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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from _______________ to ________________
COMMISSION FILE NO. 000-22474
AMERICAN BUSINESS FINANCIAL SERVICES, INC.
------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 87-0418807
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 Penn Square East, Philadelphia, PA 19107
--------------------------------------------
(Address of principal executive offices) (Zip Code)
(215) 940-4000
--------------
(Registrant's telephone number, including area code)
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 whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X] NO
The number of shares outstanding of the registrant's sole class of
common stock and treasury stock as of November 9, 2004 were 3,598,342 shares and
54,823 shares, respectively.
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2004 and June 30, 2004................................1
Consolidated Statements of Operations for the three months ended September 30, 2004 and 2003..........3
Consolidated Statement of Stockholders' Equity for the three months ended September 30, 2004..........4
Consolidated Statements of Cash Flow for the three months ended September 30, 2004 and 2003 ..........5
Notes to Consolidated Financial Statements............................................................7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......52
Item 3. Quantitative and Qualitative Disclosures about Market Risk.................................155
Item 4. Controls and Procedures ...................................................................155
PART II OTHER INFORMATION
Item 1. Legal Proceedings..........................................................................156
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds................................159
Item 3. Defaults Upon Senior Securities ...........................................................160
Item 4. Submission of Matters to a Vote of Security Holders........................................160
Item 5. Other Information..........................................................................160
Item 6. Exhibits ..................................................................................161
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollar amounts in thousands)
SEPTEMBER 30, JUNE 30,
2004 2004
------------- ----------
(UNAUDITED) (NOTE)
ASSETS
Cash and cash equivalents ........................ $ 19,673 $ 910
Restricted cash .................................. 10,419 13,307
Loan and lease receivables:
Loans available for sale ........................ 336,511 304,275
Non-accrual loans (net of allowance for credit
losses of $1,238 at
September 30, 2004 and $1,469 at June 30, 2003) 3,314 1,993
Interest and fees receivable ..................... 15,304 18,089
Deferment and forbearance advances receivable .... 5,839 6,249
Loans subject to repurchase rights ............... 40,736 38,984
Interest-only strips (includes the fair value of
overcollateralization related cash flows of
$202,215 and $216,926 at September 30, 2004 and
June 30, 2004).................................. 448,812 459,086
Servicing rights ................................. 66,712 73,738
Deferred income tax asset ........................ 66,201 59,133
Property and equipment, net ...................... 25,182 26,047
Prepaid expenses ................................. 16,740 13,511
Other assets ..................................... 27,953 27,548
---------- ----------
TOTAL ASSETS ..................................... $1,083,396 $1,042,870
========== ==========
1
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS -- (CONTINUED)
(dollar amounts in thousands)
SEPTEMBER 30, JUNE 30,
2004 2004
------------- ----------
LIABILITIES
Subordinated debentures .......................... $ 490,026 $ 522,609
Senior collateralized subordinated notes ......... 97,454 83,639
Warehouse lines and other notes payable .......... 281,472 241,200
Accrued interest payable ......................... 38,324 37,675
Accounts payable and accrued expenses ............ 35,819 28,096
Liability for loans subject to repurchase rights . 47,925 45,864
Deferred income tax liability .................... -- --
Other liabilities ................................ 80,517 71,872
---------- ----------
Total liabilities ................................ 1,071,537 1,030,955
========== ==========
STOCKHOLDERS' EQUITY
Preferred stock, par value $.001, liquidation
preference of $1.00 per share plus accrued and
unpaid dividends to the date of liquidation,
authorized, 203,000,000 shares at September 30,
2004 and June 30, 2004;
Issued: 109,435,580 shares of Series A at
September 30, 2004 and 93,787,111 shares of
Series A at June 30, 2004....................... 109 94
Common stock, par value $.001, authorized shares
209,000,000 at September 30, 2004 and June 30,
2004; Issued: 3,653,165 shares at September 30,
2004 and at June 30, 2004 3,653,165 shares in
2004 (including Treasury shares of 54,823 at
September 30, 2004 and 54,823 at June 30, 2004). 4 4
Additional paid-in capital ....................... 120,214 107,241
Accumulated other comprehensive income ........... 16,706 4,596
Unearned compensation ............................ (440) (495)
Stock awards outstanding ......................... 123 95
Retained earnings (deficit) ...................... (123,561) (98,324)
Treasury stock, at cost .......................... (696) (696)
---------- ----------
12,459 12,515
Note receivable .................................. (600) (600)
---------- ----------
Total stockholders' equity ....................... 11,859 11,915
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ....... $1,083,396 $1,042,870
========== ==========
- -----
Note: The balance sheet at June 30, 2004 has been derived from the audited
financial statements at that date.
See accompanying notes to consolidated financial statements.
2
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollar amounts in thousands, except per share data)
(unaudited)
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
-------- --------
REVENUES
Gain on sale of loans:
Whole loan sales ....................................... $ 6,119 $ 2,921
Securitizations ........................................ -- 799
Interest and fees ....................................... 7,696 4,653
Interest accretion on interest-only strips .............. 8,448 11,109
Servicing income ........................................ 845 718
Other income ............................................ 1 1
-------- --------
Total revenues .......................................... 23,109 20,201
-------- --------
EXPENSES
Interest ................................................ 18,155 16,818
Provision for credit losses ............................. 117 4,156
Employee related costs .................................. 11,943 13,852
Sales and marketing ..................................... 6,391 2,841
(Gains) and losses on derivative financial instruments .. 1,989 (5,108)
General and administrative .............................. 23,311 19,215
Securitization assets valuation adjustment .............. 29 10,795
-------- --------
Total expenses .......................................... 61,935 62,569
-------- --------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES ......... (38,826) (42,368)
Provision for income tax expense (benefit) (13,589) (16,100)
-------- --------
INCOME (LOSS) BEFORE DIVIDENDS ON PREFERRED STOCK ....... (25,237) (26,268)
Dividends on preferred stock ............................ 3,475 --
-------- --------
NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCK .......... $(28,712) $(26,268)
======== ========
EARNINGS (LOSS) PER COMMON SHARE:
Basic .................................................. $ (7.98) $ (8.10)
======== ========
Diluted ................................................ $ (7.98) $ (8.10)
======== ========
AVERAGE COMMON SHARES (IN THOUSANDS):
Basic .................................................. 3,598 3,242
======== ========
Diluted ................................................ 3,598 3,242
======== ========
See accompanying notes to consolidated financial statements.
3
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(amounts in thousands)
(unaudited)
PREFERRED STOCK COMMON STOCK
-------------------- -------------------- ACCUMULATED
NUMBER OF NUMBER OF ADDITIONAL OTHER
SHARES SHARES PAID-IN COMPREHENSIVE
OUTSTANDING AMOUNT OUTSTANDING AMOUNT CAPITAL INCOME
----------- ------ ----------- ------ ---------- -------------
Balance, June 30, 2004 .............................. 93,787 $ 94 3,598 $ 4 $107,241 $ 4,596
Comprehensive income (loss):
Net loss ........................................... -- -- -- -- -- --
Net unrealized gain on interest-only strips ........ -- -- -- -- -- 12,110
------- ---- ----- --- -------- -------
Total comprehensive income (loss) ................... -- -- -- -- -- 12,110
Issuance of preferred stock ......................... 15,649 15 -- -- 15,633 --
Valuation of restricted stock (110,000 shares) ...... -- -- -- -- (55) --
Stock awards outstanding ............................ -- -- -- -- -- --
Cash dividends declared on preferred stock
($0.025 per share)................................. -- -- -- -- (2,605) --
Preferred stock beneficial conversion feature:
Amortization of beneficial conversion feature ...... -- -- -- -- 870 --
Non-cash preferred dividend ........................ -- -- -- -- (870) --
------- ---- ----- --- -------- -------
Balance September 30, 2004 .......................... 109,436 $109 3,598 $ 4 $120,214 $16,706
======= ==== ===== === ======== =======
STOCK TOTAL
UNEARNED AWARDS RETAINED TREASURY NOTE STOCKHOLDERS'
(CONTINUED) COMPENSATION OUTSTANDING EARNINGS STOCK RECEIVABLE EQUITY
------------ ----------- --------- -------- ---------- -------------
Balance, June 30, 2004 ........................ $(495) $ 95 $ (98,324) $(696) $(600) $ 11,915
Comprehensive income (loss):
Net loss ..................................... -- -- (25,237) -- -- (25,237)
Net unrealized gain on interest-only strips .. -- -- -- -- -- 12,110
----- ---- --------- ----- ----- --------
Total comprehensive income (loss) ............. -- -- (25,237) -- -- (13,127)
Issuance of preferred stock ................... -- -- -- -- -- 15,648
Valuation of restricted stock (110,000 shares) 55 -- -- -- -- --
Stock awards outstanding ...................... -- 28 -- -- -- 28
Cash dividends declared on preferred stock
($0.025 per share) -- -- -- -- -- (2,605)
Preferred stock beneficial conversion feature:
Amortization of beneficial conversion
discount..................................... -- -- -- -- -- 870
Non-cash preferred dividend .................. -- -- -- -- -- (870)
----- ---- --------- ----- ----- --------
Balance September 30, 2004 $(440) $123 $(123,561) $(696) $(600) $ 11,859
===== ==== ========= ===== ===== ========
See accompanying notes to consolidated financial statements.
4
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(dollar amounts in thousands)
(unaudited)
THREE MONTHS ENDED
SEPTEMBER 30,
---------------------
2004 2003
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) ..................................... $ (25,237) $ (26,268)
Adjustments to reconcile net income to net cash used
in operating activities:
Gain on sale of loans ................................ (6,119) (3,720)
Depreciation and amortization ........................ 8,452 14,647
Interest accretion on interest-only strips ........... (8,448) (10,828)
Securitization assets valuation adjustment ........... 29 10,795
Provision for credit losses .......................... 117 4,156
Loans originated for sale ............................. (642,756) (158,284)
Proceeds from sale of loans ........................... 612,965 278,523
Principal payments on loans and leases ................ 1,947 4,169
(Increase) decrease in accrued interest and fees on
loan and lease receivables........................... 3,195 (2,217)
Cash proceeds from sale of securitization assets ...... 9,000 --
Required purchase of additional overcollateralization
on securitized loans................................. (4,615) (7,660)
Cash flow from interest-only strips ................... 33,141 56,222
Increase in prepaid expenses .......................... (3,229) (5,584)
(Decrease) increase in accrued interest payable ....... 649 (1,696)
Increase in accounts payable and accrued expenses ..... 6,812 2,372
Accrued interest payable reinvested in subordinated
debt................................................. 6,262 9,686
Decrease in deferred income taxes ..................... (13,587) (16,097)
Increase (decrease) in loans in process ............... 10,441 (24,148)
(Payments) on derivative financial instruments ........ (3,611) (1,378)
Other, net ............................................ 371 5,714
--------- ---------
Net cash provided by (used in) operating activities ... (14,221) 128,404
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment, net ............... (587) (6,774)
Principal receipts and maturity of investments ........ 839 11
--------- ---------
Net cash used in investing activities ................. 252 (6,763)
--------- ---------
5
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW -- (CONTINUED)
(dollar amounts in thousands)
(unaudited)
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2004 2003
-------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of subordinated debt ............ $ 45,525 $ 1,576
Redemptions of subordinated debt ....................... (53,538) (43,217)
Net borrowings (repayments) on revolving lines of
credit................................................ 40,356 (77,271)
Principal payments under capital lease obligations ..... (84) (77)
Net repayments of other notes payable .................. -- (26,158)
Financing costs incurred ............................... (721) (314)
Lease incentive receipts ............................... -- 3,562
Cash dividends paid on preferred stock ................. (1,694) --
-------- ---------
Net cash provided by (used in) financing activities .... 29,844 (141,899)
-------- ---------
Net (decrease) increase in cash and cash equivalents ... 15,875 (20,258)
Cash and cash equivalents at beginning of year ......... 14,217 47,475
-------- ---------
Cash and cash equivalents at end of year ............... $ 30,092 $ 27,217
======== =========
SUPPLEMENTAL DISCLOSURES:
Cash paid during the period for:
Interest .............................................. $ 11,244 $ 8,828
Income taxes .......................................... $ 38 $ 40
See accompanying notes to consolidated financial statements.
6
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
American Business Financial Services, Inc. ("ABFS"), together with its
subsidiaries (the "Company"), is a financial services organization operating
mainly in the eastern and central portions of the United States. Recent
expansion has positioned the Company to increase its operations in the western
portion of the United States, especially California. The Company originates,
sells and services home mortgage loans through its principal direct and
indirect subsidiaries. The Company also processes and purchases home mortgage
loans from other financial institutions through the Bank Alliance Services
program. Additionally, the Company services business purpose loans that it had
originated and sold in prior periods.
Historically, the Company's loans primarily consisted of fixed interest rate
loans secured by first or second mortgages on one-to-four family residences.
The Company's recent business strategy adjustments include increasing loan
originations by offering adjustable rate loans and purchase money mortgage
loans. The Company's customers are primarily credit-impaired borrowers who are
generally unable to obtain financing from banks or savings and loan
associations and who are attracted to the Company's products and services. The
Company originates loans through a combination of channels including a
national processing center located at its centralized operating office in
Philadelphia, Pennsylvania and a network of mortgage brokers. During fiscal
2004, the Company acquired broker operations in West Hills, California and
Austin, Texas and opened new offices in Edgewater, Maryland and Irvine,
California to support the Company's broker operations. The Company's loan
servicing and collection activities are performed at its Philadelphia office.
In addition, the Company offers subordinated debentures to the public, the
proceeds of which are used for repayment of existing debt, loan originations,
operations (including repurchases of delinquent assets from securitization
trusts and funding loan overcollateralization requirements under its credit
facilities), investments in systems and technology and for general corporate
purposes.
BUSINESS CONDITIONS
GENERAL. For its ongoing operations, the Company depends upon frequent
financings, including the sale of unsecured subordinated debentures,
borrowings under warehouse credit facilities or lines of credit and it also
depends on the sale of loans on a whole loan basis or through publicly
underwritten or privately-placed securitizations. If the Company is unable to
renew or obtain adequate funding on acceptable terms through its sale of
subordinated debentures or under a warehouse credit facility, or other
borrowings, or if it is unable to sell or securitize its loans, the lack of
adequate funds would adversely impact liquidity and result in continued losses
or reduce profitability. To the extent that the Company is not successful in
replacing existing subordinated debentures and senior collateralized
subordinated notes upon maturity, maintaining adequate warehouse credit
facilities or lines of credit to fund increasing loan originations, or
securitizing and selling its loans, it may have to limit future loan
originations and restructure its operations.
Limiting loan originations or restructuring operations could impair the
Company's ability to repay subordinated debentures and senior collateralized
subordinated notes at maturity and may result in continued losses.
The Company has historically experienced negative cash flow from operations
since 1996 primarily because, in general, its business strategy of selling
loans through securitizations had not generated cash flow immediately.
However, during fiscal 2004, the Company experienced positive cash flow from
operations of $6.8 million, primarily due to sales of loans on a whole loan
basis it originated in fiscal 2003. For the first three months of fiscal 2005,
the Company experienced negative operating cash flow of $14.2 million,
primarily due to its funding a $32.2 million increase in loans available for
sale.
7
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
For the first quarter of fiscal 2005, the Company recorded a net loss
attributable to common stock of $28.7 million. The loss for the first quarter
of fiscal 2005 primarily resulted from the Company's inability to reach the
loan origination levels required under its adjusted business strategy to
return to profitability, which substantially reduced its ability to generate
revenues, and its inability to complete a securitization during the first
quarter. Additionally, operating expenses increased in the first quarter of
fiscal 2005 as the Company began to add loan processing and marketing support
staff to support the future loan origination levels it expects to achieve
under its adjusted business strategy.
For the fiscal year ended June 30, 2004, the Company recorded a net loss
attributable to common stock of $115.1 million. The loss primarily resulted
from: a) liquidity issues described below, which substantially reduced the
Company's ability to originate loans and generate revenues during the first
nine months of fiscal 2004, b) the Company's inability to complete
securitizations of loans during the first, second and third quarters of fiscal
2004, c) operating expense levels which would support greater loan origination
volume, and d) $46.4 million of pre-tax charges for valuation adjustments on
its securitization assets. The valuation adjustments reflect the impact of
higher than anticipated prepayments on securitized loans experienced during
fiscal 2004 due to the continuing low interest rate environment. In fiscal
2004, the Company originated $982.7 million of loans, which represents a
significant reduction as compared to $1.67 billion of loans originated in the
prior fiscal year.
LIQUIDITY CONCERNS. The Company's short-term liquidity has been negatively
impacted by several events and issues, which have occurred starting in the
fourth quarter of fiscal 2003.
First, the Company's inability to complete a securitization during the
fourth quarter of fiscal 2003 adversely impacted its short-term liquidity
position and contributed to the loss for fiscal 2003. Because there was no
securitization, $453.4 million of the Company's $516.1 million of revolving
credit and conduit facilities then available was drawn upon at June 30, 2003.
The Company's revolving credit facilities and mortgage conduit facility had
$62.7 million of unused capacity available at June 30, 2003, which
significantly reduced its ability to fund loan originations in fiscal 2004
until it sold existing loans, extended existing credit facilities, or added
new credit facilities.
Second, the Company's ability to finance new loan originations in the first
three months of fiscal 2004 using borrowings under certain of its credit
facilities which carried over into fiscal 2004 was limited, terminated or
expired by October 31, 2003. Further advances under a non-committed portion of
one of these credit facilities were subject to the discretion of the lender and
subsequent to June 30, 2003, there were no new advances under the non-committed
portion. Additionally, on August 20, 2003, amendments to this credit facility
eliminated the non-committed portion of this facility, reduced the committed
portion to $50.0 million and accelerated the expiration date from November 2003
to September 30, 2003. Also, a $300.0 million mortgage conduit facility with a
financial institution that enabled the Company to sell its loans into an
off-balance sheet facility, expired pursuant to its terms on July 5, 2003. In
addition, the Company was unable to borrow under a $25.0 million warehouse
facility after September 30, 2003, and this facility expired on October 31,
2003.
8
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
Third, even though the Company was successful in obtaining one new credit
facility in September 2003 and obtaining a second new credit facility in
October 2003, see Remedial Actions to Address Liquidity Issues below, its
ability to finance new loan originations in the second and third quarters of
fiscal 2004 with borrowings under these new credit facilities was limited. The
limitations resulted from requirements to fund overcollateralization, which is
discussed below, in connection with new loan originations.
Fourth, the Company's temporary discontinuation of sales of new subordinated
debentures for approximately a six-week period during the first quarter of
fiscal 2004 further impaired its liquidity.
As a result of these liquidity issues, the Company's loan origination volume
was substantially reduced in fiscal 2004. From July 1, 2003 through June 30,
2004, the Company originated $982.7 million of loans, which represents a
significant reduction as compared to originations of $1.67 billion of loans in
fiscal 2003. As a result of the decrease in loan originations in fiscal 2004
and liquidity issues described above, the Company incurred a loss in fiscal
2004 and the first quarter of fiscal 2005 and depending on the Company's
ability to reach a profitable level of loan originations, complete
securitizations and recognize gains, it anticipates incurring losses at least
through the second quarter of fiscal 2005. During the first three months of
fiscal 2005, the Company originated $629.7 million of loans including $198.0
million in July 2004, $197.4 million in August 2004 and $234.3 million in
September 2004.
The Company anticipates that depending upon the size of its future quarterly
securitizations, it will need to increase loan originations to approximately
$400.0 million to $500.0 million per month to return to profitable operations.
If the Company is unable to complete quarterly securitizations, it will need
to increase its loan originations to approximately $500.0 million to $600.0
million per month to return to profitability.
The Company plans to achieve these increased levels of loan originations
through the continued application of its business strategy adjustments,
particularly as related to building an expanded broker channel and offering
adjustable rate mortgages and more competitively priced fixed rate mortgages.
The following actions were undertaken in fiscal 2004 to increase the Company's
ability to originate loans in its broker channel: (i) in December 2003 the
Company hired an experienced industry professional to manage the wholesale
business; (ii) in December 2003 the Company acquired a broker operation with
35 employees (63 employees at September 30, 2004) located in California; (iii)
in February 2004, the Company opened a mortgage broker office in Irvine,
California; (iv) in March 2004, the Company opened a mortgage broker office in
Maryland and hired three experienced senior managers and a loan origination
staff of 40 (74 employees at September 30, 2004); and (v) in June 2004 the
Company acquired a broker operation with 35 employees (36 employees at
September 30, 2004) located in Texas. In addition, the Company hired 38
mortgage broker account executives in its Upland Mortgage Broker Services
division to expand its broker presence in the eastern, southern and mid-
western areas of the United States and retained/hired 101 employees in its
Upland Broker Services Philadelphia headquarters to support its growing broker
network. In total, at September 30, 2004, the Company had 353 employees in its
broker operations including 182 account executives.
The Company's ability to achieve those levels of loan originations could be
hampered by a failure to implement its business strategy adjustments and by
loan funding limitations should the Company fail to maintain or replace
adequate credit facilities to finance new loan obligations.
9
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
The combination of the Company's current cash position and expected sources
of operating cash in fiscal 2005 may not be sufficient to cover its operating
cash requirements. For the next six to twelve months the Company expects to
augment its 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 will be used
to fund overcollateralization requirements in connection with loan
originations and fund the Company's operating losses. The Company can provide
no assurances that it will be able to continue issuing subordinated
debentures. In the event the Company is unable to offer additional
subordinated debentures for any reason, it has developed a contingent
financial restructuring plan. This plan is described later in this note under
"Subordinated Debentures and Senior Collateralized Subordinated Notes." On
September 30, 2004, the Company had unrestricted cash of approximately $19.7
million and up to $70.1 million available under its credit facilities.
Advances under these credit facilities can only be used to fund loan
originations and not for any other purposes.
Due to losses recorded in each of the quarters in fiscal 2004, the Company
requested and obtained waivers for its non-compliance with financial covenants
in its credit facility agreements and servicing agreements. See Note 8 for
more detail.
REMEDIAL ACTIONS TO ADDRESS LIQUIDITY ISSUES. The Company undertook
specific remedial actions to address liquidity issues including:
o The Company adjusted its business strategy beginning in early fiscal 2004.
The adjusted business strategy focuses on shifting from gain-on-sale
accounting and the use of securitization transactions as the Company's
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.
o The Company solicited bids and commitments from participants in the whole
loan sale market and entered into forward sale agreements. In total, from
June 30, 2003 through June 30, 2004, the Company sold approximately $1.1
billion (which includes $222.3 million of loans sold by the expired
mortgage conduit facility) of loans through whole loan sales. From July
1, 2004 through September 30, 2004, the Company sold an additional $586.5
million of loans through whole loan sales.
o The Company has entered into an informal arrangement with one recurring
purchaser of its loans whereby the purchaser maintains members of their
loan underwriting staff on the Company's premises to facilitate their
purchase of the Company's loans promptly after the Company originates
them. This arrangement accelerates the Company's receipt of cash proceeds
from the sale of loans, accelerates the pay down of its advances under
its warehouse credit facilities and adds to its liquidity. This quicker
turnaround time is expected to enable the Company to operate with smaller
committed warehouse credit facilities than would otherwise be necessary.
o On October 31, 2003, the Company completed a privately-placed
securitization, with servicing released, of $173.5 million of loans.
o The Company entered into two definitive loan agreements during fiscal
2004 for the purpose of funding its loan originations. These two
agreements replaced those credit facilities, which carried over into
fiscal 2004 but were limited, terminated or expired by October 31, 2003.
The Company entered into the first agreement on September 22, 2003 with a
financial institution for a one-year $200.0 million credit facility. It
entered into the second agreement on October 14, 2003 with a warehouse
lender for a three-year revolving mortgage loan warehouse credit facility
of up to $250.0 million. The one-year facility was extended to December
3, 2004, reduced on September 30, 2004 to
10
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
$100.0 million and reduced on November 4, 2004 to $60.0 million. The
reduction to $60.0 million will occur at a rate of $10.0 million per week
commencing on November 5, 2004. The three-year $250.0 million warehouse
credit facility continues to be available. See Note 10 for information
regarding the terms of these facilities.
o On November 5, 2004, the Company entered into a definitive agreement dated
as of November 4, 2004 with a warehouse lender for a one-year $100.0
million credit facility to replace the maturing $200.0 million credit
facility (reduced to $60.0 million). The Company also sold the
interest-only strips and servicing rights related to five of its mortgage
securitization trusts to an affiliate of this facility provider under the
terms of a September 27, 2004 sale agreement. The sale of these assets was
undertaken as part of the Company's negotiations to obtain the new $100.0
million credit facility and to raise cash to pay fees on new warehouse
credit facilities and as a result, the Company did not realize their full
value as reflected on its books. The Company wrote down the carrying value
of these interest-only strips and servicing rights by $5.4 million at June
30, 2004 to reflect their values under the terms of the sale agreement. On
September 27, 2004, the Company received proceeds from this sale of $9.7
million.
o On October 27, 2004, the Company entered into a commitment letter dated
October 26, 2004 and is negotiating the terms of a definitive agreement
with a warehouse lender for a three-year $30.0 million mortgage loan
warehouse facility and a two-year $23.0 million residual repurchase
facility. There can be no assurance that the Company will succeed in
entering into a definitive agreement regarding these facilities or that
this agreement will contain the terms and conditions acceptable to it. See
Note 8 for information regarding the terms of these facilities.
o On November 1, 2004, the Company received a commitment letter from two
warehouse lenders, including an affiliate of the lender on its $250.0
million credit facility, for a two-year $150.0 million mortgage loan
warehouse facility. The commitment letter becomes effective and legally
obligates the parties upon the Company's payment of fees described in the
commitment letter which have not been paid to date. However, there can be
no assurance that the Company will enter into definitive agreements
regarding the $150.0 million credit facility or that this agreement will
contain the terms and conditions acceptable to it. See Note 8 for
information regarding the terms of this facility.
o The Company mailed an Offer to Exchange on December 1, 2003 and May 14,
2004 ("the exchange offers") to holders of its subordinated debentures in
order to increase stockholders' equity and reduce the amount of
outstanding debt. These exchange offers resulted in the exchange of
$208.6 million of the Company's subordinated debentures for 109.4 million
shares of Series A preferred stock and $99.2 million of senior
collateralized subordinated notes. See Notes 10 and 11 for more detail on
the terms of the exchange offers, senior collateralized subordinated
notes and preferred stock issued. The issuance of 109.4 million shares of
Series A preferred stock results in an annual cash preferred dividend
obligation of $10.9 million.
o On January 22, 2004, the Company executed an agreement to sell its
interests in the remaining leases in its portfolio. The terms of the
agreement included a cash sale price of approximately $4.8 million in
exchange for the Company's lease portfolio balance as of December 31,
2003. The Company received the cash from this sale in January 2004 and
recognized a net gain of $0.5 million.
11
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS CONDITIONS -- (CONTINUED)
o The Company suspended payment of quarterly dividends on its common stock
beginning in the first quarter of fiscal 2004.
To the extent that the Company fails to maintain its credit facilities or
obtain alternative financing on acceptable terms and increase its loan
originations, it may have to sell loans earlier than intended and further
restructure its operations. While the Company currently believes that it will
be able to restructure its operations, if necessary, it can provide no
assurances that such restructuring will enable it to attain profitable
operations or repay subordinated debentures or senior collateralized
subordinated notes when due.
SUBORDINATED DEBENTURES AND SENIOR COLLATERALIZED SUBORDINATED NOTES. At
September 30, 2004 there were approximately $321.4 million of subordinated
debentures and $38.9 million of senior collateralized subordinated notes,
maturing within twelve months. The Company obtains the funds to repay the
subordinated debentures and senior collateralized subordinated notes at their
maturities by selling additional subordinated debentures and selling loans on
a whole loan basis and securitizing loans. Cash flow from operations, the sale
of subordinated debentures and lines of credit fund the Company's cash needs.
The Company expects these sources of funds to be sufficient to meet its cash
needs. The Company could, in the future, generate cash flows by securitizing,
selling, or borrowing against its interest-only strips and selling servicing
rights generated in past securitizations, although the Company's ability to
utilize the interest-only strips in this fashion could be restricted in whole
or in part by the terms of the Company's $250.0 million warehouse credit
facility and senior collateralized subordinated notes, both of which are
collateralized by the interest-only strips at the present time or other
prospective credit facilities. See Note 5 for more detail on obligations
collateralized by interest-only strips.
The Company can provide no assurances that it will be able to continue
issuing subordinated debentures. In the event the Company is unable to offer
additional subordinated debentures for any reason, the Company has developed a
contingent financial restructuring plan including cash flow projections for
the next twelve-month period. Based on the Company's current cash flow
projections, the Company anticipates being able to make all scheduled
subordinated debenture maturities and vendor payments.
The contingent financial restructuring plan is based on actions that the
Company would take, in addition to those indicated in its adjusted business
strategy, to reduce its 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 the Company will be able to successfully implement the contingent
financial restructuring plan, if necessary, and repay its outstanding debt
when due.
BASIS OF FINANCIAL STATEMENT PRESENTATION
The consolidated financial statements include the accounts of ABFS and its
subsidiaries (all of which are wholly owned). The consolidated financial
statements have been prepared in accordance with accounting principles
generally accepted in the United States of America. All significant
intercompany balances and transactions have been eliminated. In preparing the
consolidated financial statements, management is required to make estimates
and assumptions, which affect the reported amounts of assets and liabilities
as of the date of the consolidated financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates. These estimates include, among other
things, estimated prepayment, credit loss and discount rates on interest-only
strips and servicing rights, estimated servicing revenues and costs, valuation
of real estate owned, the net recoverable value of interest and fee
receivables and determination of the allowance for credit losses.
12
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BASIS OF FINANCIAL STATEMENT PRESENTATION -- (CONTINUED)
Certain prior period financial statement balances have been reclassified to
conform to current period presentation. All outstanding shares, average common
shares, earnings per common share and stock option amounts have been
retroactively adjusted to reflect the effect of a 10% stock dividend declared
on May 13, 2004. See Note 11 for further description.
RESTRICTED CASH
The Company held restricted cash balances of $8.0 million at September 30,
2004 collateralizing a letter of credit facility, $2.2 million and $3.1
million related to borrower escrow accounts at September 30, 2004 and June 30,
2004, respectively, and $0.1 million and $2.1 million at June 30, 2004 related
to deposits for future settlement of derivative financial instruments.
LOAN RECEIVABLES
Loans available for sale are loans the Company plans to sell or securitize
and are carried at the lower of amortized cost (principal balance, including
unamortized origination costs and fees) or fair value. Fair value is
determined by quality of credit risk, types of loans originated, current
interest rates, economic conditions, and other relevant factors.
Non-accrual loans consist primarily of loans repurchased from securitization
trusts and transferred from loans available for sale that are greater than 90
days delinquent. Non-accrual loans are carried at cost less an allowance for
credit losses.
INTEREST AND FEES RECEIVABLE
Interest and fees receivables are comprised mainly of accrued interest
receivable on loans and fees on loans that are less than 90 days delinquent.
Fee receivables include, among other types of fees, late fees and taxes and
insurance advances.
FORBEARANCE AND DEFERMENT ADVANCES RECEIVABLES
Under deferment and forbearance arrangements, the Company makes advances to
a securitization trust on behalf of a borrower in amounts equal to the
delinquent loan payments and may pay taxes, insurance and other fees on behalf
of the borrower. As a result of these arrangements the Company resets the
contractual status of a loan in its managed portfolio from delinquent to
current based upon the borrower's resumption of making their loan payments.
These amounts are carried at their estimated net recoverable value.
Advances made under deferment and forbearance arrangements result from a new
credit decision regarding the borrower's ability to repay the advance, as well
as perform under the original terms of the original loan, and do not involve
any modification of the terms of the original loan. These arrangements are
considered a new lending activity and do not qualify as troubled debt
restructurings under Statement of Financial Accounting Standard ("SFAS") No.
15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings."
The Company records the advances that it makes under deferment and forbearance
arrangements with borrowers as receivables on its balance sheet. The Company
carries these receivables at their estimated recoverable amounts. If the
original loan returns to a delinquency status of 90 days or more past due, the
Company writes the receivable off to expense. The Company did not record any
fee income on these arrangements during the three months ended September 30,
2004 or the fiscal year ended June 30, 2004.
13
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
LOANS SUBJECT TO REPURCHASE RIGHTS / LIABILITY FOR LOANS SUBJECT TO REPURCHASE
RIGHTS
Loans subject to repurchase rights is comprised of loans which were
securitized under SFAS No. 140 that the Company has a right to repurchase
because of a default by the borrower. SFAS No. 140 was effective on a
prospective basis for transfers of financial assets occurring after March 31,
2001. For securitizations recorded under SFAS No. 140 which have removal of
accounts provisions providing the Company with a contractual right to
repurchase delinquent loans, SFAS No. 140 requires that it recognize the loans
which are subject to these rights as assets on its balance sheet and record a
liability to reflect the repurchase cost. SFAS No. 140 requires this
accounting treatment because the default by the borrower has given the Company
effective control over the loans whether or not the Company actually
repurchases these loans. For securitization trusts 2001-2 through 2003-2, to
which this rule applies, the Company has the contractual right to repurchase a
limited amount of loans greater than 180 days past due, but no obligation to
do so. As delinquent loans in securitization trusts 2001-2 through 2003-2 age
greater than 180 days past due, the Company records an asset representing the
fair value of the loans and a liability to reflect the repurchase cost. In
accordance with the provisions of SFAS No. 140, the Company has recorded on
its September 30, 2004 balance sheet an asset of $40.7 million and a liability
of $47.9 million for delinquent loans subject to these removal of accounts
provisions under securitization trusts 2001-2 through 2003-2.
For securitization trusts 1998-3 through 2001-1, the Company also has rights
to repurchase a limited amount of delinquent loans, but is not obligated to do
so. No liabilities or assets have been recorded on its balance sheet related
to these rights. The amount of delinquent loans in securitization trusts 1998-
3 through 2001-1 which the company has the right to repurchase as of September
30, 2004 was $47.6 million.
ALLOWANCE FOR CREDIT LOSSES
The Company's allowance for credit losses on non-accrual loans and leases is
maintained to account for delinquent loans and leases and delinquent loans
that have been repurchased from securitization trusts. The allowance is
maintained at a level that management determines is adequate to absorb
estimated probable losses. The allowance is calculated based upon management's
estimate of its ability to collect on outstanding loans and leases based upon
a variety of factors, including, but not limited to, periodic analysis of the
non-accrual loans and leases, economic conditions and trends, historical
credit loss experience, borrowers' ability to repay and collateral
considerations. Additions to the allowance arise from the provision for credit
losses charged to operations or from the recovery of amounts previously
charged-off. Loan and lease charge-offs reduce the allowance. Delinquent loans
are charged off against the allowance in the period in which a loan is deemed
fully uncollectable or when liquidated in a payoff. Management considers the
current allowance to be adequate.
INTEREST-ONLY STRIPS
Prior to June 30, 2003, the Company sold most of the loans it originated
through securitizations. In connection with these securitizations, the Company
received cash and an interest-only strip, which represents the Company's
retained interest in the securitized loans. As a holder of the interest-only
strips, the Company is entitled to receive certain excess (or residual) cash
flows and overcollateralization cash flows, which are derived from payments
made to a trust from the securitized loans after deducting payments to
investors in the securitization trust and other miscellaneous fees. These
retained interests are carried at their fair value. Interest-only strips are
initially recorded at their allocated cost basis at the time of recording a
securitization gain and in accordance with SFAS No. 115 "Accounting for
Certain Investments in Debt and Equity Securities," referred to as SFAS No.
115 in this document, are then written up to their fair value through other
comprehensive income, a component of stockholders' equity.
14
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-ONLY STRIPS -- (CONTINUED)
Fair value is based on a discounted cash flow analysis which estimates the
present value of the future expected residual cash flows and
overcollateralization cash flows utilizing assumptions made by management at
the time the loans are sold. These assumptions include the rates used to
calculate the present value of expected future residual cash flows and
overcollateralization cash flows, referred to as the discount rates, and
expected prepayment and credit loss rates on the pools of loans sold through
securitizations. Cash flows are discounted from the date the cash is expected
to be available to the Company (the "cash-out method"). Management based its
estimates of prepayment and credit loss rates on historical experience,
current and expected economic conditions and in the case of prepayment rate
assumptions, consideration of the impact of changes in market interest rates.
Excess cash flows are retained by the trust until certain
overcollateralization levels are established. The overcollateralization is the
excess of the aggregate principal balances of loans in a securitized pool over
investor interests. The overcollateralization serves as credit enhancement for
the investors.
PREPAYMENT RATES. The assumptions the Company uses to estimate future
prepayment rates are regularly compared to actual prepayment experience of the
individual securitization pools of mortgage loans and to an average of the
actual experience of other similar pools of mortgage loans at the same age.
Current economic conditions, current interest rates, loans repurchased from
securitization trusts and other factors are considered in our analysis of
prepayment experience and in forecasting future prepayment levels.
Analysis of prepayment experience and forecasts of prepayments consider that
prepayments on securitized loans may be initiated by the borrower, such as a
refinancing for a lower interest rate, initiated by the servicer in the
collection process for delinquent loans, or as a result of our repurchase of
delinquent loans from the securitization trusts for trigger management.
Prepayments initiated by the borrower are viewed as voluntary prepayments.
Voluntary prepayments are the most significant component of prepayment
experience, generally representing approximately 91% of total prepayments, and
are full cash payoffs of a securitized loan. Prepayments initiated by the
servicer are viewed as involuntary prepayments, generally representing
approximately 4% of total prepayment experience and are the result of
delinquent loan bulk sales, REO liquidations and settlements on delinquent
loans. Losses on these involuntary prepayments are absorbed by the
securitization trusts. Prepayments as a result of the Company's repurchase of
delinquent loans from the securitization trusts are also viewed as involuntary
and generally represent approximately 5% of total prepayment experience.
Losses on the liquidation of repurchased loans are absorbed on the Company's
books. Both voluntary and involuntary loan prepayments are incorporated in the
Company's prepayment assumption forecasts.
The Company's practice in forecasting prepayment assumptions for calculation
of the initial securitization gain and subsequent revaluations had been to use
an average historical prepayment rate of similar pools for the expected
constant prepayment rate assumption while a pool of mortgage loans was less
than a year old even though actual experience may be different. During that
period, before a pool of mortgage loans reached its expected constant
prepayment rate, actual experience both quantitatively and qualitatively was
generally not considered sufficient to conclude that final actual experience
for an individual pool of mortgage loans would be materially different from
the average. For pools of mortgage loans greater than one-year old, prepayment
experience trends for an individual pool was considered to be more
significant. For these pools, adjustments to prepayment assumptions may be
made to more closely conform the assumptions to actual experience if the
variance from average experience is significant and is expected to continue.
15
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-ONLY STRIPS -- (CONTINUED)
For the past twelve quarters, actual prepayment experience was generally
higher, most significantly on home equity loans, than historical averages for
prepayments prior to that eleven-quarter period. The long duration of
historically low interest rates, combined with increasing home values and high
consumer debt levels has given borrowers an extended opportunity to engage in
mortgage refinancing activities, which resulted in elevated prepayment
experience. Low interest rates and increasing home values provide incentive to
borrowers to convert high cost consumer debt into lower rate tax deductible
loans. As home values have increased, lenders have been highly successful in
educating borrowers that they have the ability to access the cash value in
their homes.
For the past twelve quarters, the Company assumed for each quarter end
valuation that the decline in interest rates had stopped and a rise in
interest rates would occur in the near term. Economic conditions and published
mortgage industry surveys supported the Company's assumption. The Company
believes that once it moves beyond the low interest rate environment and the
impact that environment has had on prepayments, the long recurring and highly
unfavorable prepayment experience over the past eleven quarters will leave the
Company with securitized mortgage pools which will experience future
prepayment speeds substantially lower than originally believed. Also, the rate
of increase in home values has slowed considerably, which the Company expects
will mean that fewer borrowers will have excess value in their homes to
access. As a result of analysis of these factors, the Company believes
prepayments will continue to remain at higher than normal levels for the near
term before declining to historical prepayment levels and then further
declining in the future. However, the Company cannot predict with certainty
what prepayment experience will be in the future. Any unfavorable difference
between the assumptions used to value securitization assets and actual
experience may have a significant adverse impact on the value of these assets.
In addition to the use of prepayment fees on loans it originated, the
Company has implemented programs and strategies in an attempt to reduce loan
prepayments. These programs and strategies may include providing information
to a borrower regarding costs and benefits of refinancing, which at times may
demonstrate a refinancing option is not in the best economic interest of the
borrower. Other strategies include offering second mortgages to existing
qualified borrowers or offering financial incentives, such as the customer
retention incentive program, to qualified borrowers to deter prepayment of
their loan. The Company cannot predict with certainty what the impact these
efforts will have on our future prepayment experience.
CREDIT LOSS RATES. Credit loss rates are analyzed in a similar manner to
prepayment rates. Credit loss assumptions are compared to actual loss
experience for individual mortgage loan pools and averages for similar
mortgage loan pools. Delinquency trends, economic conditions, loans
repurchased from securitization trusts and other factors are also considered.
If the analysis indicates that loss experience may be different from
assumptions, the Company would adjust its assumptions as necessary. However,
the Company cannot predict with certainty what credit loss experience will be
in the future. Any unfavorable difference between the assumptions used to
value securitization assets and actual experience may have a significant
adverse impact on the value of these assets.
The Company may elect to repurchase delinquent loans from securitization
trusts to limit the level of delinquencies and losses in the securitization
trusts, and as a result, it can avoid exceeding specified limits on
delinquencies and losses that trigger a temporary reduction or discontinuation
of cash flow from its interest-only strips. See Note 4 for the amount of loans
the Company has repurchased from securitization trusts. Once a loan has been
included in a pool of securitized loans, its performance, including historical
loss experience if the loan has been repurchased, is reflected in the
performance of that pool of mortgage loans.
16
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-ONLY STRIPS -- (CONTINUED)
The Company may enter into deferment and forbearance arrangements with
borrowers in its managed portfolio who experience financial hardships. Any
credit losses ultimately realized on these arrangements are included in total
portfolio historical losses, which are used in developing credit loss
assumptions.
PERIODIC REVALUATIONS. The expected future cash flows from interest-only
strips are periodically re-evaluated. The current assumptions for prepayment
and credit loss rates are monitored against actual experience and other
economic conditions and are changed if deemed necessary. In the event of an
unfavorable change in these assumptions, the fair value of these assets would
be overstated, requiring an accounting adjustment. In accordance with the
provisions of Emerging Issues Task Force guidance on issue 99-20, "Recognition
of Interest Income and Impairment on Purchased and Retained Beneficial
Interests in Securitized Financial Assets," referred to as EITF 99-20 in this
document, and SFAS No. 115, decreases in the fair value of interest-only
strips that are deemed to be other than temporary adjustments to fair value
are recorded through the income statement, which would adversely affect our
income in the period of adjustment.
Additionally, to the extent any individual interest-only strip has a portion
of its initial write up to fair value still remaining in other comprehensive
income, other than temporary decreases in its fair value would first be
recorded as a reduction to other comprehensive income, which would adversely
affect our stockholders' equity in the period of adjustment.
See Note 5 for more information and the amounts of valuation assumptions
adjustments recorded.
The securitization trusts and their investors have no recourse to other
assets of the Company for failure of the securitized loans to pay when due.
SERVICING RIGHTS
When loans are sold through a securitization, the loans' servicing rights
have generally been retained and the Company capitalizes the benefit
associated with the rights to service securitized loans. However, the Company
does not service the loans in the 2003-2 securitization, the Company's most
recent securitization, which closed in October 2003.
Servicing rights represent the rights to receive contractual servicing fees
from securitization trusts and ancillary fees from borrowers net of adequate
compensation that would be required by a substitute servicer. Servicing rights
are carried at the lower of cost or fair value. Fair value represents the
present value of projected net cash flows from servicing. The projected cash
flows from servicing fees incorporate assumptions made by management,
including prepayment rates and discount rates. These assumptions are similar
to those used to value the interest-only strips retained in a securitization.
Amortization of the servicing rights asset for securitized loans is
calculated individually for each securitized loan pool and is recognized in
proportion to servicing income on that particular pool of loans.
The expected future cash flows from servicing rights are periodically
reevaluated. The current assumptions for prepayment rates are monitored against
actual experience and other economic conditions and are changed if deemed
necessary. A review for impairment is performed on a quarterly basis by
stratifying the serviced loans by loan type, home equity or business purpose
loans, which is considered to be the predominant risk characteristic in the
portfolio of loans the Company services. In establishing loan type as the
predominant risk characteristic, the Company considered the following additional
loan characteristics and determined these characteristics as mostly uniform
within its two types of serviced loans and not predominant for risk
stratification:
17
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SERVICING RIGHTS -- (CONTINUED)
o Fixed versus floating rate loans - All loans the Company services in its
securitizations are fixed-rate loans.
o Conforming versus non-conforming loans - All loans the Company services
are sub-prime (non-conforming) loans, with over 80% of the loans serviced
having credit grades of A or B.
o Interest rate on serviced loans - The serviced loan portfolio has a high
penetration rate of prepayment fees. Sub-prime borrowers, in general, are
not as influenced by movement in market interest rates as conforming
borrowers. A sub-prime borrower's ability to `rate shop' is generally
limited due to personal credit circumstances that are not market driven.
o Loan collateral - All loans the Company services are secured by real
estate, with approximately 85% secured with first liens on residential
property.
o Individual loan size - The average loan size in the Company's serviced
portfolio is $71 thousand. The serviced portfolio is approximately $1.6
billion at September 30, 2004 with approximately 22 thousand loans. There
are no significant defining groupings with respect to loan size. No loans
are greater than $1.0 million, only $9.1 million of loans have principal
balances greater than $500 thousand, and only $30.3 million of loans have
principal balances greater than $350 thousand.
o Geographic location of loans - The largest percentage of loans the
Company services are geographically located in the mid-Atlantic and
northeast sections of the United States.
o Original loan term - Home equity loan terms are primarily 180, 240 or 360
months. Business purpose loan terms are primarily 120 or 180 months.
If the Company's quarterly analysis indicates the carrying value of servicing
rights is not recoverable through future cash flows from contractual servicing
and other ancillary fees, a valuation allowance or write down would be required.
PREPAID EXPENSES
Prepaid assets are comprised mainly of amounts paid for fees on warehouse
lines and operating lines of credit (facility fees), insurance coverage and
printed marketing materials and customer lists, which have not yet been
utilized. Costs for facility fees, printed materials and customer lists are
expensed as they are utilized. Other marketing and advertising costs are
expensed as incurred. Prepaid expenses included prepaid facility fees of $14.0
million at September 30, 2004 and $10.4 million at June 30, 2004.
INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax
return. Under the asset and liability method used by the Company to provide
for income taxes, deferred tax assets and liabilities are recognized for the
expected future tax consequences of temporary differences between the
financial statement and tax basis carrying amounts of existing assets and
liabilities.
Estimates of deferred tax assets and liabilities make up the deferred income
tax asset on the Company's balance sheet. These estimates involve significant
judgments and estimates by management, which may have a material impact on the
carrying value of the deferred income tax asset. The deferred income tax asset
is periodically reviewed to determine if it is more likely than not that the
Company will realize this deferred tax asset.
18
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK OPTIONS
The Company has stock option plans that provide for the periodic granting of
options to key employees and non-employee directors and accounts for options
granted under these plans under APB Opinion No. 25 "Accounting for Stock
Issued to Employees" ("APB No. 25"). The Company accounts for fixed stock
options issued under these plans using the intrinsic value method, and
accordingly, no expense is recognized where the exercise price equals or
exceeds the fair value of the common stock at the date of grant. The Company
accounts for performance based stock options issued under these plans as
variable stock options and recognizes compensation expense based on the fair
value of the Company's common stock, as measured on the date of the grant, on
a straight-line basis over the vesting period of these stock options.
Had the Company accounted for stock options granted under these plans using
the fair value method of SFAS No. 123, "Accounting for Stock-Based Compensation"
("SFAS No. 123") and SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure" ("SFAS No. 148"), pro forma net income and earnings
per share would have been as follows (in thousands, except per share amounts):
THREE MONTHS ENDED SEPTEMBER 30,
--------------------------------
2004 2003
--------- ---------
Net income (loss) attributable
to common stock, as reported... $ (28,712) $(26,268)
Stock based compensation costs,
net of tax effects determined
under fair value method for all
awards......................... (64) (182)
-------- --------
Pro forma........................ $(28,776) $(26,450)
======== ========
Earnings (loss) per share -
basic
As reported.................. $ (7.98) $ (8.10)
Pro form..................... (8.00) (8.16)
-------- --------
Earnings (loss) per share -
diluted
As reported.................. $ (7.98) $ (8.10)
Pro forma ................... (8.00) (8.16)
======== ========
RECENT ACCOUNTING PRONOUNCEMENTS
No new accounting pronouncements affecting the Company have been issued
since the filing of its June 30, 2004 Form 10-K.
2. ACQUISITIONS
On December 24, 2003, the Company acquired a broker operation located in
California that operates primarily on the west coast of the United States for
the purpose of expanding its capacity to originate loans through its broker
channel, especially in the state of California. Assets acquired in this
transaction, mostly fixed assets, were not material. The purchase price was
comprised of issuing a $475 thousand convertible non-negotiable promissory
note to the seller and assuming $107 thousand of liabilities. As a result of
this transaction, the Company increased its goodwill by $582 thousand.
The $475 thousand convertible non-negotiable promissory note issued in the
December 2003 acquisition bears interest at 6% per annum and matures June 30,
2005. At any time on or after December 24, 2004 and before January 31, 2005,
the holder of the note has the option to convert the note into the number of
shares
19
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
2. ACQUISITIONS (CONTINUED)
of common stock determined by dividing the outstanding principal amount of the
note and accrued interest, if any, by $5.00, subject to adjustment for any
changes in the capitalization of the Company affecting its common stock.
On June 11, 2004, the Company acquired a broker operation located and
primarily operating in the state of Texas. This acquisition was also for the
purpose of expanding the Company's capacity to originate loans through its
broker channel. Assets acquired in this transaction, mostly fixed assets, were
not material. The purchase price was comprised of issuing a $650 thousand
convertible non-negotiable promissory note to the seller and $150 thousand of
cash. As a result of this transaction, the Company increased its goodwill by
$612 thousand.
The $650 thousand convertible non-negotiable promissory note issued in the
June 2004 acquisition bears interest at 8% per annum and is to be paid in five
semi-annual installments of $108 thousand each commencing on December 31, 2004.
The final semi-annual installment is due on June 30, 2007. At any semi-annual
installment date, the holder of the note has the option to convert the note into
the number of shares of the Company's common stock as determined by dividing the
semi-annual principal payment amount by the closing price per common share on
the immediately preceding semi-annual payment date, subject to adjustment for
any changes in the capitalization of the Company affecting its common stock.
3. LOAN AND LEASE RECEIVABLES
LOANS AVAILABLE FOR SALE
Loans available for sale were comprised of the following (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
------------------ -------------
Loans available for sale, secured by real
estate, principal balance............... $329,331 $300,143
Valuation allowance(a).................... (100) (42)
Deferred direct loan origination costs ... 7,236 4,453
Other(b) ................................. 44 (279)
-------- --------
$336,511 $304,275
======== ========
- ---------------
(a) For estimated credit losses.
(b) Represents the SFAS No. 133 adjustment to the fair value of hedged loans.
Real estate secured loans have contractual maturities of up to 30 years.
The activity in the valuation allowance against available for sale loans is
summarized as follows (in thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
-------------
2004 2003
---- ------
Balance at beginning of the period ............................ $ 42 $1,319
Provision adjustment .......................................... 58 363
---- ------
Balance at end of the period .................................. $100 $1,682
==== ======
20
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
3. LOAN AND LEASE RECEIVABLES (CONTINUED)
NON-ACCRUAL LOANS
At September 30, 2004 and June 30, 2004, the accrual of interest income was
suspended on real estate secured loans of $4.6 million and $3.5 million,
respectively. Non-accrual loans at September 30, 2004 and June 30, 2004 were
comprised of the following (in thousands):
SEPTEMBER 30, 2004 JUNE 30, 2004
------------------ -------------
Loans repurchased from securitization
trusts.................................. $ 4,392 $ 3,281
Loans transferred from available for sale 80 181
Other .................................... 80 --
------- -------
4,552 3,462
Allowance for credit losses .............. (1,238) (1,469)
------- -------
Net non-accrual loans .................... $ 3,314 $ 1,993
======= =======
Average balances of non-accrual loans for the twelve months ended September
30, 2004 and June 30, 2004 were $5.6 million and $7.3 million, respectively.
4. ALLOWANCE FOR CREDIT LOSSES
The activity in the allowance for credit losses on non-accrual loans and
leases is summarized as follows (in thousands):
THREE MONTHS
ENDED SEPTEMBER 30,
----------------
2004 2003
------ -------
Balance at beginning of the period ......................... $1,469 $ 1,529
Provision for credit losses:
Business purpose loans .................................... 146 1,129
Home equity loans ......................................... (87) 2,694
Equipment leases .......................................... -- (30)
------ -------
Total provision.......................................... 59 3,793
------ -------
Loan charge-offs:
Business purpose loans .................................... (66) (352)
Home equity loans ......................................... (328) (1,198)
Equipment leases .......................................... -- (110)
------ -------
Total loan charge offs................................... (394) (1,660)
====== =======
Recoveries of loans previously charged off:
Business purpose loans .................................... 70 4
Home equity loans ......................................... 34 14
Equipment leases .......................................... -- 108
------ -------
Total recoveries......................................... 104 126
------ -------
Total charge-offs, net ..................................... (290) (1,534)
------ -------
Balance at end of the period ............................... $1,238 $ 3,788
====== =======
Ratio of net charge offs in the portfolio to the average
portfolio(a).............................................. 0.38% 3.37%
Ratio of allowance to non-accrual loans and leases ........ 27.21% 24.61%
- ---------------
(a) The average portfolio includes loans available for sale, non-accrual loans
and leases.
21
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
4. ALLOWANCE FOR CREDIT LOSSES (CONTINUED)
The following schedule details the provision for credit losses for the three
months ended September 30, 2004 and 2003 (in thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
-------------
2004 2003
---- ------
Loans available for sale ...................................... $ 58 $ 363
Non-accrual loans ............................................. 59 3,823
Leases ........................................................ -- (30)
---- ------
Total Provision for Credit Losses ............................. $117 $4,156
==== ======
While the Company is under no obligation to do so, at times it elects to
repurchase delinquent loans from the securitization trusts. Repurchasing
delinquent loans from securitization trusts benefits the Company by allowing
it to limit the level of delinquencies and losses in the securitization trusts
and as a result, it can avoid exceeding specified limits on delinquencies and
losses that trigger a temporary reduction or discontinuation of cash flow from
its interest-only strips until the delinquency or loss triggers are no longer
exceeded. The Company has the right, but not the obligation, to repurchase a
limited amount of delinquent loans from securitization trusts. In addition,
the Company may elect to repurchase delinquent loans in situations requiring
more flexibility for the administration and collection of these loans. The
purchase price of a delinquent loan is at the loan's outstanding contractual
balance. A foreclosed loan is one where the Company, as servicer, has
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 the Company typically elects to repurchase are usually 90 days or more
delinquent and the subject of foreclosure proceedings, or where a completed
foreclosure is imminent. The related allowance for loan losses on these
repurchased loans is included in the provision for credit losses in the period
of repurchase. The related REO writedown for REO repurchased is recorded
through general and administrative expense in the period of repurchase. The
Company's ability to repurchase these loans does not disqualify sale
accounting under SFAS No. 140 or other relevant accounting literature because
the Company is not required to repurchase any loan and its ability to
repurchase a loan is limited by contract.
At September 30, 2004, one of the Company's twenty mortgage securitization
trusts was under a triggering event as a result of delinquencies exceeding
specified levels. There were no securitization trusts exceeding specified loss
levels at September 30, 2004. At June 30, 2004, four of the Company's mortgage
securitization trusts were under a triggering event. Approximately $5.0
million of excess overcollateralization is being held by the trust as of
September 30, 2004. For the three months ended September 30, 2004, the Company
repurchased delinquent loans with an aggregate unpaid principal balance of
$2.7 million from securitization trusts primarily for trigger management. The
Company cannot predict when the trust currently exceeding triggers will be
below trigger limits and release the excess overcollateralization. In order
for the trust to release the excess overcollateralization, delinquent loans
would need to decline, or the Company would need to repurchase delinquent
loans of up to $4.8 million as of September 30, 2004. If delinquencies
increase and the Company cannot cure the delinquency or liquidate the loans in
the mortgage securitization trusts without exceeding loss triggers, the levels
of repurchases required to manage triggers may increase. The Company's ability
to continue to manage triggers in its securitization trusts in the future is
affected by the availability of cash from operations or through the sale of
subordinated debentures to fund these repurchases.
22
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
4. ALLOWANCE FOR CREDIT LOSSES (CONTINUED)
The following table summarizes the principal balances of loans and real
estate owned "REO" repurchased from securitization trusts (dollars in
thousands):
THREE MONTHS
ENDED
SEPTEMBER 30,
----------------
2004 2003
------ -------
By original loan type:
Business purpose loans .................................... $2,002 $ 4,380
Home equity loans ......................................... 701 11,963
------ -------
Total.................................................... $2,703 $16,343
====== =======
By loans and REO:
Loans repurchased ......................................... $2,607 $ 9,847
REO purchased ............................................. 96 6,496
------ -------
Total.................................................... $2,703 $16,343
====== =======
Number of loans repurchased ................................ 20 215
====== =======
The Company received $1.8 million and $7.6 million of proceeds from the
liquidation of repurchased loans and REO during the three-months ended
September 30, 2004 and 2003, respectively. The Company had repurchased loans
remaining on the balance sheet in the amounts of $4.4 million at September 30,
2004 and $3.3 million at June 30, 2004 and REO of $1.5 million at September
30, 2004 and $1.9 million at June 30, 2004.
5. INTEREST-ONLY STRIPS
The activity for interest-only strip receivables is summarized as follows
(in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2004 2003
-------- --------
Balance at beginning of period .......................... $459,086 $598,278
Initial recognition of interest-only strips, including
initial overcollateralization of $0.................... -- 950
Proceeds from sale of interest-only strips(a) ........... (9,120) --
Cash flow from interest-only strips ..................... (33,141) (56,222)
Required purchases of additional overcollateralization .. 4,615 7,660
Interest accretion ...................................... 8,448 10,828
Adjustment for loans subject to repurchase rights ....... 309 162
Adjustments to fair value recorded through other
comprehensive income(b)................................ 18,644 (6,122)
Other than temporary fair value adjustment(c) ........... (29) (9,951)
-------- --------
Balance at end of period ................................ $448,812 $545,583
======== ========
- ---------------
(a) Reflects the proceeds received for the sale of interest-only strips related
to five securitization trusts. On June 30, 2004, the Company wrote down the
carrying value of these interest-only trusts by $4.1 million to reflect
their values under the terms of a September 27, 2004 sale agreement. The
sale of these assets is described in Note 8.
23
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
5. INTEREST-ONLY STRIPS (CONTINUED)
(b) Adjustments to the carrying value of interest-only strips for the initial
write up to fair value are recorded through other comprehensive income,
which is a component of stockholders' equity. Additionally, to the extent
any individual interest-only strip has a portion of its initial write up to
fair value still remaining in other comprehensive income at the time of
impairment, other than temporary decreases in its fair value would first be
recorded as a reduction to other comprehensive income.
(c) Recorded through the income statement.
Interest-only strips include overcollateralization balances that represent
undivided interests in securitizations maintained to provide credit
enhancement to investors in securitization trusts. At September 30, 2004 and
2003, the fair value of overcollateralization related cash flows were $202.2
million and $263.5 million, respectively.
The Company's interest-only strips collateralize certain obligations under
its $250.0 million credit facility with a warehouse lender. These obligations
include an amount not to exceed 10% of the outstanding principal balance under
this facility and the obligations for fees payable under this facility.
Assuming the entire $250.0 million available under this credit facility were
utilized, the maximum amount secured by the interest-only strips would be
approximately $47.6 million. Interest-only strips also secure the Company's
senior collateralized subordinated notes. The senior collateralized
subordinated notes are secured by a security interest in certain cash flows
originating from interest-only strips of certain of the Company's subsidiaries
held by ABFS Warehouse Trust 2003-1 with an aggregate value of at least an
amount equal to 150% of the outstanding principal balance of the senior
collateralized subordinated notes. At September 30, 2004, our interest in the
cash flows from the interest-only strips held in the trust, which secure the
senior collateralized subordinated notes, totaled $401.6 million, of which
approximately $146.2 million represented 150% of the outstanding principal
balance of the senior collateralized subordinated notes. See Note 8 for more
detail on the senior collateralized subordinated notes.
Declining interest rates and resulting high prepayment rates over the last
twelve quarters have required revisions to our estimates of the value of our
securitization assets. Beginning in the second quarter of fiscal 2002 and on a
quarterly basis thereafter, the Company's prepayment rates, as well as those
throughout the mortgage industry, remained at higher than expected levels due to
continuing low interest rates during this period. As a result, over the last
twelve quarters the Company has recorded cumulative pre-tax write downs to its
interest-only strips in the aggregate amount of $140.4 million and pre-tax
adjustments to the value of servicing rights of $12.1 million, for total
adjustments of $152.5 million, mainly due to the higher than expected prepayment
experience. On June 30, 2004, the Company wrote down the carrying value of its
interest-only strips and servicing rights related to five of our mortgage
securitization trusts by $5.4 million to reflect their values under the terms of
a September 27, 2004 sale agreement. The following table summarizes the net
cumulative write downs recorded on securitization assets over the last twelve
quarters (in thousands):
TOTAL INCOME OTHER
WRITE DOWN STATEMENT COMPREHENSIVE
(WRITE UP) IMPACT INCOME IMPACT
---------- --------- -------------
PRE-TAX ADJUSTMENT RESULTING FROM:
Prepayments............................................................................. $177,396 $128,697 $48,699
Discount rate........................................................................... (30,305) (18,427) (11,878)
Loss on sale............................................................................ 5,452 3,446 2,006
-------- -------- -------
Net cumulative write down............................................................... $152,543 $113,716 $38,827
======== ======== =======
During the first quarter of fiscal 2005, the Company recorded a pre-tax
write up of $18.6 million on its interest-only strips. The $18.6 million write
up was recorded as an increase to other comprehensive income, a component of
stockholders' equity. This write up of interest-only strips resulted from a
reduction to our
24
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
5. INTEREST-ONLY STRIPS (CONTINUED)
assumptions for loan prepayments expected to occur beyond 18 months.
Management believes that once it moves beyond the low interest rate
environment and the impact that environment has on loan prepayments, the long
running and highly unfavorable prepayment experience over the last twelve
quarters will leave the Company with securitized mortgage pools which will
experience future prepayment speeds substantially lower than originally
believed. No adjustments were recorded to servicing rights at September 30,
2004.
The breakout of the total securitization assets adjustments in fiscal 2004
and 2003 between interest-only strips and servicing rights was as follows (in
thousands):
YEAR ENDED JUNE 30, 2004 YEAR ENDED JUNE 30, 2003
------------------------------------ ------------------------------------
TOTAL INCOME OTHER TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE WRITE STATEMENT COMPREHENSIVE
DOWN IMPACT INCOME IMPACT DOWN IMPACT INCOME IMPACT
------- --------- ------------- ------- --------- -------------
Interest-only strips ............................... $57,031 $39,659 $17,372 $57,973 $39,900 $18,073
Servicing rights ................................... 6,791 6,791 -- 5,282 5,282 --
------- ------- ------- ------- ------- -------
Total securitization assets ........................ $63,822 $46,450 $17,372 $63,255 $45,182 $18,073
======= ======= ======= ======= ======= =======
The long duration of historically low interest rates, combined with
increasing home values and high consumer debt levels has given borrowers an
extended opportunity to engage in mortgage refinancing activities, which
resulted in elevated prepayment experience. Low interest rates and increasing
home values provide incentive to borrowers to convert high cost consumer debt
into lower rate tax deductible loans. As home values have increased, lenders
have been highly successful in educating borrowers that they have the ability
to access the cash value in their homes.
The persistence of historically low interest rate levels, unprecedented in
the last 40 years, has made the forecasting of prepayment levels difficult.
The Company assumed for each quarter end valuation that the decline in
interest rates had stopped and a rise in interest rates would occur in the
near term. This assumption was supported by published data. Consistent with
this view that interest rates would rise, the Company had utilized derivative
financial instruments to manage interest rate risk exposure on its loan
production and loan pipeline to protect the fair value of these fixed rate
items against potential increases in market interest rates. The Company
believes that once it moves beyond the low interest rate environment and the
impact that environment has had on prepayments, the long recurring and highly
unfavorable prepayment experience over the last eleven quarters will leave the
Company with securitized loan pools which will experience future prepayment
speeds substantially lower than originally believed. Also, the rate of
increase in home values has slowed considerably, which the Company expects
will mean that fewer borrowers will have excess value in their homes to
access. The Mortgage Bankers Association of America has forecast as of
September 17, 2004 that mortgage refinancings as a percentage share of total
mortgage originations will decline from 49% in the second quarter of calendar
2004 to 24% in the second quarter of calendar 2005. The Mortgage Bankers
Association of America has also projected in its September 2004 economic
forecast that the 10-year treasury rate (which generally affects mortgage
rates) will increase steadily each quarter in their forecast. As a result of
an analysis of these factors, the Company believes prepayments will continue
to remain at higher than normal levels for the near term before declining to
historical prepayment levels and then further declining in the future.
However, the Company cannot predict with certainty what our prepayment
experience will be in the future. Any unfavorable difference between the
assumptions used to value securitization assets and actual experience may have
a significant adverse impact on the value of these assets.
25
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
5. INTEREST-ONLY STRIPS (CONTINUED)
The following tables detail the net pre-tax write-up of the interest-only
strips for the first quarter of fiscal 2005 and the net pre-tax write downs of
the securitization assets by quarter for fiscal years 2004, 2003 and 2002 and
details the impact to the income statement and to other comprehensive income
in accordance with the provisions of SFAS No. 115 "Accounting for Certain
Investments in Debt and Equity Securities" and EITF 99-20 as they relate to
interest-only strips and SFAS No. 140 "Accounting for Transfers and Servicing
of Financial Assets and Extinguishment of Liabilities" as it relates to
servicing rights (in thousands):
FISCAL YEAR 2005:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED DOWN IMPACT INCOME IMPACT
- ------------- -------- --------- -------------
September 30, 2004........................................................................ $(18,614) $29 $(18,643)
FISCAL YEAR 2004:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED DOWN IMPACT INCOME IMPACT
- ------------- -------- --------- -------------
September 30, 2003......................................................................... $16,658 $10,795 $ 5,863
December 31, 2003.......................................................................... 14,724 11,968 2,756
March 31, 2004............................................................................. 23,191 15,085 8,106
June 30, 2004.............................................................................. 9,249 8,602 647
------- ------- -------
Total Fiscal 2004.......................................................................... $63,822 $46,450 $17,372
======= ======= =======
FISCAL YEAR 2003:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED DOWN IMPACT INCOME IMPACT
- ------------- -------- --------- -------------
September 30, 2002......................................................................... $16,739 $12,078 $ 4,661
December 31, 2002.......................................................................... 16,346 10,568 5,778
March 31, 2003............................................................................. 16,877 10,657 6,220
June 30, 2003.............................................................................. $13,293 $11,879 $ 1,414
------- ------- -------
Total Fiscal 2003.......................................................................... $63,255 $45,182 $18,073
======= ======= =======
FISCAL YEAR 2002:
TOTAL INCOME OTHER
WRITE STATEMENT COMPREHENSIVE
QUARTER ENDED DOWN IMPACT INCOME IMPACT
- ------------- -------- --------- -------------
December 31, 2001.......................................................................... $11,322 $ 4,462 $ 6,860
March 31, 2002............................................................................. 15,513 8,691 6,822
June 30, 2002.............................................................................. 17,244 8,900 8,344
------- ------- -------
Total Fiscal 2002.......................................................................... $44,079 $22,053 $22,026
======= ======= =======
Note: The impacts of prepayments on our securitization assets in the quarter
ended September 30, 2001 were not significant.
26
AMERICAN BUSINESS FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2004
6. SERVICING RIGHTS
The activity for the loan and lease servicing rights asset is summarized as
follows (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
------------------
2004 2003
------- --------
Balance at beginning of the period........................ $73,738 $119,291
Amortization ............................................. (6,440) (12,375)
Proceeds from sale of servicing rights(a) ................ (586) --
Write down ............................................... -- (844)
------- --------
Balance at end of the period.............................. $66,712 $106,072
======= ========
- ---------------
(a) Reflects the proceeds received for the sale of servicing rights related to
five securitization trusts. On June 30, 2004, the Company wrote down the
carrying value of these servicing rights by $1.3 million to reflect their
values under the terms of a September 27, 2004 sale agreement. The sale of
these assets is described in Note 8.
Servicing rights are valued quarterly by the Company based on the current
estimated fair value of the servicing asset. The Company's valuation analysis
for September 30, 2004 indicated that no adjustment was required in the first
quarter of fiscal 2005. In the first quarter of fiscal 2004, the Company
recorded a $0.8 million write down of its servicing rights.
Under the servicing agreements associated with 16 of the 19 securitizations
serviced by the Company, servicing rights can be terminated by financial
insurers representing bondholders or certificate holders (collectively, "bond
insurers") under certain circumstances, such as the Company's failure to make
required servicer payments, defined changes of control, reaching specified
loss levels on underlying mortgage pools or other events constituting a
breach, including, in some cases, non-compliance with financial covenants in
the servicing agreements (the term "servicing agreements" includes sale and
servicing agreements and pooling and servicing agreements). In the remaining 3
securitizations serviced by the Company, servicing rights can be terminated by
the trustee under similar circumstances.
As a result of the Company's non-compliance at September 30, 2003 with the
net worth covenant in the separate servicing agreements with each of two bond
insurers, the Company requested and obtained waivers of the non-compliance from
the two bond insurers. In connection with the waiver of non-compliance granted
by one bond insurer, applicable to the remaining term of the related servicing
agreements as well as to prior occurrences of the non-compliance, the servicing
agreements with that bond insurer were amended to provide for 120-day
term-to-term servicing. In connection with the waiver of non-compliance granted
by the second bond insurer, applicable only to prior occurrences of
non-compliance, the servicing agreements with that bond insurer were amended to
provide for 30-day term-to-term servicing. Subsequently, this bond insurer has
given the Company a waiver of non-compliance with the net worth covenant on a
monthly basis and the Company is currently operating under such a waiver.
A third bond insurer, as