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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended June 30, 2004
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to ________________
Commission file number 000-22474
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
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(Exact name of registrant as specified in its charter)
Delaware 87-0418807
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 Penn Square East, Philadelphia, PA 19107
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(Address of principal executive offices) (Zip Code)
(215) 940-4000
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.001 per share
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(Title of class)
Series A Convertible Preferred Stock, par value $.001 per share
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(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [X] YES [ ] NO
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). [ ] YES [X] NO
The aggregate market value of the registrant's common stock, par value
$.001 per share, held by non-affiliates of the registrant based on the price at
which the common stock was last sold as of the last business day of the
registrant's most recently completed second fiscal quarter was $5.8 million.
The number of shares outstanding of the registrant's sole class of
common stock as of September 30, 2004, the latest practicable date before the
filing of this Form 10-K, was 3,598,342 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the registrant's definitive proxy statement, in
connection with its 2004 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days after June 30, 2004, are
incorporated by reference into Part III of this Annual Report on Form 10-K.
2
PART I
ITEM 1. BUSINESS
FORWARD LOOKING STATEMENTS
Some of the information in this Annual Report on Form 10-K may contain
forward-looking statements. You can identify these statements by words or
phrases such as "will likely result," "may," "are expected to," "will continue
to," "is anticipated," "estimate," "believe," "projected," "intends to" or other
similar words. These forward-looking statements regarding our business and
prospects are based upon numerous assumptions about future conditions, which may
ultimately prove to be inaccurate. Actual events and results may materially
differ from anticipated results described in those statements. Forward-looking
statements involve risks and uncertainties described under "Risk Factors" as
well as other portions of this Annual Report on Form 10-K, which could cause our
actual results to differ materially from historical earnings and those presently
anticipated. When considering forward-looking statements, you should keep these
risk factors in mind as well as the other cautionary statements in this Form
10-K. You should not place undue reliance on any forward-looking statement.
GENERAL INFORMATION REGARDING OUR BUSINESS
American Business Financial Services, Inc. is a financial services
organization operating mainly in the eastern and central portions of the United
States. Recent expansion has positioned us to increase our operations in the
western portion of the United States, especially California. Through our
principal direct and indirect subsidiaries, we currently originate, sell and
service home equity and purchase money mortgage loans, to which we refer as home
mortgage loans, secured by first or second mortgages on one-to-four family
residences, which may not satisfy the eligibility requirements of Fannie Mae,
Freddie Mac or similar buyers and which we refer to in this document as home
mortgage loans. During fiscal 2004, 89.9% of loans originated by us were secured
by first mortgages and 10.1% of loans originated by us were secured by second
mortgages. See "-- Lending Activities -- Home Mortgage Loans" for a description
of our home mortgage loan lending activities.
Additionally, we service loans to businesses secured by real estate and
other business assets that we had originated and sold in prior periods, which we
refer to in this document as business purpose loans. To the extent we obtain a
credit facility to fund business purpose loans, we may originate and sell
business purpose loans in future periods.
Our customers are primarily credit-impaired borrowers who are generally
unable to obtain financing from banks or savings and loan associations and who
are attracted to our products and services. This type of borrower is commonly
referred to as a subprime borrower. Loans made to subprime borrowers are
frequently referred to as subprime loans. Financial institutions utilize a
credit rating system referred to as a FICO score to evaluate the
creditworthiness of borrowers and as a means to establish their risk associated
with lending to a particular borrower. The higher the FICO score, which can
range from 300 to 850, the more creditworthy the borrower is. Generally,
borrowers with FICO scores of 720 to 850 would receive the most favorable
interest rates. During fiscal 2004, the average FICO score of our subprime home
mortgage borrowers was 623. According to Standard & Poor's, subprime lenders
issued securitized transactions with mixed collateral (fixed and adjustable rate
mortgage loans) with a range of average FICO scores between 584 and 642 during
the second quarter of calendar 2004.
3
We originate loans through a combination of channels including a
national processing center located at our centralized operating office in
Philadelphia, Pennsylvania, and a network of mortgage brokers. During fiscal
2004, we acquired broker operations in West Hills, California and Austin, Texas,
and opened new offices in Edgewater, Maryland and Irvine, California to support
our broker operations. We also process and purchase home mortgage loans through
our Bank Alliance Services program. Through this program, we purchase home
mortgage loans from other financial institutions and hold these loans as
available for sale until they are sold in a whole loan sale or in connection
with a future securitization. Our loan servicing and collection activities were
performed at our Bala Cynwyd, Pennsylvania office, and were relocated to our
Philadelphia office on July 12, 2004. See "-- Lending Activities."
We were incorporated in Delaware in 1985 and began operations as a
finance company in 1988, initially offering business purpose loans to customers
whose borrowing needs we believed were not being adequately serviced by
commercial banks. Since our inception, we have significantly expanded our
product line and geographic scope and currently have licenses or are otherwise
qualified to offer our home mortgage loan products in 46 states.
Our business strategy has generally involved the sale of substantially
all of the loans we originate through a combination of loan sales with servicing
released, which we refer to as whole loan sales, and securitizations. Our
determination as to whether to dispose of loans through securitizations or whole
loan sales depends on a variety of factors including market conditions,
profitability and cash flow considerations. From 1995 through the fourth quarter
of fiscal 2003, we have elected to utilize securitization transactions
extensively due to the favorable conditions we experienced in the securitization
markets. We generally realized higher gain on sale in our securitization
transactions than on whole loan sales for cash. In whole loan sale transactions,
the gain on sale is generally significantly lower than the gains realized in
securitization transactions, but we receive the gain in cash. Due to our
inability to securitize our loans in the fourth quarter of fiscal 2003, we
adjusted our business strategy to emphasize more whole loan sales. The use of
whole loan sales enables us to more rapidly generate cash flow, protect against
volatility in the securitization markets and reduce risks inherent in retaining
an interest in the securitized loans. However, unlike securitizations, where we
may retain the right to service the loans we sell for a fee, which we refer to
as servicing rights, whole loan sales are typically structured as a sale with
servicing rights released and do not result in our receipt of interest-only
strips. As a result, using whole loan sales more extensively in the future will
reduce our income from servicing activities and limit the amount of
securitization assets created. Of the $982.7 million of loans originated by us
in fiscal 2004, at June 30, 2004, approximately 10% of these loans were
securitized, approximately 60% of these loans were sold in whole loan sales with
servicing released and the remainder were on our balance sheet at June 30, 2004
as available for sale pending future sale. We do not intend to hold any of these
loans on our balance sheet permanently. See "-- Recent Developments,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Whole Loan Sales" and "-- Whole Loan Sales."
When we securitize loans originated by our subsidiaries, we may retain
interests in the securitized loans in the form of interest-only strips and
servicing rights, which we refer to as our securitization assets. A
securitization is a financing technique often used by originators of financial
assets to raise capital. A securitization involves the transfer of a pool of
financial assets, in our case, loans, to a trust in exchange for certificates,
notes or other securities issued by the trust and representing an undivided
interest in the trust assets. The transfer to the trust involves a sale and
pledge of the financial assets, as well as providing representations and
warranties regarding these transferred assets, depending on the particular
transaction. Next, the trust sells a portion of the certificates, notes or other
securities to investors for cash. Often the originator of the loans retains the
servicing rights and may also retain an interest in the cash flows generated by
the securitized loans which is subordinate to the interest represented by the
notes or certificates sold to investors in the securitizations. This interest in
the cash flows generated by the securitized loans is called an interest-only
strip. See "-- Securitizations" and "-- Loan Servicing and Administrative
Procedures" for further information.
4
Loans and leases in which we have interests, either because the loans
and leases are on our balance sheet or sold into securitizations in which we
have retained interests, are referred to as our total portfolio. The managed
portfolio includes loans held as available for sale on our balance sheet and
loans serviced for others.
In addition to other sources, we fund our operations with subordinated
debentures that we offer from our principal operating office located in
Philadelphia, Pennsylvania. We offer these debentures without the assistance of
an underwriter or dealer. At June 30, 2004, we had $522.6 million in
subordinated debentures outstanding which included investment notes and
uninsured money market notes. These debentures had a weighted-average interest
rate of 9.91% and a weighted-average remaining maturity of 13.5 months. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
Our principal corporate office is located at 103 Springer Building,
3411 Silverside Road, Wilmington, Delaware 19810. The telephone number at that
address is (302) 478-6160. Our principal operating office is located at The
Wanamaker Building, 100 Penn Square East, Philadelphia, Pennsylvania 19107. The
telephone number at the Philadelphia office is (215) 940-4000. We maintain a web
site on the World Wide Web at www.abfsonline.com. The information on our web
site is not and should not be considered part of this document and is not
incorporated into this prospectus by reference. This web site is only intended
to be an inactive textual reference.
RECENT DEVELOPMENTS
EXCHANGE OFFERS. On December 1, 2003, we mailed the Offer to Exchange,
referred to as the first exchange offer in this document, to holders of our
subordinated debentures issued prior to April 1, 2003. On May 14, 2004, we
mailed a second exchange offer, referred to as the second exchange offer in this
document, to holders of our subordinated debentures issued prior to November 1,
2003. The first exchange offer and the second exchange offer are collectively
referred to as the exchange offers in this document. Pursuant to the terms of
the exchange offers, eligible holders of subordinated debentures had the ability
to exchange their debentures for (i) equal amounts of senior collateralized
subordinated notes and shares of 10.0% Series A convertible preferred stock
referred to as Series A preferred stock in this document; and/or (ii)
dollar-for-dollar for shares of Series A preferred stock. Pursuant to the terms
of the first exchange offer, we exchanged $117.2 million of subordinated
debentures for 61.8 million shares of Series A preferred stock and $55.4 million
of senior collateralized subordinated notes. As a result of the second exchange
offer, we exchanged $91.4 million of subordinated debentures for 47.6 million
shares of Series A preferred stock and $43.8 million of senior collateralized
subordinated notes. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Overview -- Exchange Offers" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources -- Subordinated Debentures" for a
more detailed discussion of the exchange offers.
Depending on market conditions and our financial condition, we may
engage in additional exchange offers in the future and we are considering
another exchange offer in our second quarter of fiscal 2005. See "Risk Factors
- -- We may issue additional preferred stock which could be entitled to dividends,
liquidation preferences and other special rights and preferences not shared by
holders of our common stock or which could have anti-takeover effects."
OUR RECENT FINANCIAL DIFFICULTIES AND LIQUIDITY CONCERNS. Several
events and issues, which occurred beginning in the fourth quarter of fiscal
2003, have negatively impacted our short-term liquidity and contributed to our
losses for fiscal 2003 and fiscal 2004. These events included our inability to
complete publicly underwritten securitizations during the fourth quarter of
fiscal 2003 and all of fiscal 2004 (we completed a privately-placed
securitization in the second quarter of fiscal 2004), our inability to draw down
upon and the expiration of several of our credit facilities, and our temporary
discontinuation of sales of new subordinated debentures for approximately a
six-week period during the first quarter of fiscal 2004. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Overview" for information regarding our continued inability to complete
publicly underwritten securitizations.
5
As a result of these liquidity issues our loan origination volume
during fiscal 2004 was substantially reduced. From July 1, 2003 through June 30,
2004, we originated $982.7 million of loans, as compared to originations of
$1.67 billion of loans for the same period in fiscal 2003. We anticipate that
depending upon the size of our future quarterly securitizations, if any, we will
need to increase our loan originations to approximately $400.0 million to $500.0
million per month to return to profitable operations. If we are unable to
complete quarterly securitizations, we will need to increase our loan
originations to approximately $550.0 million to $650.0 million per month to
return to profitability. Our ability to achieve the levels of loan originations
necessary to achieve profitable operations could be hampered by our failure to
continue to successfully implement our adjusted business strategy, funding
limitations under existing credit facilities and our ability to obtain new
credit facilities and renew existing facilities. Our plan is to increase loan
originations through the continued application of our business strategy
adjustments, particularly as related to building our expanded broker channel and
offering adjustable rate mortgages, purchase money mortgages and more
competitively priced fixed rate mortgages. See "-- Business Strategy" for a
discussion of our plans to achieve this level of originations. For a detailed
discussion of our losses, capital resources and commitments, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
On June 30, 2004, we had unrestricted cash of approximately $0.9
million and up to $210.4 million available under our warehouse credit
facilities. We can only use advances under these credit facilities to fund loan
originations and not for any other purposes. The combination of our current cash
position and expected sources of operating cash may not be sufficient to cover
our operating cash requirements.
6
For the next six to twelve months, we intend to augment our sources of
operating cash with proceeds from the issuance of subordinated debentures. In
addition to repaying maturing subordinated debentures, proceeds from the
issuance of subordinated debentures may be used to fund overcollateralization
requirements, as defined below, in connection with our loan originations and to
fund our operating losses. Under the terms of our credit facilities, our credit
facilities will advance us 75% to 97% of the value of loans we originate. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources" for a discussion of the terms of
our credit facilities. As a result of this limitation, we must fund the
difference between the loan value and the advances, which we refer to as the
overcollateralization requirement, from our operating cash. We can provide no
assurances that we will be able to continue issuing subordinated debentures.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources -- Remedial Steps Taken
to Address Liquidity Issues" for a discussion of the specific actions we
undertook to address liquidity concerns.
RECENT OPERATING LOSSES AND SALE OF ASSETS. We incurred a net loss
attributable to common stock of $115.1 million and $29.9 million for the fiscal
years ended June 30, 2004 and 2003, respectively. In addition, depending on our
ability to recognize gains on our future securitizations, we anticipate
incurring operating losses at least through the first quarter of fiscal 2005.
The loss for fiscal 2004 primarily resulted from liquidity issues we
have experienced since the fourth quarter of fiscal 2003, including the absence
of credit facilities until the second quarter of fiscal 2004, which
substantially reduced our loan origination volume and our ability to generate
revenues, our inability to complete a publicly underwritten securitization
during fiscal 2004, our shift in business strategy to focus on whole loan sales,
and charges to the income statement of $46.4 million for pre-tax valuation
adjustments on our securitization assets. Additionally, operating expense levels
that would support greater loan origination volume also contributed to the loss
for fiscal 2004.
During fiscal 2004, we recorded total pre-tax valuation adjustments on
our interest-only strips and servicing rights of $63.8 million, of which $46.4
million was charged as expense to the income statement and $17.4 million was
charged to other comprehensive income, a component of stockholders' equity. The
fiscal 2004 adjustments primarily reflect the impact of higher than anticipated
prepayments on securitized loans experienced in fiscal 2004 due to the low
interest rate environment experienced during fiscal 2004. Additionally, the
fiscal 2004 valuation adjustment also includes a write down of $5.4 million of
the carrying value of our interest-only strips and servicing rights related to
five of our mortgage securitization trusts to reflect their values under the
terms of a September 27, 2004 sale agreement. The sale of these assets was
undertaken to raise cash to pay fees on new warehouse credit facilities and as a
result, we did not realize their full value as reflected on our books. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Application of Critical Accounting Estimates - Interest-Only
Strips" for a discussion of how valuation adjustments are recorded.
AMOUNT OF OUR INDEBTEDNESS. At June 30, 2004, we had total
indebtedness of approximately $847.4 million, comprised of amounts outstanding
under our credit facilities, senior collateralized subordinated notes issued in
the exchange offers, capitalized leases and subordinated debentures. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" for a comparison at June 30, 2004
of our secured and unsecured obligations to assets which were available to repay
those obligations.
7
BUSINESS STRATEGY ADJUSTMENTS. In response to our inability to
securitize and liquidity issues described above, we adjusted our business
strategy at the beginning of fiscal 2004 to shift from gain-on-sale accounting
and the use of securitization transactions as our primary method of selling
loans to a more diversified strategy which utilizes a combination of whole loan
sales and securitizations, while protecting revenues, controlling costs and
improving liquidity. See "-- Business Strategy."
If we fail to generate sufficient liquidity through the sales of our
loans, the sale of our subordinated debentures, the maintenance of credit
facilities or a combination of the foregoing, we will have to restrict loan
originations and make additional changes to our business strategy, including
restricting or restructuring our operations which could result in losses and
impair our ability to repay our subordinated debentures and other outstanding
debt. While we currently believe that we will be able to restructure our
operations, if necessary, we cannot assure you that such restructuring will
enable us to attain profitable operations or repay the subordinated debentures
when due. If we fail to successfully implement our adjusted business strategy,
we will be required to consider other alternatives, including raising additional
equity, seeking to convert an additional portion of our subordinated debentures
to equity, seeking protection under federal bankruptcy laws, seeking a strategic
investor, or exploring a sale of the company or some or all of its assets. See
"Risk Factors -- We depend upon the availability of financing to fund our
continuing operations. Any failure to obtain adequate funding could hurt our
ability to operate profitably, restrict our ability to repay our outstanding
debt, and negatively impact the value of our capital stock" and "-- If we are
unable to obtain additional financing, we may not be able to restructure our
business to permit profitable operations or repay our outstanding debt and the
value of our capital stock will be negatively impacted."
In addition to these restrictions and changes to our business strategy
in the event we are unable to offer additional subordinated debentures for any
reason, we have developed a contingent financial restructuring plan including
cash flow projections for the next twelve-month period. Based on our current
cash flow projections, we anticipate being able to make all scheduled
subordinated debenture maturities and vendor payments.
The contingent financial restructuring plan is based on actions that we
would take, in addition to those indicated in our adjusted business strategy, to
reduce our operating expenses and conserve cash. These actions would include
reducing capital expenditures, selling all loans originated on a whole loan
basis, eliminating or downsizing various lending, overhead and support groups,
and obtaining working capital funding. No assurance can be given that we will be
able to successfully implement the contingent financial restructuring plan, if
necessary, and repay the outstanding debt when due. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources -- Remedial Steps Taken to Address Liquidity Issues."
CREDIT FACILITIES, SERVICING AGREEMENTS AND WAIVERS RELATED TO
FINANCIAL COVENANTS. At various times since June 30, 2003, we have been out of
compliance with one or more financial covenants contained in our $200.0 million
credit facility (reduced to $100.0 million on September 30, 2004). We have
continued to operate on the basis of waivers granted by the lender under this
facility. We currently anticipate that we will be out of compliance with one or
more of these financial covenants at October 31, 2004 and will need a waiver
from this lender for this noncompliance to continue to operate. The expiration
date of this facility was originally September 21, 2004, but the lender agreed
to extend the expiration date until November 5, 2004 in consideration for, among
other things, a reduction in the amount that could be borrowed under this
facility to $100.0 million.
8
At various times since June 30, 2003 we have also been out of
compliance with the net worth requirement in several of our pooling and
servicing agreements and sale and servicing agreements (collectively referred to
in this document as the servicing agreements) and have been required to obtain
waivers from and amendments to these agreements. As a result of the amendments
to our servicing agreements, all of our servicing agreements associated with
bond insurers now provide for term-to-term servicing and, in the case of our
servicing agreements with two bond insurers, our rights as servicer may be
terminated at the expiration of a servicing term in the sole discretion of the
bond insurer.
We cannot assure you that we will continue to receive the waivers and
servicing agreement extensions that we need to operate or that they will not
contain conditions that are unacceptable to us. Because we anticipate incurring
losses through at least the first quarter of fiscal 2005, we anticipate that we
will need to obtain additional waivers from our lenders and bond insurers as a
result of our non-compliance with financial covenants contained in our credit
facilities and servicing agreements. To the extent we are not able to obtain
waivers under our credit facilities, we may be unable to pay dividends on the
Series A preferred stock. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" for
additional information regarding the waivers obtained. See also "Risk Factors --
Restrictive covenants in the agreements governing our indebtedness may reduce
our operating flexibility and limit our ability to operate profitability, and
our ability to repay our outstanding debt may be impaired and the value of our
capital stock could be negatively impacted" and " -- Our servicing rights may be
terminated if we fail to satisfactorily perform our servicing obligations, or
fail to meet minimum net worth requirements or financial covenants which could
hinder our ability to operate profitably, impair our ability to repay our
outstanding debt and negatively impact the value of our capital stock."
9
SECURITIES CLASS ACTION LAWSUITS AND SHAREHOLDER DERIVATIVE ACTION. In
January and February of 2004, four class action lawsuits were filed against us
and certain of our officers and directors. A consolidated amended class action
complaint that supersedes these four complaints was filed on August 19, 2004 in
the United States District Court for the Eastern District of Pennsylvania. The
consolidated complaint alleges that, during the applicable class period, our
forbearance and deferment practices enabled us to, among other things, lower our
delinquency rates to facilitate the securitization of our loans which
purportedly allowed us to collect interest income from our securitized loans and
inflate our financial results and market price of our common stock. The
consolidated amended class action complaint seeks unspecified compensatory
damages, costs and expenses related to bringing the action, and other
unspecified relief.
On March 15, 2004, a shareholder derivative action was filed against
us, as a nominal defendant, and our director and Chief Executive Officer,
Anthony Santilli, our Chief Financial Officer, Albert Mandia, our directors,
Messrs. Becker, DeLuca and Sussman, and our former director Mr. Kaufman, as
defendants, in the United States District Court for the Eastern District of
Pennsylvania and alleges that the named directors and officers breached their
fiduciary duties to the Company, engaged in the abuse of control, gross
mismanagement and other violations of law. The lawsuit seeks unspecified
compensatory damages, equitable or injunctive relief and costs and expenses
related to bringing the action, and other unspecified relief. The parties have
agreed to stay this case pending disposition of any motion to dismiss the
consolidated amended complaint filed in the putative consolidated securities
class action. See "Legal Proceedings" and "Risk Factors -- We are subject to
private litigation, including lawsuits resulting from the alleged "predatory"
lending practices, as well as securities class action and derivative lawsuits,
the impact of which on our financial position is uncertain. The inherent
uncertainty related to litigation of this type and the preliminary stage of
these suits makes it difficult to predict the ultimate outcome or potential
liability that we may incur as a result of these matters."
WHERE YOU CAN GET ADDITIONAL INFORMATION
We file annual, quarterly and current reports, proxy statements and
other information with the SEC. You may read and copy our reports or other
filings made with the SEC at the SEC's Public Reference Room, located at 450
Fifth Street, N.W., Washington, DC 20549. You can obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. You
can also access these reports and other filings electronically on the SEC's web
site, www.sec.gov.
We also make these reports and other filings available free of charge
on our web site, www.abfsonline.com, as soon as reasonably practicable after
filing with the SEC. We will provide, at no cost, paper or electronic copies of
our reports and other filings made with the SEC. Requests should be directed to:
Stephen M. Giroux, Esquire
American Business Financial Services, Inc.
100 Penn Square East
Philadelphia, PA 19107
(215) 940-4000
The information on the web sites listed above, is not and should not be
considered part of this Annual Report on Form 10-K and is not incorporated by
reference in this document. These web sites are and are only intended to be
inactive textual references.
10
BUSINESS STRATEGY
Our adjusted business strategy focuses on a shift from gain-on-sale
accounting and the use of securitization transactions as our primary method of
selling loans to a more diversified strategy which utilizes a combination of
whole loan sales and securitizations, while protecting revenues, controlling
costs and improving liquidity.
Our adjusted business strategy involves significantly increasing the
use of loan brokers to increase loan origination volume and retaining and hiring
senior officers to manage the broker program. In December 2003, we hired an
experienced industry professional who manages our wholesale business and
acquired a broker operation with 35 employees (67 employees at June 30, 2004)
located in California. In March 2004, we opened a mortgage broker office in
Maryland and hired three experienced senior managers and a loan origination
staff of 40 (56 employees at June 30, 2004). In June 2004, we acquired a broker
operation with 35 employees in Texas. In addition, we hired 25 account
executives to develop relationships with mortgage brokers and to expand our
broker presence in the eastern, southern and mid-western areas of the United
States and retained 67 employees in our Upland Broker Services Philadelphia
headquarters to support our growing broker network. In total at June 30, 2004,
we had 285 employees in our broker operations, including 136 account executives.
Our business strategy includes the following:
o Selling substantially all of the loans we originate through a
combination of whole loan sales and securitizations. Whole loan
sales are generally completed on a weekly basis.
o Shifting from a predominantly publicly underwritten securitization
strategy and gain-on-sale business model to a strategy focused on a
combination of whole loan sales and smaller securitization
transactions. When securitization opportunities are available to us,
the size of our quarterly loan securitizations will be reduced from
previous levels. We expect to execute our securitizations, if any,
as private placements to institutional investors or publicly
underwritten securitizations, subject to market conditions.
Historically, the market for whole loan sales has provided reliable
liquidity for numerous originators as an alternative to
securitization. Whole loan sales provide immediate cash premiums to
us, while securitizations generate cash over time but generally
result in higher gains at the time of sale. We intend to rely less
on gain-on-sale accounting and loan servicing activities for our
revenue and earnings and will rely more on cash premiums earned on
whole loan sales. This strategy is expected to result in relatively
lower earnings levels at current loan origination volumes, but will
increase cash flow, accelerate the timeframe for becoming cash flow
positive and improve our liquidity position. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" for more detail on
cash flow.
o Broadening our mortgage loan product line and increasing loan
originations. Historically we have originated primarily fixed-rate
home equity loans. Under our business strategy, we originate
adjustable-rate, alt-A and alt-B mortgage loans which have higher
credit scores as well as a wide array of fixed-rate and adjustable
rate mortgage loans in order to appeal to a broader base of
prospective customers and increase loan originations. During the
three months ended June 30, 2004, 46.7% of the loans which we
originated were adjustable-rate mortgage loans. We have also begun
to originate purchase money mortgage loans primarily through our
broker channel. In fiscal 2004, we originated $176.9 million of
purchase money mortgages, or 18.0% of total home mortgage loans
originated.
11
o Offering more competitive interest rates charged to borrowers on new
products. By offering more competitive interest rates charged on new
products, we originate loans to borrowers with higher credit
quality. In addition, by offering more competitive interest rates
our loans appeal to a wider customer base which we expect will
substantially reduce our marketing costs, make more efficient use of
marketing leads and increase loan origination volume.
o Reducing origination of the types of loans that are not well
received in the whole loan sale and securitization markets. During
fiscal 2004, we originated only $587,000 of business purpose loans.
In the future, we may originate business purpose loans to meet
demand in the whole loan sale and securitization markets to the
extent we obtain a credit facility to fund business purpose loans.
We can utilize our current credit facilities only to fund home
mortgage loans.
o Expanding the use of e-commerce in our retail and broker channels.
This is expected to increase loan applications and reduce the cost
to originate loans.
o Reducing the cost of loan originations. We have implemented plans
to:
o reduce the cost to originate in our Upland Mortgage
direct retail channel by broadening the product line and
offering more competitive interest rates in order to
increase origination volume, and reducing marketing
costs;
o reduce the cost to originate in our broker channel by:
a) increasing volume by broadening the mortgage loan
product line, b) consolidating some of the broker
channel's operating functions to our centralized
operating office in Philadelphia, and c) developing and
expanding broker relationships; we also introduced Easy
Loan Advisor on our Internet-based website for our
offices supporting our broker operations. Easy Loan
Advisor offers significant efficiencies by automating
the origination and underwriting of loans; and
o reduce the cost to originate in the Bank Alliance
Services program by broadening our product line and
increasing the amount of fees we would charge to any new
participating financial institutions.
o Reducing the amount of outstanding subordinated debentures. The
increase in cash flow expected under our business strategy is
expected to accelerate a reduction in our reliance on issuing
subordinated debentures to meet our liquidity needs and allow us to
begin to pay down existing subordinated debentures.
o Reducing operating costs. From June 30, 2003 to June 30, 2004, our
workforce has experienced a net reduction of 150 employees. With our
business strategy's focus on whole loan sales and offering a broader
mortgage product line that we expect will appeal to a wider array of
customers, we currently require a smaller employee base with fewer
sales, servicing and support positions. However, we expect to
increase our sales, servicing and support positions as necessary in
the future to handle higher levels of loan originations. Since June
30, 2003 we reduced our workforce by approximately 255 employees and
experienced a net loss of approximately 90 additional employees who
resigned. Partially offsetting this workforce reduction, we have
added 195 loan origination employees in our broker channel as part
of our business strategy's focus on expanding our broker operations.
12
Our business strategy is dependent on our ability to emphasize lending
related activities that provide us with the most economic value. The
implementation of this strategy will depend in large part on a variety of
factors outside of our control, including, but not limited to, our ability to
obtain adequate financing on reasonable terms and to profitably securitize or
sell our loans on a regular basis. Our failure with respect to any of these
factors could impair our ability to successfully implement our strategy, which
could adversely affect our results of operations and financial condition. See
"Risk Factors -- If we are unable to successfully implement our adjusted
business strategy which focuses on whole loan sales, we may be unable to attain
profitable operations which could impair our ability to repay our outstanding
debt and could negatively impact the value of our capital stock."
SUBSIDIARIES
As a holding company, our activities have been limited to:
o providing management oversight over subsidiary operations;
13
o holding the shares of our subsidiaries; and
o raising capital for use in the subsidiaries' lending and loan
servicing operations.
We are the parent holding company of American Business Credit, Inc. and
its primary subsidiaries, HomeAmerican Credit, Inc. (doing business as Upland
Mortgage), American Business Mortgage Services, Inc., and Tiger Relocation
Company.
American Business Credit, Inc., a Pennsylvania corporation incorporated
in 1988 and acquired by us in 1993, currently services business purpose loans
and home mortgage loans. In the past, this subsidiary also originated and sold
business purpose loans.
HomeAmerican Credit, Inc., a Pennsylvania corporation incorporated in
1991, originates, purchases, sells and services home mortgage loans.
HomeAmerican Credit, Inc. acquired Upland Mortgage Corp. in 1996 and since that
time has conducted business as "Upland Mortgage." HomeAmerican Credit, Inc. also
administers the Bank Alliance Services program. See "-- Lending Activities --
Home Mortgage Loans."
American Business Mortgage Services, Inc., a New Jersey corporation
organized in 1938 and acquired by us in October 1997, originates, purchases,
sells and services home mortgage loans.
Tiger Relocation Company, a Pennsylvania corporation, was incorporated
in 1992 to hold, maintain and sell real estate properties acquired due to the
default of a borrower under the terms of our loan documents.
We also have numerous special purpose subsidiaries that were
incorporated solely to facilitate our securitizations and off-balance sheet
mortgage conduit facilities. None of these corporations engage in any business
activity other than holding the subordinated certificate, if any, and the
interest-only strips created in connection with completed securitizations. See
"-- Securitizations" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Securitizations." We also utilize special
purpose entities in connection with our financing activities, including credit
facilities. We also have several additional subsidiaries that are inactive or
not significant to our operations.
14
The following chart sets forth our basic organizational structure and
our primary subsidiaries.(a)
---------------------------------------------
AMERICAN BUSINESS FINANCIAL
SERVICES, INC.
==============================================
Holding Company
Management oversight over subsidiary
operations and raising capital for lending
and servicing operations
---------------------------------------------
|
|
---------------------------------------------
AMERICAN BUSINESS CREDIT, INC.
==============================================
Services business purpose loans and
home mortgage loans
---------------------------------------------
|
-------------------------------------------------------
| | |
| | |
---------------- ---------------------- ---------------------
AMERICAN HOMEAMERICAN TIGER
BUSINESS CREDIT, INC. D/B/A RELOCATION
MORTGAGE UPLAND COMPANY
SERVICES, INC. MORTGAGE
---------------- ---------------------- ---------------------
---------------- ---------------------- ---------------------
Originates, Originates, purchases, Holds, maintains
purchases, sells sells and services and sells foreclosed
and home mortgage loans real estate
services home and administers the
mortgage Bank Alliance
loans Services program
---------------- ---------------------- ---------------------
____________________________
(a) In addition to the corporations pictured in this chart, we organized at
least one special purpose corporation for each securitization and have
several other subsidiaries that are inactive or not significant to our
operations.
15
LENDING ACTIVITIES
GENERAL. The following table sets forth information concerning our loan
origination, purchase and sale activities for the periods indicated.
YEAR ENDED JUNE 30,
-------------------------------------
2004 2003 2002
--------- ------ ---------
(DOLLARS IN THOUSANDS)
Loans Originated/Purchased
Business purpose loans.................... $ 587 $ 122,790 $ 133,352
Home mortgage loans....................... $ 982,093 $ 1,543,730 $ 1,246,505
Number of Loans Originated/Purchased
Business purpose loans.................... 2 1,340 1,372
Home mortgage loans....................... 8,281 17,003 14,015
Average Loan Size
Business purpose loans.................... $ 293 $ 92 $ 97
Home mortgage loans....................... $ 119 $ 91 $ 89
Weighted-Average Interest Rate on Loans
Originated/Purchased
Business purpose loans.................. 14.62% 15.76% 15.75%
Home mortgage loans..................... 7.86% 9.99% 10.91%
Combined................................ 7.86% 10.42% 11.38%
Weighted-Average Term (in months)
Business purpose loans.................... 150 160 161
Home mortgage loans....................... 294 272 260
Loans Securitized or Sold
Business purpose loans.................... $ 18,931 $ 112,025 $ 129,074
Home mortgage loans....................... $ 930,853 $ 1,339,752 $ 1,279,740
Number of Loans Securitized or Sold
Business purpose loans.................... 198 1,195 1,331
Home mortgage loans....................... 9,932 14,952 14,379
The following table sets forth information regarding the average
loan-to-value ratios for loans we originated and purchased during the periods
indicated.
YEAR ENDED JUNE 30,
------------------------------
LOAN TYPE 2004 2003 2002
--------- ---- ---- ----
Business purpose loans........................ 70.1% 62.2% 62.6%
Home mortgage loans........................... 81.3 78.2 77.8
16
The following table shows the geographic distribution of our loan
originations and purchases during the periods indicated.
YEAR ENDED JUNE 30,
-------------------------------------------------------------------------------------
2004 2003 2002
-------------------------- ---------------------------- -------------------------
Amount % Amount % Amount %
---------- ------- ------------- -------- -------------- --------
(dollars in thousands)
California $230,665 23.47% $ -- --% $ -- --%
New York 99,631 10.14 376,425 22.59 341,205 24.73
Pennsylvania 83,594 8.51 118,915 7.14 103,865 7.53
Massachusetts 64,254 6.54 134,342 8.06 101,383 7.35
Florida 57,092 5.81 135,164 8.11 97,686 7.08
Maryland 48,777 4.96 36,542 2.19 25,307 1.83
Virginia 41,294 4.20 46,508 2.79 33,169 2.40
Michigan 40,975 4.17 92,009 5.52 89,224 6.47
Ohio 39,949 4.07 70,957 4.26 65,884 4.77
New Jersey 38,108 3.88 212,035 12.72 159,117 11.53
Illinois 37,617 3.83 90,111 5.41 73,152 5.30
Georgia 26,127 2.66 21,022 1.26 49,956 3.62
Indiana 17,583 1.79 33,671 2.02 27,833 2.02
Texas 17,155 1.75 9,746 0.58 304 0.02
Connecticut 16,841 1.71 42,525 2.55 30,461 2.21
Other (a) 123,018 12.51 246,548 14.80 181,311 13.14
-------- ------ ---------- ------ ---------- -------
Total $982,680 100.00% $1,666,520 100.00% $1,379,857 100.00%
======== ====== ========== ====== ========== =======
- ----------
(a) No individual state included in "Other" constitutes more than 1.5% of
total loan originations for the fiscal year ended June 30, 2004.
CUSTOMERS. Our loan customers are primarily credit-impaired borrowers
who are generally unable to obtain financing from banks or savings and loan
associations and who are attracted to our products and services. These
institutions have historically provided loans only to individuals with the most
favorable credit characteristics. These borrowers generally have impaired or
unsubstantiated credit histories and/or unverifiable income. Our experience has
indicated that these borrowers are attracted to our loan products as a result of
our marketing efforts, the personalized service provided by our staff of highly
trained lending officers and our timely response to loan requests. Historically,
our customers have been willing to pay our origination fees and interest rates
even though they are generally higher than those charged by traditional lending
sources. This type of borrower is commonly referred to as a subprime borrower.
Loans made to subprime borrowers are frequently referred to as subprime loans.
See "-- Business Strategy."
HOME MORTGAGE LOANS. We originate home mortgage loans, consisting of
home equity loans and purchase money mortgage loans, through Upland Mortgage and
American Business Mortgage Services, Inc. We also process and purchase loans
through the Bank Alliance Services program. We originate home mortgage loans
primarily to credit-impaired borrowers through various channels including retail
marketing and broker operations. Our retail channel includes direct mail and our
subsidiaries' interactive web sites, and have included radio and television
advertisements.
In total at June 30, 2004, we had 285 employees in our broker
operations including 136 account executives. Our broker operations originate
loans using a broker network that after recent expansion is spread
geographically throughout the continental United States. During fiscal 2004, we
added four offices with 192 employees at June 30, 2004 to support our broker
operations and hired 25 account executives to expand our broker presence and
increase loan originations. We also introduced Easy Loan Advisor on our
Internet-based broker website for our offices supporting our broker operations.
Easy Loan Advisor offers significant efficiencies by automating the origination
and underwriting of these loans.
17
We entered the home equity loan market in 1991. With the recent
expansion of our broker operations, we added purchase money mortgage loans in
2004. Currently, we are licensed or otherwise qualified to originate home
mortgage loans in 46 states. We also hired 25 account executives to develop
relationships with mortgage brokers and to expand our broker presence in the
eastern, southern and mid-western areas of the United States. We generally sell
on a whole loan basis with servicing released, or securitize the loans
originated and funded by our subsidiaries.
The business strategy that we are emphasizing beginning in fiscal 2004
has impacted our origination of home mortgage loans. Our business strategy is
designed to appeal to a broader prospective customer base and increase the
amount of loan originations. We have broadened our mortgage loan product line to
include adjustable-rate, alt-A and alt-B and purchase money mortgage loans. Our
strategy also emphasizes reducing the cost to originate loans by expanding our
broker network and reducing retail marketing costs. Our business strategy also
focuses on shifting from a predominantly publicly underwritten securitization
strategy and gain-on-sale business model to a strategy focused on a combination
of whole loan sales and smaller securitization transactions. For a discussion of
our business strategy and its potential impact on our home mortgage loan
business, see "-- Business Strategy."
Our retail operations receive home mortgage loan applications from
potential borrowers over the phone, in writing, in person or through our
subsidiaries' interactive web sites, and most recently through third-party
lending-related web sites with whom we have working agreements. The loan request
is then evaluated for possible loan approval. The loan processing staff
generally provides its home mortgage applicants who qualify for loans with a
conditional loan approval within 24 hours and closes its home mortgage loans
within approximately fifteen to twenty days of obtaining a conditional loan
approval.
Our broker operations receive home mortgage loan applications from
third-party unrelated brokers both in writing and increasingly through our newly
introduced broker Internet web site. The loan request is then evaluated for
possible loan approval. The loan processing staff generally provides the brokers
with a conditional loan approval within 24 hours and closes its home mortgage
loans within approximately fifteen to twenty days of obtaining a conditional
loan approval.
18
The following table presents the amounts of loans we originated in 2004
in our retail and broker operations channels (in thousands):
Bank
Retail Broker Alliance
Channel Channel Services Total
-------------- ------------- -------------- ------------
Purchase Money Mortgage Loans:
Fixed rate $ 2,177 $ 45,617 $ 634 $ 48,428
Adjustable rate 836 127,607 - 128,443
-------- -------- -------- --------
Total $ 3,013 $173,224 $ 634 $176,871
======== ======== ======== ========
Home Equity Loans:
Fixed rate $424,619 $ 94,051 $127,770 $646,440
Adjustable rate 40,423 104,503 13,856 158,782
-------- -------- -------- --------
Total $465,042 $198,554 $141,626 $805,222
======== ======== ======== ========
Total Home Mortgage Loans:
Fixed rate $426,796 $139,668 $128,404 $694,868
Adjustable rate 41,259 232,110 13,856 287,225
-------- -------- -------- --------
Total $468,055 $371,778 $142,260 $982,093
======== ======== ======== ========
Home mortgage loans ranged from $7,700 to $658,500 with an average loan
size of approximately $119,000 during 2004 and $91,000 during 2003. We
originated $982.1 million of home mortgage loans during fiscal 2004 and $1.5
billion during fiscal 2003. These loans were made both at fixed rates of
interest and adjustable rates of interest, which were tied to 6 month LIBOR, and
for terms ranging from five to thirty years, generally, with average origination
fees of approximately 1.5% of the aggregate loan amount. The weighted-average
interest rate received on home mortgage loans during fiscal 2004 was 7.86% and
during fiscal 2003 was 9.99%. The average loan-to-value ratios for the loans
originated by us during fiscal 2004 and fiscal 2003 were 81.3% and 78.2%,
respectively.
We attempt to maintain our interest rates and other charges on home
mortgage loans to be competitive with the lending rates of other sub-prime
mortgage finance companies. To the extent permitted by law, borrowers are given
an option to choose between a loan without a prepayment fee at a higher interest
rate or a loan with a prepayment fee at a lower interest rate. We may waive the
collection of a prepayment fee, if any, in the event the borrower refinances a
home mortgage loan with us.
We have business arrangements with several financial institutions,
which provide for our purchase of home mortgage loans that meet our underwriting
criteria, but do not meet the guidelines of the selling institution for loans to
be held in its portfolio. This program is called the Bank Alliance Services
program. The Bank Alliance Services program is designed to provide an additional
source of home mortgage loans. This program targets traditional financial
institutions, such as banks, which because of their strict underwriting and
credit guidelines for loans held in their portfolio have generally provided
mortgage financing only to the most credit-worthy borrowers. This program allows
these financial institutions to originate loans to credit-impaired borrowers in
order to achieve community reinvestment goals and to generate fee income and
subsequently sell such loans to one of our subsidiaries.
Pursuant to the program, a financial institution adopts our
underwriting criteria for home mortgage loans not intended to be held in its
portfolio. If an applicant meets our underwriting criteria, as adopted by the
program, we process the application materials and underwrite the loan for final
approval by the financial institution. If the financial institution approves the
loan, we close the loan for the financial institution in its name with funding
provided by the financial institution. We purchase the loan from the financial
institution shortly after the closing. Following our purchase of the loans
through this program, we hold these loans as available for sale until they are
sold in a whole loan sale or securitization.
19
During fiscal 2004, we received referrals from approximately ten
financial institutions participating in this program. As of June 30, 2004, seven
financial institutions located in the eastern portion of the United States were
actively participating in this program. These financial institutions provide us
with the opportunity to process and purchase loans generated by the branch
networks of such institutions, which consists of approximately 575 branches.
These seven financial institutions accounted for approximately 20.5% of the
referrals received by us under the Bank Alliance Services program during fiscal
2004. Pursuant to this program, our subsidiaries purchased approximately $142.3
million of loans during the year ended June 30, 2004 and $201.9 million of loans
during the fiscal year ended June 30, 2003. During the year ended June 30, 2004,
our top three financial institutions under the Bank Alliance Services program
accounted for approximately 96.1% of our loan volume from this program. Only one
of the seven remaining active participants was in our top three volume providers
in fiscal 2004. We intend to expand the Bank Alliance Services program with
financial institutions across the United States. See "-- Business Strategy."
During fiscal 1999, we launched a retail Internet loan distribution
channel through Upland Mortgage's web site. Through this interactive web site,
borrowers can examine available loan options and calculate monthly principal and
interest payments. The Upland Mortgage Internet platform provides borrowers with
convenient access to the mortgage loan information 7 days a week, 24 hours a
day. Throughout the loan processing period, borrowers who submit applications
are supported by our staff of highly trained loan officers. Currently, in
addition to the ability to utilize an automated rapid pre-approval process,
which we believe reduces time and manual effort required for loan approval, the
site features our proprietary software, Easy Loan Advisor, which provides
personalized services and solutions to retail customers through interactive web
dialog. We have applied to the U.S. Patent and Trademark Office to patent this
product.
During fiscal 2004, using our Easy Loan Advisor (referred to as ELA in
this document) proprietary software, we launched a broker Internet loan
distribution channel. We have added functionality to service the brokerage
community and sales channels through its automated underwriting engine thereby
providing access to the brokerage communities 7 days a week, 24 hours a day as
well as loan structuring options to provide the various loan solutions to
borrowers. The ELA software is a state of the art loan restructuring system
which provides brokers almost instantaneous loan structure options. This
technology is key to our forecasted loan growth.
BUSINESS PURPOSE LOANS. Through our subsidiary, American Business
Credit, Inc., we service business purpose loans that we originated and sold in
prior periods predominantly in the eastern and central portions of the United
States through a network of salespeople, loan brokers and through our business
loan web site.
During prior periods, we originated business purpose loans to
corporations, partnerships, sole proprietors and other business entities for
various business purposes including, but not limited to, working capital,
business expansion, equipment acquisition, tax payments and debt-consolidation.
We did not target any particular industries or trade groups and, in fact, took
precautions against a concentration of loans in any one industry group. All
business purpose loans originated generally were collateralized by a first or
second mortgage lien on a principal residence of the borrower or a guarantor of
the borrower or some other parcel of real property, such as office and apartment
buildings and mixed use buildings, owned by the borrower, a principal of the
borrower, or a guarantor of the borrower. In most cases, these loans were
further collateralized by personal guarantees, pledges of securities,
assignments of contract rights, life insurance and lease payments and liens on
business equipment and other business assets. Prior to the fourth quarter of
fiscal 2003, we generally securitized business purpose loans subsequent to their
origination. We originated less than $1.0 million of business purpose loans in
fiscal 2004. We are currently not originating these loans; however, in the
future, we may originate business purpose loans to meet demand in the whole loan
sale and securitization markets to the extent we obtain a credit facility to
fund business purpose loans. If we originate business purpose loans in the
future, we will focus our marketing efforts on small businesses that do not meet
all of the credit criteria of commercial banks and small businesses that our
research indicates may be predisposed to using our products and services. See
"-- Business Strategy."
20
We originated $587,000 in business purpose loans during the year ended
June 30, 2004, and originated $122.8 million during fiscal 2003. When we
originated larger volumes of business purpose loans, these loans generally
ranged from $14,000 to $685,000 and had an average loan size of approximately
$92,000 for the loans originated during the fiscal year ended June 30, 2003.
Generally, our business purpose loans are made at fixed interest rates and for
terms ranging from five to fifteen years. We generally charged origination fees
for these loans of 4.75% to 5.75% of the outstanding principal balance. The
weighted-average interest rate charged on the business purpose loans originated
by us during the year ended June 30, 2004 was 14.62% and during fiscal year 2003
was 15.76%. Business purpose loans we originated during fiscal 2004 and fiscal
2003 had a loan-to-value ratio, based solely upon the real estate collateral
securing the loans, of 70.1% and 62.2%, respectively.
Generally, we compute interest due on our outstanding business purpose
loans using the simple interest method. We generally impose a prepayment fee.
Although prepayment fees imposed vary based upon applicable state law, the
prepayment fees on our business purpose loan documents can be a significant
portion of the outstanding loan balance. Whether a prepayment fee is imposed and
the amount of such fee, if any, is negotiated between the individual borrower
and American Business Credit, Inc. prior to closing of the loan. We may waive
the collection of a prepayment fee, if any, in the event the borrower refinances
a business loan with us.
PREPAYMENT FEES. Approximately 80% to 85% of our home mortgage loans
serviced had prepayment fees at the time of their origination. On home mortgage
loans where the borrower has elected the prepayment fee option, the prepayment
fee is generally a certain percentage of the outstanding principal balance of
the loan. Our typical prepayment fee structure provides for a fee of 5% or less
of the outstanding principal loan balance and will not extend beyond the first
three years after a loan's origination. Prepayment fees on our existing home
mortgage loans range from 1% to 5% of the outstanding principal balance and
remain in effect for one to five years. At the time of their origination,
approximately 90% to 95% of our business purpose loans had prepayment fees. The
prepayment fee on business purpose loans is generally 8% to 12% of the
outstanding principal balance, provided that no prepayment option is available
until after the 24th scheduled payment is made and no prepayment fee is due
after the 60th scheduled payment is made. From time to time, a different
prepayment fee arrangement may be negotiated or we may waive prepayment fees for
borrowers who refinance their loans with us. At June 30, 2004, approximately 50%
to 55% of securitized home mortgage loans in our total portfolio had prepayment
fees and approximately 50% to 55% of securitized business purpose loans in our
total portfolio had prepayment fees.
State law sometimes restricts our ability to charge a prepayment fee
for both home mortgage and business purpose loans. Prior to its preclusion, we
used the Parity Act to preempt these state laws for home mortgage loans which
meet the definition of alternative mortgage transactions under the Parity Act.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations - Legal and Regulatory Considerations" for a discussion of how the
adoption by the Office of Thrift Supervision in July 2003 of a rule which
precludes us from using the Parity Act to preempt state prepayment penalty and
late fees laws may impact our new loan originations.
In states which have overridden the Parity Act and in the case of some
fully amortizing home mortgage loans, state laws may restrict prepayment fees
either by the amount of the prepayment fee or the time period during which it
can be imposed. Federal law restrictions in connection with certain high
interest rate and fee loans may also preclude the imposition of prepayment fees
on these loans. Similarly, in the case of business purpose loans, some states
prohibit or limit prepayment fees when the loan is below a specific dollar
threshold or is secured by residential property.
21
MARKETING STRATEGY
RETAIL LOAN ORIGINATION CHANNEL. Historically, we concentrated our
marketing efforts for home mortgage loans primarily on credit-impaired borrowers
who are generally unable to obtain financing from banks or savings and loan
associations and who are attracted to our products and services. Although we
still intend to lend to credit-impaired borrowers under our current business
strategy, we have broadened our mortgage loan product line to include
adjustable-rate, alt-A and alt-B and purchase money mortgage loans and to offer
competitive interest rates in order to appeal to a wider range of customers. See
"-- Business Strategy" and "Risk Factors -- Lending to credit-impaired borrowers
may result in higher delinquencies in our total portfolio, which could hinder
our ability to operate profitably, impair our ability to repay our outstanding
debt and negatively impact the value of our capital stock."
We market home mortgage loans through direct mail campaigns and our
interactive web sites, and have in the past used telemarketing, radio and
television advertising. Recently, we have begun to accept applications forwarded
to us by third-party lending-related web sites with whom we have working
agreements. We believe that our targeted direct mail strategy delivers more
leads at a lower cost than broadcast marketing channels. Our integrated approach
to media advertising that utilizes a combination of direct mail and Internet
advertising is intended to maximize the effect of our advertising campaigns. We
expect the implementation of our business strategy to improve our response and
conversion rates, which will reduce our overall marketing costs. We also use the
Bank Alliance Services program as additional sources of loans.
Our marketing efforts for home mortgage loans in our retail channel are
focused on the eastern and central portions of the United States and continuing
to expand to the western portion of the United States. We previously utilized
branch offices in various states to market our loans. Effective June 30, 2003,
we no longer originate loans through retail branch offices.
BROKER OPERATIONS CHANNEL. We also use a network of loan brokers as a
source of home mortgage loans. We continue to expand our network of loan brokers
as part of our focus on whole loan sales in order to increase the amount of
loans originated and reduce origination costs. During fiscal 2004, we acquired
broker operations in West Hills, California and Austin, Texas, and opened new
offices in Edgewater, Maryland and Irvine, California to support our broker
operations.
We market our broker operations though various sources including direct
broker solicitation, trade shows and trade advertising. We also introduced Easy
Loan Advisor on our Internet-based website for our offices supporting our broker
operations. Additionally, we market our programs and rates through e-mail.
BUSINESS PURPOSE LOANS. In prior fiscal years, our marketing efforts
for business purpose loans focused on our niche market of selected small
businesses located in our market area, which generally included the eastern and
central portions of the United States. We targeted businesses, which might
qualify for loans from traditional lending sources, but elected to use our
products and services. Our experience had indicated that these borrowers were
attracted to us as a result of our marketing efforts, the personalized service
provided by our staff of highly trained lending officers and our timely response
to loan applications. Historically, such customers had been willing to pay our
origination fees and interest rates, which were generally higher than those
charged by traditional lending sources.
We had marketed business purpose loans through various forms of
advertising, including large direct mail campaigns, our business loan web site
and a direct sales force and loan brokers, and had in the past used newspaper
and radio advertising. Although we originated only $587,000 of business purpose
loans during the year ended June 30, 2004, we may originate and sell business
purpose loans in future periods to the extent we obtain a credit facility to
fund business purpose loans. Certain business purpose loans originated by us in
prior periods are held for sale. See "-- Business Strategy" and "-- Lending
Activities -- Business Purpose Loans."
22
UNDERWRITING PROCEDURES AND PRACTICES
Summarized below are some of the policies and practices which are
followed in connection with the origination of home mortgage loans and business
purpose loans. These policies and practices may be altered, amended and
supplemented, from time to time, as conditions warrant. We reserve the right to
make changes in our day-to-day practices and policies at any time.
Our loan underwriting standards are applied to evaluate prospective
borrowers' credit standing and repayment ability as well as the value and
adequacy of the mortgaged property as collateral. Initially, the prospective
borrower is required to provide pertinent credit information in order to
complete a detailed loan application. As part of the description of the
prospective borrower's financial condition, the borrower is required to provide
information concerning assets, liabilities, income, credit, employment history
and other demographic and personal information. If the application demonstrates
the prospective borrower's ability to repay the debt as well as sufficient
income and equity, loan processing personnel generally obtain and review an
independent credit bureau report on the credit history of the borrower and
verify the borrower's income. Once all applicable employment, credit and
property information is obtained, a determination is made as to whether
sufficient unencumbered equity in the property exists and whether the
prospective borrower has sufficient monthly income available to meet the
prospective borrower's monthly obligations.
The following table outlines the key parameters of the major credit
grades of our current home mortgage loan underwriting guidelines. During fiscal
2004, we adjusted our credit grade and underwriting guidelines. We believe these
adjustments provide more consistency with the guidelines used by institutional
purchasers in the whole loan sale secondary market. As a result, we have
broadened our home mortgage loan products to include loan programs allowing
higher overall loan-to-value ratios, which are offset by compensating credit
characteristics. These loans are originated with the primary intent of being
sold as whole loans on the secondary market. The implementation of the new
credit and underwriting guidelines allows us to be more competitive in the whole
loan sale secondary market and enhances our ability to execute our adjusted
business strategy. We will continue to monitor our credit and underwriting
guidelines to maintain consistency with demand by institutional purchasers of
whole loans. During the year ended June 30, 2004, home mortgage loans
represented 99.9% of the loans we originated.
23
"A" CREDIT GRADE "B" CREDIT GRADE "C" CREDIT GRADE HOPE
- -------------------- ------------------------- ------------------------- ------------------------- -------------------------
General Repayment Has good credit but might Pays the majority of Marginal credit history Designed to provide a
have some minor accounts on time but has which is offset by other borrower with poor credit
delinquency some 30 and/or 60 day positive attributes. history an opportunity to
delinquency correct past credit
problems through lower
monthly payment.
Existing Mortgage Cannot exceed a maximum Cannot exceed a maximum Cannot exceed two 60 day Cannot exceed a maximum
Loans of three 30 day of four 30 day delinquencies and/or one of one 120 day
delinquencies in the past delinquencies/ one 60 day 90 day delinquency in the delinquency in the past
12 months. delinquency in the past past 12 months. 12 months.
12 months.
Non-Mortgage Credit Major credit and Major credit and Major credit and Major and minor credit
installment debt should installment debt can installment debt can delinquency is
be current but may exhibit some minor 30 exhibit some minor 30 acceptable, but must
exhibit some minor 30 day and/or 60 day and/or 90 day demonstrate some payment
delinquency. Minor credit delinquency. Minor credit delinquency. Minor credit regularity.
may exhibit some minor may exhibit up to 90 day may exhibit more serious
delinquency. delinquency. delinquency.
Bankruptcy Filings Discharged more than 2 Discharged more than 18 Discharged more than 1 Discharged more than 2
Chapter 7 years with reestablished months with reestablished year with reestablished years with reestablished
credit. credit. credit. credit.
Chapter 13 Filed more than 2 years, Filed more than 18 Filed more than 1 year, Filed more than 1 year,
satisfactory payment plan months, satisfactory satisfactory payment plan satisfactory payment plan
performance payment plan performance performance performance
Debt Service-to- Generally not to exceed Generally not to exceed Generally not to exceed Generally not to exceed
Income 50%. 50%. 55%. 55%.
Owner Occupied: Generally 80% to 100% for Generally 80% to 85% for Generally 70% to 80% for Generally 65% to 70% for
Loan-to-value ratio a 1-4 family dwelling a 1-4 family dwelling a 1-4 family dwelling a 1-4 family dwelling
residence; 90% for a residence; 85% for a residence; 70% for a residence.
condominium. condominium. condominium.
Non-Owner Occupied: Generally 85% for a 1-4 Generally 75% for a 1-4 Generally 70% for a 1-4 N/A
Loan-to-value ratio family dwelling or family dwelling or family dwelling or
condominium. condominium. condominium.
24
In addition to the home mortgage loans we originate under the standard
home mortgage loan underwriting guidelines outlined in the preceding table, we
also originate a limited number of second mortgage home equity loans that have
loan-to-value ratios ranging from 90% to 100%. We consider these loans to be
high loan-to-value home equity loans and we underwrite these loans with a more
restrictive approach to evaluating the borrowers' qualifications and we require
a stronger credit history than our standard guidelines. The borrowers' existing
mortgage and installment debt payments must generally be paid as agreed, with no
more than one 30-day delinquency on a mortgage within the last 12 months. No
bankruptcy or foreclosure is permitted in the last 24 months.
Pursuant to our current business strategy, a greater number of loans
that we originate will be offered to the secondary market through whole loan
sales. These loans will be underwritten, allocated and sold to specific third
party purchasers based on agreed upon products and underwriting guidelines. The
purchaser products and guidelines currently being utilized generally conform to
key parameters outlined in the preceding table. See "-- Business Strategy."
If originated, business purpose loans generally are secured by
residential real estate and at times commercial real estate. Loan amounts
generally ranged from $14,000 to $685,000. The loan-to-value ratio (based solely
on the appraised fair market value of the real estate collateral securing the
loan) on the properties collateralizing the loans generally has a maximum range
of 50% to 75%. The actual maximum loan-to-value ratio varies depending on a
variety of factors including, the credit grade of the borrower, whether the
collateral is a one to four family residence, a condominium or a commercial
property and whether the property is owner occupied or non-owner occupied. The
credit grade of a business purpose loan borrower will vary depending on the
payment history of their existing mortgages, major lines of credit and minor
lines of credit, allowing for delinquency but generally requiring major credit
to be current at closing. The underwriting of the business purpose loan included
confirmation of income or cash flow through tax returns, bank statements and
other forms of proof of income and business cash flow. Generally, we made loans
to businesses whose bankruptcy was discharged at least two years prior to
closing, but we had made exceptions to allow for the bankruptcy to be discharged
just prior to or at closing. In addition, we generally received additional
collateral in the form of, among other things, personal guarantees, pledges of
securities, assignments of contract rights, assignments of life insurance and
lease payments and liens on business equipment and other business assets, as
available. Based solely on the value of the real estate collateral securing our
business purpose loans, the average loan-to-value ratio of business purpose
loans we originated during fiscal 2004 and 2003 were 70.1% and 62.2%,
respectively.
Generally, the maximum acceptable loan-to-value ratio for home mortgage
loans to be securitized is 100%. The average loan-to-value ratios of home
mortgage loans we originated during the years ended June 30, 2004 and 2003 were
81.3% and 78.2%, respectively. We generally obtain title insurance in connection
with our loans.
In determining whether the mortgaged property is adequate as
collateral, we have an appraisal performed for each property considered for
financing. The appraisal is completed by a licensed qualified appraiser on a
Fannie Mae form and generally includes pictures of comparable properties and
pictures of the property securing the loan.
Any material decline in real estate values reduces the ability of
borrowers to use home equity to support borrowings and increases the
loan-to-value ratios of loans previously made by us, thereby weakening
collateral coverage and increasing the possibility of a loss in the event of
borrower default. Further, delinquencies, foreclosures and losses generally
increase during economic slowdowns or recessions. As a result, we cannot assure
that the market value of the real estate underlying the loans will at any time
be equal to or in excess of the outstanding principal amount of those loans.
Although we have expanded the geographic area in which we originate loans, a
downturn in the economy generally or in a specific region of the country may
have an effect on our originations. See "Risk Factors -- A decline in value of
the collateral securing our loans could result in an increase in losses on
foreclosure, which could hinder our ability to attain profitable operations,
limit our ability to repay our outstanding debt and negatively impact the value
of our capital stock."
25
LOAN SERVICING AND ADMINISTRATIVE PROCEDURES
We service the loans in accordance with our established servicing
procedures. The loans we service include loans we hold as available for sale and
most of the loans we have securitized. Our servicing procedures include
practices regarding processing of mortgage payments, processing of disbursements
for tax and insurance payments, maintenance of mortgage loan records,
performance of collection efforts, including disposition of delinquent loans,
foreclosure activities and disposition of real estate owned and performance of
investor accounting and reporting processes, which in general conform to the
mortgage servicing practices of prudent mortgage lending institutions. We
generally receive contractual servicing fees for our servicing responsibilities
for securitized loans, calculated as a percentage of the outstanding principal
amount of the loans serviced. In addition, we receive other ancillary fees
related to the loans serviced. On July 12, 2004, our servicing and collections
activities, which were previously located at our operating office in Bala
Cynwyd, Pennsylvania, were relocated to our Philadelphia, Pennsylvania office.
At June 30, 2004, the portfolio we serviced consisted of 27,165 loans with an
aggregate outstanding balance of $2.1 billion.
In servicing loans, we send an invoice to borrowers on a monthly basis
advising them of the required payment and its scheduled due date. We begin the
collection process promptly after a borrower fails to make a scheduled monthly
payment. When a loan becomes 45 to 60 days delinquent, it is transferred to a
senior collector in the collections department. The senior collector tries to
resolve the delinquency by reinstating a delinquent loan, seeking a payoff, or
entering into a deferment or forbearance arrangement with the borrower to avoid
foreclosure. All proposed arrangements are evaluated on a case-by-case basis,
based on, among other things, the borrower's past credit history, current
financial status, cooperativeness, future prospects and the reasons for the
delinquency. If a mortgage loan becomes 45 days delinquent and we do not reach a
satisfactory arrangement with the borrower, our legal department will mail a
notice of default to the borrower. If the delinquency is not cured within the
time period provided for in the loan documents, we generally start a foreclosure
action. The collection department maintains normal collection efforts during the
cure periods following a notice of default and the initiation of foreclosure
action. If a borrower declares bankruptcy, our in-house attorneys and paralegals
promptly act to protect our interests. We may initiate legal action earlier than
45 days following a delinquency if we determine that the circumstances warrant
such action.
We employ a staff of experienced mortgage collectors and managers
working in shifts seven days a week to manage delinquent loans. In addition, a
staff of in-house attorneys and paralegals works closely with the collections
staff to optimize collection efforts. The primary goal of our labor-intensive
collections program is to emphasize delinquency and loss prevention.
From time to time, borrowers are confronted with events, usually
involving hardship circumstances or temporary financial setbacks that adversely
affect their ability to continue payments on their loan. To assist borrowers, we
may agree to enter into a deferment or forbearance arrangement. Prevailing
economic conditions, which may affect the borrower's ability to make their
regular payments, may also have an impact on the value of the real estate or
other collateral securing the loans, resulting in a change to the loan-to-value
ratio. We may take these conditions into account when we evaluate a borrower's
request for assistance for relief from the borrower's financial hardship.
26
Our policies and practices regarding deferment and forbearance
arrangements, like all of our collections policies and practices, are designed
to manage customer relationships, maximize collections and avoid foreclosure (or
repossession of other collateral, as applicable) if reasonably possible. We
review and regularly revise these policies and procedures in order to enhance
their effectiveness in achieving these goals.
In a deferment arrangement, we make advances on behalf of the borrower
in amounts equal to the delinquent loan payments, which include principal and
interest. Additionally, we may pay taxes, insurance and other fees on behalf of
the borrower. Based on our review of the borrower's current financial
circumstances, the borrower must repay the advances and other payments and fees
we make on the borrower's behalf either at the termination of the loan or on a
payment plan. Borrowers must provide a written explanation of their hardship,
which generally requests relief from their delinquent loan payments. We review
the borrower's current financial situation and based upon this review, we may
create a payment plan for the borrower which allows the borrower to pay past due
amounts over a period ranging from approximately 12 to 42 months, depending on
the period for which deferment is requested, but not beyond the maturity date of
the loan, in addition to making regular monthly loan payments. Each deferment
arrangement must be approved by two of our managers. Deferment arrangements
which defer two or more past due payments must also be approved by at least two
senior vice presidents.
Principal guidelines currently applicable to the deferment process
include: (i) the borrower may have up to six payments deferred during the life
of the loan; (ii) no more than three payments may be deferred during a
twelve-month period; and (iii) the borrower must have made a minimum of six
payments on the loan and twelve months must have passed since the last deferment
in order to qualify for a new deferment arrangement. Any deferment arrangement,
which includes an exception to our guidelines, must be approved by two senior
vice presidents. If the deferment arrangement is approved, a collector contacts
the borrower regarding the approval and the revised payment terms.
For borrowers who are three or more payments delinquent, we will
consider using a forbearance arrangement. In a forbearance arrangement, we make
advances on behalf of the borrower in amounts equal to the delinquent loan
payments, which include principal and interest. Additionally, we may pay taxes,
insurance and other fees on behalf of the borrower. We assess the borrower's
current financial situation and based upon this assessment, we will create a
payment plan for the borrower which allows the borrower to pay past due amounts
over a longer period than a typical deferment arrangement, but not beyond the
maturity date of the loan. We typically structure a forbearance arrangement to
require the borrower to make payments of principal and interest equivalent to
the original loan terms plus additional monthly payments, which in the aggregate
represent the amount that we advanced on behalf of the borrower.
Principal guidelines currently applicable to the forbearance process
include the following: (i) the borrower must have first and/or second mortgages
with us; (ii) the borrower's account was originated at least six months prior to
the request for forbearance; (iii) the borrower's account must be at least three
payments delinquent to qualify for a forbearance agreement; (iv) the borrower
must submit a written request for forbearance containing an explanation for his
or her previous delinquency and setting forth the reasons that the borrower now
believes he or she is able to meet his or her loan obligations; and (v) the
borrower must make a down payment of at least one month's past due payments of
principal and interest in order to enter into a forbearance agreement, and the
borrower who is six or more payments delinquent must make a down payment of at
least two past due payments. No request for forbearance may be denied without
review by our senior vice president of collections or his designee.
27
We do not enter into a deferment or forbearance arrangement based
solely on the fact that a loan meets the criteria for one of the arrangements.
Our use of any of these arrangements also depends upon one or more of the
following factors: our assessment of the individual borrower's current financial
situation, reasons for the delinquency and our view of prevailing economic
conditions. Because deferment and forbearance arrangements are account
management tools which help us to manage customer relationships, maximize
collection opportunities and increase the value of our account relationships,
the application of these tools generally is subject to constantly shifting
complexities and variations in the marketplace. We attempt to tailor the type
and terms of the arrangement we use to the borrower's circumstances, and we
prefer to use deferment over forbearance arrangements, if possible.
As a result of these arrangements, we reset the contractual status of a
loan in our managed portfolio from delinquent to current based upon the
borrower's resumption of making their principal and interest loan payments. A
loan remains current after a deferment or forbearance arrangement with the
borrower only if the borrower makes the principal and interest payments as
required under the terms of the original note (exclusive of delinquent payments
advanced or fees paid by us on the borrower's behalf as part of the deferment or
forbearance arrangement), and we do not reflect it as a delinquent loan in our
delinquency statistics. However, if the borrower fails to make principal and
interest payments, we will declare the account in default, reflect it as a
delinquent loan in our delinquency statistics and resume collection actions. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Total Portfolio Quality -- Deferment and Forbearance Arrangements"
for information regarding the impact of these arrangements on our operations.
Based on information learned by our in-house legal staff while
participating in industry forums and conferences and statements made by outside
attorneys to us in the course of their legal representation of us, we believe we
are among a small number of non-conforming lenders that have an in-house legal
staff dedicated to the collection of delinquent loans and the handling of
bankruptcy cases. As a result, we believe our delinquent loans are reviewed from
a legal perspective earlier in the collection process than is the case with
loans made by traditional lenders so that troublesome legal issues can be noted
and, if possible, resolved earlier. For example, if in the course of the
collection of a loan or fee the servicing department or collections department
becomes aware of problems with a loan, such as title issues, department
personnel will immediately notify an in-house attorney who will review the file
and immediately initiate any necessary corrective action, including referral to
outside counsel if appropriate. Also as an example, every notice of default and
bankruptcy proof of claim is signed by an in-house attorney. Frequently, when
reviewing the file relevant to a particular notice of default or proof of claim,
the reviewing attorney will become aware of inconsistencies or issues and
immediately initiate any necessary corrective action, including referral to
outside counsel if appropriate. This frequent day-to-day contact between our
servicing and collections departments, our in-house legal staff and outside
counsel, and the early involvement of an in-house attorney in emerging legal
issues that this facilitates, enables our in-house attorneys to resolve issues
before they become costly disputes and to negotiate alternatives to foreclosure
for problem loans.
Real estate acquired as a result of foreclosure or by deed in lieu of
foreclosure is classified as real estate owned until it is sold. After
acquisition, all costs incurred in maintaining the property are accounted for as
expenses. When carried on our balance sheet, we record real estate owned at the
lower of cost or estimated fair value.
Most foreclosures are handled by outside counsel who are managed by our
in-house legal staff to ensure that the time period for handling foreclosures
meets or exceeds established industry standards. Frequent contact between
in-house and outside counsel ensures that the process moves quickly and
efficiently in an attempt to achieve a timely and economical resolution to
contested matters.
28
Our ability to foreclose on some properties may be affected by state
and federal environmental laws. The costs of investigation, remediation or
removal of hazardous substances may be substantial and can easily exceed the
value of the property. The presence of hazardous substances, or the failure to
properly eliminate the substances from the property, can hurt the owner's
ability to sell or rent the property and prevent the owner from using the
property as collateral for another loan. Even parties who arrange for the
disposal or treatment of hazardous or toxic substances may be liable for the
costs of removal and remediation, whether or not the facility is owned or
operated by the party who arranged for the disposal or treatment. See "Risk
Factors -- Environmental laws and regulations and other environmental
considerations may restrict our ability to foreclose on loans secured by real
estate or increase costs associated with those loans which could hinder our
ability to operate profitably, limit the funds available to repay our
outstanding debt and negatively impact the value of our capital stock." The
technical nature of some laws and regulations, such as the Truth in Lending Act,
can also contribute to difficulties in foreclosing on real estate and other
assets, as even immaterial errors can trigger foreclosure delays or other
difficulties.
As the servicer of securitized loans, we are obligated to advance funds
for scheduled interest payments that have not been received from the borrower
unless we determine that our advances will not be recoverable from subsequent
collections of the related loan payments. See "-- Securitizations" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Securitizations." We are also required to compensate investors
(without a right to reimbursement) for interest shortfall resulting from loan
prepayments up to the amount of our servicing fee. See "Risk Factors -- Our
securitization agreements impose obligations on us to make cash outlays which
could impair our ability to operate profitably and our ability to repay our
outstanding debt and could negatively impact the value of our capital stock."
Beginning in the fourth quarter of fiscal 2002, we offered customer
retention incentives to borrowers who were exploring loan refinancing
opportunities for the purpose of lowering their monthly loan payments. In an
attempt to retain the loans we were servicing for these borrowers, we offered
the borrowers the opportunity to receive a monthly cash rebate equal to a
percentage of their scheduled monthly loan payments for periods of six to twelve
months. When we were successful in retaining these loans, we reduced the level
of loan prepayments in our managed portfolio of securitized loans. To initially
qualify for this program, a borrower has to be current on their loan principal
and interest payments and to continue to qualify and receive each month's cash
rebate, a borrower has to remain current. The percentage of rebates on scheduled
monthly loan payments offered to participants ranged from 15% to 20%. At June
30, 2004, $344.8 million in principal amount outstanding on loans were
participating in this program on which we expect to pay rebates of approximately
$1.3 million.
SECURITIZATIONS
We were unable to complete quarterly publicly underwritten
securitizations during the fourth quarter of fiscal 2003 and all of fiscal 2004.
We completed a privately-placed securitization in the second quarter of fiscal
2004. Our inability to complete a publicly underwritten securitization during
the fourth quarter of fiscal 2003 was the result of our investment bankers'
decision in late June 2003 not to underwrite the contemplated June 2003
securitization transaction. Management believes that a number of factors
contributed to this decision, including a highly-publicized lawsuit finding
liability of an underwriter in connection with the securitization of loans for
another unaffiliated subprime lender, an inquiry by the Civil Division of the
U.S. Attorney's Office in Philadelphia regarding our forbearance practices, an
anonymous letter regarding us received by our investment bankers, the SEC's
enforcement action against another unaffiliated subprime lender related to its
loan restructuring practices and related disclosure, a federal regulatory agency
investigation of practices by another subprime servicer and our investment
bankers' prior experience with securitization transactions with non-affiliated
originators.
29
During the year ended June 30, 2004, we completed a securitization of
$135.9 million of loans in the second quarter and sold $5.5 million of loans
into an off-balance sheet mortgage conduit facility. During fiscal 2003, we
securitized $112.0 million of business purpose loans and $1.3 billion of home
equity loans. During fiscal 2002, we securitized $129.1 million of business
purpose loans and $1.2 billion of home equity loans. The securitization of loans
and sale into the mortgage conduit facility generated gains on sale of loans of
$15.1 million during the year ended June 30, 2004, $171.0 million during fiscal
2003 and $185.6 million during fiscal 2002. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Securitizations"
for additional information regarding our securitizations.
Securitization is a financing technique often used by originators of
financial assets to raise capital. A securitization involves the sale of a pool
of financial assets, in our case loans, to a trust in exchange for cash and a
retained interest in the securitized loans which is called an interest-only
strip. The trust issues multi-class securities which derive their cash flows
from a pool of securitized loans. These securities, which are senior to our
retained interest-only strips in the trust, are sold to public or private
investors. We may also retain servicing on securitized loans. See "-- Loan
Servicing and Administrative Procedures."
As the holder of the interest-only strips received in a securitization,
we are entitled to receive excess (or residual) cash flows. These cash flows are
the difference between the payments made by the borrowers on securitized loans
and the sum of the scheduled and prepaid principal and pass-through interest
paid to trust investors, servicing fees, trustee fees and, if applicable, surety
fees. Surety fees are paid to an unrelated insurance entity to provide
protection for the trust investors. These cash flows also include cash flows
from overcollateralization. Overcollateralization is the excess of the aggregate
principal balances of loans in a securitized pool over investor interests.
Overcollateralization requirements are established to provide credit enhancement
for the trust investors.
We may be required either to repurchase or to substitute loans which do
not conform to the representations and warranties we made in the agreements
entered into when the loans are sold through a securitization. As of June 30,
2004, we have been required to substitute only one such loan from the
securitization trusts for this reason.
When borrowers are delinquent in making scheduled payments on loans
included in a securitization trust, we are obligated to advance interest
payments with respect to such delinquent loans if we deem that these advances
will ultimately be recoverable. These advances can first be made out of funds
available in the trust's collection account. If the funds available from the
collection account are insufficient to make the required interest advances, then
we are required to make the advances from our operating cash. The advances made
from a trust's collection account, if not recovered from the borrower or
proceeds from the liquidation of the loan, require reimbursement from us. These
advances may require funding from our capital resources and may create greater
demands on our cash flow than either selling loans with servicing released or
maintaining a portfolio of loans on our balance sheet. However, any advances we
make from our operating cash can be recovered from the subsequent mortgage loan
payments to the applicable trust prior to any distributions to the certificate
holders. See "Risk Factors -- Our securitization agreements impose obligations
on us to make cash outlays which could impair our ability to operate profitably
and our ability to repay our outstanding debt and could negatively impact the
value of our capital stock."
30
At times we elect to repurchase some delinquent loans from the
securitization trusts, some of which may be in foreclosure. Repurchasing loans
benefits us by allowing us to limit the level of delinquencies and losses in the
securitization trusts and as a result, we can avoid exceeding specified limits
on delinquencies and losses that trigger a temporary reduction or
discontinuation of residual or stepdown overcollateralization cash flows from
our interest-only strips until the delinquencies or losses no longer exceed the
triggers. We have the right, but are not obligated, to repurchase a limited
amount of delinquent loans from securitization trusts. The purchase price of a
delinquent loan is at the loan's outstanding contractual balance plus accrued
and unpaid interest and unreimbursed servicing advances, however, unpaid
interest and unreimbursed servicing advances are returned to us by the trust. A
foreclosed loan is one where we, as servicer, have initiated formal foreclosure
proceedings against the borrower and a delinquent loan is one that is 31 days or
more past due. The foreclosed and delinquent loans we typically elect to
repurchase are usually 90 days or more delinquent and the subject of foreclosure
proceedings, or where a completed foreclosure is imminent. In addition, we elect
to repurchase loans in situations requiring more flexibility for the
administration and collection of these loans in order to maximize their economic
recovery. See "Risk Factors - Our securitization agreements impose obligations
on us to make cash outlays which could impair our ability to operate profitably
and our ability to repay our outstanding debt and could negatively impact the
value of our capital stock." See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Securitizations -- Trigger
Management" for a description of the impact of these repurchases on our
business.
In the past, certain of our securitizations included a prefunding
option where a portion of the cash received from investors is withheld until
additional loans are transferred to the trust. The loans to be transferred to
the trust to satisfy the prefund option must be substantially similar in terms
of collateral, size, term, interest rate, geographic distribution and
loan-to-value ratio as the loans initially transferred to the trust. We had no
prefund obligations at June 30, 2004.
WHOLE LOAN SALES
Our determination to engage in whole loan sales depends upon a variety
of factors, including market conditions in the securitization markets and the
secondary loan markets, profitability and cash flow considerations. Due to our
inability to complete a quarterly securitization during the fourth quarter of
fiscal 2003, we adjusted our business strategy from a predominantly publicly
underwritten securitization strategy to a strategy focused on a combination of
whole loan sales and securitizations. See "Managements Discussion and Analysis
of Financial Condition and Results of Operations -- Whole Loan Sales" for more
detail.
COMPETITION
We have significant competition for home mortgage loans. We concentrate
our marketing efforts for home mortgage loans on credit-impaired borrowers.
Through Upland Mortgage and American Business Mortgage Services, Inc., we
compete with banks, thrift institutions, mortgage bankers and other finance
companies. Many large financial institutions have gradually expanded their
sub-prime lending capabilities. Many of these companies have name recognition
and greater access to capital at a cost lower than our cost of capital.
Additionally, federally chartered banks and thrifts can preempt some of the
state and local lending laws to which we are subject, thereby giving them a
competitive advantage.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, customer service, marketing and distribution
channels, amount and term of the loan, loan origination fees and interest rates.
Additional competition may lower the interest rates we can charge borrowers,
thereby potentially lowering gain on future whole loan sales and
securitizations.
31
We attempt to mitigate these factors through a highly trained staff of
professionals, rapid response to prospective borrowers' requests and by
maintaining a relatively short average loan processing time. See "-- Marketing
Strategy" for information regarding the markets in which we compete. See "--
Business Strategy" for discussion of our emphasis on broadening our mortgage
loan product line and offering competitive interest rates. See "Risk Factors --
Competition from other lenders could adversely affect our ability to attain
profitable operations and our ability to repay our outstanding debt may be
impaired and the value of our capital stock could be negatively impacted."
REGULATION
GENERAL. Our business is regulated by federal, state and, in certain
cases, local laws. All home mortgage loans must meet the requirements of, among
other statutes and regulations, the Truth in Lending Act, the Real Estate
Settlement Procedures Act, the Equal Credit Opportunity Act of 1974, and their
associated Regulations Z, X and B, respectively.
TRUTH IN LENDING. The Truth in Lending Act and Regulation Z contain
disclosure requirements designed to provide consumers with uniform,
understandable information about the terms and conditions of loans and credit
transactions so that consumers may compare credit terms. The Truth in Lending
Act also guarantees consumers a three-day right to cancel certain transactions
described in the act and imposes specific loan feature restrictions on some
loans, including some of the same types of loans originated by us. If we were
found not to be in compliance with the Truth in Lending Act, some aggrieved
borrowers could, depending on the nature of the non-compliance, have the right
to recover actual damages, statutory damages, penalties, rescind their loans
and/or to demand, among other things, the return of finance charges and fees
paid to us and third parties. Other fines and penalties can also be imposed
under the Truth in Lending Act and Regulation Z.
EQUAL CREDIT OPPORTUNITY ACT, FAIR CREDIT REPORTING ACT AND OTHER LAWS.
We are also required to comply with the Equal Credit Opportunity Act and
Regulation B, which prohibit creditors from discriminating against applicants on
the basis of race, color, religion, national origin, sex, age or marital status.
Regulation B also restricts creditors from obtaining certain types of
information from loan applicants. Among other things, it also requires lenders
to advise applicants of the reasons for any credit denial. Equal Credit
Opportunity Act violations can also result in fines, penalties and other
remedies.
In instances where the applicant is denied credit or the rate of
interest for a loan increases as a result of information obtained from a
consumer credit reporting agency, the Fair Credit Reporting Act of 1970, as
amended, requires lenders to supply the applicant with the name and address of
the reporting agency whose credit report was used in making such determinations.
It also requires that lenders provide other information and disclosures about
the loan application rejection. In addition, we are subject to the Fair Housing
Act and regulations under the Fair Housing Act, which broadly prohibit
discriminatory practices in connection with our home equity and other lending
businesses.
Pursuant to the Home Mortgage Disclosure Act and Regulation C, we are
also required to r