Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
(Mark One)
[ X ] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the fiscal year ended June 30, 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.)
100 Penn Square East, Philadelphia, PA 19107
---------------------------------------------------
(Address of principal executive offices) (zip code)
(215) 940-4000
----------------------------------------------------
(Registrant's telephone number, including area code)
111 Presidential Boulevard, Bala Cynwyd, PA 19004
-------------------------------------------------------------
(Former name or former address, if changed since last report)
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of
the Exchange Act:
Common Stock, par value
$.001 per share
----------------
(Title of Class)
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 if disclosure of delinquent filers in response
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of Registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of the Form 10-K or
amendment to this Form 10-K. [ X ]
Indicate by check mark whether the Registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). [X] YES [ ] NO
The aggregate market value of the Registrant's common stock, $.001 par
value per share, held by non-affiliates of the Registrant based on the price at
which the common stock last sold as of June 30, 2003 was $8.4 million.
The number of shares outstanding of the Registrant's sole class of
common stock as of September 23, 2003 was 2,946,892 shares.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III - Proxy Statement for 2003 Annual Meeting of Stockholders
PART I
Item 1. Business
Forward Looking Statements
Some of the information in this Annual Report on Form 10-K may contain
forward-looking statements. You can identify these statements by words or
phrases such as "will likely result," "may," "are expected to," "will continue
to," "is anticipated," "estimate," "believe," "projected," "intends to" or other
similar words. These forward-looking statements regarding our business and
prospects are based upon numerous assumptions about future conditions, which may
ultimately prove to be inaccurate. Actual events and results may materially
differ from anticipated results described in those statements. Forward-looking
statements involve risks and uncertainties described under "Risk Factors" as
well as other portions of this Annual Report on Form 10-K, which could cause our
actual results to differ materially from historical earnings and those presently
anticipated. When considering forward-looking statements, you should keep these
risk factors in mind as well as the other cautionary statements in this Form
10-K. You should not place undue reliance on any forward-looking statement.
General
We are a diversified financial services organization operating
predominantly in the eastern and central portions of the United States. Through
our principal direct and indirect subsidiaries, we originate, sell and service
fixed interest rate:
o mortgage loans, secured by first and second mortgages on
one-to-four family residences, which may not satisfy the
eligibility requirements of Fannie Mae, Freddie Mac or similar
buyers and which we refer to in this document as home equity
loans; and
o loans to businesses, secured by real estate and other business
assets, which we refer to in this document as business purpose
loans.
We also process and purchase home equity loans through our Bank
Alliance Services program. Through this program, we purchase home equity loans
from financial institutions and hold them as available for sale until they are
sold in connection with a future securitization or whole loan sale. See "Lending
Activities -- Home Equity Loans."
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 Philadelphia, Pennsylvania and a regional
processing center in Roseland, New Jersey. Our centralized operating office was
located in Bala Cynwyd, Pennsylvania prior to July 7, 2003. Prior to June 30,
2003 we also originated home equity loans through several retail branch offices.
1
Effective June 30, 2003, we no longer originate loans through retail branch
offices. Our loan servicing and collection activities are performed at our Bala
Cynwyd, Pennsylvania office, but are expected to relocate to our Philadelphia,
Pennsylvania office.
We sell substantially all of the loans we originate on a quarterly
basis through a combination of securitizations and the sale of loans with
servicing released, which we refer to as whole loan sales. When we securitize
loans, we retain interests in the securitized loans in the form of interest-only
strips and servicing rights, which we refer to as our securitization assets. 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.
Recent Developments
Fiscal 2003 Loss of $29.9 Million. In fiscal 2003, we recorded a net
loss of $29.9 million. The loss was primarily due to our inability to complete
our typical quarterly securitization of loans during the fourth quarter of our
fiscal year and to $45.2 million of pre-tax charges for net valuation
adjustments on our securitization assets charged to the income statement,
compared to $22.1 million of net valuation adjustments in fiscal 2002. Our
business strategy requires the sale of substantially all of the loans we
originate at least on a quarterly basis through a combination of securitizations
and whole loan sales. From 1995 until the fourth quarter of fiscal 2003, we had
elected to utilize securitization transactions extensively due to the favorable
conditions we had experienced in the securitization markets and the higher gains
recorded on securitizations through the application of gain-on-sale accounting
versus the gain realized on whole loan sales.
During fiscal 2003, we charged to the income statement total pre-tax
valuation adjustments on our interest-only strips and servicing rights, which we
refer to as securitization assets, of $63.1 million, which primarily reflect the
impact of higher than anticipated prepayments on securitized loans experienced
in fiscal 2003 due to the low interest rate environment experienced during
fiscal 2003. The pre-tax valuation adjustments charged to the income statement
were partially offset by $17.9 million due to the impact of a decrease in the
discount rates used to value our securitization assets, resulting in the $45.2
million of pre-tax charges for net valuation adjustments charged to the income
statement. We reduced the discount rates on our interest-only strips and our
servicing rights primarily to reflect the impact of the sustained decline in
market interest rates. The discount rate on the projected residual cash flows
from our interest-only strips was reduced from 13% to 11% at June 30, 2003. The
discount rate used to determine the fair value of the overcollateralization
portion of the cash flows from our interest-only strips was minimally impacted
by the decline in interest rates and remained at 7% on average. As a result, the
blended rate used to value our interest-only strips, including the
overcollateralization cash flows, was 9% at June 30, 2003. The discount rate on
our servicing rights was reduced from 11% to 9% at June 30, 2003.
Our inability to complete our typical publicly underwritten
securitization during the fourth quarter of fiscal 2003 was the result of our
investment bankers' decision in late June not to underwrite the contemplated
June 2003 securitization transaction. Management believes that a number of
factors contributed to this decision, including a highly-publicized lawsuit
finding liability of an underwriter in connection with the securitization of
loans for another unaffiliated subprime lender, an inquiry by the U.S.
Attorney's Office in Philadelphia regarding our forbearance practices, an
anonymous letter regarding the Company received by our investment bankers, the
SEC's recent enforcement action against another unaffiliated subprime lender
related to its loan restructuring practices and related disclosure, a federal
regulatory agency investigation of practices by another subprime servicer and
our investment bankers' prior experience with securitization transactions with
non-affiliated originators. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
Short-Term Liquidity and Remedial Steps Taken. Because we have
historically experienced negative cash flows from operations, our business
requires continual access to short and long-term sources of debt to generate the
cash required to fund our operations. Our short term liquidity was negatively
impacted by several recent events. Our inability to complete our typical
publicly underwritten securitization during the fourth quarter of fiscal 2003
contributed to our loss for fiscal 2003 and adversely impacted our short-term
liquidity position. In addition, further advances under a non-committed portion
of one of our credit facilities were subject to the discretion of the lender and
subsequent to June 30, 2003, there were no new advances under the non-committed
portion. Additionally, on August 20, 2003, this credit facility was amended and,
among other changes, the non-committed portion was eliminated. We also had a
2
$300.0 million mortgage conduit facility with a financial institution that
enabled us to sell our loans into an off-balance sheet facility, which expired
pursuant to its terms on July 5, 2003. At June 30, 2003, of the $516.1 million
in revolving credit and conduit facilities available to us, $453.4 million was
drawn upon. At September 19, 2003, of the $117.0 million in revolving credit
facilities available to us, $102.3 million was drawn upon. Our revolving credit
facilities and mortgage conduit facility had $62.7 million of unused capacity
available at June 30, 2003 (and $14.7 million of unused capacity at September
19, 2003), which significantly reduced our ability to fund future loan
originations until we sell existing loans, extend or expand existing credit
facilities, or add new credit facilities. In addition, we have temporarily
discontinued sales of new subordinated debt, which further impaired our
liquidity.
As a result of these liquidity issues, since June 30, 2003, we
substantially reduced our loan origination volume. From July 1, 2003 through
August 31, 2003, we originated $85.7 million of loans which represents a
significant reduction as compared to originations of $245.8 million of loans for
the same period in fiscal 2003. Our inability to originate loans at previous
levels may adversely impact the relationships our subsidiaries have or are
developing with their brokers and our ability to retain employees. As a result
of the decrease in loan originations and liquidity issues described above, we
anticipate incurring a loss for the first quarter of fiscal 2004. The amount of
the loss will depend, in part, upon our ability to complete a securitization
prior to September 30, 2003 and, if completed, the size and terms of the
securitization. Further, we can provide no assurances that we will be able to
sell our loans, extend existing facilities or expand or add new credit
facilities. If we are unable to obtain additional financing, we may not be able
to restructure our business to permit profitable operations or repay our
subordinated debt when due. Even if we are able to obtain adequate financing,
our inability to securitize our loans could hinder our ability to operate
profitably in the future and repay our subordinated debt when due.
We undertook specific remedial actions to address short-term liquidity
concerns including entering into an agreement on June 30, 2003 with an
investment bank to sell up to $700.0 million of mortgage loans, subject to the
satisfactory completion of the purchaser's due diligence review and other
conditions, and soliciting bids and commitments from other participants in the
whole loan sale market. In total, from June 30, 2003 through September 17, 2003,
we sold approximately $482.9 million (which includes $221.9 million of loans
sold by the expired mortgage conduit facility) of loans through whole loan
sales. We are continuing the process of selling our loans. We also suspended
paying quarterly cash dividends on our common stock.
On September 22, 2003, we entered into definitive agreements with a
financial institution for a new $200.0 million credit facility for the purpose
of funding our loan originations. Pursuant to the terms of this facility, we are
required to, among other things: (i) obtain a written commitment for another
credit facility of at least $200.0 million and close that additional facility by
October 3, 2003 (which condition would be satisfied by the closing of the $225.0
million facility described below); (ii) have a net worth of at least $28.0
million by September 30, 2003; with quarterly increases of $2.0 million
thereafter; (iii) apply 60% of our net cash flow from operations each quarter to
reduce the outstanding amount of subordinated debt commencing with the quarter
ending March 31, 2004, and (iv) provide a parent company guaranty of 10% of the
outstanding principal amount of loans under the facility. Prior to the closing
of the second facility, our borrowing capacity on this $200.0 million credit
facility is limited to $80.0 million. This facility has a term of 12 months
expiring in September 2004 and is secured by the mortgage loans which are funded
by advances under the facility with interest equal to LIBOR plus a margin. This
facility is subject to representations and warranties and covenants, which are
customary for a facility of this type, as well as amortization events and events
of default related to our financial condition. These provisions require, among
other things, our maintenance of a delinquency ratio for the managed portfolio
(which represents the portfolio of securitized loans and leases we service for
others) at the end of each fiscal quarter of less than 12.0%, our subordinated
debt not to exceed $705.0 million at any time, our ownership of an amount of
repurchased loans not to exceed 1.5% of the managed portfolio and our
registration statement registering $295.0 million of subordinated debt be
declared effective by the SEC no later than October 31, 2003.
3
On September 22, 2003, we executed a commitment letter for a mortgage
warehouse credit facility with a warehouse lender, which consists of a senior
secured revolving credit facility of up to $225.0 million and a secured last out
revolver facility up to $25.0 million to fund loan originations. The commitment
letter is subject to certain conditions, including, among other things: (i)
entering into definitive agreements, except as provided in the commitment
letter; (ii) the absence of a material adverse change in the business,
operations, property, condition (financial or otherwise) or prospects of us or
our affiliates; and (iii) our receipt of another credit facility in an amount
not less than $200.0 million, subject to terms and conditions acceptable to this
lender (which condition is satisfied by the new $200.0 million facility
described above). The commitment letter provides that these facilities will have
a term of three years with an interest rate on amounts outstanding under the
$225.0 million portion of the credit facility equal to the greater of one-month
LIBOR plus a margin or the difference between the yield maintenance fee (as
defined in the commitment letter) and the one-month LIBOR plus a margin.
Advances under this facility would be collateralized by substantially all of our
present and future assets including pledged loans and a security interest in
substantially all of our interest-only strips and residual interests which will
be contributed to a special purpose entity organized by us to facilitate this
transaction. We also agreed to pay fees of approximately $14.6 million annually
plus a nonusage fee based on the difference between the average daily
outstanding balance for the current month and the maximum credit amount under
the facility and the lender's out-of-pocket expenses.
We anticipate that these facilities will be subject to representations
and warranties, events of default and covenants which are customary for
facilities of this type, as well as our agreement to: (i) maintain sales or
renewals of our subordinated debt securities of $10.0 million per month; (ii)
restrict total principal and interest outstanding on our subordinated debt to
$750.0 million or less; (iii) make quarterly reductions commencing in April 2004
of an amount of subordinated debt outstanding to be determined; (iv) maintain
maximum interest rates payable on subordinated debt securities not to exceed 10
percentage points above comparable rates for FDIC insured products; and (v) the
lender's receipt of our audited financial statements for the period ended June
30, 2003. The definitive agreements will grant the lender an option at any time
after the first anniversary of entering into definitive agreements to increase
the credit amount on the $250.0 million facility to $400.0 million with
additional fees payable by us plus additional interest as may be required by the
institutions or investors providing the lender with these additional funds. The
commitment letter requires that we enter into definitive agreements not later
than October 17, 2003. While we anticipate that we will close this transaction
prior to such date, we cannot assure you that these negotiations will result in
definitive agreements or that such agreements, as negotiated, will be on terms
and conditions acceptable to us. In the event we are unable to close these
facilities or another facility within the time frame provided under the new
$200.0 million credit facility described above, the lender on that facility
would be under no obligation to make further advances under the terms of that
facility and outstanding advances would have to be repaid over a period of time.
During the first quarter of fiscal 2004, we explored a number of
strategic alternatives to address these liquidity issues in the event we are
unable to borrow under the new $200.0 million credit facility, close the $250.0
million credit facilities or obtain alternative financing. In the event we were
unable to obtain the additional credit facilities necessary to operate our
business, we developed a contingent business plan (described more fully under
"Business Strategy Adjustments") which contemplates, among other things, the
sale of $100 million principal amount of additional subordinated debt through
March 2004 and the renewal of approximately 50% of outstanding subordinated debt
upon maturity. We believe that this contingent business plan addresses our
liquidity issues and may permit us to restructure our operations, if necessary,
without the receipt of an expanded or additional credit facility. There can be
no assurance that our contingent business plan will be successful or that it
will enable us to repay our subordinated debt when due.
4
To the extent that we are not successful in maintaining, replacing or
obtaining alternative financing sources on acceptable terms, we may have to
limit our loan originations, sell loans earlier than intended and further
restructure our operations. Limiting our originations or earlier than intended
sales of our loans could reduce our profitability or result in losses and
restrict our ability to repay our subordinated debt upon maturity. While we
currently believe that we would be able to restructure our operations, if
necessary, we cannot assure you that such restructuring will enable us to attain
profitable operations or repay the subordinated debt when due. See "Risk Factors
- -- We depend upon the availability of financing to fund our continuing
operations. Any failure to obtain adequate funding could hurt our ability to
operate profitably and restrict our ability to repay our subordinated debt and
negatively impact the value of our common stock," and "-- If we are unable to
obtain additional financing, we may be not able to restructure our business to
permit profitable operations or repay our subordinated debt when due, which
would negatively impact the value of our common stock."
Credit Facilities and Waivers Related to Financial Covenants. We borrow
against various warehouse credit facilities as the primary funding source for
our loan originations. The sale of our loans through a securitization or whole
loan sale generates the cash proceeds necessary to repay the borrowings under
the warehouse facilities. In addition, we have the availability of revolving
credit facilities, which we may use to fund our operations. Each credit
agreement requires that we comply with specific financial covenants and has
multiple individualized financial covenant thresholds and ratio limits that we
must meet as a condition to drawing on that particular facility. Pursuant to the
terms of these credit facilities, the failure to comply with the financial
covenants constitutes an event of default and the lender may, at its option,
take certain actions including: terminate commitments to make future advances to
us, declare all or a portion of the loan due and payable, foreclose on the
collateral securing the loan, require servicing payments be made to the lender,
or other third party, or assume the servicing of the loans securing the credit
facility. An event of default under these credit facilities could result in
defaults pursuant to cross-default provisions of our other agreements, including
our other loan agreements and lease agreements. The failure to comply with the
terms of these credit facilities or to obtain the necessary waivers from the
lenders related to any default would have a material adverse effect on our
liquidity and capital resources, could result in us not having sufficient cash
to repay our indebtedness, require us to restructure our operations and may
force us to sell assets on less than optimal terms and conditions.
As a result of the loss experienced during fiscal 2003, we were not in
compliance with the terms of certain of the financial covenants under two of our
principal credit facilities (one for $50.0 million and the other for $200.0
million, of which $100.0 million was non-committed) and we requested and
obtained waivers of these requirements from our lenders. The lender under the
$50.0 million warehouse credit facility has granted us a waiver for our
non-compliance with a financial covenant in that credit facility through
September 30, 2003. This facility was amended to reduce the available credit to
$8.0 million and the financial covenants were replaced with new covenants with
which we are currently in compliance.
We also entered into an amendment to the $200.0 million credit facility
which provides for the waiver of our non-compliance with the financial covenants
in that facility, the reduction of the committed portion of this facility from
$100.0 million to $50.0 million, the elimination of the $100.0 million
non-committed portion of this credit facility and the acceleration of the
termination date of this facility from November 2003 to September 30, 2003. Our
ability to repay this facility upon termination is dependent on our ability to
refinance the loans in one of our new facilities or our sale of loans currently
warehoused in the terminating facility by September 30, 2003.
In addition, if the anticipated loss for the first quarter of fiscal
2004 described above results in our non-compliance with any financial covenants,
we intend to seek the appropriate waivers. There can be no assurances that we
will obtain any of these waivers.
5
Business Strategy Adjustments. Our business strategy requires the sale
of substantially all of the loans we originate at least on a quarterly basis
through a combination of securitizations and the sale of loans with servicing
released, which we refer to as whole loan sales. Our determination as to whether
to dispose of loans through securitizations or whole loan sales depends on a
variety of factors including market conditions, profitability and cash flow
considerations. From 1995 until the fourth quarter of fiscal 2003, we had
elected to utilize securitization transactions extensively due to the favorable
conditions we had experienced in the securitization markets. During fiscal 2003,
2002, and 2001, we securitized $1.42 billion, $1.35 billion, and $1.1 billion of
loans, respectively. During the same periods, we sold $28.3 million, $57.7
million, and $76.3 million of loans, respectively, through whole loan sales.
Under generally accepted accounting principles, we are permitted to record the
gain on the sale of these securitized loans utilizing an accounting method
referred to as "gain-on-sale" accounting. This accounting method permits us to
record a non-cash gain based upon the estimated value of securitization assets
generated in connection with the securitization of our loans even though only a
small portion of the gain is received in cash during the period the gain is
recorded. We are then required to reevaluate these assets quarterly and make
adjustments based upon changes in the fair value of these assets.
After we recognized our inability to securitize our assets in the
fourth quarter of fiscal 2003, we adjusted our business strategy to emphasize
more whole loan sales. We intend to continue to evaluate both public and
privately placed securitization transactions, subject to market conditions. We
generally realized higher gain on sale in our securitization transactions than
on whole loan sales for cash. Although the gain on whole loan sales is generally
significantly lower than gains realized in securitization transactions, we
receive the gain in cash immediately and generally receive more cash immediately
in a whole loan sale transaction than from securitizations of an equal principal
amount of loans. As a result of the emphasis on whole loan sales in late June
and July 2003, at July 31, 2003, our cash position was consistent with our
projected cash position, which assumed the completion of a fourth quarter
securitization.
The use of whole loan sales will enable us to immediately generate cash
flow, protect against volatility in the securitization markets and reduce risks
inherent in retaining securitization assets. However, unlike securitizations,
where we retain the right to service the loans for a fee, which we refer to as
servicing rights, and receive securitization assets in the form of interest-only
strips which generate future cash flows, whole loan sales are typically
structured as a sale with servicing rights released and do not result in our
receipt of securitization assets. As a result, using whole loan sales more
extensively in the future will reduce our income from servicing activities and
limit the amount of securitization assets created.
We believe that our adjustments to our business strategy focus on a
more diversified strategy of selling our loans, while protecting revenues,
controlling costs and improving liquidity. However, if we are unable to generate
sufficient liquidity through the sales of our loans, the sale of our
subordinated debt, the receipt of new credit facilities or a combination of the
foregoing, we will be required to restrict loan originations and make additional
changes to our business strategy, including restricting or restructuring our
operations which could reduce our profitability or result in losses and impair
our ability to repay the subordinated debt.
We have historically experienced negative cash flow from operations. To
the extent we are unable to successfully implement our adjusted business
strategy, which requires access to capital to originate loans and our ability to
profitably sell these loans, we would continue to experience negative cash flows
from operations which would impair our ability to repay our subordinated debt.
See "Risk Factors -- If we are unable to successfully implement our adjusted
business strategy which focuses on whole loan sales, we may be unable to attain
profitable operations which could impair our ability to repay our subordinated
debt and negatively impact the value of our common stock."
6
In the event we are unable to maintain the new $200.0 million credit
facility described above, close the $250.0 million credit facilities described
above within the required timeframes or obtain other credit facilities, we have
developed a contingent business plan which management believes will enable us to
repay the subordinated debt when due and continue operations, although with a
materially reduced amount of loan originations as compared to historical levels.
The major assumptions of our contingent business plan include, but are not
limited to, the following: (i) the sale of $100.0 million of subordinated debt
over a five month period ending in March 2004; (ii) the renewal of approximately
50% of our outstanding subordinated debt upon maturity; (iii) the securitization
of approximately $40.0 million of business purpose loans which are less
attractive to purchasers in the secondary loan market; (iv) the sale of
substantially all of the home equity loans we originate in whole loan sales in
the secondary market with servicing released; and (v) substantial cost
reductions in our operations. If we utilize the contingent business plan, we
currently anticipate incurring losses through the second quarter of fiscal 2004.
Although management believes that the contingent business plan is feasible,
there can be no assurance that we will be able to successfully implement it.
Civil Subpoena from the U.S. Attorney's Office. We received a civil
subpoena, dated May 14, 2003, from the Civil Division of the U.S. Attorney for
the Eastern District of Pennsylvania. The subpoena requests that we provide
certain documents and information with respect to us and our lending
subsidiaries for the period from May 1, 2000 to May 1, 2003: (i) all loan files
in which we entered into a forbearance agreement with a borrower who is in
default; (ii) the servicing, processing, foreclosing, and handling of delinquent
loans and non-performing loans, the carrying, processing and sale of real estate
owned, and forbearance agreements; and (iii) agreements to sell or otherwise
transfer mortgage loans (including, but not limited to, any pooling or
securitization agreements) or to obtain funds to finance the underwriting,
origination or provision of mortgage loans, any transaction in which mortgage
loans were sold or transferred, any instance in which we were not to service or
not to act as custodian for a mortgage loan, representations and warranties made
in connection with mortgage loans, secondary market loan sale schedules, and
credit loss, delinquency, default, and foreclosure rates of mortgage loans. We
have directed our attorneys to cooperate fully with this inquiry. Currently,
this inquiry appears to be focused on our practices relating to obtaining
forbearance agreements from delinquent borrowers who would otherwise be subject
to foreclosure. Because the inquiry is at a preliminary stage, we cannot reach
any conclusions about the ultimate scope of the inquiry or the potential
liability or financial consequences to us at this time.
To the extent management is unsuccessful in resolving this matter, the
ongoing review by the U.S. Attorney's Office could limit our ability to engage
in publicly underwritten securitization transactions or otherwise sell or
service our loans. In addition, the U.S. Attorney's inquiry could reduce sales
of subordinated debt upon which we rely to fund our operations and limit our
ability to obtain additional credit facilities, which are necessary for the
implementation of our business strategy. Furthermore, the U.S. Attorney could
impose sanctions or otherwise restrict our ability to restructure loans, which
could negatively impact our profitability and our ability to repay the
subordinated debt. See "-- Regulation."
Delinquencies; Forbearance and Deferment Arrangements. During fiscal
2003, we experienced an increase in the total delinquencies in our total managed
portfolio to $229.1 million at June 30, 2003 from $170.8 million and $107.0
million at June 30, 2002 and 2001, respectively. Total delinquencies (loans and
leases, excluding real estate owned, with payments past due for more than 30
days) as a percentage of the total managed portfolio were 6.27% at June 30, 2003
compared to 5.57% and 4.13% at June 30, 2002 and 2001, respectively.
As the managed portfolio continues to season and if our economy
continues to lag or worsen, the delinquency rate may continue to increase, which
could negatively impact our ability to sell or securitize loans and reduce our
profitability and the funds available to repay our subordinated debt. Continuing
low market interest rates could continue to encourage borrowers to refinance
their loans and increase the levels of loan prepayments we experience which
would negatively impact our delinquency rate.
7
Delinquencies in our total managed portfolio do not include $197.7
million of previously delinquent loans at June 30, 2003, which are subject to
deferment and forbearance arrangements. Generally, a loan remains current after
we enter into a deferment or forbearance arrangement with the borrower only if
the borrower makes the principal and interest payments as required under the
terms of the original note (exclusive of the delinquent payments advanced or
fees paid by us on the borrower's behalf as part of the deferment or forbearance
arrangement) and we do not reflect it as a delinquent loan in our delinquency
statistics. However, if the borrower fails to make principal and interest
payments, the account will generally be declared in default and collection
actions resumed.
During the final six months of fiscal 2003, we experienced a pronounced
increase in the number of borrowers under deferment arrangements than in prior
periods. At June 30, 2003, there was approximately $197.7 million of cumulative
unpaid principal balance under deferment and forbearance arrangements as
compared to approximately $138.7 million of cumulative unpaid principal balance
at June 30, 2002. Total cumulative unpaid principal balances under deferment or
forbearance arrangements as a percentage of the total managed portfolio were
5.41% at June 30, 2003 compared to 4.52% at June 30, 2002. Additionally, there
are loans under deferment and forbearance arrangements which have returned to
delinquent status. At June 30, 2003 there was $28.7 million of cumulative unpaid
principal balance under deferment arrangements and $51.5 million of cumulative
unpaid principal balance under forbearance arrangements that are now reported as
delinquent 31 days or more. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Managed Portfolio Quality --
Deferment and Forbearance Arrangements."
8
Business Strategy
The business strategy that we are emphasizing beginning in fiscal 2004
focuses on a shift from gain-on-sale accounting and the use of securitization
transactions as our primary method of selling loans to a more diversified
strategy which utilizes a combination of whole loan sales and securitizations,
while protecting revenues, controlling costs and improving liquidity. Our
business strategy includes the following:
o Selling substantially all of the loans we originate on a
quarterly basis through a combination of securitizations and
whole loan sales. Whole loan sales may be completed on a more
frequent basis.
o Shifting from a predominantly publicly underwritten
securitization strategy and gain-on-sale business model to a
strategy focused on a combination of whole loan sales and
smaller securitization transactions. Quarterly loan
securitization levels will be reduced significantly from
previous levels. Securitizations for the foreseeable future
are expected to be executed as private placements to
institutional investors or publicly underwritten
securitizations, subject to market conditions. Historically,
the market for whole loan sales has provided reliable
liquidity for numerous originators as an alternative to
securitization. Whole loan sales provide immediate cash
premiums to us, while securitizations generate cash over time
but generally result in higher gains at the time of sale. We
intend to rely less on gain-on-sale accounting and loan
servicing activities for our revenue and earnings and will
rely more on cash premiums earned on whole loan sales. This
strategy is expected to result in relatively lower earnings
levels at current loan origination volumes, but will increase
cash flow, accelerate the timeframe for becoming cash flow
positive and improve our liquidity position. See
"Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources"
for more detail on cash flow.
9
o Broadening our mortgage loan product line and increasing loan
originations. We currently originate primarily fixed-rate
loans. Under our business strategy, we plan to originate
adjustable-rate and alt-A mortgage loans as well as a wide
array of fixed-rate mortgage loans in order to appeal to a
broader base of prospective customers and increase loan
originations.
o Offering competitive interest rates charged to borrowers on
new products. By offering competitive interest rates charged
on new products, we expect to originate loans with higher
credit quality. In addition, by reducing interest rates we
expect to appeal to a wider customer base and substantially
reduce our marketing costs, make more efficient use of
marketing leads and increase loan origination volume.
o Reducing origination of the types of loans that are not well
received in the whole loan sale and securitization markets.
We intend to reduce the level of business purpose loans that
we will originate, but we will continue to originate business
purpose loans to meet demand in the whole loan sale and
securitization markets.
o Reducing the cost of loan originations. We have implemented
plans to:
- Eliminate our high cost origination branches.
- Reduce the cost to originate in Upland Mortgage by
among other things: a) broadening the product line and
offering competitive interest rates in order to
increase origination volume, b) reducing marketing
costs, and c) developing broker relationships.
- Reduce the cost to originate in American Business
Mortgage Services by increasing volume through a
broadening of the mortgage loan product line.
- Reduce the cost to originate in the Bank Alliance
Services program by broadening our product line and
increasing the amount of fees we charge to
participating financial institutions.
o Reducing the amount of outstanding subordinated debt. The
increase in cash flow expected under our business strategy is
expected to accelerate a reduction in our reliance on issuing
subordinated debt to meet our liquidity needs and allow us to
begin to pay down existing subordinated debt.
o Reducing operating costs. Since June 30, 2003, we reduced our
workforce by 170 employees. With our shift in focus to whole
loan sales with servicing released and offering a broader
mortgage product line that we expect will appeal to a wider
array of customers, we currently require a smaller employee
base with fewer sales, servicing and support positions. These
workforce reductions represent more than a 15% decrease in
staffing levels.
Our business strategy is expected to leverage our demonstrated
strengths which include:
o A strong credit culture which consistently originates quality
performing loans. Our delinquency rates are among the lowest
in the subprime industry.
10
o Long-term broker relationships at American Business Mortgage
Services.
o Upland Mortgage brand identity.
o Relationships with participating financial institutions in the
Bank Alliance Services program.
o Institutional investors' interest in the bonds issued in our
securitizations.
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 or
sell our loans on a regular basis. Our failure with respect to any of these
factors could impair our ability to successfully implement our strategy, which
could adversely affect our results of operations and financial condition. See
"Risk Factors -- If we are unable to continue to successfully implement our
adjusted business strategy, which focuses on whole loan sales, we may be unable
to attain profitable operations which could impair our ability to repay our
subordinated debt and negatively impact the value of our common stock."
The Company
We were incorporated in Delaware in 1985 and began operations as a
finance company in 1988, initially offering business purpose loans to customers
whose borrowing needs we believed were not being adequately serviced by
commercial banks. Since our inception, we have significantly expanded our
product line and geographic scope and currently have licenses, or are in the
process of becoming licensed, to offer our home equity loan products in 44
states.
Our principal corporate office in Delaware is located at 103 Springer
Building, 3411 Silverside Road, Wilmington, Delaware 19810. The telephone number
at that address is (302) 478-6160. Our principal operating office is located at
100 Penn Square East, Philadelphia, Pennsylvania 19107. The telephone number at
our principal operating office is (215) 940-4000. We maintain a site on the
World Wide Web at www.abfsonline.com as well as web sites for most of our
primary subsidiary companies.
We file annual, quarterly and current reports, proxy statements and
other information with the SEC. You may read and copy our reports or other
filings made with the SEC at the SEC's Public Reference Room, located at 450
Fifth Street, N.W., Washington, DC 20549. You can obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. You
can also access these reports and other filings electronically on the SEC's web
site, www.sec.gov.
We also make these reports and other filings available free of charge
on our web site, www.abfsonline.com, as soon as reasonably practicable after
filing with the SEC. We will provide, at no cost, paper or electronic copies of
our reports and other filings made with the SEC. Requests should be directed to:
11
Stephen M. Giroux, Esquire
American Business Financial Services, Inc.
100 Penn Square East
Philadelphia, PA 19107
(215) 940-4000
The information on the web sites listed above, is not and should not be
considered part of this Annual Report on Form 10-K and is not incorporated by
reference in this document. These web sites are and are only intended to be
inactive textual references.
Subsidiaries
As a holding company, our activities have been limited to:
(1) holding the shares of our subsidiaries, and
(2) raising capital for use in the subsidiaries' lending and loan
servicing operations.
We are the parent holding company of American Business Credit, Inc. and
its primary subsidiaries, HomeAmerican Credit, Inc. (doing business as Upland
Mortgage), American Business Mortgage Services, Inc., and Tiger Relocation
Company.
American Business Credit, Inc., a Pennsylvania corporation incorporated
in 1988 and acquired by us in 1993, originates, sells and services business
purpose loans and services home equity loans.
HomeAmerican Credit, Inc., a Pennsylvania corporation incorporated in
1991, originates, purchases and sells home equity loans. HomeAmerican Credit
acquired Upland Mortgage Corp in 1996 and since that time has conducted business
as "Upland Mortgage." HomeAmerican Credit also administers the Bank Alliance
Services program.
American Business Mortgage Services, Inc., a New Jersey corporation
organized in 1938 and acquired by us in October 1997, is currently engaged in
the origination and sale of home equity loans.
12
Tiger Relocation Company, a Pennsylvania corporation, was incorporated
in 1992 to hold, maintain and sell real estate properties acquired due to the
default of a borrower under the terms of our loan documents.
We also have numerous special purpose subsidiaries that were
incorporated solely to facilitate our securitizations and off-balance sheet
mortgage conduit facility. None of these corporations engage in any business
activity other than holding the subordinated certificate, if any, and the
interest-only strips created in connection with completed securitizations. See
"-- Securitizations" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Securitizations." We also utilize special
purpose subsidiaries in connection with our financing activities, including
credit facilities. We also have several additional subsidiaries that are
inactive or not significant to our operations.
13
The following chart sets forth our basic organizational structure and
our primary subsidiaries.(a)
------------------------------------
AMERICAN BUSINESS FINANCIAL
SERVICES, INC.
------------------------------------
Holding company
Issues subordinated debt securities
----------------|-------------------
|
|
----------------|-------------------
AMERICAN BUSINESS CREDIT, INC.
------------------------------------
Originates, sells and services business
purpose loans and services home equity loans
----------------|-------------------
|
|-----------------------------|------------------------|
| | |
- --------|------------ -------------|------------- -------|--------
AMERICAN HOMEAMERICAN TIGER
BUSINESS CREDIT, INC. RELOCATION
MORTGAGE D/B/A COMPANY
SERVICES, INC. UPLAND
MORTGAGE
- --------------------- --------------------------- ---------------
Originates, Originates, Holds
purchases, sells purchases, sells and foreclosed real
and services services home estate
home equity equity loans and
loans administers the
Bank Alliance
Services program
- --------------------- --------------------------- ---------------
_____________________
(a) In addition to the corporations pictured in this chart, we organized at
least one special purpose corporation for each securitization and have
several other subsidiaries that are inactive or not significant to our
operations.
14
Lending Activities
General. The following table sets forth information concerning our loan
origination, purchase and sale activities for the periods indicated.
Year Ended June 30,
-------------------------------------
2003 2002 2001
-------------------------------------
(dollars in thousands)
Loans Originated/Purchased
Business purpose loans........................... $ 122,790 $ 133,352 $ 120,537
Home equity loans................................ $1,543,730 $1,246,505 $1,096,440
Number of Loans Originated/Purchased
Business purpose loans........................... 1,340 1,372 1,318
Home equity loans................................ 17,003 14,015 13,443
Average Loan Size
Business purpose loans........................... $ 92 $ 97 $ 91
Home equity loans................................ $ 91 $ 89 $ 82
Weighted-Average Interest Rate on Loans
Originated/Purchased
Business purpose loans........................... 15.76% 15.75% 15.99%
Home equity loans................................ 9.99% 10.91% 11.46%
Combined......................................... 10.42% 11.38% 11.91%
Weighted-Average Term (in months)
Business purpose loans........................... 160 161 163
Home equity loans................................ 272 260 259
Loans Securitized or Sold
Business purpose loans........................... $ 112,025 $ 129,074 $ 109,892
Home equity loans................................ $1,339,752 $1,279,740 $1,068,507
Number of Loans Securitized or Sold
Business purpose loans........................... 1,195 1,331 1,208
Home equity loans................................ 14,952 14,379 13,031
The following table sets forth information regarding the average
loan-to-value ratios for loans we originated and purchased during the periods
indicated.
Year Ended June 30,
---------------------------------------
Loan Type 2003 2002 2001
- --------------------------------------------------------------------------------
Business purpose loans................. 62.2% 62.6% 62.2%
Home equity loans...................... 78.2 77.8 78.4
15
The following table shows the geographic distribution of our loan
originations and purchases during the periods indicated.
Year Ended June 30,
-------------------------------------------------------------------
2003 2002 2001
------------------- ------------------- -------------------
Amount % Amount % Amount %
---------- ----- --------- ----- ---------- -----
(dollars in thousands)
New York $ 376,425 22.59% $ 341,205 24.73% $ 337,218 27.71%
New Jersey 212,035 12.72 159,117 11.53 161,087 13.24
Florida 135,164 8.11 97,686 7.08 89,169 7.33
Massachusetts 134,342 8.06 101,383 7.35 75,958 6.24
Pennsylvania 118,915 7.14 103,865 7.53 102,789 8.44
Michigan 92,009 5.52 89,224 6.47 40,477 3.33
Illinois 90,111 5.41 73,152 5.30 51,904 4.26
Ohio 70,957 4.26 65,884 4.77 66,877 5.50
North Carolina 47,806 2.87 38,060 2.76 34,065 2.80
Virginia 46,508 2.79 33,169 2.40 33,739 2.77
Connecticut 42,525 2.55 30,461 2.21 18,741 1.54
Maryland 36,542 2.19 25,307 1.83 26,632 2.19
Indiana 33,671 2.02 27,833 2.02 21,489 1.76
Other(a) 229,510 13.77 193,511 14.02 156,832 12.89
---------- ------ ---------- ------ ----------- ------
Total $1,666,520 100.00% $1,379,857 100.00% $ 1,216,977 100.00%
========== ====== ========== ====== =========== ======
____________________________
(a) No individual state included in "Other" constitutes more than 2% of total
loan originations for fiscal 2003.
Customers. Our loan customers are primarily credit-impaired borrowers
who are generally unable to obtain financing from banks or savings and loan
associations and who are attracted to our products and services. These
institutions have historically provided loans only to individuals with the most
favorable credit characteristics. These borrowers generally have impaired or
unsubstantiated credit histories and/or unverifiable income. Our experience has
indicated that these borrowers are attracted to our loan products as a result of
our marketing efforts, the personalized service provided by our staff of highly
trained lending officers and our timely response to loan requests. Historically,
our customers have been willing to pay our origination fees and interest rates
even though they are generally higher than those charged by traditional lending
sources. See "-- Business Strategy."
Home Equity Loans. We originate home equity loans through Upland
Mortgage and American Business Mortgage Services. We also process and purchase
loans through the Bank Alliance Services program. We originate home equity loans
primarily to credit-impaired borrowers through various channels of retail
marketing which include direct mail and our subsidiaries' interactive web sites,
and have included radio and television advertisements. We entered the home
equity loan market in 1991. Currently, we are licensed or otherwise qualified to
originate home equity loans in 44 states and originate home equity loans
predominantly in the eastern and central portions of the United States. We
generally securitize or sell on a whole loan basis with servicing released, the
home equity loans originated and funded by our subsidiaries.
The business strategy that we are emphasizing beginning in fiscal 2004
will impact our origination of home equity loans. Our business strategy includes
broadening our mortgage loan product line to include adjustable rate and alt-A
mortgage loans and competitive interest rates in order to appeal to a broader
prospective customer base and increase the amount of loan originations, and
16
reducing our cost to originate loans by expanding our broker network and
reducing marketing costs. Our business strategy also focuses on shifting from a
predominantly publicly underwritten securitization strategy and gain-on-sale
business model to a strategy focused on a combination of whole loan sales and
smaller securitization transactions. For a discussion of our business strategy
and its potential impact on our home equity loan business see "-- Business
Strategy."
Home equity loan applications are obtained from potential borrowers
over the phone, in writing, in person or through our Internet web site. The loan
request is then evaluated for possible loan approval. The loan processing staff
generally provides its home equity applicants who qualify for loans with a
conditional loan approval within 24 hours and closes its home equity loans
within approximately fifteen to twenty days of obtaining a conditional loan
approval.
Home equity loans generally ranged from $5,000 to $580,000 and had an
average loan size of approximately $91,000 for the loans originated during
fiscal 2003 and $89,000 during fiscal 2002. We originated $1.5 billion of home
equity loans during the fiscal year ended June 30, 2003 and $1.2 billion during
the fiscal year ended June 30, 2002. Home equity loans are generally made at
fixed rates of interest and for terms ranging from five to thirty years,
generally, with average origination fees of approximately 1.5% of the aggregate
loan amount. The weighted-average interest rate received on home equity loans
during fiscal 2003 was 9.99% and during fiscal 2002 was 10.91%. The average
loan-to-value ratio for the loans originated by us during fiscal 2003 was 78.2%
and was 77.8% for the loans originated during fiscal 2002. We attempt to
maintain our interest and other charges on home equity loans to be competitive
with the lending rates of other non-conforming mortgage finance companies.
Interest on home equity loans originated subsequent to January 2001 is generally
computed based on the scheduled interest method. Prior to January 2001, most of
the home equity loans we originated computed interest on the simple interest
method. To the extent permitted by law, borrowers are given an option to choose
between a loan without a prepayment fee at a higher interest rate, or a loan
with a prepayment fee at a lower interest rate. We may waive the collection of a
prepayment fee, if any, in the event the borrower refinances a home equity loan
with us.
We have exclusive business arrangements with several financial
institutions which provide for our purchase of home equity loans that meet our
underwriting criteria, but do not meet the guidelines of the selling institution
for loans to be held in its portfolio. This program is called the Bank Alliance
Services program. The Bank Alliance Services program is designed to provide an
additional source of home equity loans. This program targets traditional
financial institutions, such as banks, which because of their strict
underwriting and credit guidelines for loans held in their portfolio have
generally provided mortgage financing only to the most credit-worthy borrowers.
This program allows these financial institutions to originate loans to
credit-impaired borrowers in order to achieve community reinvestment goals and
to generate fee income and subsequently sell such loans to one of our
subsidiaries.
Under the Bank Alliance Services program, we enter into business
arrangements with financial institutions which provide for the purchase by our
lending subsidiaries of home equity loans which do not meet the underwriting
criteria of the financial institutions for home equity loans to be held in the
financial institutions' portfolios. Pursuant to the program, a financial
institution adopts our underwriting criteria for home equity loans not intended
to be held in its portfolio. If an applicant meets our underwriting criteria, as
adopted by the program, we process the application materials and underwrite the
loan for final approval by the financial institution. If the financial
institution approves the loan, we close the loan for the financial institution
in its name with funding provided by the financial institution. We purchase the
loan from the financial institution shortly after the closing. Following our
purchase of the loans through this program, we hold these loans as available for
sale until they are sold in connection with a future securitization or whole
loan sale.
17
During fiscal 2003 we received referrals from approximately 20
financial institutions participating in this program. These financial
institutions provide us with the opportunity to process and purchase loans
generated by the branch networks of such institutions, which consist of over
1,700 branches located in various states throughout the country. Pursuant to
this program, our subsidiaries purchased approximately $201.9 million of loans
during the fiscal year ended June 30, 2003 and $145.9 million during fiscal
2002. In fiscal 2003, our top three financial institutions under the Bank
Alliance Services program accounted for approximately 96.1% of our loan volume
from this program. We intend to continue to expand the Bank Alliance Services
program with financial institutions across the United States. See " -- Business
Strategy."
During fiscal 1999, we launched an Internet loan distribution channel
through Upland Mortgage's web site. Through this interactive web site, borrowers
can examine available loan options and calculate monthly principal and interest
payments. The Upland Mortgage Internet platform provides borrowers with
convenient access to the mortgage loan information 7 days a week, 24 hours a
day. Throughout the loan processing period, borrowers who submit applications
are supported by our staff of highly trained loan officers. Currently, in
addition to the ability to utilize an automated rapid pre-approval process,
which we believe reduces time and manual effort required for loan approval, the
site features our proprietary software, Easy Loan Advisor, which provides
personalized services and solutions to retail customers through interactive web
dialog. We have applied to the U.S. Patent and Trademark Office to patent this
product.
Business Purpose Loans. Through our subsidiary, American Business
Credit, we originate business purpose loans predominantly in the eastern and
central portions of the United States through a network of salespeople, loan
brokers and through our business loan web site. We focus our marketing efforts
on small businesses that do not meet all of the credit criteria of commercial
banks and small businesses that our research indicates may be predisposed to
using our products and services.
We originate business purpose loans to corporations, partnerships, sole
proprietors and other business entities for various business purposes including,
but not limited to, working capital, business expansion, equipment acquisition,
tax payments and debt-consolidation. We do not target any particular industries
or trade groups and, in fact, take precautions against a concentration of loans
in any one industry group. All business purpose loans generally are
collateralized by a first or second mortgage lien on a principal residence of
the borrower or a guarantor of the borrower or some other parcel of real
property, such as office and apartment buildings and mixed use buildings, owned
by the borrower, a principal of the borrower, or a guarantor of the borrower. In
most cases, these loans are further collateralized by personal guarantees,
pledges of securities, assignments of contract rights, life insurance and lease
payments and liens on business equipment and other business assets. Prior to the
fourth quarter of fiscal 2003, we generally securitized business purpose loans
subsequent to their origination. Under our business strategy, we intend to
reduce the level of business purpose loans that we will originate, but we will
continue to originate business purpose loans to meet demand in the whole loan
sale and securitization markets. See "-- Business Strategy."
Our business purpose loans generally ranged from $14,000 to $685,000
and had an average loan size of approximately $92,000 for the loans originated
18
during the fiscal year ended June 30, 2003 and $97,000 in fiscal 2002.
Generally, our business purpose loans are made at fixed interest rates and for
terms ranging from five to fifteen years. We generally charge origination fees
for these loans of 4.75% to 5.75% of the original principal balance. The
weighted-average interest rate charged on the business purpose loans originated
by us was 15.76% for the fiscal year ended June 30, 2003 and 15.75% for fiscal
2002. Business purpose loans we originated during fiscal 2003 had a
loan-to-value ratio of 62.2%, based solely upon the real estate collateral
securing the loans. Business purpose loans we originated during fiscal 2002 had
a loan-to-value ratio, based solely upon the real estate collateral securing the
loans, of 62.6%. We originated $122.8 million of business purpose loans during
fiscal 2003 and $133.4 million of business purpose loans during fiscal 2002.
Generally, we compute interest due on our outstanding business purpose
loans using the simple interest method. We generally impose a prepayment fee.
Although prepayment fees imposed vary based upon applicable state law, the
prepayment fees on our business purpose loan documents can be a significant
portion of the outstanding loan balance. Whether a prepayment fee is imposed and
the amount of such fee, if any, is negotiated between the individual borrower
and American Business Credit prior to closing of the loan. We may waive the
collection of a prepayment fee, if any, in the event the borrower refinances a
business loan with us.
Prepayment Fees. At origination, approximately 80% to 85% of our home
equity loans had prepayment fees and approximately 90% to 95% of our business
purpose loans had prepayment fees. Home equity loans comprise approximately 93%
of all loans we originate and the remaining 7% are business purpose loans. On
home equity loans where the borrower has elected the prepayment fee option, the
prepayment fee is generally a certain percentage of the outstanding principal
balance of the loan. Our typical prepayment fee structure provides for a fee of
5% or less of the outstanding principal loan balance and will not extend beyond
the first three years after a loan's origination. Prepayment fees on our
existing home equity loans range from 1% to 5% of the outstanding principal
balance and remain in effect for one to five years. The prepayment fee on
business purpose loans is generally 8% to 12% of the outstanding principal
balance, provided that no prepayment option is available until after the 24th
scheduled payment is made and no prepayment fee is due after the 60th scheduled
payment is made. From time to time, a different prepayment fee arrangement may
be negotiated or we may waive prepayment fees for borrowers who refinance their
loans with us. At June 30, 2003, approximately 60% to 65% of securitized home
equity loans in our managed portfolio had prepayment fees and approximately 50%
to 55% of securitized business purpose loans in our managed portfolio had
prepayment fees.
State law sometimes restricts our ability to charge a prepayment fee
for both home equity and business purpose loans. We have used the Parity Act to
preempt these state laws for home equity loans which meet the definition of
alternative mortgage transactions under the Parity Act. However, the Office of
Thrift Supervision has adopted a rule effective in July 2003, which precludes us
and other non-bank, non-thrift creditors from using the Parity Act to preempt
state prepayment penalty and late fee laws on new loan originations. Under the
provisions of this rule, we are required to modify or eliminate the practice of
charging prepayment and other fees in some of the states where we originate
loans. We are continuing to evaluate the impact of the adoption of the new rule
by the Office of Thrift Supervision on our future lending activities and results
of operations. We currently expect that the percentage of home equity loans
containing prepayment fees that we will originate in the future will decrease to
approximately 65% to 70%, from 80% to 85% prior to this rule becoming effective.
19
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. Although this New Jersey decision is subject to appeal and may not
be final, we are currently evaluating its impact on our future lending
activities and results of operations.
In states which have overridden the Parity Act and in the case of some
fully amortizing home equity loans, state laws may restrict prepayment fees
either by the amount of the prepayment fee or the time period during which it
can be imposed. Federal law restrictions in connection with certain high
interest rate and fee loans may also preclude the imposition of prepayment fees
on these loans. Similarly, in the case of business purpose loans, some states
prohibit or limit prepayment fees when the loan is below a specific dollar
threshold or is secured by residential property.
Marketing Strategy
Historically, we concentrated our marketing efforts for home equity
loans primarily on credit-impaired borrowers who are generally unable to obtain
financing from banks or savings and loan associations and who are attracted to
our products and services. Although we still intend to lend to credit-impaired
borrowers under our business strategy, we intend to broaden our mortgage loan
product line to include adjustable rate and alt-A mortgage loans and to offer
competitive interest rates in order to appeal to a wider range of customers. See
"-- Business Strategy" and "Risk Factors -- Lending to credit-impaired borrowers
may result in higher delinquencies in our managed portfolio, which could hinder
our ability to operate profitably, impair our ability to repay our subordinated
debt and negatively impact the value of our common stock."
We market home equity loans through direct mail campaigns and our
interactive web sites, and have in the past used telemarketing, radio and
television advertising. We believe that our targeted direct mail strategy
delivers more leads at a lower cost than broadcast marketing channels. Our
integrated approach to media advertising that utilizes a combination of direct
mail and Internet advertising is intended to maximize the effect of our
advertising campaigns. We expect the implementation of our business strategy to
improve our response and conversion rates, which will reduce our overall
marketing costs. We also use a network of loan brokers along with the Bank
Alliance Services program as additional sources of loans. We intend to expand
our network of loan brokers as part of our focus on whole loan sales in order to
increase the amount of loans originated and reduce origination costs.
Our marketing efforts for home equity loans are focused on the eastern
and central portions of the United States with plans to expand to the western
portion of the United States. We previously utilized branch offices in various
states to market our loans. Effective June 30, 2003, we no longer originate
loans through retail branch offices. Loan processing and underwriting procedures
are performed at our centralized operating office located in Philadelphia,
Pennsylvania and a regional processing center in Roseland, New Jersey. Our
centralized operating office relocated from Bala Cynwyd, Pennsylvania on July 7,
2003.
Our marketing efforts for business purpose loans focus on our niche
market of selected small businesses located in our market area, which generally
includes the eastern and central portions of the United States.
20
We target businesses, which might qualify for loans from traditional lending
sources, but would elect to use our products and services. Our experience has
indicated that these borrowers are attracted to us as a result of our marketing
efforts, the personalized service provided by our staff of highly trained
lending officers and our timely response to loan applications. Historically,
such customers have been willing to pay our origination fees and interest rates,
which are generally higher than those charged by traditional lending sources.
We market business purpose loans through various forms of advertising,
including large direct mail campaigns, our business loan web site and a direct
sales force and loan brokers, and have in the past used newspaper and radio
advertising. Our commissioned sales staff, which consists of full-time
salespersons, is responsible for converting advertising leads into loan
applications. We use a proprietary training program involving extensive and
on-going training of our lending officers. Our sales staff uses significant
person-to-person contact to convert advertising leads into loan applications and
maintains contact with the borrower throughout the application process. While we
intend to reduce the level of business purpose loans that we will originate
under our business strategy, we will continue to originate business purpose
loans to meet demand in the whole loan sale and securitization markets. See "--
Business Strategy" and "-- Lending Activities -- Business Purpose Loans."
Underwriting Procedures and Practices
Summarized below are some of the policies and practices which are
followed in connection with the origination of business purpose loans and home
equity loans. These policies and practices may be altered, amended and
supplemented, from time to time, as conditions warrant. We reserve the right to
make changes in our day-to-day practices and policies at any time.
Our loan underwriting standards are applied to evaluate prospective
borrowers' credit standing and repayment ability as well as the value and
adequacy of the mortgaged property as collateral. Initially, the prospective
borrower is required to provide pertinent credit information in order to
complete a detailed loan application. As part of the description of the
prospective borrower's financial condition, the borrower is required to provide
information concerning assets, liabilities, income, credit, employment history
and other demographic and personal information. If the application demonstrates
the prospective borrower's ability to repay the debt as well as sufficient
income and equity, loan processing personnel generally obtain and review an
independent credit bureau report on the credit history of the borrower and
verification of the borrower's income. Once all applicable employment, credit
and property information is obtained, a determination is made as to whether
sufficient unencumbered equity in the property exists and whether the
prospective borrower has sufficient monthly income available to meet the
prospective borrower's monthly obligations.
21
The following table outlines the key parameters of the major credit
grades of our current home equity loan underwriting guidelines. Home equity
loans represent approximately 90% of the loans we originate.
- ---------------------------------- ------------------------------- --------------------------------
"A" Credit Grade "B" Credit Grade
- ---------------------------------- ------------------------------- --------------------------------
General Repayment Has good credit but might have Pays the majority of accounts
some minor delinquency. on time but has some 30
and/or 60 day delinquency.
- ---------------------------------- ------------------------------- --------------------------------
Existing Mortgage Loans Current at application time Current at application time
and a maximum of two 30 day and a maximum of four 30 day
delinquencies in the past 12 delinquencies in the past 12
months. months.
- ---------------------------------- ------------------------------- --------------------------------
Non-Mortgage Credit Major credit and installment Major credit and installment
debt should be current but debt can exhibit some minor 30
may exhibit some minor 30 day and/or 60 day delinquency.
delinquency. Minor credit Minor credit may exhibit up to
may exhibit some minor 90 day delinquency.
delinquency.
- ---------------------------------- ------------------------------- --------------------------------
Bankruptcy Filings Discharged more than 2 years Discharged more than 2 years
with reestablished credit. with reestablished credit.
- ---------------------------------- ------------------------------- --------------------------------
Debt Service-to-Income Generally not to exceed 50%. Generally not to exceed 50%.
- ---------------------------------- ------------------------------- --------------------------------
Owner Occupied: Generally 80% to 90% for a Generally 80% to 85% for a 1-4
Loan-to-value ratio 1-4 family dwelling family dwelling residence; 80%
residence; 80% for a for a condominium.
condominium.
- ---------------------------------- ------------------------------- --------------------------------
Non-Owner Occupied: Generally 80% for a 1-4 Generally 70% for a 1-4 family
Loan-to-value ratio family dwelling or dwelling or condominium.
condominium.
- ---------------------------------- ------------------------------- --------------------------------
(a) Purchasers in the whole loan sale market generally do not accept "D" credit
grade loans. As a result, we will also originate "C-" credit grade loans, which
are substantially similar to "D" credit grade loans except that the acceptable
mortgage delinquency is limited to 90 days at time of loan closing.
22
The following table outlines the key parameters of the major credit
grades of our current home equity loan underwriting guidelines. Home equity
loans represent approximately 90% of the loans we originate.
- ---------------------------------- --------------------------------- ---------------------------------
"C" Credit Grade "D" Credit Grade (a)
- ---------------------------------- --------------------------------- ---------------------------------
Marginal credit history which is Designed to provide a borrower
General Repayment offset by other positive with poor credit history an
attributes. opportunity to correct past
credit problems through lower
monthly payments.
- ---------------------------------- --------------------------------- ---------------------------------
Existing Mortgage Loans Cannot exceed four 30 day Must be paid in full from loan
delinquencies and/or two 60 day proceeds and no more than 120
delinquencies in the past 12 days delinquent.
months.
- ---------------------------------- --------------------------------- ---------------------------------
Non-Mortgage Credit Major credit and installment Major and minor credit
debt can exhibit some minor 30 delinquency is acceptable, but
and/or 90 day delinquency. must demonstrate some payment
Minor credit may exhibit more regularity.
serious delinquency.
- ---------------------------------- --------------------------------- ---------------------------------
Bankruptcy Filings Discharged more than 1 year Discharged prior to closing or
with reestablished credit. payoff of bankruptcy debts with
proceeds.
- ---------------------------------- --------------------------------- ---------------------------------
Debt Service-to-Income Generally not to exceed 55%. Generally not to exceed 55%.
- ---------------------------------- --------------------------------- ---------------------------------
Owner Occupied: Generally 70% to 80% for a 1-4 Generally 60% to 65% for a 1-4
Loan-to-value ratio family dwelling residence; 70% family dwelling residence.
for a condominium.
- ---------------------------------- --------------------------------- ---------------------------------
Non-Owner Occupied: Generally 60% for a 1-4 family N/A
Loan-to-value ratio dwelling or condominium.
- ---------------------------------- --------------------------------- ---------------------------------
(a) Purchasers in the whole loan sale market generally do not accept "D" credit
grade loans. As a result, we will also originate "C-" credit grade loans, which
are substantially similar to "D" credit grade loans except that the acceptable
mortgage delinquency is limited to 90 days at time of loan closing.
23
In addition to the home equity loans we originate under the standard
home equity loan underwriting guidelines outlined in the preceding table, we
also originate a limited number of second mortgages that have loan-to-value
ratios ranging from 90% to 100%. We consider these loans to be high
loan-to-value home equity loans and we underwrite these loans with a more
restrictive approach to evaluating the borrowers' qualifications and we require
a stronger credit history than our standard guidelines. The borrowers' existing
mortgage and installment debt payments must generally be paid as agreed, with no
more than one 30-day delinquency on a mortgage within the last 12 months. No
bankruptcy or foreclosure is permitted in the last 36 months.
Pursuant to our business strategy, a greater number of loans that we
originate will be offered to the secondary market through whole loan sales.
These loans will be underwritten, allocated and sold to specific third party
purchasers based on agreed upon products and underwriting guidelines. The
purchaser products and guidelines currently being utilized generally conform to
key parameters outlined in the preceding table. See "-- Business Strategy."
Generally, business purpose loans are secured by residential real
estate and at times commercial real estate. Loan amounts generally range from
$14,000 to $685,000. The loan-to-value ratio (based solely on the appraised fair
market value of the real estate collateral securing the loan) on the properties
collateralizing the loans generally have a maximum range of 50% to 75%. The
actual maximum loan-to-value ratio varies depending on a variety of factors
including, the credit grade of the borrower, whether the collateral is a one to
four family residence, a condominium or a commercial property and whether the
property is owner occupied or non-owner occupied. The credit grade of a business
purpose loan borrower will vary depending on the payment history of their
existing mortgages, major lines of credit and minor lines of credit, allowing
for delinquency but generally requiring major credit to be current at closing.
The underwriting of the business purpose loan includes confirmation of income or
cash flow through tax returns, bank statements and other forms of proof of
income and business cash flow. Generally, we make loans to businesses whose
bankruptcy was discharged at least two years prior to closing, but we may make
exceptions to allow for the bankruptcy to be discharged just prior to or at
closing. In addition, we generally receive additional collateral in the form of,
among other things, personal guarantees, pledges of securities, assignments of
contract rights, assignments of life insurance and lease payments and liens on
business equipment and other business assets, as available. Based solely on the
value of the real estate collateral securing our business purpose loans, the
average loan-to-value ratio of business purpose loans we originated during the
fiscal year ended June 30, 2003 was 62.2% and during fiscal 2002 was 62.6%.
Generally, the maximum acceptable loan-to-value ratio for home equity
loans to be securitized is 100%. The average loan-to-value ratio of home equity
loans we originated during fiscal 2003 was 78.2% and during fiscal 2002 was
77.8%. We generally obtain title insurance in connection with our loans.
In determining whether the mortgaged property is adequate as
collateral, we have an appraisal performed for each property considered for
financing. The appraisal is completed by a licensed qualified appraiser on a
Fannie Mae form and generally includes pictures of comparable properties and
pictures of the property securing the loan.
24
Any material decline in real estate values reduces the ability of
borrowers to use home equity to support borrowings and increases the
loan-to-value ratios of loans previously made by us, thereby weakening
collateral coverage and increasing the possibility of a loss in the event of
borrower default. Further, delinquencies, foreclosures and losses generally
increase during economic slowdowns or recessions. As a result, we cannot assure
that the market value of the real estate underlying the loans will at any time
be equal to or in excess of the outstanding principal amount of those loans.
Although we have expanded the geographic area in which we originate loans, a
downturn in the economy generally or in a specific region of the country may
have an effect on our originations. See "Risk Factors -- A decline in value of
the collateral securing our loans could result in an increase in losses on
foreclosure, which could hinder our ability to attain profitable operations,
limit our ability to repay our subordinated debt and negatively impact the value
of our common stock."
Loan Servicing and Administrative Procedures
We service the loans we hold as available for sale or that we
securitize, in accordance with our established servicing procedures. Our
servicing procedures include practices regarding processing of mortgage
payments, processing of disbursements for tax and insurance payments,
maintenance of mortgage loan records, performance of collection efforts,
including disposition of delinquent loans, foreclosure activities and
disposition of real estate owned and performance of investor accounting and
reporting processes, which in general conform to the mortgage servicing
practices of prudent mortgage lending institutions. We generally receive
contractual servicing fees for our servicing responsibilities for securitized
loans, calculated as a percentage of the outstanding principal amount of the
loans serviced. In addition, we receive other ancillary fees related to the
loans serviced. Our servicing and collections activities are principally located
at our operating office in Bala Cynwyd, Pennsylvania, but we expect to relocate
these activities to our Philadelphia, Pennsylvania office. At June 30, 2003, the
total managed portfolio consisted of 44,538 loans with an aggregate outstanding
balance of $3.6 billion. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Reconciliation of Non-GAAP Financial
Measures" for a reconciliation of total managed portfolio to our balance sheet.
In servicing loans, we send an invoice to borrowers on a monthly basis
advising them of the required payment and its scheduled due date. We begin the
collection process promptly after a borrower fails to make a scheduled monthly
payment. When a loan becomes 45 to 60 days delinquent for a home equity loan or
90 days delinquent for a business purpose loan, it is transferred to a senior
collector in the collections department. The senior collector tries to resolve
the delinquency by reinstating a delinquent loan, seeking a payoff, or entering
into a deferment or forbearance arrangement with the borrower to avoid
foreclosure. All proposed arrangements are evaluated on a case-by-case basis,
based on, among other things, the borrower's past credit history, current
financial status, cooperativeness, future prospects and the reasons for the
delinquency. If a mortgage loan becomes 45 days delinquent and we do not reach a
satisfactory arrangement with the borrower, our legal department will mail a
notice of default to the borrower. If the delinquency is not cured within the
time period provided for in the loan documents, we generally start a foreclosure
action. The collection department maintains normal collection efforts during the
cure periods following a notice of default and the initiation of foreclosure
action. If a borrower declares bankruptcy, our in-house attorneys and paralegals
promptly act to protect our interests. We may initiate legal action earlier than
45 days following a delinquency if we determine that the circumstances warrant
such action.
25
We employ a staff of experienced mortgage collectors and managers
working in shifts seven days a week to manage delinquent loans. In addition, a
staff of in-house attorneys and paralegals works closely with the collections
staff to optimize collection efforts. The primary goal of our labor-intensive
collections program is to emphasize delinquency and loss prevention.
From time to time, borrowers are confronted with events, usually
involving hardship circumstances or temporary financial setbacks that adversely
affect their ability to continue payments on their loan. To assist borrowers, we
may agree to enter into a deferment or forbearance arrangement. Prevailing
economic conditions, which affect the borrower's ability to make their regular
payments, may also have an impact on the value of the real estate or other
collateral securing the loans, resulting in a change to the loan-to-value
ratios. We may take these conditions into account when we evaluate a borrower's
request for assistance for a relief from their financial hardship.
Our policies and practices regarding deferment and forbearance
arrangements, like all of our collections policies and practices, are designed
to manage customer relationships, maximize collections and avoid foreclosure (or
repossession of other collateral, as applicable) if reasonably possible. We
review and regularly revise these policies and procedures in order to enhance
their effectiveness in achieving these goals. We permit exceptions to the
policies and practices from time to time based on individual borrowers'
situations.
In a deferment arrangement, we make advances to a securitization trust
on behalf of the borrower in amounts equal to the delinquent loan payments,
which include principal and interest. Additionally, we may pay taxes, insurance
and other fees on behalf of the borrower. Based on our review of the borrower's
current financial circumstances, the borrower must repay the advances and other
payments and fees we make on borrower's behalf either at the termination of the
loan or on a monthly payment plan. Borrowers must provide a written explanation
of their hardship, which generally requests relief from their loan payments. We
review the borrower's current financial situation and based upon this review, we
may create a payment plan for the borrower which allows the borrower to pay past
due amounts over a period from 12 to 42 months, but not beyond the maturity date
of the loan, in addition to making regular monthly loan payments. Each deferment
arrangement must be approved by two of our managers. Deferment arrangements
which defer two or more past due payments must also be approved by a senior vice
president.
Principal guidelines currently applicable to the deferment process are:
(i) the borrower may have up to six payments deferred during the life of the
loan; (ii) no more than three payments may be deferred during a twelve-month
period; and (iii) the borrower must have made a minimum of six payments on the
loan and twelve months must have passed since the last deferment in order to
qualify for a new deferment arrangement. Any deferment arrangement which
includes an exception to our guidelines must be approved by the senior vice
president of collections and an executive vice president. If the deferment
arrangement is approved, a collector contacts the borrower regarding the
approval and the revised payment terms.
For borrowers who are two or more payments delinquent, we will consider
using a forbearance arrangement if permitted under applicable state law. In a
forbearance arrangement, we make advances to a securitization trust on behalf of
the borrower in amounts equal to the delinquent loan payments, which include
principal and interest. Additionally, we may pay taxes, insurance and other fees
on behalf of the borrower. We assess the borrower's current financial situation
and based upon this assessment, we may create a payment plan for the borrower
which generally allows the borrower to pay past due amounts over a longer period
than a typical deferment arrangement, but not beyond the maturity date of the
loan. We typically structure a forbearance arrangement to require the borrower
to make payments of principal and interest equivalent to the original loan terms
plus additional monthly payments, which in the aggregate represent the amount
that we advanced to the securitization trust and other fees we paid on behalf of
the borrower. We currently require the borrower to provide a written explanation
of their financial hardship, and we offer these arrangements to borrowers who we
believe have the ability to remit post-forbearance principal and interest
payments in addition to the amounts advanced or paid by us. As part of the
written forbearance agreement, the borrower must execute a deed in lieu of
foreclosure. If the borrower subsequently defaults before repaying the amount
due under the forbearance agreement in full and becomes 60 days delinquent on
principal and interest payments, we may elect to record the deed after providing
proper notification to the borrower and a reasonable period of time to cure.
Recording the deed in lieu of foreclosure gives us immediate legal title to the
property without the need for further legal action.
26
Principal guidelines currently applicable to the forbearance process
are: (i) the subject loan should be at least six months old; (ii) the loan
should be a minimum of three payments delinquent; and (iii) each forbearance
arrangement must be approved by a manager, the senior vice president of
collections and the senior vice president of asset allocation. Forbearance
arrangements which defer ten or more past due payments, involve advances or
other payments of more than $25,000 or include an exception to our guidelines
must also be approved by an executive vice president.
For delinquent borrowers with business purpose loans, we may enter into
written forbearance agreements pursuant to which we do not obtain a deed in lieu
of foreclosure. These arrangements typically allow the borrower to pay past due
amounts over a period of 12-36 months, but not beyond the maturity date of the
loan and generally require the borrower to make a payment at the time of
entering into a forbearance agreement.
We do not enter into a deferment or forbearance arrangement based
solely on the fact that a loan meets the criteria for one of the arrangements.
Our use of any of these arrangements depends upon one or more of the following
factors: our assessment of the individual borrower's current financial situation
and reasons for the delinquency, a valuation of the real estate securing the
loan and our view of prevailing economic conditions. Because deferment and
forbearance arrangements are account management tools which help us to manage
customer relationships, maximize collection opportunities and increase the value
of our account relationships, the application of these tools generally is
subject to constantly shifting complexities and variations in the marketplace.
We attempt to tailor the type and terms of the arrangement we use to the
borrower's circumstances, and we prefer to use deferment over forbearance
arrangements, if possible.
As a result of these arrangements, we reset the contractual status of a
loan in our managed portfolio from delinquent to current based upon the
borrower's resumption of making their loan payments. Generally, a loan remains
current after a deferment or forbearance arrangement with the borrower only if
the borrower makes the principal and interest payments as required under the
terms of the original note (exclusive of delinquent payments advanced or fees
paid by us on the borrower's behalf as part of the deferment or forbearance
arrangement), and we do not reflect it as a delinquent loan in our delinquency
statistics. However, if the borrower fails to make principal and interest
payments, the account will generally be declared in default and collection
actions resumed. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Managed Portfolio Quality -- Deferment
and Forbearance Arrangements" for information regarding the impact of these
arrangements on our operations. See also "Regulation -- Equal Credit Opportunity
Fair Credit Reporting and Other Laws" and "Risk Factors -- The inquiry regarding
our forbearance practices by the U.S. Attorney could result in concerns
regarding our loan servicing and limit our ability to sell or service our loans,
sell subordinated debt, or obtain additional credit facilities, which would
hinder our ability to operate profitably and repay our subordinated debt, which
could negatively impact the value of our common stock."
We believe we are among a small number of non-conforming mortgage
lenders that have an in-house legal staff dedicated to the collection of
delinquent loans and the handling of bankruptcy cases. As a result, we believe
our delinquent loans are reviewed from a legal perspective earlier in the
collection process than is the case with loans made by traditional lenders so
that troublesome legal issues can be noted and, if possible, resolved earlier.
Our in-house legal staff also attempts to find solutions for delinquent loans,
other than foreclosure.
Real estate acquired as a result of foreclosure or by deed in lieu of
foreclosure is classified as real estate owned until it is sold. When property
is acquired by foreclosure or deed in lieu of foreclosure, we record it at the
lower of cost or estimated fair value. After acquisition, all costs incurred in
maintaining the property are accounted for as expenses.
27
Most foreclosures are handled by outside counsel who are managed by our
in-house legal staff to ensure that the time period for handling foreclosures
meets or exceeds established industry standards. Frequent contact between
in-house and outside counsel ensures that the process moves quickly and
efficiently in an attempt to achieve a timely and economical resolution to
contested matters.
Our ability to foreclose on some properties may be affected by state
and federal environmental laws. The costs of investigation, remediation or
removal of hazardous substances may be substantial and can easily exceed the
value of the property. The presence of hazardous substances, or the failure to
properly eliminate the substances from the property, can hurt the owner's
ability to sell or rent the property and prevent the owner from using the
property as collateral for another loan. Even parties who arrange for the
disposal or treatment of hazardous or toxic substances may be liable for the
costs of removal and remediation, whether or not the facility is owned or
operated by the party who arranged for the disposal or treatment. See "Risk
Factors -- Environmental laws and regulations and other environmental
considerations may restrict our ability to foreclose on loans secured by real
estate or increase costs associated with those loans which could hinder our
ability to operate profitably and the funds available to repay our subordinated
debt and negatively impact the value of our common stock." The technical nature
of some laws and regulations, such as the Truth in Lending Act, can also
contribute to difficulties in foreclosing on real estate and other assets, as
even immaterial errors can trigger foreclosure delays or other difficulties.
As the servicer of securitized loans, we are obligated to advance funds
for scheduled interest payments that have not been received from the borrower
unless we determine that our advances will not be recoverable from subsequent
collections of the related loan payments. See "-- Securitizations" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Off-Balance Sheet Arrangements." We are also required to
compensate investors (without a right to reimbursement) for interest shortfall
resulting from loan prepayments up to the amount of our servicing fee. See "Risk
Factors -- Our securitization agreements impose obligations on us to make cash
outlays which could impair our ability to operate profitably and our ability to
repay the subordinated debt and negatively impact the value of our common
stock."
Securitizations
We were unable to complete our typical quarterly securitization during
the fourth quarter of fiscal 2003. Our inability to complete our typical
publicly underwritten securitization during the fourth quarter of fiscal 2003
was the result of our investment bankers' decision in late June 2003 not to
underwrite the contemplated June 2003 securitization transaction. Management
believes that a number of factors contributed to this decision, including a
highly-publicized lawsuit finding liability of an underwriter in connection with
the securitization of loans for another unaffiliated subprime lender, an inquiry
by the U.S. Attorney's Office in Philadelphia regarding our forbearance
practices, an anonymous letter regarding the Company received by one of our
investment bankers, the SEC's recent enforcement action against another
unaffiliated subprime lender related to its loan restructuring practices and
related disclosure, a federal regulatory agency investigation of practices by
another subprime servicer and our investment bankers' prior experience with
securitization transactions with non-affiliated originators.
28
During fiscal 2003, we securitized $112.0 million of business purpose
loans and $1.3 billion of home equity loans. During fiscal 2002, we securitized
$129.1 million of business purpose loans and $1.2 billion of home equity loans.
During fiscal 2001, we securitized $109.9 million of business purpose loans and
$992.2 million of home equity loans. The securitization of loans generated gains
on sale of loans of $171.0 million during fiscal 2003, $185.6 million during
fiscal 2002 and $129.0 million during fiscal 2001. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Off-Balance
Sheet Arrangements -- Securitizations" for additional information regarding our
securitizations.
Securitization is a financing technique often used by originators of
financial assets to raise capital. A securitization involves the sale of a pool
of financial assets, in our case loans, to a trust in exchange for cash and a
retained interest in the securitized loans which is called an interest-only
strip. The trust issues multi-class securities which derive their cash flows
from a pool of securitized loans. These securities, which are senior to our
retained interest-only strips in the trust, are sold to public or private
investors. We also retain servicing on securitized loans. See "-- Loan Servicing
and Administrative Procedures"
As the holder of the interest-only strips received in a securitization,
we are entitled to receive excess (or residual) cash flows. These cash flows are
the difference between the payments made by the borrowers on securitized loans
and the sum of the scheduled and prepaid principal and pass-through interest
paid to trust investors, servicing fees, trustee fees and, if applicable, surety
fees. Surety fees are paid to an unrelated insurance entity to provide
protection for the trust investors. These cash flows also include cash flows
from overcollateralization. Overcollateralization is the excess of the aggregate
principal balances of loans in a securitized pool over investor interests.
Overcollateralization requirements are established to provide credit enhancement
for the trust investors.
We may be required either to repurchase or to substitute loans which do
not conform to the representations and warranties we made in the agreements
entered into when the loans are sold through a securitization. As of June 30,
2003, we have been required to substitute only one such loan from the
securitization trusts for this reason.
When borrowers are delinquent in making scheduled payments on loans
included in a securitization trust, we are obligated to advance interest
payments with respect to such delinquent loans if we deem that these advances
will ultimately be recoverable. These advances can first be made out of funds
available in the trust's collection account. If the funds available from the
collection account are insufficient to make the required interest advances, then
we are required to make the advances from our operating cash. The advances made
from a trust's collection account, if not recovered from the borrower or
proceeds from the liquidation of the loan, require reimbursement from us. These
advances may require funding from our capital resources and may create greater
demands on our cash flow than either selling loans with servicing released or
maintaining a portfolio of loans on our balance sheet. However, any advances we
make from our operating cash can be recovered from the subsequent mortgage loan
payments to the applicable trust prior to any distributions to the certificate
holders. See "Risk Factors -- Our securitization agreements impose obligations
on us to make cash outlays which could impair our ability to operate profitably
and our ability to repay the subordinated debt and negatively impact the value
of our common stock."
29
At times we elect to repurchase some delinquent loans from the
securitization trusts, some of which may be in foreclosure. Repurchasing loans
benefits us by allowing us to limit the level of delinquencies and losses in the
securitization trusts and as a result, we can avoid exceeding specified limits
on delinquencies and losses that trigger a temporary reduction or
discontinuation of residual or stepdown overcollateralization cash flows from
our interest-only strips until the delinquencies or losses no longer exceed the
triggers. We have the right, but are not obligated, to repurchase a limited
amount of delinquent loans from securitization trusts. The purchase price of a
delinquent loan is at the loan's outstanding contractual balance plus accrued
and unpaid interest and unreimbursed servicing advances, however unpaid interest
and unreimbursed servicing advances are returned to us by the trust. A
foreclosed loan is one where we, as servicer, have initiated formal foreclosure
proceedings against the borrower and a delinquent loan is one that is 31 days or
more past due. The foreclosed and delinquent loans we typically elect to
repurchase are usually 90 days or more delinquent and the subject of foreclosure
proceedings, or where a completed foreclosure is imminent. In addition, we elect
to repurchase loans in situations requiring more flexibility for the
administration and collection of these loans in order to maximize their economic
recovery. See "Risk Factors -- Our securitization agreements impose obligations
on us to make cash outlays which could impair our ability to operate profitably
and our ability to repay the subordinated debt and negatively impact the value
of our common stock." See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Off-Balance Sheet Arrangements -- Trigger
Management" for a description of the impact of these repurchases on our
business.
Our securitizations can include a prefunding option where a portion of
the cash received from investors is withheld until additional loans are
transferred to the trust. The loans to be transferred to the trust to satisfy
the prefund option must be substantially similar in terms of collateral, size,
term, interest rate, geographic distribution and loan-to-value ratio as the
loans initially transferred to the trust. We had no prefund obligations at June
30, 2003.
Whole Loan Sales
Our determination to engage in whole loan sales depends upon a variety
of factors, including market conditions in the securitization markets and the
secondary loan markets, profitability and cash flow considerations. In recent
years, we experienced a decrease in our whole loan sales as a result of our
decision to emphasize the securitization of additional loans, due to the
favorable conditions we experienced in the securitization markets during those
years and, to a lesser extent, our decision to de-emphasize conventional first
mortgage loans which we primarily sold on a whole loan basis. Due to our
inability to complete our typical quarterly securitization during the fourth
quarter of fiscal 2003, we adjusted our business strategy from a predominantly
publicly underwritten securitization strategy to a strategy focused on a
combination of whole loan sales and securitizations. See "-- Business Strategy."
In whole loan sale transactions, the gain on sale is generally significantly
lower than the gains realized in securitization transactions, but we receive the
gain in cash. Whole loan sales enable us to immediately generate cash flow,
protect against the potential volatility of the securitization market and reduce
the risks inherent in retaining securitization assets. However, unlike
securitizations, where we retain the servicing rights and receive securitization
assets in the form of interest-only strips which generate future cash flows,
whole loan sales are typically structured as a sale with servicing rights
released and do not result in our receipt of securitization assets. As a result,
using whole loan sales more extensively in the future will reduce our income
from servicing activities and limit the amount of securitization assets created.
30
Competition
We have significant competition for home equity loans. We concentrate
our marketing efforts for home equity loans on credit-impaired borrowers.
Through Upland Mortgage and American Business Mortgage Services, Inc., we
compete with banks, thrift institutions, mortgage bankers and other finance
companies, which may have greater resources and name recognition. We attempt to
mitigate these factors through a highly trained staff of professionals, rapid
response to prospective borrowers' requests and by maintaining a relatively
short average loan processing time. See "-- Business Strategy" for discussion of
our emphasis on broadening our mortgage loan product line and offering
competitive interest rates. In addition, we implemented our Bank Alliance
Services program in order to generate additional loan volume. See "Risk Factors
- -- Competition from other lenders could adversely affect our ability to attain
profitable operations and our ability to repay our subordinated debt and
negatively impact the value of our common stock."
We compete for business purpose loans against many other finance
companies and financial institutions. Although many other entities originate
business purpose loans, we have focused our lending efforts on our niche market
of businesses which may qualify for loans from traditional lending sources but
who we believe are attracted to our products as a result of our marketing
efforts, responsive customer service and rapid processing and closing periods.
Regulation
General. Our business is regulated by federal, state and, in certain
cases, local laws. All home equity loans must meet the requirements of, among
other statutes and regulations, the Truth in Lending Act, the Real Estate
Settlement Procedures Act, the Equal Credit Opportunity Act of 1974, and their
associated Regulations Z, X and B, respectively.
Truth in Lending. The Truth in Lending Act and Regulation Z contain
disclosure requirements designed to provide consumers with uniform,
understandable information about the terms and conditions of loans and credit
transactions so that consumers may compare credit terms. The Truth in Lending
Act also guarantees consumers a three-day right to cancel certain transactions
described in the act and imposes specific loan feature restrictions on some
loans, including some of the same types of loans originated by us. If we were
found not to be in compliance with the Truth in Lending Act, some aggrieved
borrowers could, depending on the nature of the non-compliance, have the right
to recover actual damages, statutory damages, penalties, rescind their loans
and/or to demand, among other things, the return of finance charges and fees
paid to us and third parties. Other fines and penalties can also be imposed
under the Truth in Lending Act and Regulation Z.
Equal Credit Opportunity, Fair Credit Reporting Act and Other Laws. We
are also required to comply with the Equal Credit Opportunity Act and Regulation
B, which prohibit creditors from discriminating against app