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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------
FORM 10-K
(Mark one)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT
OF 1934
for the Fiscal Year Ended June 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ________ to __________
Commission file number 0-19604
AAMES FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 95-4340340
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
350 S. GRAND AVENUE, LOS ANGELES, CALIFORNIA 90071
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (213) 640-5000
Securities registered pursuant to Section 12(b) of the Act:
Title of each Class Name of each exchange on which registered
- ------------------- -----------------------------------------
COMMON STOCK, PAR VALUE $0.001 NEW YORK STOCK EXCHANGE
PREFERRED STOCK PURCHASE RIGHTS NEW YORK STOCK EXCHANGE
10.50% SENIOR NOTES DUE 2002 NEW YORK STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act:
9.125% Senior Notes Due 2003
----------------------------
(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.[ ]
At September 2, 1997, there were outstanding 27,771,035 shares of the
Common Stock of Registrant, and the aggregate market value of the shares held on
that date by non-affiliates of the Registrant, based on the closing price
($19.625 per share) of the Registrant's Common Stock on the New York Stock
Exchange was $477,826,340. For purposes of this computation, it has been assumed
that the shares beneficially held by directors and executive officers of
Registrant were "held by affiliates"; this assumption is not to be deemed to be
an admission by such persons that they are affiliates of Registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrant's Proxy Statement relating to its 1997 Annual
Meeting of Stockholders are incorporated by reference in Items 10, 11, 12 and 13
of Part III of this Annual Report.
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PART I
ITEM 1. BUSINESS
GENERAL
Aames Financial Corporation (the "Company") is a consumer finance
company primarily engaged, through its subsidiaries, in the business of
originating, purchasing, selling and servicing home equity mortgage loans
secured by single family residences. In late fiscal 1997, the Company began
offering small commercial loans on a limited basis which it plans to sell on a
whole loan basis servicing released. The Company, upon its formation in 1991,
acquired Aames Home Loan, a home equity lender founded in 1954.
The Company's principal market is borrowers whose financing needs are
not being met by traditional mortgage lenders for a variety of reasons,
including the need for specialized loan products or credit histories that may
limit such borrowers' access to credit. The Company believes these borrowers
continue to represent an underserved niche of the home equity loan market and
present an opportunity to earn a superior return for the risk assumed. The
mortgage loans originated and purchased by the Company, which include fixed and
adjustable rate loans, are generally used by borrowers to consolidate
indebtedness or to finance other consumer needs rather than to purchase homes.
The Company originates and purchases loans on a nationwide basis through
three production channels--retail, broker and correspondent. For the year ended
June 30, 1997, the Company originated and purchased $2.35 billion of mortgage
loans. The Company underwrites and appraises every loan it originates and
generally re-underwrites and reviews appraisals on all loans it purchases. See
"-- Mortgage Loan Production." The Company retains the servicing rights
(collecting loan payments and managing borrower defaults) to substantially all
of the loans it originates or purchases. At June 30, 1997, the Company had a
servicing portfolio of $3.17 billion, of which 53% was subserviced by third
parties. In fiscal 1997, the Company's servicing division implemented systems
and personnel that will allow it to service directly substantially all of its
servicing portfolio by the end of fiscal 1998. See "-- Loan Servicing."
During fiscal 1997, the Company experienced a dramatic shift up the
credit grade spectrum reflecting its previously announced strategic decision to
diversify the loans it originates and purchases to include more of the higher
credit grade loans. In fiscal 1997, of the total loans originated and purchased
by the Company, 82% were A, A-, B and C credit grade loans and 18% were C- and D
credit grade loans, compared to 66% and 34%, respectively, in fiscal 1996. This
diversification was accomplished primarily through the acquisition of One Stop
Mortgage, Inc. ("One Stop") in August 1996, which focuses on the higher credit
grade spectrum, the decrease in C- and D originations in certain non-judicial
foreclosure states and the adoption of pricing structures by credit grade in the
correspondent and retail divisions. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Revenues."
As a fundamental part of its business and financing strategy, the
Company sells substantially all of its loans to third party investors in
securitization transactions. These transactions enhance
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profitability, maximize liquidity and reduce the Company's exposure to
fluctuations in interests rates. The Company securitized and sold in the
secondary market $317 million, $791 million and $2.26 billion of loans in the
fiscal years ended June 30, 1995, 1996 and 1997, respectively. See
"--Securitization of Loans."
RECENT EVENTS
During the fourth quarter of fiscal 1997, two factors caused the Company
to re-evaluate its correspondent bulk purchase program--uncertainties in the
capital markets and the increase in the pricing for bulk loan product. These
uncertainties were evidenced by the sudden decline in common stock prices of
companies in the subprime home equity sector, including the Company, and pricing
sensitivity encountered by companies in the sector in accessing the public
equity and debt markets. Given that the Company funded the significant negative
cash flow associated with the bulk correspondent business in the public equity
and debt markets, the uncertainties in those markets increased the risk to the
Company that its cost of capital would be excessively high. Additionally, the
premiums paid by the Company for bulk product during the 1997 fiscal year
reached a peak of 8.25% in March 1997. These high premiums, together with the
apparent increase in the cost of capital, adversely impacted the projected
profitability of the bulk product. As a result of these developments, the
Company changed the approach used in the pricing of its bulk loan product.
Specifically, the Company established lower prices to be paid for this product
based primarily on its historical performance. This change is expected to
decrease the amount of bulk loans purchased in fiscal 1998 compared to fiscal
1997.
The Company also incorporated the results of the fourth quarter pricing
review into the regular quarterly fair market valuation of the interest-only
strips. The Company determines the fair market value of the interest-only
strips, in part, by applying management's expectations as to future prepayment
rates to the present value of the future cash flows from prior securitizations.
The use of revised prepayment rates resulted in a fourth quarter unrealized loss
of $28.0 million on the valuation of that asset. These same prepayment
assumptions materially lowered the Company's gain on sale expressed as a
percentage of total loans securitized. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Revenue."
In June 1997, the Company retained Donaldson, Lufkin & Jenrette
Securities Corporation to develop a means to maximize opportunities for the
Company and its stockholders. These opportunities include remaining independent
and continuing to grow internally and through acquisition, or selling the
Company or entering into a business combination transaction. While the Company
is in discussions concerning a possible business combination, it also believes
the profit-enhancing steps taken in the fourth quarter create a strong
foundation upon which to remain independent and continue to grow its production
channels and servicing platform.
BUSINESS STRATEGY
The Company continues to build on its position as a leading lender in
its niche market. The expansion of the Company's business over the last three
years has been driven by the growth in the volume of loans originated and
purchased by the Company and by the Company's ability to continue to access the
capital markets to facilitate the sale of these loans through securitizations.
As an
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independent entity, the Company intends to pursue its growth strategy by (i)
continuing to expand its retail loan office network, independent mortgage broker
network and flow and mini-bulk correspondent program; (ii) diversifying the
products offered; (iii) increasing its servicing portfolio and servicing
capabilities; (iv) continuing to enhance its corporate and operating
infrastructure; and (v) diversifying its funding sources. An important long-term
goal of the Company's business strategy is to continue to build its investment
in interest-only strips and mortgage servicing rights. The Company believes that
its investments in these assets yield attractive rates of returns. In addition,
the Company believes its cash flow profile will change over time as the rate of
loan production growth moderates and as the size of its servicing portfolio and
its interest-only strips increase. In particular, the Company intends to employ
the following strategies:
Geographic Diversification. The Company plans to continue the geographic
expansion of its loan production. During fiscal 1997, the Company expanded its
retail loan office network into the Midwest and East. The Company intends to
continue focusing on its nationwide retail expansion and to expand its loan
purchasing capabilities by opening new broker offices and building new
relationships with independent mortgage brokers and flow and mini-bulk loan
correspondents nationwide, with the goal of increasing market share in these
areas. The Company also is considering expanding operations on an international
basis.
Diversification of Loan Products. The Company regularly reviews its loan
offerings and introduces new loan products to attempt to meet the needs of its
customers. In furtherance of this strategy, during the fourth quarter of fiscal
1997, the Company began offering higher credit grade loans with higher
loan-to-value ratios which it intends to include in its securitizations. In
addition, the Company recently began offering 125% loan-to-value home
improvement loans to qualified borrowers which the Company intends initially to
sell on a whole loan basis servicing released. The Company believes these home
improvement loans will enhance cash flow as a result of the origination fees
charged and the cash gain on sale received. It may also slow down prepayment
rates, in cases in which the Company holds both the junior home improvement loan
and the senior loan on the property, by employing more of the borrower's
available equity. The Company also offers commercial loans to qualified
borrowers ranging from $250,000 to $2.0 million. At June 30, 1997, the Company
had $6.85 million in commercial loans, all of which it intends to sell on a
whole loan basis servicing released. The Company is considering establishing a
real estate investment trust to provide another distribution channel for its
commercial loans and certain of its residential loans.
Increase Servicing Portfolio; Increase Margins and Develop Subservicing
Capabilities. The Company plans to continue to build the size of its servicing
portfolio to provide a stable, and ultimately more significant, source of
recurring revenue. At June 30, 1997, the Company's servicing portfolio was $3.17
billion, up 131% from $1.37 billion at the end of the 1996 fiscal year, 53% of
which was subserviced by third parties. The Company expects to increase the size
of its loan servicing portfolio by continuing to increase loan originations and
purchases, completing new securitizations and subservicing on behalf of third
parties. Through December 1996, the Company was capable of servicing loans only
in a limited number of Western states. A new servicing system deployed in
November 1996 allows the Company to service loans in all 50 states. The Company
now services directly substantially all loans originated through its retail
network. In fiscal 1998, the Company intends to service directly substantially
all of its servicing portfolio.
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Continue to Enhance Corporate and Operational Management and
Infrastructure. From June 30, 1995 to June 30, 1997, the Company's loan
origination volume grew 561% and its employee base grew from 370 employees at
June 30, 1995 to 1,385 employees at June 30, 1997. To support this significantly
larger operation, the Company has invested in additional corporate and operating
management. Additionally, to enhance its infrastructure, the Company has
expanded its telemarketing operations, including a predictive dialer system
which became operational in fiscal 1997 and a data warehouse which significantly
enhanced the Company's ability to analyze its loans in fiscal 1997. In fiscal
1998, the Company intends to purchase a new loan origination system which will
further enhance efficiency and loan production capabilities.
Continue to Diversify Funding Sources and Become Self-Financing. The
Company intends to continue to expand and diversify its funding sources by
adding additional warehouse facilities, seeking to increase the advance rates on
existing and new facilities and establishing credit facilities to finance the
interest-only strips and the residual assets. In addition, the Company intends
to seek to obtain higher credit ratings by improving its financial condition and
operating results. The Company believes that achieving higher credit ratings,
obtaining higher advance rates on warehouse facilities and establishing residual
financing facilities will help it attain its goal of becoming self-financing
and, thereby, reduce its dependence on the capital markets. Principally as a
result of the developments described under "-- Recent Events," several rating
agencies have placed certain debt of the Company on credit watch. The Company
continues to improve its cash flows through such mechanisms as whole loan sales
and new securitization structures. The Company also believes it will improve its
cash flow by improving the efficiency of its servicing operations.
The strategies discussed above contain forward-looking statements. Such
statements are based on current expectations and are subject to risks,
uncertainties and assumptions, including those discussed under "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Risk Factors." Should one or more of these risks or uncertainties
materialize, or should underlying assumptions prove incorrect, actual results
may vary materially from those anticipated, estimated or projected. Thus, no
assurance can be given that the Company will be able to accomplish the above
strategies.
ONE STOP ACQUISITION
On August 28, 1996, the Company acquired One Stop, a residential
mortgage lender specializing in originating and purchasing home equity mortgage
loans made to credit-impaired borrowers from a network of independent mortgage
brokers. The acquisition is part of the Company's strategy to diversify its
mortgage loan production sources and to expand the geographic scope of its
operations. The acquisition was accomplished through the merger of a
wholly-owned subsidiary of the Company into One Stop, in a tax-free exchange
accounted for as a pooling-of-interests. See "-- Mortgage Loan Production --
Independent Mortgage Broker Network."
MORTGAGE LOAN PRODUCTION
The Company's principal loan product is a non-conforming home equity
loan with a fixed principal amount and term to maturity which is typically
secured by a first mortgage on the borrower's
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residence with either a fixed or adjustable rate. Non-conforming home equity
loans are loans made to homeowners whose borrowing needs may not be met by
traditional financial institutions due to credit exceptions or other factors and
that cannot be marketed to agencies such as the Federal National Mortgage
Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
In addition, the Company offers junior mortgages and other products in order to
meet a wide variety of borrower needs. In fiscal 1997, the Company obtained its
loans through three primary channels: its retail loan office network,
independent mortgage broker network and correspondent program. In fiscal 1997,
the Company also expanded its retail production to include an outbound
telemarketing loan production capability.
The following table illustrates the sources of the Company's loan
production during the periods indicated:
FISCAL YEARS ENDED JUNE 30,
---------------------------
1995 1996 1997
---- ---- ----
(DOLLARS IN THOUSANDS)
Retail loans:
Total dollar amount .................. $148,200 $ 220,900 $ 436,900
Number of loans ...................... 3,734 4,792 8,565
Average loan amount .................. 40 46 51
Average initial combined loan to value 55% 60% 67%
Weighted average interest rate ....... 11.8% 11.0% 10.5%
Broker loans:
Total dollar amount .................. $ -- $ 319,800 $ 741,000
Number of loans ...................... -- 4,182 8,985
Average loan amount .................. -- 77 83
Average initial combined loan to value -- 68% 71%
Weighted average interest rate ........ -- 10.6% 10.0%
Correspondent program:
Total dollar amount .................. $206,800 $ 628,200 $1,170,000
Number of loans ...................... 2,314 7,166 12,500
Average loan amount .................. 89 88 94
Average initial combined loan to value 65% 66% 71%
Weighted average interest rate ....... 11.4% 11.7% 11.0%
Total loans:
Total dollar amount .................. $355,000 $1,168,900 $2,347,900
Number of loans ...................... 6,048 16,140 30,050
Average loan amount .................. 59 72 78
Average initial combined loan to value 61% 65% 70%
Weighted average interest rate ....... 11.6% 11.3% 10.6%
Retail Loan Office Network. The Company originates home equity mortgage
loans through its network of retail loan offices which, at September 25, 1997,
consisted of 59 retail loan offices located in 23 states. Prior to fiscal year
1994, the retail offices were located only in California. Then, in fiscal year
1994, the Company expanded into two Western states. The Company has been
aggressively pursuing a strategy of expanding its retail loan office network
beyond the offices located in California and the other Western states. Of the
Company's 59 retail loan offices, 16 are located in the Midwest,
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9 in the Central U.S. and 16 in the East. The Company believes that it has
significant additional expansion opportunities in these areas.
The Company selects areas in which to introduce or expand its retail
presence on the basis of selected demographic statistics, marketing analyses and
other criteria developed by the Company. Typically, new office locations have
become profitable within 90 days of opening.
The Company's expansion of its retail loan office network has resulted
in significant increases in retail loan production over the last three fiscal
years. The Company originated $148 million, $221 million and $437 million of
mortgage loans through this network in fiscal 1995, 1996 and 1997, respectively.
The Company generates applications for loans through its retail loan
office network principally through a multimedia advertising program, which
relies primarily on the use of direct mailings to homeowners, television
advertising, yellow-page listings and telemarketing. The Company believes that
its advertising campaigns establish name recognition and serve to distinguish
the Company from its competitors. The Company continually monitors the sources
of its applications to determine the most effective methods and manner of
advertising.
The Company's advertising invites prospective borrowers to call its
headquarters office through the Company's toll-free telephone numbers. On the
basis of an initial screening conducted at the time of the call, the Company's
customer service representative makes a preliminary determination of whether the
customer and the property meet the Company's lending criteria, and schedules an
appointment with a loan officer in the retail loan office most conveniently
located to the customer or in the customer's home. If the customer cannot
schedule an appointment or is located in an area without a retail office, the
representative refers the customer to a loan officer in the "loan-by-phone"
department who takes the loan application by telephone.
The Company's loan officer at the local retail loan office assists the
applicant in completing the loan application, arranges for an appraisal, orders
a credit report from an independent, nationally recognized credit reporting
agency and performs various other tasks in connection with the completion of the
loan package. The loan package is then forwarded to the Company's headquarters
office for review by underwriters and for loan approval. If the loan package is
approved, the loan is funded by the Company. The Company's loan officers are
trained to structure loans that meet the applicant's needs, while satisfying the
Company's lending guidelines.
Through its retail loan office network, the Company also takes
applications from prospective borrowers who respond to the Company's advertising
but fall outside the Company's target market. These loans may be sold to other
institutional lenders or, until August 1997, to private investors. In these
cases, the Company receives commissions on loans sold.
Independent Mortgage Broker Network. Through its independent mortgage
broker network, One Stop funded $320 million and $741 million in loans during
the fiscal years ended June 30, 1996 and 1997, respectively. At August 31, 1997,
One Stop operated 41 offices in 35 states and had 3,700 approved mortgage
brokers. During fiscal 1997, One Stop originated loans through approximately
1,800 brokers, no one of which accounted for
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more than 10% of One Stop's total originations. All loans originated by One Stop
are underwritten in accordance with the Company's underwriting guidelines. Once
approved, the loan is funded or purchased by One Stop directly.
The broker's role is to identify the applicant, assist in completing the
loan application form, gather necessary information and documents and serve as
One Stop's liaison with the borrower through the lending process. One Stop
reviews and underwrites the applications submitted by the broker, approves or
denies the application, sets the interest rate and other terms of the loan and,
upon acceptance by the borrower and satisfaction of all conditions imposed by
One Stop, funds the loan. Because brokers conduct their own marketing and employ
their own personnel to complete loan applications and maintain contact with
borrowers, originating loans through its broker network allows One Stop to
increase its loan volume without incurring the higher marketing, personnel and
other overhead costs associated with increased retail originations.
Because mortgage brokers generally submit loan files to several
prospective lenders simultaneously, consistent underwriting, quick response
times and personal service are critical to successfully producing loans through
independent mortgage brokers. To meet these requirements, One Stop strives to
provide quick response time to the loan application (generally within 24 hours).
In addition, loan consultants and loan processors, including underwriters, are
available in One Stop's branch offices to answer questions, assist in the loan
application process and facilitate ultimate funding of the loan.
Correspondent Program. The Company purchases closed loans from mortgage
bankers and other financial institutions on a continuous or "flow" basis, and
through bulk and mini-bulk purchases. In fiscal 1997, 50% of the Company's loan
production came from these sources. The Company believes that its flow and
mini-bulk correspondent program represents a cost effective means of increasing
loan production.
During the fourth quarter of fiscal 1997, two factors caused the Company
to re-evaluate its correspondent bulk purchase program--uncertainties in the
capital markets and the increase in the pricing for bulk loan product. These
uncertainties were evidenced by the sudden decline in common stock prices of
companies in the subprime home equity sector, including the Company, and pricing
sensitivity encountered by companies in the sector in accessing the public
equity and debt markets. Given that the Company funded the significant negative
cash flow associated with the bulk correspondent business in the public equity
and debt markets, the uncertainties in those markets increased the risk to the
Company that its cost of capital would be excessively high. Additionally, the
premiums paid by the Company for bulk product during the 1997 fiscal year
reached a peak of 8.25% in March 1997. These high premiums, together with the
apparent increase in the cost of capital, adversely impacted the projected
profitability of the bulk product. As a result of these developments, the
Company changed the approach used in the pricing of its bulk loan product.
Specifically, the Company established lower prices to be paid for this product
based primarily on its historical performance. This change is expected to
decrease the amount of bulk loans purchased in fiscal 1998 compared to fiscal
1997.
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Underwriting. The Company underwrites every loan it originates and
generally re-underwrites each loan it purchases. The Company's underwriting
guidelines are designed to assess the adequacy of the real property as
collateral for the loan and the borrower's creditworthiness. An assessment of
the adequacy of the real property as collateral for the loan is primarily based
upon an appraisal of the property and a calculation of the ratio (the "combined
loan-to-value ratio") of all mortgages existing on the property (including the
loan applied for) to the appraised value of the property at the time of
origination. As a lender that specializes in loans made to credit-impaired
borrowers, the Company ordinarily makes home equity mortgage loans to borrowers
with credit histories or other factors that would typically disqualify them from
consideration for a loan from traditional financial institutions. Consequently,
the Company's underwriting guidelines generally require substantially lower
combined loan-to-value ratios than would typically be the case if the borrower
could qualify for a loan from a traditional financial institution.
Creditworthiness is assessed by examination of a number of factors, including
calculation of debt-to-income ratios, which is the sum of the borrower's monthly
debt payments divided by the borrowers's monthly income before taxes and other
payroll deductions, an examination of the borrower's credit history through
standard credit reporting bureaus, and by evaluating the borrower's payment
history with respect to existing mortgages, if any, on the property.
The underwriting of a mortgage loan to be originated or purchased by the
Company includes a review of the completed loan package, which includes the loan
application, a current appraisal, a preliminary title report and a credit
report. All loan applications and all closed loans offered to the Company for
purchase must be approved by the Company in accordance with its underwriting
criteria. On an exception basis, and approval of the Company's underwriters,
home equity mortgage loans may be made that do not conform to the Company's
guidelines but only with the approval of a senior underwriter or by certain
executive officers of the Company. The Company regularly reviews its
underwriting guidelines and makes changes when appropriate to respond to market
conditions, the poor performance of loans representing a particular loan product
or changes in laws or regulations.
Until June 1997, all appraisals in connection with loans originated by
the Company through its retail loan office network were performed by Company
appraisers. Beginning in June 1997, the Company streamlined its retail loan
appraisal department and currently uses Company-qualified contract appraisers
for most of its originations. Appraisers determine a property's value by
reference to the sales prices of comparable properties recently sold, adjusted
to reflect the condition of the property as determined through inspection.
Appraisals on loans purchased as part of the Company's correspondent program are
reviewed by Company appraisers or Company-qualified contract appraisers to
assure that they meet the Company's standards.
The Company requires title insurance coverage issued on an American Land
Title Association form of title insurance on all properties securing mortgage
loans it originates or purchases. The loan originator and its assignees are
generally named as the insured. Title insurance policies indicate the lien
position of the mortgage loan and protect the Company against loss if the title
or lien position is not as indicated. The applicant is also required to maintain
hazard and, in certain instances, flood insurance, in an amount sufficient to
cover the new loan and any senior mortgage, subject to the maximum amount
available under the National Flood Insurance Program.
Quality Control. The Company's quality control program is intended to
(i) monitor and improve the overall quality of loan production generated by the
Company's retail loan office network,
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independent mortgage broker network and correspondent program and (ii) identify
and communicate to management existing or potential underwriting and loan
packaging problems or areas of concern. The quality control file review examines
compliance with the Company's underwriting guidelines and federal and state
regulations. This is accomplished by focusing on: (i) the accuracy of all credit
and legal information; (ii) a collateral analysis which may include a desk or
field re-appraisal of the property and review of the original appraisal; (iii)
employment and/or income verification; and (iv) legal document review to ensure
that the necessary documents are in place.
Credit Grades. The Company believes that it originates a greater
proportion of lower credit quality loans ("C-" and "D" loans) than other lenders
who lend to credit-impaired borrowers and as a result has historically
experienced delinquency rates that are higher than those generally prevailing in
its industry. Although the Company has not historically experienced significant
loan losses because its loan portfolio has been characterized by relatively low
combined loan-to-value ratios, the Company's loan losses may increase in future
periods as a result of its migration to higher credit grade loans and
correspondingly higher permitted combined loan-to-value ratios. During fiscal
1997, the Company increased its provision for loan losses as higher credit grade
loans with higher loan-to-value ratios increased as a percentage of total loans
securitized. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Capital Resources -- Securitization
Program." The weighted average initial combined loan-to-value ratio of loans in
its servicing portfolio at June 30, 1995, 1996 and 1997 was 59%, 64% and 68%,
respectively. The increase in weighted average combined loan-to-value ratios at
June 30, 1997 reflected a changing mix in the mortgage loans in the servicing
portfolio to include a greater proportion of first mortgages and higher credit
grade loans and from 1995 to 1996 a change in underwriting guidelines to remain
competitive.
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The following chart generally outlines certain parameters of the credit
grades of the Company's underwriting guidelines at August 31, 1997:
"A" CREDIT "A-" CREDIT "B" CREDIT "C" CREDIT "C-" CREDIT "D" CREDIT
GRADE GRADE GRADE GRADE GRADE GRADE
---------- ----------- ---------- ---------- ----------- ----------
GENERAL Has good Has good Pays the Marginal credit Marginal credit Designed to
REPAYMENT credit. credit but majority of history which history not provide a
might have accounts on is offset by offset by other borrower with
some minor time but has other positive positive poor credit
delinquency. some 30- attributes. attributes. history an
and/or 60-day opportunity to
delinquency. correct past
credit
problems
through lower
monthly
payments.
EXISTING No delinquen- Current at Current at Can have Must be paid Must be paid
MORTGAGE cies in past application application multiple 30-day in full from from loan
LOANS 12 months. time and a time and a delinquencies loan proceeds proceeds.
maximum of maximum of and one 60-day and no more Rating not a
two 30-day four 30-day delinquency than 120 days factor.
delinquencies delinquencies and one 90-day delinquent.
in the past 12 in the past 12 delinquency
months. months. in the past 12
months; currently
not more than
90 days delinquent
NON-MORTGAGE Major credit Major credit Major credit Major credit Major and Major credit
CREDIT and installment and installment and installment and installment minor credit delinquency is
debt should be debt should be debt can debt can delinquency is acceptable.
current. No current but exhibit some exhibit some acceptable, but
60-day delin- may exhibit minor 30- minor 60- must
quencies in some minor and/or 60-day and/or 90-day demonstrate
past 24 30-day delinquency. delinquency. some payment
months. delinquency. regularity.
Minor credit Minor credit Minor credit
may exhibit may exhibit up may exhibit
some minor to 90-day more serious
delinquency. delinquency. delinquency.
BANKRUPTCY Charge-offs, Charge-offs, Discharged Discharged Discharged Current
FILINGS judgments, judgments, more than two more than two prior to bankruptcy
liens, and liens, and years with years with closing. must be paid
former former reestablished reestablished through loan.
bankruptcies bankruptcies credit. credit.
are are
unacceptable. unacceptable.
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"A" CREDIT "A-" CREDIT "B" CREDIT "C" CREDIT "C-" CREDIT "D" CREDIT
GRADE GRADE GRADE GRADE GRADE GRADE
---------- ----------- ---------- ---------- ----------- ----------
DEBT SERVICE- Generally not Generally not Generally not Generally not Generally not Generally not
TO-INCOME to exceed to exceed to exceed to exceed to exceed to exceed
RATIO 42%. 45%. 50%. 50%. 55%. 60%.
MAXIMUM
COMBINED
LOAN-TO -
VALUE RATIO:
OWNER Generally 90% Generally 90% Generally 80% Generally 75% Generally 70% Generally 65%
OCCUPIED for a 1 to 4 for a 1 to 4 for a 1 to 4 for a 1 to 4 for a 1 to 4 for a 1 to 4
family family family family family family
dwelling. dwelling; dwelling; dwelling; dwelling. dwelling.
70% for a 65% for a 65% for a
condominium. condominium. condominium.
NON- Generally 80% Generally 75% Generally 70% Generally 65% Generally 65% Generally 60%
OWNER for a 1 to 4 for a 1 to 2 for a 1 to 2 for a 1 to 4 for a 1 to 4 for a 1 to 2
OCCUPIED family family family family family family
dwelling. dwelling; 65% dwelling; 60% dwelling; 60% dwelling. dwelling.
for a 3 to 4 for a 3 to 4 for a 3 to 4
family. family. family.
The following tables present certain information about the Company's
loan production through its retail loan office network, independent mortgage
broker network and correspondent program during fiscal 1995, 1996 and 1997:
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1995
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
------------ ------- ----- ------------- -------
A- $111,808,000 31% 63% 10.6%
B 55,338,000 16 65 11.1
C 70,515,000 20 59 11.7
C- 53,635,000 15 62 12.2
D 63,629,000 18 58 13.3
------------ ---
Total $354,925,000 100%
============ ===
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LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1996
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
------------ ------- ----- ------------- -------
A $ 126,790,000 11% 70% 9.4%
A- 224,943,000 19 68 10.2
B 227,117,000 19 69 10.5
C 197,389,000 17 65 11.6
C- 107,039,000 9 63 12.1
D 285,668,000 25 61 13.0
-------------- ---
Total $1,168,946,000 100%
============== ===
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1997
WEIGHTED
WEIGHTED AVERAGE AVERAGE
DOLLAR AMOUNT % OF COMBINED INTEREST
CREDIT GRADE OF LOAN TOTAL LOAN-TO-VALUE RATE(1)
------------ ------- ----- ------------- -------
A $ 327,574,000 14% 72% 9.2%
A- 758,842,000 32 73 9.8
B 573,125,000 24 72 10.3
C 277,002,000 12 67 11.2
C- 112,209,000 5 65 12.0
D 299,186,000 13 62 13.4
-------------- ---
Total $2,347,938,000 100%
============== ===
(1) Calculated with respect to the interest rate at the time the loan is
originated or purchased by the Company, as applicable.
SECURITIZATION OF LOANS
The primary funding strategy of the Company is to securitize and sell
mortgage loans originated or purchased by the Company. Securitization is a cost
competitive source of capital compared to other debt financing sources available
to the Company. Through June 30, 1997, the Company had completed 22
securitizations totaling $3.54 billion. The Company's operations have been
restructured in recent years specifically for the purpose of efficiently
originating, purchasing, underwriting and servicing loans for securitization in
order to meet the requirements of rating agencies, credit enhancers and
investors. The Company generally seeks to complete a securitization once each
quarter. The Company applies the net proceeds of the securitization to pay down
its warehouse facilities in order to make these facilities available for future
funding of mortgage loans. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Certain Accounting
Considerations."
The Company securitized and sold in the secondary market $317 million,
$791 million and $2.26 billion of loans in the fiscal years ended June 30, 1995,
1996 and 1997, respectively. Of the 22 securitization transactions completed
through June 30, 1997, 21 have been credit-enhanced by monoline
13
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insurance to receive ratings of "Aaa" by Moody's Investors Service, Inc.
("Moody's") and "AAA" by Standard & Poor's Ratings Group, a Division of The
McGraw-Hill Companies ("S&P") and, in the case of 1997-A, "AAA" by Fitch
Investors Service, Inc. ("Fitch"). For the 1997-B transaction completed in June
1997, the Company utilized a senior/ subordinated structure in which the senior
tranches received ratings of "Aaa" by Moody's, "AAA" by S&P and "AAA" by Fitch.
In a senior/subordinated structure, the senior certificate holders are protected
from losses by outstanding subordinated certificates, rather than a monoline
insurance company.
Each agreement that the Company has entered into in connection with its
securitizations requires either the overcollateralization of the trust or the
establishment of a reserve account that may initially be funded by cash
deposited by the Company. The Company's interest in each overcollateralization
amount and reserve account is reflected on the Company's Consolidated Financial
Statements as "residual assets." If losses exceed the amount of the
over-collateralization or the reserve account, as applicable, the
credit-enhancement aspects of the trust are triggered. In a securitization
credit-enhanced by a monoline insurance policy, any further losses experienced
by holders of the senior interests in the related trust will be paid under such
policy. To date, there have been no claims on any monoline insurance policy
obtained in any of the Company's securitizations. Further, in the event
delinquencies exceed certain specified percentages, the monoline insurer may
terminate the Company as servicer. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Capital Resources
- -- Securitization Program" and " -- Risk Factors -- Delinquencies; Negative
Impact on Cash Flows; Right to Terminate Mortgage Servicing." In a
senior/subordinated structure, losses in excess of the overcollateralization
amount generally are allocated first to the holders of the subordinated
interests and then to the holders of the senior interests of the trust.
LOAN SERVICING
Servicing includes collecting and remitting loan payments, accounting
for principal and interest, contacting delinquent borrowers, managing borrower
defaults and liquidating foreclosed properties. The Company retains the
servicing rights to substantially all of the residential loans it originates or
purchases. The following table sets forth certain information regarding the
Company's servicing portfolio for the periods indicated:
FISCAL YEARS ENDED JUNE 30,
---------------------------
1995 1996 1997
---- ---- ----
(IN THOUSANDS)
Loans added to the servicing portfolio......... $355,000 $1,168,900 $2,347,900
Servicing portfolio (period end)............... 608,700 1,370,000 3,174,000
Loan service revenue (1)....................... 8,246 18,186 25,804
(1) For a description of loan service revenue, see Note 1 of Notes to
Consolidated Financial Statements.
The Company directly services substantially all newly originated or
purchased loans which are secured by mortgaged properties located in 44 states.
Loans secured by properties located in other states are serviced through one or
more subservicers which are paid a fee per loan and a participation in certain
other fees paid by the borrowers. Through December 1996, the Company was capable
of servicing loans in a limited number of Western states. A new servicing system
deployed in November 1996
14
15
allows the Company to service loans in all 50 states. During fiscal 1998, the
Company intends to service directly substantially all of its servicing
portfolio. The Company believes that the successful implementation of its new
servicing system will provide it with improved margins on its servicing and
potentially a new source of servicing revenue through subservicing for third
parties.
The agreements between the Company and the real estate mortgage
investment conduit ("REMIC") or owner trusts established in connection with
securitizations typically require the Company to advance interest (but not
principal) on delinquent loans to the holders of the senior interests in the
related trust. The agreements also require the Company to make certain servicing
advances (e.g., for property taxes or hazard insurance) unless the Company
determines that such advances would not be recoverable. Realized losses on the
loans are paid out of the related loss reserve account or paid out of principal
and interest payments on overcollateralized amounts as applicable, and if
necessary, from the related monoline insurance policy or the subordinated
interests.
In the case of securitizations credit-enhanced by monoline insurance,
the agreements also typically provide that the Company may be terminated as
servicer by the monoline insurance company (or by the trustee with the consent
of the monoline insurance company) upon certain events of default, including the
Company's failure to perform its obligations under the servicing agreement, the
rate of over 90-day delinquency (including properties acquired by foreclosure
and not sold) exceeding specified limits, losses on liquidation of collateral
exceeding certain limits, any payment being made by the monoline insurance
company under its policy, and certain events of bankruptcy or insolvency. At
June 30, 1997, seven trusts representing approximately 21% (by dollar volume)
of the Company's servicing portfolio exceeded the specified delinquency rate,
although the servicing rights of the Company have not been terminated. See "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Capital Resources -- Securitization Program." In the case of the
Company's recent senior/subordinated securitization transactions, holders of 51%
of the certificates may terminate the servicer upon certain events of default.
The senior/subordinated securitization completed in June 1997 provides for
servicer termination upon the occurrence of certain levels of loss experience,
but not in the event of delinquency rates exceeding target percentages. No such
events of default have occurred to date in the Company's senior/subordinated
securitizations. The senior/subordinated securitization completed in September
1997 contains no loss or delinquencies triggers for servicer termination.
The Company receives a servicing fee based on a percentage of the
declining principal balance of each loan serviced. Servicing fees are collected
by the Company out of the borrower's monthly payments. In addition, the Company,
as servicer, generally receives all late and assumption charges paid by the
borrower on loans serviced directly by the Company, as well as other
miscellaneous fees for performing various loan servicing functions. The Company
also generally receives any prepayment fees paid by borrowers.
The Company's servicing portfolio is subject to reduction by normal
monthly principal amortization, by prepayment and by foreclosure. It is the
Company's strategy to build and retain its servicing portfolio. In general,
revenue from the Company's loan servicing portfolio may be adversely affected as
interest rates decline and loan prepayments increase. This effect has
historically been partially offset by
15
16
increases in prepayment fee income received from borrowers. In some states in
which the Company currently operates, prepayment fees may be limited or
prohibited by applicable law. The Company is considering alternative licensing
structures that would eliminate or reduce the effects of such limitations and
prohibitions.
The following table illustrates the mix of credit grades in the
Company's servicing portfolio as of June 30, 1997:
WEIGHTED WEIGHTED
AVERAGE AVERAGE
COMBINED ORIGINAL
DOLLAR AMOUNT INITIAL INTEREST
CREDIT GRADE OF LOAN % OF TOTAL LOAN-TO-VALUE RATE
------------ ------- ---------- ------------- ----
(Dollars in thousands)
A $ 97,900 3% 71% 9.6%
A- 1,205,100 38 71 9.9
B 707,200 22 71 10.6
C 402,000 13 66 11.6
C- 194,700 6 64 12.3
D 474,700 15 61 13.4
Other 92,400 3 54 12.1
---------- ---
Total $3,174,000 100%
========== ===
COLLECTIONS, DELINQUENCIES AND FORECLOSURES
The Company sends borrowers a monthly billing statement approximately
ten days prior to the monthly payment due date. Although borrowers generally
make loan payments within ten to fifteen days after the due date (the "grace
period"), if a borrower fails to pay the monthly payment within the grace
period, the Company commences collection efforts by notifying the borrower of
the delinquency. In the case of borrowers in the "C-" and "D" credit grades,
collection efforts begin immediately after the due date. The Company continues
contact with the borrower to determine the cause of the delinquency and to
obtain a commitment to cure the delinquency at the earliest possible time.
As a general matter, if efforts to obtain payment have not been
successful, a pre-foreclosure notice will be sent to the borrower immediately
after the due date of the next subsequently scheduled installment (five days
after the initial due date for C- and D credit grades), providing 30 days'
notice of impending foreclosure action. During the 30-day notice period,
collection efforts continue and the Company evaluates various legal options and
remedies to protect the value of the loan, including accepting a deed-in-lieu of
foreclosure, entering into a short sale or commencing foreclosure proceedings.
If no substantial progress has been made in collecting delinquent payments from
the borrower, foreclosure proceedings will begin. Generally, the Company will
have commenced foreclosure proceedings when a loan is 45 to 100 days delinquent,
depending upon credit grade.
Servicing and collection practices change over time in accordance with,
among other things, the Company's business judgment, changes in portfolio
performance and applicable laws and regulations.
16
17
Loans originated or purchased by the Company are secured by mortgages,
deeds of trust, security deeds or deeds to secure debt, depending upon the
prevailing practice in the state in which the property securing the loan is
located. Depending on local law, foreclosure is effected by judicial action or
nonjudicial sale, and is subject to various notice and filing requirements. In
general, the borrower, or any person having a junior encumbrance on the real
estate, may cure a monetary default by paying the entire amount in arrears plus
other designated costs and expenses incurred in enforcing the obligation during
a statutorily prescribed reinstatement period. Generally, state law controls the
amount of foreclosure expenses and costs, including attorneys' fees, which may
be recovered by a lender, the minimum time required to foreclose and the
reinstatement or redemption rights of the borrower.
Although foreclosure sales are typically public sales, frequently no
third-party purchaser bids in excess of the lender's lien because of the
difficulty of determining the exact status of title to the property, the
possible deterioration of the property during the foreclosure proceedings and a
requirement that the purchaser pay for the property in cash or by cashier's
check. Thus, the Company often purchases the property from the trustee or
referee through a credit bid in an amount up to the principal amount outstanding
under the loan, accrued and unpaid interest and the expenses of foreclosure.
Depending upon market conditions, the ultimate proceeds of the sale may not
equal the Company's investment in the property.
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18
The following table sets forth delinquency, foreclosure, loss and
reserve information relating to the Company's servicing portfolio for the
periods indicated:
FISCAL YEARS ENDED JUNE 30,
---------------------------
1995 1996 1997
---- ---- ----
(Dollars in thousands)
Percentage of dollar amount of delinquent
loans to loans serviced (period end)(1)(2)(3)
One Month.............................................. 3.9% 4.9% 4.3%
Two Months............................................. 1.6 1.8 1.9
Three or More Months
Not foreclosed (4)................................... 5.0 8.0 8.1
Foreclosed (5)....................................... 1.5 1.0 1.0
---- ---- ----
Total............................................ 12.0% 15.7% 15.3%
==== ==== ====
Percentage of dollar amount of loans
foreclosed to loans serviced (period end)(2)........... 1.2% 1.1% 1.5%
Number of loans foreclosed............................... 159 221(6) 560(6)
Principal amount of foreclosed loans..................... $6,675 $14,349 $48,029
Net losses on foreclosed loans included
in pools (7)........................................... $ 127 $ 931 $ 5,470
Percentage of losses to average servicing
portfolio.............................................. .03% .09% .24%
Liquidation loss reserve (8)............................. $3,371 $10,300 $43,586
(1) Delinquent loans are loans for which more than one payment is past due.
(2) The delinquency and foreclosure percentages are calculated on the basis of
the total dollar amount of mortgage loans originated or purchased by the
Company and, in each case, serviced by the Company and any subservicers as
of the end of the periods indicated. Percentages for fiscal year 1996 have
not been restated to include delinquencies of loans originated by One Stop.
The Company believes any such adjustment would not be material.
(3) At June 30, 1997, the dollar volume of loans delinquent more than 90 days in
the Company's seven REMIC trusts formed during the period from December 1994
to June 1996 exceeded the permitted limit in the related pooling and
servicing agreements. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Capital Resources;" and
"--Risk Factors -- Delinquencies; Negative Impact on Cash Flow; Right to
Terminate Mortgage Servicing".
(4) Represents loans which are in foreclosure but as to which foreclosure
proceedings have not concluded.
(5) Represents properties acquired following a foreclosure sale and still
serviced by the Company.
(6) The increase in the number of loans foreclosed and principal amount of loans
foreclosed in 1997 relative to 1996 is due to the larger and more seasoned
servicing portfolio.
(7) Represents losses net of gains on foreclosed properties in pools sold during
the periods indicated.
(8) Represents period end reserves for future liquidation losses.
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The Company's servicing portfolio has grown over the periods presented.
However, because foreclosures and losses typically occur months or years after a
loan is originated, data relating to delinquencies, foreclosures and losses as a
percentage of the current portfolio can understate the risk of future
delinquencies, losses or foreclosures.
COMPETITION
The Company faces intense competition in the business of originating,
purchasing and selling mortgage loans. The Company's competitors in the industry
include other consumer finance companies, mortgage banking companies, commercial
banks, credit unions, thrift institutions, credit card issuers and insurance
companies. Many of these competitors are substantially larger and have
considerably greater financial, technical and marketing resources than the
Company. In addition, many financial services organizations that are much larger
than the Company have formed national loan origination networks offering loan
products that are substantially similar to the Company's loan programs.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, customer service, marketing and distribution
channels, amount and term of the loan, loan origination fees and interest rates.
In addition, the current level of gains realized by the Company and its
competitors on the sale of subprime loans could attract additional competitors
into this market. Additional competition may lower the rates the Company can
charge borrowers and increase the price paid for purchased loans, thereby
potentially lowering gain on future loan sales and securitizations. To the
extent any of these competitors significantly expand their activities in the
Company's market, the Company could be materially adversely affected.
Fluctuations in interest rates and general economic conditions may also affect
the Company's competition. During periods of rising rates, competitors that have
locked in low borrowing costs may have a competitive advantage. During periods
of declining rates, competitors may solicit the Company's customers to refinance
their loans.
The Company believes its competitive strengths include: (i) its emphasis
on customer service to attract borrowers; (ii) providing a high level of service
to brokers and their customers; (iii) offering competitive loan programs for
borrowers whose needs are not met by conventional mortgage lenders; and (iv) the
convenience of its retail and broker offices.
REGULATION
The Company's operations are subject to extensive regulation,
supervision and licensing by federal, state and local governmental authorities
and are subject to various laws and judicial and administrative decisions
imposing requirements and restrictions on part or all of its operations. The
Company's consumer lending activities are subject to the Federal
Truth-in-Lending Act and Regulation Z (including the Home Ownership and Equity
Protection Act of 1994), the Federal Equal Credit Opportunity Act, as amended,
and Regulation B, the Fair Credit Reporting Act of 1970, as amended, the Federal
Real Estate Settlement Procedures Act and Regulation X, the Home Mortgage
Disclosure Act, the Federal Debt Collection Practices Act and the National
Housing Act of 1934, as well as other federal and state statutes and regulations
affecting the Company's activities. The Company is also subject to the rules and
regulations of, and examinations by, state regulatory authorities with respect
to originating, processing, underwriting, selling, securitizing and servicing
loans. These rules and regulations, among other things, impose licensing
obligations on the Company, establish eligibility
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criteria for mortgage loans, prohibit discrimination, govern inspections and
appraisals of properties and credit reports on loan applicants, regulate
assessment, collection, foreclosure and claims handling, investment and interest
payments on escrow balances and payment features, mandate certain disclosures
and notices to borrowers and, in some cases, fix maximum interest rates, fees
and mortgage loan amounts. Failure to comply with these requirements can lead to
loss of approved status, certain rights of rescission for mortgage loans, class
action lawsuits and administrative enforcement action. See "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations -- Risk
Factors -- Government Regulation."
In the course of its business, the Company may acquire properties as a
result of foreclosure. There is a risk that hazardous or toxic waste could be
found on such properties. In such event, the Company could be held responsible
for the cost of cleaning up or removing such waste, and such cost could exceed
the value of the underlying properties.
The Company is also subject to various other federal and state laws
regulating the issuance and sale of securities, relationships with entities
regulated by the Employee Retirement Income Security Act of 1974, as amended,
and other aspects of its business.
EMPLOYEES
At June 30, 1997, the Company employed 1,385 persons. The Company has
satisfactory relations with its employees.
ITEM 2. PROPERTIES
The executive and administrative offices of the Company are located at
350 S. Grand Avenue, Los Angeles, California, and consist of approximately
178,000 square feet. The lease on these premises extends through February 2012.
The Company also continues to lease space at its former headquarters location at
3731 Wilshire Boulevard, Los Angeles, California, which it uses for its
telemarketing operations. This lease expires in July 2000. The executive and
administrative offices of One Stop are located at 200 Baker Street, Costa Mesa,
California, and consist of approximately 19,544 square feet.
The lease on these premises extends through November 8, 1998.
The Company and One Stop also lease space for their branch offices.
These facilities aggregate approximately 178,000 square feet and are leased
under terms which vary as to duration. In general, the leases expire between
1997 and 2002, and provide for rent escalations tied to either increases in the
lessor's operating expenses or fluctuations in the consumer price index in the
relevant geographical area.
ITEM 3. LEGAL PROCEEDINGS
In September 1997, three purported class actions were filed against the
Company and certain of its directors and officers. One case, filed in the Los
Angeles Superior Court of the State of California (Polin, et al. v. Aames
Financial Corporation, et al., Case No. BC177236), alleges violations of the
California securities laws and the two other cases, filed in the United States
District Court for the
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21
Central District of California (Dauber, et al. v. Aames Financial Corporation,
et al., Case No. 97-6714 and Plaut, et al. v. Aames Financial Corporation, et
al., Case No. 97-6814), allege violations of the federal securities laws. In
these cases, plaintiffs allege that the Company and certain of its directors and
officers issued false and misleading statements regarding the Company's
correspondent bulk purchase program. Plaintiffs further allege that such
directors and officers sold shares of the Company's stock with knowledge of
material non-public information concerning such program. In the California
action, plaintiffs purport to represent a class of persons who purchased the
Company's stock between January 29, 1997 and April 30, 1997. In the federal
actions, plaintiffs purport to represent a class of persons who purchased the
Company's stock between January 23, 1996 and April 30, 1997. In all three cases,
plaintiffs seek unspecified compensatory damages, attorneys' fees and costs. The
Company believes that it has meritorious defenses to these actions and intends
to defend them vigorously.
The Company is involved in litigation arising in the normal course of
business. The Company believes that any liability with respect to such legal
actions, individually or in the aggregate, is not likely to be material to the
Company's consolidated financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of fiscal 1997 to a
vote of the security holders of the Company.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
In November 1995, the Company's common stock began trading under the
symbol AAM on the New York Stock Exchange (NYSE). Prior to that time, the
Company's common stock traded on the NASDAQ National Market under the symbol
AAMS. The following table sets forth the range of high and low sale prices and
per share cash dividends declared for the periods indicated. All share prices
and cash dividends through February 21, 1997 have been adjusted to reflect the
three-for-two stock split in the form of stock dividend effected on that date
and the three-for-two stock split in the form of a stock dividend effected on
May 17, 1996.
CASH
HIGH LOW DIVIDEND
FISCAL 1996*
First Quarter................... $13.000 $ 7.667 $.033
Second Quarter.................. 16.333 10.750 .033
Third Quarter................... 16.750 10.833 .033
Fourth Quarter.................. 24.667 16.083 .033
FISCAL 1997*
First Quarter................... $37.922 $20.750 $.033
Second Quarter.................. 39.328 22.500 .033
Third Quarter................... 32.375 20.250 .033
Fourth Quarter.................. 20.500 10.750 .033
------------------------
* As reported by Bloomberg
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As of September 23, 1997, the Company had 190 stockholders of record.
Since its initial public offering on December 3, 1991, the Company has
consistently paid quarterly cash dividends on its common stock. The Company
declared and subsequently paid an aggregate of $0.13 per share in dividends for
the year ended June 30, 1997, representing approximately 21.4% of its net income
for the period. The Board of Directors of the Company reviews the Company's
dividend policy at least annually in light of the earnings, cash position and
capital needs of the Company, general business conditions and other relevant
factors. Bank agreements generally limit the Company's ability to pay dividends
if such payment would result in an event of default under the agreements. The
Company's Indenture relating to its 9.125% Senior Notes due 2003 (the
"Indenture") prohibits the payment of dividends if the aggregate amount of such
dividends since October 26, 1996 exceeds the sum of (a) 25% of the Company's net
income during that period; (b) net cash proceeds from any securities issuances;
and (c) proceeds from the sale of certain investments. The Company's Indenture
of Trust relating to its 10.50% Senior Notes due 2002 restricts the payment of
dividends to an amount which does not exceed (i) $2.0 million, plus (ii) 50% of
the Company's aggregate net income for each fiscal year after the year ended
June 30, 1994, plus (iii) 100% of the net proceeds received by the Company on
offerings of its equity securities after December 31, 1994.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data for the Company for the five
year period ended June 30, 1997 have been derived from the audited Consolidated
Financial Statements. The selected consolidated financial data should be read in
conjunction with the Consolidated Financial Statements and Notes thereto and
other financial information included herein. Results of operations of the
Company for the year ended June 30, 1997, reflect the Company's adoption of SFAS
No. 125. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations." The selected consolidated financial data
gives pro forma effect to the acquisition of One Stop. See "Item 1.
Business--One Stop Acquisition."
FISCAL YEAR ENDED JUNE 30,
--------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(Dollars in thousands except per share data)
STATEMENT OF INCOME DATA:
Revenue:
Gain on sale of loans............. $ 3,791 $ 8,705 $25,438 $ 95,299 $198,736
Net unrealized loss on valuation
of interest-only strips......... (18,950)
Commissions....................... 18,686 16,432 15,799 21,564 29,250
Loan service...................... 4,377 6,099 8,246 18,186 25,804
Fees and other.................... 4,762 5,595 7,940 15,215 37,679
------- ------- ------- -------- --------
Total revenue................. 31,616 36,831 57,423 150,264 272,519
Total expenses.................... 23,260 27,848 40,272 97,965 239,012
------- ------- ------- -------- --------
Income before income taxes........ 8,356 8,983 17,151 52,299 33,507
Provision for income taxes........ 3,353 3,684 7,117 22,508 16,398
------- ------- ------- -------- --------
Net income........................ $ 5,003 $ 5,299 $10,034 $ 29,791 $ 17,109
======= ======= ======= ======== ========
Net income per share (fully diluted) $ 0.50 $ 0.41 $ 0.74 $ 1.14 $ 0.60
======= ======== ======= ======== ========
Weighted average number of shares
outstanding (in thousands)
(fully diluted)................. 9,935 13,127 13,532 27,248 34,516
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FISCAL YEAR ENDED JUNE 30,
--------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(Dollars in thousands except per share data)
CASH FLOW DATA:
(Used in) operating activities $ (1,490) $(13,857) $(43,375) $ (241,073) $ (280,073)
(Used in) investing activities (489) (870) (988) (5,885) (8,865)
Provided by (used in) financing activities (1,522) 22,855 48,209 250,540 291,899
Net increase (decrease) in cash and
cash equivalents (3,501) 8,128 3,846 3,582 2,961
RATIOS AND OTHER DATA:
Return on average common equity 36% 18% 27% 28% 23%(5)
Return on average managed receivables(1) 2.1% 1.6% 2.0% 3.0% .8%
Loans originated or purchased:
Retail loans $122,200 $130,200 $148,200 $ 220,900 $ 436,900
Broker network -- -- -- 319,800 741,000
Correspondent loans -- 19,700 206,800 628,200 1,170,000
-------- -------- -------- ---------- ----------
Total $122,200 $149,900 $355,000 $1,168,900 $2,347,900
======== ======== ======== ========== ==========
Whole loans sold......................... -- -- -- $ 202,200 $ 7,500
Loans pooled and sold in the secondary
market................................. $ 52,500 $106,800 $316,600 $ 791,300 $2,262,700
Loans serviced (period end).............. $262,100 $381,800 $608,700 $1,370,000 $3,174,000
Weighted average commission rate on
retail loan originations (2) 14.0% 12.0% 9.4% 7.7% 4.9%
Weighted average interest rate (2) 11.2% 10.3% 11.6% 11.3% 10.6%
Weighted average initial combined
loan-to-value ratio (2)(3):
Retail loans........................... 51% 52% 55% 60% 67%
Broker network......................... -- -- 68% 71%
Correspondent loan..................... NM NM 65% 66% 71%
Number of retail loan offices
(period end)........................... 24 27 32 48 56
Number of One Stop branch offices
(period end)........................... -- -- -- 25 37
AT JUNE 30,
-----------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
BALANCE SHEET DATA:
Cash and cash equivalents........... $ 8,385 $ 16,513 $ 20,359 $ 23,941 $ 26,902
Servicing assets (4)................ 7,555 18,780 56,960 184,691 404,890
Total assets........................ 21,307 53,344 114,623 421,475 761,593
------- -------- -------- -------- --------
10.5% Senior Notes due 2002......... -- -- 23,000 23,000 23,000
9.125% Senior Notes due 2003 -- -- -- -- 150,000
5.5% Convertible Subordinated Debentures
due 2006.......................... -- -- -- 115,000 113,990
Other long-term debt................ 944 1,104 144 45 --
------- -------- -------- -------- --------
Total long-term debt.......... 944 1,104 23,144 138,045 286,990
Stockholders' equity................ 15,850 31,669 80,047 133,429 268,354
- ------------
(1) Represents net income divided by the average servicing portfolio for the
fiscal year.
(2) Computed on loans originated or purchased, as the case may be, during the
period.
(3) The weighted average initial combined loan-to-value ratio is determined by
dividing the sum of all loans secured by the junior or senior mortgages on
the property by the appraised value at origination.
(4) Represents the sum of interest-only strips, residual assets and mortgage
servicing rights. See Note 1 of Notes to Consolidated Financial Statements.
(5) Excludes nonrecurring charges of $32 million (pre-tax).
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with Item 6.
Selected Financial Data and Item 8. Financial Statements and Supplementary Data.
This Report contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Such statements are indicated by words or
phrases such as "anticipate," "estimate," "project," "management believes," "the
Company believes" and similar words or phrases. Such statements are based on
current expectations and are subject to risks, uncertainties and assumptions,
including those discussed under "--Risk Factors." Should one or more of these
risks or uncertainties materialize, or should underlying assumptions prove
incorrect, actual results may vary materially from those anticipated, estimated
or projected.
OVERVIEW
The Company is a consumer finance company primarily engaged, through its
subsidiaries, in the business of originating, purchasing, selling and servicing
home equity mortgage loans secured by single family residences. In late fiscal
1997, the Company began offering commercial loans on a limited basis which it
plans to sell on a whole loan basis servicing released. The Company, upon its
formation in 1991, acquired Aames Home Loan, a home equity lender founded in
1954.
The Company's principal market is borrowers whose financing needs are
not being met by traditional mortgage lenders for a variety of reasons,
including the need for specialized loan products or credit histories that may
limit such borrowers' access to credit. The Company believes these borrowers
continue to represent an underserved niche of the home equity loan market and
present an opportunity to earn a superior return for the risk assumed. The
mortgage loans originated and purchased by the Company, which include fixed and
adjustable rate loans, are generally used by borrowers to consolidate
indebtedness or to finance other consumer needs rather than to purchase homes.
The Company originates and purchases loans on a nationwide basis through
three production channels--retail, broker and correspondent. For the year ended
June 30, 1997, the Company originated and purchased $2.35 billion of mortgage
loans. The Company underwrites and appraises every loan it originates and
generally re-underwrites and reviews appraisals on all loans it purchases. See
"Item 1. Business--Mortgage Loan Production." The Company retains the servicing
rights (collecting loan payments and managing borrower defaults) to
substantially all of the loans it originates or purchases. At June 30, 1997, the
Company had a servicing portfolio of $3.17 billion, of which 53% was subserviced
by third parties. In fiscal 1997, the Company's servicing division implemented
systems and personnel that will allow it to service directly substantially all
of its servicing portfolio by the end of fiscal 1998. See "Item 1.
Business--Loan Servicing."
During fiscal 1997, the Company experienced a dramatic shift up the
credit grade spectrum reflecting its previously announced strategic decision to
diversify the loans it originates and purchases to include more of the higher
credit grade loans. In fiscal 1997, of the total loans originated and purchased
by the Company, 82% were A, A-, B and C credit grade loans and 18% were C- and D
credit grade loans, compared to 66% and 34%, respectively, in fiscal 1996. This
diversification was
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accomplished primarily through the acquisition of One Stop in August 1996, which
focuses on the higher credit grade spectrum, the decreasing of C- and D
originations in certain non-judicial foreclosure states and the adoption of
pricing structures by credit grade in the correspondent and retail divisions.
As a fundamental part of its business and financing strategy, the
Company sells substantially all of its loans to third party investors in
securitization transactions. These transactions enhance profitability, maximize
liquidity and reduce the Company's exposure to fluctuations in interests rates.
The Company securitized and sold in the secondary market $317 million, $791
million and $2.26 billion of loan in the fiscal years ended June 30, 1995, 1996
and 1997, respectively. See "Item 1. Business-- Securitization of Loans."
The Company has experienced significant growth in the last three years.
Management believes that this growth is primarily attributable to (i) the
Company's geographic expansion of its retail loan office network from 21 offices
in California at July 1, 1993 to 58 offices located in 25 states at August 31,
1997, (ii) the Company's acquisition of One Stop, (iii) the commencement of the
Company's correspondent program in fiscal 1994, (iv) the Company's ability to
complete mortgage loan securitizations on a quarterly basis, (v) the Company's
increased access to warehouse and other credit facilities over this period, and
(vi) the Company's ability to effect additional debt and equity financings over
this period, which in the aggregate raised net proceeds of approximately $279
million and $179 million, respectively. The Company has managed its growth by
employing experienced senior management, regularly monitoring its underwriting
guidelines, strengthening quality control procedures and enhancing technology.
In June 1997, the Company retained Donaldson, Lufkin & Jenrette
Securities Corporation to develop a means to maximize opportunities for the
Company and its stockholders. These opportunities include remaining independent
and continuing to grow internally and through acquisition, or selling the
Company or entering into a business combination transaction. While the Company
is in discussions concerning a possible business combination, it also believes
the profit-enhancing steps taken in the fourth quarter create a strong
foundation upon which to remain independent and continue to grow its production
channels and servicing platform. See "-- Revenue."
CERTAIN ACCOUNTING CONSIDERATIONS
As a fundamental part of its business and financing strategy, the
Company sells substantially all of its loans in securitization transactions. In
a securitization, the Company conveys loans that it has originated or purchased
to a separate entity (such as a trust or trust estate) in exchange for cash
proceeds and an interest in the loans securitized represented by the gain on
sale of loans. The cash proceeds are raised through an offering of the
pass-through certificates or bonds evidencing the right to receive principal
payments on the securitized loans and the interest rate on the certificate
balance or on the bonds. The gain on sale of loans (net of the unrealized gain
or loss on valuation of interest-only strips) represents, over the estimated
life of the loans, the present value of the excess of the weighted average
coupon on each pool of loans sold over the sum of the interest rate paid to
investors, the contractual servicing fee (currently 0.50%) and a monoline
insurance fee, if any. The gain on sale of loans provides the basis for the
calculation of the interest-only strips, which are recorded as an asset on the
Company's consolidated balance sheet. The interest-only strips represent the
present value of
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the future cash flows, adjusted for the provision for loan losses. The Company
determines the present value of the cash flows at the time each securitization
transaction closes using certain estimates made by management at the time the
loans are sold. These estimates include the following: (i) rate of prepayment;
(ii) discount rate used to calculate present value; and (iii) the provision for
credit losses on loans sold. There can be no assurance of the accuracy of
management's estimates.
Rate of Prepayment. The estimated life of the securitized loans depends
on the assumed annual prepayment rate which is a function of estimated voluntary
(full and partial) and involuntary (liquidations) prepayments. The prepayment
rate represents management's expectations of future prepayment rates based on
prior and expected loan performance, the type of loans in the relevant pool
(fixed or adjustable rate) and industry data. The rate of prepayment may be
affected by a variety of economic and other factors, including the production
channel which produced the loan, prevailing interest rates, the presence of
prepayment penalties, the loan-to-value ratios and the credit grades of the
loans included in the securitization. Generally, a declining interest rate
environment will encourage prepayments. Lower credit grade loans tend to be more
payment and less interest rate sensitive than higher credit grade loans. The
valuation adjustment recorded in the fourth quarter of fiscal 1997 was due to
the continued acceleration of prepayment rates of adjustable rate loans included
in the Company's earlier pools. For fiscal 1996 and 1997, prepayment rates used
in the valuation of the interest-only strips ranged from 22.0% to 25.5% and
23.5% to 38.3%, respectively. These rates represent a weighted average loan life
of approximately 2.8 to 4.3 years and 2.6 to 3.9 years for fiscal 1996 and 1997,
respectively. See "-- Revenue" and "-- Risk Factors -- Prepayment and Credit
Risk."
Discount Rate. In order to determine the present value of the cash flow
from the interest-only strips, the Company discounts the cash flows based upon
rates prevalent in the market. See Note 3 to Notes to Consolidated Financial
Statements.
Provision for credit losses on loans sold. In determining the provision
for credit losses on loans sold, the Company uses assumptions that it believes
are reasonable based on information from its prior securitizations and the
loan-to-value ratios of the loans included in the current securitizations. At
June 30, 1997, the Company had reserves of $43.6 million related to these credit
risks, or 1.6% of the outstanding balance of loans securitized as of that date.
Cumulative net losses to date from the Company's securitization transactions
since June 1992 have totaled $6.49 million. Losses ranged from .03% to .24% of
the average servicing portfolio for the fiscal years ended June 1995, 1996 and
1997. The weighted average loan-to-value ratio of the loans serviced by the
Company was 68% as of June 30, 1997.
The interest-only strips are amortized over the expected lives of the
related loans and a corresponding reduction in servicing fee income is recorded.
On a quarterly basis, the Company reviews the fair value of the interest-only
strips by analyzing its prepayment and other assumptions in relation to its
actual experience and current rates of prepayment prevalent in the industry. See
"-- Risk Factors -- Prepayment and Credit Risk." The interest-only strips are
marked to market through a charge to earnings. See "-- Revenue."
Additionally, upon sale or securitization of servicing retained
mortgages, the Company capitalizes the fair value of mortgage servicing rights
assets separate from the loan. The Company
26
27
determines fair value based on the present value of estimated net future cash
flows related to servicing income. The cost allocated to the servicing rights is
amortized over the period of estimated net future servicing fee income. The
Company periodically reviews the valuation of capitalized servicing fees
receivable. This review is performed on a disaggregated basis for the
predominant risk characteristics of the underlying loans which are loan type and
origination date. The Company generally makes loans to credit-impaired borrowers
whose borrowing needs may not be met by traditional financial institutions due
to credit exceptions. The Company has found that credit impaired borrowers are
payment sensitive rather than interest rate sensitive. As such, the Company does
not consider interest rate a predominant risk characteristic for purposes of
valuation. As the Company increases the amount of higher credit grade loans it
originates and purchases, it may find that interest rate sensitivity among its
borrower base also increases.
The Company adopted Statement of Financial Accounting Standards No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities" ("SFAS 125") effective January 1, 1997. The adoption of SFAS 125
did not have a material effect on the Company's results of operations for the
year ended June 30, 1997. As a result of the adoption of FAS 125, the Company
records amounts previously categorized as "Excess servicing gains" in the
Consolidated Statements of Income as "Gain on sale of loans." Additionally, the
Company now records the right to future interest income that exceeds
contractually specified servicing fees and previously recorded as "Excess
servicing receivable" as an investment security called "Interest-only strips."
The Company has classified this asset as a trading security and, through June
30, 1997, recorded a mark-to-market loss of $19.0 million on this security
consisting of a $9.05 million gain on securitizations completed since March 1997
and a $28 million loss on securitizations recorded prior to March 1997. SFAS 125
requires that this mark-to-market adjustment be reported separately from "Gain
on sale of loans" and the adjustment has been labeled "Net unrealized loss on
valuation of interest-only strips" in the Consolidated Statements of Income.
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS
128"). SFAS 128 establishes standards for computing and presenting earnings per
share ("EPS") by replacing the presentation of primary EPS with a presentation
of basic EPS. Primary EPS included common stock equivalents while basic EPS
excludes them. This change simplifies the computation of EPS, while making the
United States computation more compatible to the standards of other countries.
It also requires dual presentation of basic and fully diluted EPS on the face of
the income statement for all entities with complex capital structures. The
Company will adopt SFAS 128 effective December 31, 1997 and does not expect the
adoption of SFAS 128 to have a material impact on its financial statements.
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 129, "Disclosure of Information
about Capital Structure" ("SFAS 129"). SFAS 129 establishes disclosure
requirements regarding pertinent rights and privileges of outstanding
securities. Examples of disclosure items regarding securities include, though
are not limited to, items such as dividend and liquidation preferences,
participation rights, call prices and dates, conversion or exercise prices or
rates. The number of shares issued upon conversion, exercise or satisfaction of
required conditions during at least the most recent annual fiscal period and any
subsequent interim period must also be disclosed. Disclosure of liquidation
preferences of preferred stock in the equity
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section of the statement of financial condition is also required. SFAS 129 is
effective for financial periods beginning after December 15, 1997.
In October 1995, the FASB released SFAS No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"). This statement establishes methods of
accounting for stock-based compensation plans. SFAS 123 is effective for fiscal
years beginning after December 15, 1995. The Company adopted SFAS 123 in fiscal
year 1997. The adoption of SFAS 123 did not have a material effect on the
financial position of the Company.
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RESULTS OF OPERATIONS -- FISCAL YEARS 1995, 1996 AND 1997
The following table sets forth information regarding the components of
the Company's revenue and expenses in fiscal 1995, 1996 and 1997:
1995 1996 1997
---------------------- ---------------------- --------------------
(Dollars in thousands)
Dollars Percentage Dollars Percentage Dollars Percentage
------- ---------- ------- ---------- ------- ----------
Revenue:
Gain on sale of loans........ $ 25,438 44.3% $ 95,299 63.4% $198,736 72.9%
Net unrealized loss on valuation
of interest-only strips -- -- -- -- (18,950) (6.9)
Commissions................... 15,799 27.5 21,564 14.4 29,250 10.7
Loan Service:
Servicing spread............ 4,399 7.7 12,667 8.4 16,265 6.0
Prepayment fees............. 1,974 3.4 3,229 2.1 5,815 2.1
Late charges and
other servicing fees 1,873 3.3 2,290 1.5 3,724 1.4
Fees and other:
Closing..................... 2,077 3.6 2,512 1.7 2,723 1.0
Appraisal................... 988 1.7 1,167 0.8 1,854 0.7
Underwriting................ 1,091 1.9 1,600 1.1 1,382 0.5
Interest income............. 2,339 4.1 9,127 6.1 31,160 11.4
Other....................... 1,445 2.5 809 0.5 560 0.2
-------- ----- -------- ----- -------- -----
Total revenue........... $ 57,423 100.0% $150,264 100.0% $272,519 100.0%
======== ===== ======== ===== ======== =====
Expenses:
Compensation and
related expenses.......... $ 17,610 30.7% $ 40,758 27.1% $ 81,021 29.7%
Sales and
advertising costs......... 9,906 17.2 19,036 12.7 27,229 10.0
General and administrative
expenses.................. 7,067 12.3 17,377 11.6 31,716 11.6
Interest expense............ 3,205 5.6 12,370 8.2 33,105 12.2
Provision for loan losses 2,484 4.3 8,424 5.6 33,941 12.5
Nonrecurring charges -- -- -- -- 32,000 11.7
-------- ----- -------- ----- -------- -----
Total expenses......... $40,272 70.1% $ 97,965 65.2% $239,012 87.7%
======== ===== ======== ===== ======== =====
Income before income taxes 17,151 29.9 52,299 34.8 33,507 12.3
Income taxes.................... 7,117 12.4 22,508 15.0 16,398 6.0
-------- ----- -------- ----- -------- -----
Net income.............. $ 10,034 17.5% $ 29,791 19.8% $ 17,109 6.3%
======== ===== ======== ===== ======== =====
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REVENUE
Total revenue for fiscal 1997 increased $122 million, or 81%, from total
revenue for fiscal 1996 which, in turn, increased $92.8 million, or 162%, over
total revenue in fiscal 1995. The 1997 revenue includes a net unrealized loss on
the valuation of the Company's interest-only strips (see below). Increases in
total revenue for these periods were primarily the result of higher gain on sale
and loan service revenue resulting from increased volumes of mortgage loans
originated and purchased by the Company and securitized and sold. The Company
originated and purchased $355 million, $1.17 billion and $2.35 billion of
mortgage loans during fiscal 1995, 1996 and 1997, respectively. The substantial
increase from 1995 to 1996 was primarily the result of the increase in loans
purchased through the Company's correspondent loan division and, to a lesser
extent, the national expansion of the Company's retail division. The substantial
increase in 1997 over 1996 was due primarily to the increase in loans purchased
through the Company's correspondent loan division, loans originated through the
independent mortgage broker network and, to a lesser extent, the further
expansion of the retail network.
Gain on sale increased by $84.5 million, or 89%, in fiscal 1997 compared
to fiscal 1996 and $69.9 million, or 275%, in fiscal 1996 compared to fiscal
1995. These increases resulted primarily from the greater size of the mortgage
loan pools securitized and sold by the Company and, in fiscal 1996, increased
servicing spreads and the recognition of mortgage servicing rights pursuant to
SFAS 122 (see "--Certain Accounting Considerations"). The Company securitized
and sold $317 million, $791 million and $2.26 billion of loans during fiscal
1995, 1996 and 1997, respectively. The weighted average servicing spread (the
weighted average interest rate on the pool of loans sold over the sum of the
investor pass-through or bond rate and the monoline insurance fee, if any) on
loans securitized and sold during these periods was 3.91%, 4.93% and 4.16% for
fiscal 1995, 1996 and 1997, respectively. The lower weighted average servicing
spread in 1997 reflected a decrease in weighted average interest rates on pooled
loans due primarily to the higher percentage of higher credit grade loans
included in the loans securitized during the year and, to a lesser degree,
increased pass-through or bond rates due to the current interest rate
environment. The larger percentage of higher credit grade loans included in the
loans securitized during fiscal 1997 reflects the Company's previously announced
diversification of its loan originations and purchases to include more A, A-, B
and C credit grade loans. In addition, in the fourth quarter, the Company
increased the prepayment rate assumption used to record the gain on sale,
thereby reducing the total amount of gain recorded in the fourth quarter
securitization.
The $19.0 million net unrealized loss on the valuation of the Company's
interest-only strips in fiscal 1997 resulted from the Company's quarterly review
of that asset to determine its current fair market value. The Company determines
the fair market value of the interest-only strips, in part, by applying
management's expectations as to future prepayment rates to the present value of
the future cash flows from prior securitizations. In conjunction with its bulk
pricing strategy change in the fourth quarter of fiscal 1997, management revised
its expectations as to future prepayment rates based primarily on the continued
acceleration of prepayment rates in adjustable rate loans included in some of
the Company's earlier pools. As a result, the Company recorded a $28 million
loss adjustment which is included in the $19 million unrealized loss on the
Company's interest-only strips. See "--Certain Accounting Considerations" and
"Item 1. Business -- Recent Events."
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Commissions earned on loan originations continue to be an important
component of total revenue, although to a lesser degree than in prior years,
comprising 28%, 14% and 11% of total revenue in fiscal 1995, 1996 and 1997,
respectively. Commissions increased $7.69 million, or 36%, in fiscal 1997
compared to fiscal 1996, and increased $5.77 million, or 36%, in fiscal year
1996 compared to fiscal 1995. Commission revenue is primarily a function of the
volume of mortgage loans originated by the Company through its retail loan
office network and the weighted average commission rate charged on such loans.
The increase in commissions in fiscal year 1997 was a result of increased
origination volume, offsetting a decline in weighted average commission rate.
The weighted average commission rate was 9.4%, 7.7% and 4.9% during fiscal 1995,
1996 and 1997, respectively. The lower weighted average commission rate in 1997
reflected the increase of higher credit grade loans originated through the
Company's retail loan office network, which generally carry lower commission
rates, and competitive factors. Commissions do not include $1.0 million and
$1.18 million of commissions on loans which were held for sale as of June 30,
1996 and 1997, respectively.
Loan service revenue increased $7.62 million, or 42%, in fiscal 1997
compared to fiscal 1996 and $9.94 million, or 121%, in fiscal 1996 compared to
fiscal 1995. Loan service revenue consists of net servicing spread earned on the
principal balances of the loans in the Company's loan servicing portfolio,
prepayment fees, late charges and other fees retained by the Company in
connection with the servicing of loans reduced by the amortization of the
interest-only strips. The increases in fiscal 1997 and 1996 were due primarily
to the greater size of the portfolio of loans serviced in each of these periods
offset by increased amortization of the interest-only strips. The Company's loan
servicing portfolio increased to $3.17 billion at June 30, 1997, up 131% from
the June 30, 1996 balance of $1.37 billion which, in turn, increased 125% over
the June 30, 1995 balance. At June 30, 1997, 53% of the Company's servicing
portfolio was subserviced by third parties. In fiscal 1998, the Company intends
to service directly substantially all the loans in its servicing portfolio.
Management believes that the business of loan servicing provides a more
consistent revenue stream and is less cyclical than the business of loan
origination and purchasing.
Fees and other revenue increased by $22.5 million, or 148%, in fiscal
1997 compared to fiscal 1996 and increased $7.28 million, or 92%, in fiscal 1996
compared to fiscal 1995. Fees and other revenue consist of fees received by the
Company through its retail loan office network in the form of closing,
appraisal, underwriting and other fees, plus interest income. The dollar amount
of these fees increased in each of the years presented due to the larger number
of mortgage loans originated through the Company's retail loan office network
during the respective periods. Interest income increased in fiscal 1997 and 1996
due to interest earned on larger amounts of loans held by the Company during the
period from origination or purchase of the loans until the date sold by the
Company.
EXPENSES
Compensation and related expenses increased $40.3 million, or 99%, in
fiscal 1997 compared to fiscal 1996. This increase was primarily due to the
continued effort to accommodate increased origination volumes and origination
channel expansion. Compensation and related expenses as a percentage of total
loan originations and purchases were 5.0%, 3.5% and 3.5% for fiscal 1995, 1996
and 1997, respectively.
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32
Sales and advertising costs increased $8.19 million, or 43%, in fiscal
1997 compared to fiscal 1996 and $9.13 million, or 92%, in fiscal 1996 compared
to fiscal 1995. This increase was primarily due to increased origination volume
and continued expansion into new geographical areas requiring concentrated
marketing efforts. Sales and advertising costs as a percentage of origination
volume were 2.8%, 1.6% and 1.2% for fiscal 1995, 1996 and 1997, respectively.
General and administrative expenses increased $14.3 million, or 83%, in
fiscal 1997 compared to fiscal 1996 and $10.3 million, or 146%, in fiscal 1996
compared to fiscal 1995. These increases were primarily the result of increased
occupancy and communication costs related to the Company's expansion and
increased origination volumes.
Interest expense increased to $33.1 million in fiscal 1997 compared to
$12.4 million in fiscal 1996 and $3.2 million in fiscal 1995. The increase was
primarily the result of increased borrowings under various financing
arrangements used to fund the origination and purchase of mortgage loans prior
to their securitization and sale in the secondary market and as a result of the
Company's sale of $115 million of its 5.5% Convertible Subordinated Debentures
due 2006 in the third quarter of fiscal 1996 and $150 million of its 9.125%
Senior Notes due 2003 in the second quarter of fiscal 1997. Interest expense is
expected to increase in future periods due to the Company's continued reliance
on warehousing arrangements to fund increased originations and purchases of
loans pending their securitization.
The provision for loan losses for fiscal 1997 increased to $33.9
million, up 303% when compared to fiscal 1996. The provision for loan losses
represents 1.50% of the loans securitized during fiscal 1997 compared to 1.06%
of the loans securitized during fiscal 1996. This increase reflects the greater
amount of higher credit grade loans with generally higher loan-to-value ratios
originated during fiscal 1997.
In fiscal 1997, the Company incurred $32.0 million of nonrecurring
charges. Approximately $25 million of these charges were recognized in August
1996 directly related to the acquisition of One Stop. The remaining amount
relates to a reserve for vacating corporate headquarters recorded in the first
quarter and to severance and other strategic decisions made in the fourth
quarter.
INCOME TAXES
The Company's provision for income taxes decreased to $16.4 million in
fiscal 1997 from $22.5 million in fiscal 1996 and increased from $7.1 million in
fiscal 1995, primarily as a result of the fluctuation in pre-tax income after
consideration of the tax impact of nonrecurring charges.
FINANCIAL CONDITION
Loans held for sale. The Company's portfolio of loans held for sale
increased to $243 million at June 30, 1997 from $186 million at June 30, 1996.
This increase is directly related to production volume and the size of the
Company's securitizations. In the quarter ended June 30, 1997, the Company
securitized only $500 million of its $644 million of loan production, increasing
the amount
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33
of loans carried over to the first quarter of fiscal 1998 to $243 million. This
represents an increase in loan carryover of approximately $136 million, or 127%,
over the third fiscal quarter's carryover amount. Management believes the
increase in the carryover amount will provide the Company with additional cash
flows, efficiencies and flexibility in the future.
Accounts receivable. Accounts receivable representing servicing fees and
advances and other receivables, increased from $9.7 million at June 30, 1996 to
$59.2 million at June 30, 1997. This increase was primarily the result of larger
pools serviced and increases in related advances and receivables.
Interest-only strips. Interest-only strips increased from $129 million
at June 30, 1996 to $270 million at June 30, 1997 reflecting the increased size
of the Company's securitizations during 1997.
See "-- Certain Accounting Considerations."
Mortgage servicing rights. Mortgage servicing rights increased from
$10.9 million at June 30, 1996 to $21.6 million at June 30, 1997 reflecting the
increased size of the Company's securitizations during 1997. See "-- Certain
Accounting Considerations."
Residual assets. Residual assets represent the reserve accounts and
overcollateralization amounts required to be maintained in connection with the
securitization of loans. Residual assets include cash and mortgage loans in
excess of the principal amounts of the senior and subordinated certificates or
bonds of the securitization trusts. Residual assets increased from $44.7 million
at June 30, 1996 to $113 million at June 30, 1997 due to the size of the
Company's recent securitizations.
Equipment and improvements, net. Primarily as a result of the Company's
expansion and the associated investment in technology, equipment and
improvements, net, increased from $6.7 million at June 30, 1996 to $12.7 million
at June 30, 1997.
Prepaid and other assets. Prepaid and other assets increased from $10.3
million at June 30, 1996 to $14.9 million at June 30, 1997 primarily as a result
of the capitalization, net of amortization, of debt issuance costs related to
the issuance of the Company's 9.125% Senior Notes due 2003.
Borrowings. Borrowings increased from $138 million at June 30, 1996 to
$287 million at June 30, 1997. This increase was the result of the sale in
October 1996 of $150 million of the Company's 9.125% Senior Notes due 2003.
Revolving warehouse facilities. Amounts outstanding under warehouse
facilities increased from $112 million at June 30, 1996 to $138 million at June
30, 1997 primarily as a result of the larger amount of loans held for sale at
such dates. Proceeds from the Company's securitizations are used to pay down the
Company's warehouse facilities.
33
34
LIQUIDITY
The Company's operations require continued access to short-term and
long-term sources of cash. The Company's operating cash requirements include the
funding of: (i) mortgage loan originations and purchases prior to their
securitization