,508) (20,984)
------------- ------------
Cash flows from investing activities
Purchase of property and equipment, net (4,277) (3,090)
Principal receipts and maturity of investments 25 19
------------- ------------
Net cash used in investing activities (4,252) (3,071)
------------- ------------
4
American Business Financial Services, Inc. and Subsidiaries
Consolidated Statements of Cash Flow (continued)
(dollars in thousands)
(unaudited)
Nine Months Ended
March 31,
-----------------------------------
2003 2002
------------- ------------
Cash flows from financing activities
Proceeds from issuance of subordinated debt $ 136,977 $ 177,820
Redemptions of subordinated debt (110,653) (95,579)
Net borrowings on revolving lines of credit (495) (7,311)
Principal payments on lease funding facility (2,091) (2,474)
Principal payments under capital lease obligations (138) -
Net repayments of other notes payable - (156)
Financing costs incurred (688) (1,497)
Lease incentive receipts 2,123 -
Exercise of employee stock options (2) -
Exercise of non-employee stock options 50 -
Grant of restricted stock option 9 -
Cash dividends paid (699) (628)
Repurchase of treasury stock - (5,652)
------------- ------------
Net cash provided by financing activities 24,393 64,523
------------- ------------
Net (decrease) increase in cash and cash equivalents (21,367) 40,468
Cash and cash equivalents at beginning of year 108,599 91,092
------------- ------------
Cash and cash equivalents at end of year $ 87,232 $ 131,560
============= ============
Supplemental disclosures:
Noncash transaction recorded for capitalized lease agreement:
Increase in property and equipment $ (1,020) $ -
Increase in warehouse lines and other notes payable $ 1,020 $ -
Cash paid during the period for:
Interest $ 20,439 $ 19,324
Income taxes $ 759 $ 1,086
See accompanying notes to consolidated financial statements.
5
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
March 31, 2003
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 Services 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, the Company's operations
(including repurchases of delinquent assets from securitization trusts),
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
nine-month period ended March 31, 2003 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)
March 31, 2003
1. Basis of Financial Statement Presentation (continued)
In December 2002, the Company's shareholders approved an increase in the number
of shares of authorized preferred stock from 1.0 million shares to 3.0 million
shares. The preferred shares may be used to raise equity capital, redeem
outstanding debt or acquire other companies, although no such acquisitions are
currently contemplated. The Board of Directors has discretion with respect to
designating and establishing the terms of each series of preferred stock prior
to issuance.
Certain prior period financial statement balances have been reclassified to
conform to current period presentation.
Recent Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Financial Interpretation No. ("FIN") 45 "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others." FIN 45 standardizes practices related to the recognition of a liability
for the fair value of a guarantor's obligation. The rule requires companies to
record a liability for the fair value of its guarantee to provide or stand ready
to provide services, cash or other assets. The rule applies to contracts that
require a guarantor to make payments based on an underlying factor such as
change in market value of an asset, collection of the scheduled contractual cash
flows from individual financial assets held by an SPE, non-performance of a
third party, for indemnification agreements, or for guarantees of the
indebtedness of others among other things. The provisions of FIN 45 are
effective on a prospective basis for guarantees that are issued or modified
after December 31, 2002. The disclosure requirements were effective for
statements of annual or interim periods ending after December 15, 2002.
Based on the requirements of this guidance for the quarter ended March 31, 2003,
the Company has recorded a $0.7 million liability in conjunction with the sale
of mortgage loans to the ABFS 2003-1 securitization trust which occurred in
March 2003. This liability represents the fair value of periodic interest
advances that the Company, as servicer of the securitized loans, is obligated to
pay on behalf of delinquent loans in the trust. Recording of this liability
reduces the gain on sale recorded for the securitization. The Company would
expect to record a similar liability for each subsequent securitization, which
generally occurs on a quarterly basis. The amount of the liability that will be
recorded is dependent mainly on the volume of loans the Company securitizes, the
expected performance of those loans and the interest rate of the loans. In the
quarter ended March 31, 2003, the adoption of FIN 45 reduced net income by
approximately $0.3 million and diluted earnings per share by $0.11. See Note 8
for further detail of this obligation.
In December 2002, the FASB issued Statement of Financial Accounting Standard
("SFAS") No. 148 "Accounting for Stock-Based Compensation - Transition and
Disclosure." SFAS No. 148 amends SFAS No. 123 "Accounting for Stock-Based
Compensation." SFAS No. 148 provides alternative methods of transition
7
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
1. Basis of Financial Statement Presentation (continued)
Recent Accounting Pronouncements (continued)
for a voluntary change to the fair value method of accounting for stock-based
compensation and requires pro forma disclosures of the effect on net income and
earnings per share had the fair value method been used to be included in annual
and interim reports and disclosure of the effect of the transition method used
if the accounting method was changed, among other things. SFAS No. 148 is
effective for annual reports of fiscal years beginning after December 15, 2002
and interim reports for periods beginning after December 15, 2002. The Company
plans to continue using the intrinsic value method of accounting for stock-based
compensation and therefore the new rule will have no effect on the Company's
financial condition or results of operations. The Company has adopted the new
standard related to disclosure in the interim period beginning January 1, 2003.
See Note 11 for further detail of the adoption of this rule.
In April 2003, the FASB began reconsidering the current alternatives available
for accounting for stock-based compensation. The Company cannot predict whether
the guidance will change the Company's current accounting for stock-based
compensation, or what effect, if any, changes may have on the Company's current
financial condition or results of operations.
In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest
Entities." FIN 46 provides guidance on the identification of variable interest
entities that are subject to consolidation requirements by a business
enterprise. A variable interest entity subject to consolidation requirements is
an entity that does not have sufficient equity at risk to finance its operations
without additional support from third parties and the equity investors in the
entity lack certain characteristics of a controlling financial interest as
defined in the guidance. Special purpose entities ("SPEs") are one type of
entity, which under certain circumstances may qualify as a variable interest
entity. Although the Company uses unconsolidated SPEs extensively in its loan
securitization activities, the guidance will not affect the Company's current
consolidation policies for SPEs as the guidance does not change the guidance
incorporated in SFAS No. 140 "Accounting for Transfers and Servicing of
Financial Assets and Extinguishment of Liabilities" which precludes
consolidation of a qualifying SPE by a transferor of assets to that SPE. FIN 46
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. In March 2003,
the FASB announced that it is reconsidering the permitted activities of a
qualifying SPE. The Company cannot predict whether the guidance will change or
what effect, if any, changes may have on the Company's current consolidation
policies for SPEs.
Restricted Cash Balances
The Company held restricted cash balances of $9.4 million and $9.0 million
related to borrower escrow accounts at March 31, 2003 and June 30, 2002,
respectively, and $3.4 million at March 31, 2003 related to deposits for future
settlement of interest rate swap contracts. There was no restricted cash related
to interest rate swap contracts at June 30, 2002.
8
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
2. Loan and Lease Receivables
Loan and lease receivables - Available for sale - were comprised of the
following (in thousands):
March 31, June 30,
2003 2002
--------- ---------
Real estate secured loans (a) $ 49,121 $ 48,116
Leases, net of unearned income of $806 and $668 (b) 5,483 8,211
--------- ---------
54,604 56,327
Less: allowance for credit losses on loan and lease
receivables available for sale 1,953 3,705
--------- ---------
$ 52,651 $ 52,622
========= =========
(a) Includes deferred direct loan origination costs of $1.4 million at March 31,
2003 and June 30, 2002.
(b) Includes deferred direct lease origination costs of $0.1 million and $0.4
million at March 31, 2003 and June 30, 2002, respectively.
Real estate secured loans have contractual maturities of up to 30 years.
At March 31, 2003 and June 30, 2002, the accrual of interest income was
suspended on real estate secured loans of $5.9 million and $7.0 million,
respectively. The allowance for loan losses includes reserves established for
expected losses on these loans in the amount of $1.3 million and $2.9 million at
March 31, 2003 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.
Loan and lease receivables - Interest and fees - are comprised mainly of accrued
interest and fees on loans and leases that are less than 90 days delinquent.
Additionally, Interest and fees include forbearance and deferment advances. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Managed Portfolio Quality" for a further description of these
agreements. These amounts are carried at their estimated net recoverable value.
Loan and lease receivables - Other - is comprised of receivables for securitized
loans. In accordance with the Company's securitization 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. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Off-Balance Sheet Arrangements - Trigger Management" for more detail of removal
of accounts provisions for securitized loans.
9
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
3. Interest-Only Strips
Activity for interest-only strip receivables for the nine months ended March 31,
2003 and 2002 were as follows (in thousands):
March 31,
2003 2002
---------------------------------
Balance at beginning of period $ 512,611 $ 398,519
Initial recognition of interest-only strips, including
initial overcollateralization of $3.8 million and $0 141,511 112,869
Cash flow from interest-only strips (109,849) (70,729)
Required purchases of additional overcollateralization 53,496 35,468
Interest accretion 34,361 25,920
Termination of lease securitization (a) (1,741) -
Net temporary adjustments to fair value (b) 8,286 1,253
Other than temporary fair value adjustment (b) (28,784) (13,153)
---------------------------------
Balance at end of period $ 609,891 $ 490,147
=================================
(a) Reflects release of lease collateral from a lease securitization trust which
was terminated in accordance with the trust documents after the full payout
of trust note certificates. Lease receivables of $1.6 million were recorded
on the balance sheet as a result of the termination.
(b) 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 the
excess of the principal balance of loans in a securitized pool over investor
interests. Overcollateralization is established to provide credit enhancement to
investors in securitization trusts. At March 31, 2003 and 2002, the fair value
of overcollateralization related cash flows were $290.6 million and $223.1
million, respectively.
After a two-year period during which management's estimates required no
valuation adjustments to its interest-only strips and servicing rights,
declining interest rates and high prepayment rates over the last six quarters
have required revisions to management's estimates of the value of these retained
interests. Beginning in the second quarter of fiscal 2002 and on a quarterly
basis thereafter, the Company increased the prepayment rate assumptions used to
value its securitization assets, thereby lowering the fair value of these
assets. However, because the Company's prepayment rates as well as those
throughout the mortgage industry continued to remain at higher than expected
levels due to continuous declines in interest rates during this period to
40-year lows, the Company's prepayment experience exceeded even management's
revised assumptions. As a result, over the last six quarters the Company has
recorded cumulative write downs to its interest-only strips in the aggregate
amount of $89.5 million and
10
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
3. Interest-Only Strips (continued)
an adjustment to the value of servicing rights of $4.5 million, for total
adjustments of $94.0 million mainly due to its higher than expected prepayment
experience. Of this amount, $55.3 million was expensed through the income
statement and $38.7 million resulted in a write down through other comprehensive
income, a component of stockholders' equity.
During the first nine months of fiscal 2003, write downs of $50.0 million were
recorded on the Company's securitization assets, including $45.5 million on
interest-only strips and $4.5 million on servicing rights. Within the $50.0
million write down was a charge of $58.3 million mainly due to increases in
prepayment experience, offset by $8.3 million of favorable fair value
adjustments. The income statement impact on interest-only strips for the first
nine months of fiscal 2003 was a write down of $33.3 million while the remaining
$16.7 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 Issue No. 99-20.
The long duration of historically low interest rates has given borrowers an
extended opportunity to engage in mortgage refinancing activities which resulted
in elevated prepayment experience. The persistence of historically low interest
rate levels, unprecedented in the last 40 years, has made the forecasting of
prepayment levels in future fiscal periods difficult. The Company had assumed
that the decline in interest rates had stopped and a rise in interest rates
would occur in the near term. Consistent with this view, the Company had
utilized derivative financial instruments to manage interest rate risk exposure
on the Company's loan production and loan pipeline to protect the fair value of
these fixed rate items against potential increases in market interest rates.
Based on current economic conditions and published mortgage industry surveys
including the Mortgage Bankers Association's Refinance Indexes available at the
time of the Company's quarterly revaluation of its interest-only strips and
servicing rights, and the Company's own prepayment experience, the Company
believes prepayments will continue to remain at higher than normal levels for
the near term before returning to average historical levels. The Mortgage
Bankers Association of America has forecast as of April 8, 2003 that mortgage
refinancings as a percentage share of total mortgage originations will decline
from 71% in the first quarter to 33% in the fourth quarter of calendar 2003. The
Mortgage Bankers Association of America has also projected in its April 2003
economic forecast that the 10-year treasury rate (which generally affects
mortgage rates) will increase over the next three quarters. As a result of the
analysis of these factors, the Company has increased its prepayment rate
assumptions for home equity loans for the near term, but at a declining rate,
before returning to its 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 the Company's
securitization assets and its actual experience may have a significant adverse
impact on the value of these assets.
11
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
3. Interest-Only Strips (continued)
The following table details the pre-tax write downs of the securitization assets
(in thousands):
Income Other
Total Statement Comprehensive
Quarter Ended Write down Impact Income Impact
- ---------------------- ---------- --------- -------------
September 30, 2002 $ 16,739 $ 12,078 $ 4,661
December 31, 2002 (a) 16,346 10,568 5,778
March 31, 2003 (b) 16,877 10,657 6,220
--------- -------- ---------
Total Fiscal 2003 $ 49,962 $ 33,303 $ 16,659
========= ======== =========
(a) includes a write down of $2.6 million to the carrying value of servicing
rights through the income statement.
(b) Includes a write down of $1.9 million to the carrying value of servicing
rights through the income statement.
4. Servicing Rights
Activity for the loan servicing rights asset for the nine months ended March 31,
2003 and 2002 were as follows (in thousands):
March 31,
2003 2002
-------------------------
Balance at beginning of period $ 125,288 $ 102,437
Initial recognition of servicing rights 42,171 37,371
Amortization (30,015) (21,614)
Write down (4,519) -
-------------------------
Balance at end of period $ 132,925 $ 118,194
=========================
A write down of $4.5 million was recorded for the nine-month period ended March
31, 2003 on the value of servicing rights mainly due to the impact of increases
in prepayment experience. This adjustment was recorded on the income statement
for the nine months ended March 31, 2003 in accordance with SFAS No. 140, as a
component of the securitization assets valuation adjustment.
12
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
5. Other Assets and Other Liabilities
Other assets were comprised of the following (in thousands):
March 31, June 30,
2003 2002
----------- ------------
Goodwill $ 15,121 $ 15,121
Real estate owned 6,348 3,784
Financing costs, debt offerings 4,424 5,849
Due from securitization trusts for
servicing related activities 2,805 1,616
Investments held to maturity 892 917
Other 3,566 1,507
----------- ------------
$ 33,156 $ 28,794
=========== ============
Other liabilities were comprised of the following (in thousands):
March 31, June 30,
2003 2002
----------- ------------
Commitments to fund closed loans $ 31,750 $ 29,866
Obligation for repurchase of securitized loans 25,005 10,621
Escrow deposits held 9,460 9,011
Hedging liabilities, at fair value 2,809 -
Unearned lease incentives 2,123 -
Periodic advance guarantee 667 -
Trading liabilities, at fair value 562 461
Other 657 949
----------- ------------
$ 73,033 $ 50,908
=========== ============
See Note 2 for an explanation of the obligation for the repurchase of
securitized loans and Note 9 for an explanation of the Company's hedging and
trading activities.
Unearned lease incentives represent reimbursements received in conjunction with
the lease agreement for the Company's new corporate office space. These funds
represent reimbursement from the landlord for leasehold improvements and
furniture and equipment in the rented space and will be recognized as an offset
to rent expense over the term of the lease.
13
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable
Subordinated debt was comprised of the following (in thousands):
March 31, June 30,
2003 2002
--------- ---------
Subordinated debt (a) $ 690,781 $ 640,411
Subordinated debt - money market notes (b) 19,437 15,309
--------- ---------
Total subordinated debt (a) $ 710,218 $ 655,720
========= =========
Warehouse lines and other notes payable were comprised of the following (in
thousands):
March 31, June 30,
2003 2002
---------- ---------
Warehouse and operating revolving line of credit (c) $ 5,862 $ 6,171
Lease funding facility (d) 38 2,128
Warehouse revolving line of credit (e) - 187
Capitalized leases (f) 882 -
--------- ---------
Total warehouse lines and other notes payable $ 6,782 $ 8,486
========= =========
(a) Subordinated debt due April 2003 through March 2012, interest rates ranging
from 4.00% to 13.00%; average rate at March 31, 2003 was 9.05%, average
remaining maturity was 18 months, subordinated to all of the Company's
senior indebtedness. The average rate on subordinated debt including money
market notes was 8.91% at March 31, 2003.
(b) Subordinated debt-money market notes due upon demand, interest rate at
4.00%; subordinated to all of the Company's senior indebtedness.
(c) $50 million warehouse and operating revolving line of credit expiring
December 2003, which includes a sublimit for a letter of credit that
expires in December 2003 to secure lease obligations for corporate office
space, collateralized by certain pledged loans, advances to securitization
trusts, real estate owned and certain interest-only strips. The amount of
the letter of credit was $8.0 million at March 31, 2003 and will vary over
the term of the office lease.
(d) Lease funding facility matures through May 2003, collateralized by certain
lease receivables.
(e) $25 million warehouse revolving line of credit expiring October 2003,
collateralized by certain pledged loans.
(f) Capitalized leases, maturing through January 2006, imputed interest rate of
8.0%, collateralized by computer equipment.
At March 31, 2003, warehouse lines and other notes payable were collateralized
by $8.2 million of loan and lease receivables and $1.0 million of computer
equipment.
14
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued)
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 2004, fundings to be
collateralized by an investment in the 99-A lease securitization trust. This
line was unused at March 31, 2003.
o $200 million warehouse revolving line of credit expiring November 2003,
collateralized by certain pledged loans. This line was unused at March 31,
2003.
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 --
Off-Balance Sheet Arrangements" for further discussion of the off-balance
sheet features of this facility. At March 31, 2003, $29.5 million of this
facility was utilized.
Interest rates paid on the revolving credit facilities range from London
Inter-Bank Offered Rate ("LIBOR") plus 1.25% to LIBOR plus 2.50%. The
weighted-average interest rate paid on the revolving credit facilities was 2.80%
and 3.35% at March 31, 2003 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 a particular line of credit.
At March 31, 2003, 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 3, 2002, the Company registered $315.0 million of
subordinated debt. Of the $315.0 million, $187.5 million of debt from this
registration statement was available for future issuance as of March 31, 2003.
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.
15
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
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 Hale case consists of five separate counts - three purported class action
counts and two individual counts. On November 22, 2002 the Illinois Federal
District Court granted Upland Mortgage's motion to dismiss the three class
action counts, but a judgment erroneously dismissing all five counts of the case
was entered in the docket. The plaintiff appealed the dismissal to the United
States Court of Appeals for the Seventh Circuit but, on February 14, 2003, the
Court of Appeals dismissed the appeal for lack of jurisdiction, on the grounds
that the judgment entered by the Illinois Federal District Court was erroneous
and did not constitute a final disposition of all counts of the case. Action on
the two remaining individual counts in the Illinois Federal District Court has
resumed and discovery has been scheduled.
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.
16
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
8. Commitments
Lease Agreements
In December 2002, the Company entered into a new lease for an office space for
the relocation of the Company's corporate headquarters into Philadelphia,
Pennsylvania. The eleven-year operating lease is expected to commence in fiscal
2004. The terms of the rental agreement require increased payments annually for
the term of the lease with average minimum annual rental payments of $4.2
million.
The Company has entered into contracts, or may engage parties in the future,
related to the relocation of the corporate headquarters such as contracts for
building improvements to the leased space, office furniture and equipment and
moving services. As of March 31, 2003, the Company has contracted for services
and equipment totaling $10.5 million related to the office relocation. The
provisions of the lease and local and state grants will provide the Company with
reimbursement of a substantial amount of these costs related to the relocation,
subject to certain conditions and limitations. The Company does not believe that
its unreimbursed expenses or unreimbursed cash outlay related to the relocation
will be material to its operations.
The lease requires the Company to maintain a letter of credit in favor of the
landlord to secure the Company's obligations to the landlord throughout the term
of the lease. The amount of the letter of credit is currently $8.0 million and
will decline over time to $4.0 million. The letter of credit is currently issued
by JPMorgan Chase under the Company's current lending facility with JPMorgan
Chase.
In March 2003, the Company entered into a new lease agreement for office space
in Roseland, New Jersey for the relocation of the Company's regional processing
center presently located in Roseland, New Jersey. The nine-year lease is
expected to commence in May 2003. The terms of the rental agreement require
increased payments periodically for the term of the lease with average minimum
annual rental payments of $0.8 million. The provisions of the lease require the
landlord to assume the costs to ready the premises for occupancy, subject to
certain conditions and limitations. The Company does not believe that its
expenses or cash outlay related to the relocation will be material to its
operations.
Periodic Advance Guarantees
As the servicer of securitized loans, the Company is obligated to advance
interest payments for delinquent loans if we deem that the advances will
ultimately be recoverable. These advances can first be made out of funds
available in a trust's collection account. If the funds available from the
trust's collection account are insufficient to make the required interest
advances, then the Company is required to make the advance from its operating
cash. The advances made from a trust's collection account, if not recovered from
the borrower or proceeds from the liquidation of the loan, require reimbursement
from the Company. However, the Company can recover any advances the Company
makes from its operating cash from the subsequent month's mortgage loan
17
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
8. Commitments (continued)
Periodic Advance Guarantees (continued)
payments to the applicable trust prior to any distributions to the certificate
holders.
The Company adopted FIN 45 on a prospective basis for guarantees that are issued
or modified after December 31, 2002. Based on the requirements of this guidance
for the quarter ended March 31, 2003, the Company has recorded a $0.7 million
liability in conjunction with the sale of mortgage loans to the ABFS 2003-1
securitization trust which occurred in March 2003. This liability represents its
estimate of the fair value of periodic interest advances that the Company as
servicer of the securitized loans, is obligated to pay to the trust on behalf of
delinquent loans. The fair value of the liability was estimated based on an
analysis of historical periodic interest advances and recoveries from
securitization trusts.
9. 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.
18
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
9. Derivative Financial Instruments (continued)
The Company recorded the following gains and losses on the fair value of
derivative financial instruments accounted for as hedges for the three and
nine-month periods ended March 31, 2003 and 2002. 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 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
---------------------------- --------------------------
2003 2002 2003 2002
---------------------------- --------------------------
Offset by gains and losses recorded on
securitizations:
Losses on derivative financial instruments $ (2,071) $ (135) $ (3,806) $ (4,923)
Offset by gains and losses recorded on the
fair value of hedged items:
Losses on derivative financial instruments (16) -- (3,070) --
Amount settled in cash - paid (2,619) (135) (5,041) (4,923)
At March 31, 2003 outstanding forward starting interest rate swap contracts
accounted for as hedges and unrealized losses recorded as liabilities on the
balance sheet were as follows (in thousands):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate swaps $47,497 $ 2,809
Trading activity
The Company recorded the following losses on forward starting interest rate swap
contracts, which were used to manage interest rate risk on loans in the
Company's pipeline and were therefore classified as trading for the three and
nine-month periods ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended
March 31, March 31,
---------------------------- --------------------------
2003 2002 2003 2002
---------------------------- --------------------------
Trading losses on forward starting interest
rate swaps $ (784) $ -- $ (3,708) $ --
Amount settled in cash - paid -- -- (2,671) --
At March 31, 2003 outstanding forward starting interest rate swap contracts used
to manage interest rate risk on loans in the Company's pipeline and associated
unrealized losses recorded as liabilities on the balance sheet were as follows
(in thousands):
Notional Unrealized
Amount Loss
-------- ----------
Forward starting interest rate swaps $72,503 $ 22
19
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
9. Derivative Financial Instruments (continued)
In addition, for the three and nine-month periods ended March 31, 2003,
respectively, the Company recorded losses of $0.1 million and $1.1 million on an
interest rate swap contract which is not designated as an accounting hedge, and
gains of $0.5 million for the three and nine-month periods ended March 31, 2002.
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 losses recognized during the
nine-month period, $0.3 million were unrealized losses representing the net
change in the fair value of the contract during the period and $0.8 million were
cash losses. The cumulative net unrealized loss of $0.5 million is included as a
trading liability in Other liabilities at March 31, 2003.
10. 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 Nine Months Ended
March 31, March 31,
------------------------- ------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
Earnings
(a) Net Income $ 221 $ 1,761 $ 4,153 $ 5,573
========= ========= ========= ========
Average Common Shares
(b) Average common shares outstanding 2,941 2,844 2,909 2,963
Average potentially dilutive shares 162 190 134 239
--------- --------- --------- --------
(c) Average common and potentially
dilutive shares 3,103 3,034 3,043 3,202
========= ========= ========= ========
Earnings Per Common Share
Basic (a/b) $ 0.07 $ 0.58 $ 1.43 $ 1.88
Diluted (a/c) $ 0.06 $ 0.55 $ 1.36 $ 1.74
11. Stock Option and Stock Incentive Plans
The Company has stock option plans that provide for the periodic granting of
options to key employees and non-employee directors. These plans have been
approved by the Company's shareholders. Options are generally granted to key
employees at the market price of the Company's stock on the date of grant and
expire five to ten years from date of grant. Options either fully vest when
granted or over periods of up to five years.
The Company accounts for stock options issued under these plans using the
intrinsic value method, and accordingly, no expense is recognized where the
exercise price equals or exceeds the fair value of the common stock at the date
of grant. Had the Company accounted for stock options granted under these plans
using the fair value method, pro forma net income and earnings per share would
have been as follows (in thousands, except per share data):
20
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
11. Stock Option and Stock Incentive Plans (continued)
Three Months Ended Nine Months Ended
March 31, March 31,
------------------------------- -----------------------------
2003 2002 2003 2002
------------------------------- -----------------------------
Net income
As reported $ 221 $ 1,761 $ 4,153 $ 5,573
Pro forma $ 285 $ 1,694 $ 4,101 $ 5,488
Earnings per share - basic
As reported $ 0.07 $ 0.58 $ 1.43 $ 1.88
Pro forma $ 0.10 $ 0.60 $ 1.41 $ 1.85
Earnings per share - diluted
As reported $ 0.06 $ 0.55 $ 1.36 $ 1.74
Pro forma $ 0.09 $ 0.56 $ 1.35 $ 1.71
12. 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 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.
The All Other caption on the following tables mainly represents segments that do
not meet the SFAS No. 131 "Disclosures about Segments of an Enterprise and
Related Information" defined thresholds for determining reportable segments,
financial assets not related to operating segments and is mainly comprised of
interest-only strips, unallocated overhead and other expenses of the Company
unrelated to the reportable segments identified.
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.
21
American Business Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
March 31, 2003
12. Segment Information (continued)
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
Nine months ended Loan and Reconciling
March 31, 2003: Origination Funding Servicing All Other Items Consolidated
----------- ------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 170,394 $ - $ - $ - $ - $ 170,394
Interest income................. 5,930 322 590 34,361 - 41,203
Non-interest income............. 6,169 3 33,031 - (29,949) 9,254
Inter-segment revenues - 56,681 - 57,673 (114,354) -
Operating expenses:
Interest expense................ 17,263 50,025 (247) 40,697 (56,681) 51,057
Non-interest expense............ 37,621 7,068 30,221 49,087 - 123,997
Depreciation and amortization... 2,467 84 885 2,250 - 5,686
Securitization assets valuation
adjustment.................... - - - 33,303 - 33,303
Inter-segment expense........... 87,622 - - - (87,622) -
Income tax expense (credit)........ 14,633 (67) 1,077 (12,988) - 2,655
--------- --------- --------- --------- --------- ---------
Net income (loss).................. $ 22,887 $ (104) $ 1,685 $ (20,315) $ - $ 4,153
========= ========= ========= ========= ========= =========
Segment assets..................... $ 100,636 $ 192,470 $ 126,763 $ 647,729 $ (94,659) $ 972,939
========= ========= ========= ========= ========= =========
Treasury
Nine months ended Loan and Reconciling
March 31, 2002: Origination Funding Servicing All Other Items Consolidated
----------- ------- --------- --------- ----------- ------------
External revenues:
Gain on sale of loans........... $ 129,139 $ - $ - $ - $ - $ 129,139
Interest income................. 5,705 738 1,041 25,920 - 33,404
Non-interest income............. 9,222 1 25,762 102 (21,489) 13,598
Inter-segment revenues - 56,028 - 53,754 (109,782) -
Operating expenses:
Interest expense................ 14,485 50,417 99 42,494 (56,028) 51,467
Non-interest expense............ 30,005 8,297 22,883 35,537 - 96,722
Depreciation and amortization... 2,518 105 823 1,745 - 5,191
Securitization assets valuation
adjustment.................... - - - 13,153 - 13,153
Inter-segment expense........... 75,243 - - - (75,243) -
Income tax expense (credit)........ 9,162 (862) 1,259 (5,524) - 4,035
--------- --------- --------- --------- --------- ---------
Net income (loss).................. $ 12,653 $ (1,190) $ 1,739 $ (7,629) $ - $ 5,573
========= ========= ========= ========= ========= =========
Segment assets..................... $ 87,211 $ 204,993 $ 119,069 $ 551,845 $ (77,772) $ 885,346
========= ========= ========= ========= ========= =========
22
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. Factors that could affect our assumptions
include, but are not limited to, general economic conditions, including interest
rate risk, future residential real estate values, regulatory changes
(legislative or otherwise) affecting the real estate market and mortgage lending
activities, competition, demand for American Business Financial Services, Inc.
and its subsidiaries' services, availability of funding, loan payment rates,
delinquency and default rates, changes in factors influencing the loan
securitization market and other risks identified in our Securities and Exchange
Commission filings. 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
Services 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 (including repurchases of
delinquent assets from securitization trusts), investments in systems and
technology and for general corporate purposes.
23
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 March 31, 2003, $710.2 million of
subordinated debt was outstanding and revolving credit and conduit facilities
totaling $576.2 million were available, of which $35.4 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 and subordinated debt see "-- Liquidity and Capital
Resources." For a description of our securitization activity see "-- Off-Balance
Sheet Arrangements."
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.
Local, state and federal legislatures, state and federal banking
regulatory agencies, state attorneys general offices, the Federal Trade
Commission, the U.S. Department of Justice, the U.S. Department of Housing and
Urban Development and state and local governmental authorities have increased
their focus on lending practices by companies in the subprime lending industry,
more commonly referred to as "predatory lending" practices. State, local and
federal governmental agencies have imposed sanctions for practices including,
but not limited to, charging borrowers excessive fees, imposing higher interest
rates than the borrower's credit risk warrants, failing to adequately disclose
the material terms of loans to the borrowers and abusive servicing and
collections practices. As a result of initiatives such as these, we are unable
to predict whether state, local or federal authorities will require changes in
our lending practices in the future, including the reimbursement of borrowers as
a result of fees charged or the imposition of fines, or the impact of those
changes on our profitability. These laws and regulations may limit our ability
to securitize loans originated in certain states or localities due to rating
agency, investor or market restrictions. As a result, we have limited the types
of loans we offer in some states and may discontinue originating loans in other
states or localities.
24
Additionally, the United States Congress is currently considering a
number of proposed bills or proposed amendments to existing laws, such as the
"Ney - Lucas Responsible Lending Act of 2003" introduced February 11, 2003 into
the U.S. House of Representatives, which could affect our lending activities and
make our business less profitable. These bills and amendments, if adopted as
proposed, could reduce our profitability by limiting the fees we are allowed to
charge, including prepayment fees, restricting the terms we are allowed to
include in our loan agreements and increasing the amount of disclosure we are
required to give to potential borrowers. While we cannot predict whether or in
what form Congress may adopt these bills or amendments, we are currently
evaluating the potential impact of these bills and amendments, if adopted, on
our lending practices and results of operations.
In addition to new regulatory initiatives with respect to so-called
"predatory lending" practices, current laws or regulations in some states
restrict our ability to charge prepayment penalties and late fees. We have used
the Federal Alternative Mortgage Transactions Parity Act of 1982, which we refer
to as the Parity Act, to preempt these state laws for loans which meet the
definition of alternative mortgage transactions under the Parity Act. However,
the Office of Thrift Supervision has adopted a rule effective in July 2003,
which will preclude us and other non-bank, non-thrift creditors from using the
Parity Act to preempt state prepayment penalty and late fee laws on new loan
originations. Under the provisions of this rule, we will be required to modify
or eliminate the practice of charging prepayment and other fees in some of the
states where we originate loans. Additionally, in a recent decision, the
Appellate Division of the Superior Court of New Jersey determined that the
Parity Act's preemption of state law was invalid and that the state laws
precluding some lenders from imposing prepayment fees are applicable to loans
made in New Jersey, including alternative mortgage transactions. We are
currently evaluating the impact of the adoption of the new rule by the Office of
Thrift Supervision and of the recent court decision in New Jersey on our future
lending activities and results of operations.
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 and the recent New Jersey court decision
regarding the Parity Act, 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.
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 nine months ended March 31, 2003 were 77.2% 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 80%
in the first nine months of fiscal 2003 and 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.
25
Interest-Only Strips. Interest-only strips, which represent the right
to receive future cash flows from securitized loans, represented 62.7% of our
total assets at March 31, 2003 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 re-evaluated on a
quarterly basis. 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 appropriate. Even a small unfavorable change in our
assumptions made as a result of unfavorable actual experience or other
considerations could have a significant adverse impact on our estimate of
residual cash flows and on the value of these assets. In the event of an
unfavorable change in these assumptions, the fair value of these assets would be
overstated, requiring an accounting adjustment. In accordance with the
provisions of Emerging Issues Task Force guidance, referred to as EITF 99-20 in
this document, changes in the fair value of interest-only strips that are deemed
to be temporary changes are recorded through other comprehensive income, a
component of stockholders' equity. Other than temporary adjustments to decrease
the fair value of interest-only strips are recorded through the income statement
which would adversely affect our income in the period of adjustment. See "--
Off-Balance Sheet Arrangements -- 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.
Interest accretion income represents the yield component of cash flows
received on interest-only strips. We use a prospective approach to estimate
interest accretion. As previously discussed, we update estimates of residual
cash flow from our securitizations on a quarterly basis. Under the prospective
approach, when it is probable that there is a favorable or unfavorable change in
estimated residual cash flow from the cash flow previously projected, we
recognize a larger or smaller percentage of the cash flow as interest accretion.
Any change in value of the underlying interest-only strip could impact our
current estimate of residual cash flow earned from the securitizations. For
example, a significant change in market interest rates could increase or
decrease the level of prepayments, thereby changing the size of the total
managed loan portfolio and related projected cash flows. The managed portfolio
includes loans held as available for sale on our balance sheet and loans
serviced for others.
26
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 13.7% of our total assets at March 31, 2003.
Servicing rights are carried at the lower of cost or fair value. The fair value
of servicing rights is determined by computing the benefits of servicing in
excess of adequate compensation, which would be required by a substitute
servicer. The benefits of servicing are the present value of projected net cash
flows from contractual servicing fees and ancillary servicing fees. We believe
the accounting estimates used in determining the fair value of servicing rights
are critical accounting estimates because the projected cash flows from
servicing fees incorporate assumptions made by management, including prepayment
rates, 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 appropriate. Even a small unfavorable change in our assumptions, made as
a result of unfavorable actual experience or other considerations could have a
significant adverse impact on the value of these assets. In the event of an
unfavorable change in these assumptions, the fair value of these assets would be
overstated, requiring an adjustment, which would adversely affect our income in
the period of adjustment. See "-- Off-Balance Sheet Arrangements --
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.
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 performed on a quarterly
basis 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 or write
down would be required. During the nine months ended March 31, 2003, our
valuation analysis indicated that valuation adjustments of $4.5 million were
required for impairment due to higher than expected prepayment experience. The
write downs were recorded in the income statement in the second and third
quarters of fiscal 2003. Impairment is measured as the excess of carrying value
over fair value.
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.
27
Development of Critical Accounting Estimates. On a quarterly basis,
senior management reviews the estimates used in our critical accounting
policies. As a group, senior management discusses the development and selection
of the assumptions used to perform its estimates described above. Management has
discussed the development and selection of the estimates used in our critical
accounting policies as of March 31, 2003 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 nine months
ended March 31, 2003, see "-- Off-Balance Sheet Arrangements --
Securitizations."
Initial Adoption of Accounting Policies. In conjunction with the
relocation of our corporate headquarters to new leased office space, we have
entered into a lease agreement and are in the process of finalizing certain
governmental grant agreements that will provide us with reimbursement for
certain expenditures related to our office relocation. The reimbursable
expenditures include both capitalizable items for leasehold improvements,
furniture and equipment and expense items such as legal costs, moving costs and
employee communication programs. Amounts reimbursed to us in accordance with our
lease agreement will be initially recorded as a liability on our balance sheet
and will be recognized in the income statement on a straight-line basis over the
term of the lease as a reduction of rent expense. Amounts received from
government grants will be initially recorded as a liability. Grant funds
received to offset expenditures for capitalizable items will be reclassified as
a reduction of the related fixed asset and amortized to income over the
depreciation period of the related asset as an offset to depreciation expense.
Amounts received to offset expense items will be recognized in the income
statement as an offset to the expense item.
OFF-BALANCE SHEET ARRANGEMENTS
We use off-balance sheet arrangements extensively in our business
activities. The types of off-balance sheet arrangements we use include special
purpose entities for the securitization of loans, obligations we incur as the
servicer of securitized loans and other contractual obligations such as
operating leases for corporate office space. See "-- Liquidity and Capital
Resources" for additional information regarding our off-balance sheet
contractual obligations.
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 of
its balance sheet by selling them to a special purpose entity. We sell our loans
into off-balance sheet facilities to generate the cash to pay off revolving
credit facilities and to generate revenue through securitization gains. The
special purpose entities described below meet our objectives for mortgage loan
securitization structures and comply with accounting principles generally
accepted in the United States of America.
28
Our securitizations involve a two-step transfer that qualifies for sale
accounting under SFAS No. 140. First, we sell the loans to a special purpose
entity, which has been established for the limited purpose of buying and
reselling the loans and establishing a true sale under legal standards. Next,
the special purpose entity sells the loans to a qualified special purpose
entity, which we refer to as the trust. The trust is a distinct legal entity,
independent from us. By transferring title of the loans to the trust, we isolate
those assets from our assets. Finally, the trust issues certificates to
investors to raise the cash purchase price for the loans we have sold. Cash from
the sale of certificates to third party investors is returned to us in exchange
for our loan receivables and we use this cash to repay any borrowings under
warehouse and credit facilities. The off-balance sheet trusts' activities are
restricted to holding title to the loan collateral, issuing certificates to
investors and distributing loan payments to the investors and us in accordance
with the agreement. We also retain the right to service the loans. We have no
additional obligations to the off-balance sheet facilities other than those
required as servicer of the loans and for breach of warranty obligations. We are
not required to make any additional investments in the trusts. Under current
accounting rules, the trusts do not qualify for consolidation in our financial
statements. The trusts carry the loan collateral as assets and the certificates
issued to investors as liabilities. Residual cash from the loans after required
principal and interest payments are made to the investors provide us with cash
flows from our interest-only strips. We expect that future cash flows from our
interest-only strips and servicing rights will generate more of the cash flows
required to meet maturities of our subordinated debt and our operating cash
needs.
We retain the rights to service the loans we sell through
securitizations. As the servicer of securitized loans, we are obligated to
advance interest payments for delinquent loans if we deem that the advances will
ultimately be recoverable. These advances can first be made out of funds
available in a trust's collection account. If the funds available from the
collection account are insufficient to make the required interest advances, then
we are required to make the advance from our operating cash. The advances made
from a trust's collection account, if not recovered from the borrower or
proceeds from the liquidation of the loan, require reimbursement from us. These
advances may require funding from our capital resources and may create greater
demands on our cash flow than either selling loans with servicing released or
maintaining a portfolio of loans on our balance sheet. However, any advances we
make from our operating cash can be recovered from the subsequent month's
mortgage loan payments to the applicable trust prior to any distributions to the
certificate holders.
At March 31, 2003 and June 30, 2002, the mortgage securitization trusts
held loans with an aggregate principal balance due of $3.4 billion and $2.9
billion as assets and owed $3.2 billion and $2.8 billion to third party
investors, respectively. Revenues from the sale of loans to securitization
trusts were $170.4 million, or 77.2% of total revenues for the nine months ended
March 31, 2003 and $129.1 million, or 73.3% of total revenues for the nine
months ended March 31, 2002. These amounts are net of $5.1 million of expenses
for underwriting fees, legal fees and other expenses associated with
securitization transactions during the periods. We have interest-only strips and
servicing rights with fair values of $609.9 million and $132.9 million,
respectively at March 31, 2003, which represent 76.3% of our total assets. Cash
flows received from interest-only strips and servicing rights were $140.1
million for the nine months ended March 31, 2003. These amounts are included in
our operating cash flows.
29
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 third party sponsor to dispose of
the loans. Typically the loans are disposed of by securitizing the loans in a
term securitization. The third party note purchaser also has the right to have
the loans sold. Under this off-balance sheet facility arrangement, the loans
have been isolated from us and our subsidiaries and as a result, transfers to
the facility are treated as sales for financial reporting purposes. When loans
are sold to this facility, we assess 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 March 31, 2003, the off-balance sheet mortgage conduit facility
held loans with principal balances due of $29.4 million as assets and owed $29.5
million to third parties.
Securitizations
In our mortgage loan securitizations, pools of mortgage loans are sold
to a trust. The trust then issues certificates or notes, which we refer to as
certificates in this document, to third-party investors, representing the right
to receive a pass-through interest rate and principal collected on the mortgage
loans each month. These certificates, which are senior in right to our
interest-only strips in the trusts, are sold to public or private offerings. 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. The interest rate spread is distributed from the trust to us and is the
basis of the value of our interest-only strips. In addition, when we securitize
our loans we retain the right to service the loans for a fee, which is the basis
for our servicing rights. Servicing includes processing of mortgage payments,
processing of disbursements for tax and insurance payments, maintenance of
mortgage loan records, performance of collection efforts, including disposition
of delinquent loans, foreclosure activities and disposition of real estate
owned, referred to as REO, and performance of investor accounting and reporting
processes.
Since fiscal 2000, declines in securitization pass-through interest
rates resulted in interest rate spreads improving by approximately 235 basis
points at March 31, 2003 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. No assurances can be made that market interest rates will 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
during the period 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 by only 71 basis points. We would seek
to address the challenge presented by a rising interest rate environment by
carefully monitoring our product pricing, the actions of our competition, market
trends and the use of hedging strategies in order to continue to originate loans
in as profitable a manner as possible. See "-- Strategies for Use of Derivative
Financial Instruments" for a discussion of our hedging strategies.
30
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. These effects may be
offset by the positive effect of a decline in prepayment activity that we would
expect in a rising interest rate environment. See "-- Liquidity and Capital
Resources" for a discussion of both long and short-term liquidity.
Conversely, a declining interest rate environment could unfavorably
impact the valuation of our interest-only strips. In a declining interest rate
environment the level of mortgage refinancing activity tends to increase, which
could result in an increase in loan prepayment experience and may require
increases in assumptions for prepayments for future periods.
After a two-year period during which management's estimates required no
valuation adjustments to our interest-only strips and servicing rights,
declining interest rates and high prepayment rates over the last six quarters
have required revisions to management's estimates of the value of these retained
interests. Beginning in the second quarter of fiscal 2002 and on a quarterly
basis thereafter, we increased the prepayment rate assumptions used to value our
securitization assets, thereby decreasing the fair value of these assets.
However, because our prepayment rates as well as those throughout the mortgage
industry continued to remain at higher than expected levels due to continuous
declines in interest rates during this period to 40-year lows, our prepayment
experience exceeded even our revised assumptions. As a result, over the last six
quarters we have recorded cumulative write downs to our interest-only strips in
the aggregate amount of $89.5 million and an adjustment to the value of
servicing rights of $4.5 million, for total adjustments of $94.0 million mainly
due to our higher than expected prepayment experience. Of this amount, $55.3
million was expensed through the income statement and $38.7 million resulted in
a write down through other comprehensive income, a component of stockholders'
equity.
During the first nine months of fiscal 2003, write downs of $50.0
million were recorded on our securitization assets, including $45.5 million on
interest-only strips and $4.5 million servicing rights. Within the $50.0 million
write down was a charge of $58.3 million mainly due to increases in prepayment
experience, offset by $8.3 million of favorable fair value adjustments in the
second quarter.
The long duration of historically low interest rates has given
borrowers an extended opportunity to engage in mortgage refinancing activities
which resulted in elevated prepayment experience. The persistence of
historically low interest rate levels, unprecedented in the last 40 years, has
made the forecasting of prepayment levels in future fiscal periods difficult. We
had assumed that the decline in interest rates had stopped and a rise in
interest rates would occur in the near term. Consistent with this view, we had
utilized derivative financial instruments to manage interest rate risk ex