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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
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FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
COMMISSION FILE NO. 1-12109
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DELTA FINANCIAL CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 11-3336165
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1000 WOODBURY ROAD, SUITE 200,
WOODBURY, NEW YORK 11797
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:(516) 364-8500
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE NEW YORK STOCK EXCHANGE
(TITLE OF EACH CLASS) (NAME OF EACH EXCHANGE ON WHICH REGISTERED)
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE
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 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. [_]
As of March 15, 2000, the aggregate market value of the voting stock held by
non-affiliates of the Registrant, based on the closing price of $2.75, was
approximately $13,362,628.
As of March 30, 2000, the Registrant had 15,883,749 shares of Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III, Items 10, 11, 12 and 13 are incorporated by reference from Delta
Financial Corporation's definitive proxy statement to stockholders which will be
filed with the Securities and Exchange Commission no later than 120 days after
December 31, 1999.
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PART I
ITEM 1. BUSINESS
BUSINESS OVERVIEW
Delta Financial Corporation (together with its subsidiaries, the "Company" or
"Delta") is a Delaware corporation that was organized in August 1996. On October
31, 1996, in connection with its initial public offering, the Company acquired
all of the outstanding common stock of Delta Funding Corporation ("Delta
Funding"), a New York corporation that had been organized on January 8, 1982 to
originate, sell, service and invest in residential first and second mortgages.
On November 1, 1996, the Company completed an initial public offering of
4,600,000 shares of common stock, par value $.01 per share.
Delta, through its subsidiaries, is a specialty consumer finance company that
has engaged in originating, acquiring, selling and servicing non-conforming home
equity loans since 1982. Throughout its operating history, Delta has focused on
lending to individuals who generally do not qualify for conforming credit.
Management believes that these borrowers have largely been unsatisfied by the
more traditional sources of mortgage credit, which underwrite loans to
conventional guidelines established by the Federal National Mortgage
Associations ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
The Company makes loans to these borrowers for such purposes as debt
consolidation, home improvement, refinancing or education, and these loans are
primarily secured by first mortgages on one- to four-family residential
properties.
Through its wholly-owned subsidiary, Delta Funding, the Company originates
home equity loans indirectly through licensed mortgage brokers and other real
estate professionals who submit loan applications on behalf of borrowers
("Brokered Loans") and also purchases loans from mortgage bankers and smaller
financial institutions that satisfy Delta's underwriting guidelines
("Correspondent Loans"). Delta Funding Corporation currently originates and
purchases the majority of its loans in 24 states, through its network of
approximately 1,600 brokers and correspondents.
Through its wholly-owned subsidiary, Fidelity Mortgage Inc. ("Fidelity
Mortgage") - which the Company acquired in February 1997 to broaden its
origination sources and to expand its geographic presence - the Company develops
retail loan leads primarily through its telemarketing system and its network of
14 retail offices located in Florida (3), Illinois, Indiana, Missouri, North
Carolina, Ohio (4), Pennsylvania (2) and Tennessee. In March 2000, the Company
decided to close a branch located in Georgia.
For the year ended December 31, 1999, the Company originated or purchased
approximately $1.47 billion of loans, of which approximately $891 million were
originated through its network of brokers, $319 million were originated through
its Fidelity Mortgage retail network and $261 million were purchased from its
network of correspondents.
Substantially all of the loans originated and purchased by the Company were
sold in securitizations in which the loans were transferred to a trust, which
had raised the cash payment to purchase the loans through the sale of
asset-backed pass-through securities of the trust. For the year ended December
31, 1999, Delta sold a total of $1.46 billion of loans through three real estate
mortgage investment conduit ("REMIC") securitizations. Each of these three
securitizations was credit-enhanced, by an insurance policy provided through a
monoline insurance company and/or a senior-subordinated structure, to receive
ratings of Aaa from Moody's Investors Service, Inc. ("Moody's"), Fitch IBCA
("Fitch") and Duff & Phelps Credit Rating Company ("Duff & Phelps") and AAA from
Standard & Poor's Ratings Group, a division of The McGraw-Hill Companies, Inc.
("S&P"). The Company sells loans through securitizations to improve its
operating leverage and liquidity, to minimize financing costs and to reduce its
exposure to fluctuations in interest rates.
The majority of the Company's revenues and cash flows result from its
securitizations and servicing of home-equity loans that it has originated or
purchased. In a securitization, the Company sells the loans to a trust for a
cash
1
payment while retaining (1) the right to service the loans, and receive a
contractual servicing fee and (2) interest-only and residual certificates in the
trust. The interest-only and residual certificates entitle the Company to
receive any "Excess Servicing" income, consisting of any remaining cash flows
collected by the trust from principal and interest payments on its loans after
the trust has first paid (a) all principal and interest required to be passed
through to holders of the trust's securities, (b) all contractual servicing
fees, and (c) other recurring fees and costs of administering the trust. Upon
securitizing a pool of loans, the Company recognizes a gain on sale of loans
("net gain on sale of mortgage loans") equal to the difference between cash
received from the trust when it sells asset-backed pass-through certificates and
the investment in the loans remaining after allocating portions of that
investment to record the value of servicing rights and interest-only and
residual certificates received by Delta in the securitization. The majority of
the net gain on the sale of mortgage loans results from, and is initially
realized in the form of, the retention of the mortgage servicing rights and
interest-only and residual certificates. The servicing rights and interest-only
and residual certificates are each recorded based on their fair values,
estimated based on a discount rate which management believes reflects the rate
market participants would utilize in purchasing similar servicing rights and
interest-only and residual certificates, and the stated terms of the transferred
loans adjusted for estimates of future prepayment rates and defaults among those
loans. If actual prepayments and/or defaults exceed the Company's estimates, the
future cash flows from the servicing rights and interest-only and residual
certificates would be negatively affected. (See "Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Certain Accounting Considerations.")
Although the Company recognizes income from the securitization of loans at
the time of the securitization, the Company receives cash flows from the
securitization, in particular the retained servicing rights and interest-only
and residual certificates, over the life of the transferred loans. The Company
begins to receive cash flows from monthly contractual servicing fees in the
month following a securitization. The Company's servicing fees range from 0.50%
to 0.65% per annum of the outstanding balance of the loans being serviced.
The Company typically begins to receive cash flows from the interest-only and
residual certificates retained upon securitization approximately 12 to
20 months after a securitization, with the specific timing depending on
the structure and performance of the securitization. Initially, securitization
trusts utilize the Excess Servicing cash flows to make additional payments of
principal on the pass-through certificates in order to establish a spread
between the principal amount of the trust's outstanding loans and the amount of
outstanding pass-through certificates. Once a spread of between 2% and 3% of the
initial securitization principal (the "overcollateralization limit") is
established, the Excess Servicing cash flows are distributed to Delta as the
holder of the interest-only and residual certificates. The Company utilizes the
more conservative "cash-out" method of valuing future cash flows from residual
certificates (See "Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Accounting Considerations.").
The Company services substantially all of the loans it has originated or
purchased, including all of the loans sold through securitizations. As of
December 31, 1999, the Company had a loan servicing portfolio of $3.64 billion.
In addition to the income and cash flows earned from the Company's
securitizations, the Company also earns income and generates cash flows from
whole loan sales, the net interest spread earned on loans while they are held
for sale, and from loan origination fees on Brokered Loans and retail loans.
The Company's business strategy is to increase the size of its servicing
portfolio and focus on its more profitable broker and retail channels of
originations (instead of correspondent purchases) by (1) continuing to provide
top quality service to its network of brokers, correspondents and retail
clients, (2) maintaining its underwriting standards, (3) further penetrating its
established and recently-entered markets and expanding into new geographic
markets, (4) expanding its retail origination capabilities, (5) leveraging and
continuing its investment in information and processing technologies, and (6)
strengthening its loan production capabilities through acquisitions.
2
HOME EQUITY LENDING OPERATIONS
OVERVIEW
Delta's consumer finance activities consist of originating, acquiring,
selling and servicing non-conforming mortgage loans. These loans are primarily
secured by first mortgages on one- to four-family residences. Once loan
applications have been received, the underwriting process completed and the
loans funded or purchased, Delta typically packages the loans in a portfolio and
sells the loan portfolio through a securitization. Generally, Delta retains the
right to service the loans that it securitizes.
The Company provides its customers with an array of loan products designed to
meet their needs. The Company uses a risk-based pricing strategy and has
developed products for various risk categories. Historically, the Company
offered fixed-rate loan products and, to date, the majority of the Company's
loan production is fixed-rate. As the Company has expanded geographically, it
has expanded its product offerings to include adjustable-rate mortgages and
fixed/adjustable-rate mortgages. However, since the fourth quarter of 1998, the
Company has virtually eliminated originations of its six-month LIBOR (London
Inter Bank Offered Rate) adjustable rate mortgages, which are less profitable
and more prepayment sensitive.
Historically, Delta Funding conducted substantially all of its broker and
correspondent lending operations out of its Woodbury, New York headquarters. In
recent years, Delta Funding has opened regional branch offices - which are
typically staffed with a combination of experienced Delta personnel and local
employees - to supplement its in some of its newer geographic regions.
Currently, Delta Funding maintains regional branch offices in the Southeast,
Midwest and West. Final underwriting approval is required from the Woodbury, New
York headquarters or Southeast branch office for all mortgage loans. Fidelity
Mortgage retail loans are underwritten by two operational offices (Cincinnati,
Ohio and West Palm Beach, Florida), which have full underwriting authority.
The Company adheres to a Best Practice Lending Program to help better protect
consumers, which include (a) fair lending initiatives to ensure all borrowers
are treated fairly and similarly regardless of race, color, creed, religion,
national origin, sex, sexual orientation, marital status, age, disability, and
the applicant's exercise, in good faith, of any right under the Consumer Credit
Protection Act; (b) increased oversight of mortgage brokers and closing agents;
(c) enhanced fraud detection and protection; (d) enhanced plain English
disclosures; and (e) other originations, underwriting and servicing initiatives
which Delta's management believes help protect consumers.
LOAN ORIGINATION AND PURCHASES
The Company's loan originations and purchases decreased by 15% to $1.47
billion in 1999 from $1.73 billion in 1998. Loan originations and purchases in
1998 had increased 38% over 1997 production of $1.25 billion.
3
The following table shows the channels of the Company's loan originations and
purchases for the years shown:
YEAR ENDED DECEMBER 31,
1997 1998 1999
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(DOLLARS IN THOUSANDS)
Broker:
Principal balance...................... $ 481,586 $ 841,079 $ 890,822
Average principal balance per loan..... $ 87 $ 92 $ 85
Combined weighted average initial loan-
to-value ratio(1).................... 69.9% 72.8% 72.8%
Weighted average interest rate......... 10.8% 10.0% 10.4%
Correspondent:
Principal balance...................... $ 632,639 $ 652,503 $ 261,289
Average principal balance per loan..... $ 77 $ 82 $ 77
Combined weighted average initial loan-
to-value ratio(1).................... 72.8% 73.9% 72.0%
Weighted average interest rate......... 11.3% 10.8% 11.0%
Retail:
Principal balance...................... $ 140,386 $ 234,011 $ 319,227
Average principal balance per loan..... $ 69 $ 75 $ 68
Combined weighted average initial loan-
to-value ratio(1).................... 80.1% 79.9% 77.6%
Weighted average interest rate......... 10.1% 9.4% 9.8%
Total loan purchases and originations:
Principal balance...................... $1,254,611 $ 1,727,593 $ 1,471,338
Average principal balance per loan..... $ 80 $ 85 $ 79
Combined weighted average initial loan-
to-value ratio(1).................... 72.5% 74.2% 73.7%
Weighted average interest rate......... 11.0% 10.2% 10.4%
Percentage of loans secured by:
First mortgage......................... 94.0% 95.5% 94.6%
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(1) The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the lesser
of the purchase price or the appraised value of the mortgage property at
origination. The weighted average initial loan-to-value ratio of a loan
secured by a second mortgage is determined by taking the sum of the loan
secured by the first and second mortgages and dividing by the lesser of the
purchase price or the appraised value of the mortgage property at
origination.
4
The following table shows the channels of loan originations and purchases on
a quarterly basis for 1999:
THREE MONTHS ENDED
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MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
1999 1999 1999 1999
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(DOLLARS IN THOUSANDS)
Broker:
Number of Brokered Loans...................... 2,590 2,881 2,731 2,339
Principal balance............................. $ 235,435 $ 257,011 $ 222,249 $ 176,128
Average principal balance per loan............ $ 91 $ 89 $ 81 $ 75
Combined weighted average initial loan-
to-value ratio(1)........................... 73.4% 72.7% 72.8% 72.0%
Weighted average interest rate................ 10.1% 10.0% 10.7% 11.1%
Correspondent:
Number of Correspondent Loans................. 1,188 833 765 611
Principal balance............................. $ 91,243 $ 65,535 $ 59,367 $ 45,144
Average principal balance per loan............ $ 77 $ 79 $ 78 $ 74
Combined weighted average initial loan-
to-value ratio(1)........................... 73.2% 71.9% 70.5% 71.6%
Weighted average interest rate................ 10.9% 10.9% 11.1% 11.4%
Retail:
Number of retail loans........................ 1,067 1,341 1,186 1,070
Principal balance............................. $ 77,430 $ 91,945 $ 79,400 $ 70,452
Average principal balance per loan............ $ 73 $ 69 $ 67 $ 66
Combined weighted average initial loan-
to-value ratio(1)........................... 78.7% 77.5% 76.3% 78.1%
Weighted average interest rate................ 9.6% 9.5% 10.0% 10.1%
Total loan purchases and originations:
Total number of loans......................... 4,845 5,055 4,682 4,020
Principal balance............................. $ 404,108 $ 414,491 $ 361,016 $ 291,723
Average principal balance per loan............ $ 83 $ 82 $ 77 $ 73
Combined weighted average initial loan-
to-value ratio(1)........................... 74.4% 73.6% 73.2% 73.4%
Weighted average interest rate................ 10.2% 10.0% 10.6% 10.9%
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(1) The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. The weighted average initial loan-to-value ratio
of a loan secured by a second mortgage is determined by taking the sum of
the loan secured by the first and second mortgages and dividing by the
lesser of the purchase price or the appraised value of the mortgage
property at origination.
5
The following table shows lien position, weighted average interest rates and
loan-to-value ratios for the years shown:
YEAR ENDED DECEMBER 31,
-----------------------
1997 1998 1999
---- ---- ----
First mortgage:
Percentage of total purchases and originations... 94.0% 95.5% 94.6%
Weighted average interest rate................... 11.0% 10.2% 10.3%
Weighted average initial loan-to-value ratio(1).. 72.6% 74.3% 74.1%
Second mortgage:
Percentage of total purchases and originations... 6.0% 4.5% 5.4%
Weighted average interest rate................... 11.3% 10.5% 10.8%
Weighted average initial loan-to-value ratio(1).. 71.1% 70.6% 66.6%
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(1)The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the lesser
of the purchase price or the appraised value of the mortgage property at
origination. The weighted average initial loan-to-value ratio of a loan
secured by a second mortgage is determined by taking the sum of the loan
secured by the first and second mortgages and dividing by the lesser of the
purchase price or the appraised value of the mortgage property at
origination.
The following table shows the geographic distribution of loan purchases and
originations for the periods indicated:
YEAR ENDED DECEMBER 31,
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1997 1998 1999
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REGION PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE
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(DOLLARS IN MILLIONS)
NY, NJ and PA............. 52.9% $ 664.3 55.0% $ 949.3 50.8% $ 747.9
Midwest................... 21.6 270.9 19.7 340.3 24.5 361.1
Southeast................. 9.7 121.4 9.3 161.0 8.4 123.5
New England............... 7.1 89.3 7.3 125.8 5.8 85.1
Mid-Atlantic*............. 6.5 81.3 6.9 119.1 8.6 126.7
West...................... 2.2 27.3 1.5 26.6 1.9 27.1
Canada.................... n/a n/a 0.3 5.5 n/a n/a
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* Excluding New York (NY), New Jersey (NJ) and Pennsylvania (PA).
BROKER AND CORRESPONDENT MARKETING. Throughout its history Delta has been
successful in establishing and maintaining relationships with brokers and
correspondents offering non-conforming mortgage products to their clientele.
Management believes that this success is attributable primarily to the quality
of service the Company provides to its network of brokers and correspondents.
Delta typically initiates contact with a broker or correspondent through
Delta's Business Development Department, comprised of approximately 40 business
development representatives, supervised by a senior officer with over ten years
of sales and marketing experience in the industry. The Company usually hires
business development representatives who have contacts with brokers and
correspondents that originate nonconforming mortgage loans within their
geographic territory. The business development representatives are responsible
for developing and maintaining the Company's broker and correspondent networks
within their geographic territory by frequently visiting the broker or
correspondent, communicating the Company's underwriting guidelines,
disseminating new product information and pricing changes, and by demonstrating
a continuing commitment to understanding the needs of the customer. The business
development representatives attend industry trade shows and inform Delta about
the products and pricing being offered by competitors and new market entrants.
This information assists Delta in refining its programs and product offerings in
order to remain competitive. Business development representatives are
compensated with a base salary and commissions based on the volume of loans
originated or purchased as a result of their efforts.
6
APPROVAL PROCESS. Before a broker or correspondent becomes part of Delta's
network, it must go through an approval process. Once approved, brokers and
correspondents may begin submitting applications and/or loans to Delta.
To be approved, a broker must demonstrate that it is properly licensed and
registered in the state in which it seeks to transact business, submit to a
credit check and sign a standard broker agreement with Delta that requires
brokers to requires brokers to, among other things, abide by Delta's fair
lending policy, follow the National Association of Mortgage Brokers Best
Practices Policies, comply with all state and federal laws, and submit only true
and accurate documents and disclosures. Delta also performs searches on all new
brokers using a third party database that contains public and nonpublic
information on individuals and companies that have incidents of potential fraud
and misrepresentation. A correspondent is eligible to submit loans to Delta for
purchase only after an extensive investigation of the prospective
correspondent's lending operations including an on-site visit, a review of the
correspondent's financial statements for the prior two years, a credit report on
the correspondent, a review of sample loan documentation and business references
provided by the correspondent. Once approved, Delta requires that each
correspondent sign an Agreement of Purchase and Sale in which the correspondent
makes representations and warranties governing both the mechanics of doing
business with Delta and the quality of the loan submissions themselves. Delta
also performs an annual review of each approved correspondent in order to ensure
continued compliance with legal requirements and that lending operations and
financial information continue to meet Delta's standards. In addition, Delta
regularly reviews the performance of loans originated or purchased through its
brokers or correspondents.
BROKERED LOANS. For the year ended December 31, 1999, the Company's broker
network accounted for $890.8 million, or 60%, of Delta's loan purchases and
originations compared to $841.1 million, or 49%, of Delta's loan purchases and
originations for the year ended December 31, 1998 and $481.6 million, or 38%, of
Delta's loan purchases and originations for the year ended December 31, 1997. No
single broker contributed more than 3.1%, 5.2% or 5.8% of Delta's total loan
production in the years ended December 31, 1999, 1998 and 1997, respectively.
Once approved, a broker may submit loan applications for prospective
borrowers to Delta. To process broker submissions, Delta's broker originations
area is organized by geographic regions and into teams, each consisting of loan
officers and processors, which are generally assigned to specific brokers.
Because Delta operates in a highly competitive environment where brokers may
submit the same loan application to several prospective lenders simultaneously,
Delta strives to provide brokers with a rapid and informed response. Loan
officers analyze the application and provide the broker with a preliminary
approval, subject to final underwriting approval, or a denial, typically within
one business day. If the application is approved by the Company's underwriters,
a "conditional approval" will be issued to the broker with a list of specific
conditions to be met and additional documents to be supplied prior to funding
the loan. The loan officer and processor team will then work directly with the
submitting broker to collect the requested information and meet all underwriting
conditions. In most cases, the Company funds loans within 14 to 21 days after
preliminary approval of the loan application. In the case of a denial, Delta
will make all reasonable attempts to ensure that there is no missing information
concerning the borrower or the application that might change the decision on the
loan.
The Company compensates its loan officers, who on a loan-by-loan basis are
the primary relationship contacts with the brokers, predominantly on a
commission basis. All of the Company's loan officers must complete an extensive
9- to 12-month training program to attain the level of knowledge and experience
integral to the Company's commitment to providing the highest quality service
for brokers. Management believes that by maintaining an efficient, trained and
experienced staff, it has addressed three central factors which determine where
a broker sends its business: (i) the speed with which a lender closes loans,
(ii) the lender's knowledge concerning the broker and his business and (iii) the
support a lender provides. Included in this support, the Company offers fair
lending training to all brokers with whom it does business.
CORRESPONDENT LOANS. For the year ended December 31, 1999, Delta's
correspondent network accounted for $261.3 million, or 18%, of Delta's loans
purchases and originations compared to $652.5 million, or 38%, of Delta's loan
purchases and originations for the year ended December 31, 1998 and $632.6
million, or 51%, of Delta's loan purchases and originations for the year ended
December 31, 1997. No single correspondent contributed more than 1.9%, 3.8% or
6.5% of Delta's total loan production in 1999, 1998 or 1997, respectively.
An approved correspondent is a licensed mortgage banker or savings and loan
who sells loans to Delta that conform with Delta's underwriting standards, which
the correspondent has originated, processed, close and funded
7
in its own name. The loans are sold to Delta either on an individual flow basis
or in block sales. When selling on a flow basis, a correspondent typically will
seek a pre-approval from Delta prior to closing the loan, and Delta will approve
the loan based on a partial or full credit package, stipulating any items needed
to complete the package in adherence to Delta's underwriting guidelines. On a
block sale, a correspondent will offer a group of loans, generally loans that
have not been pre-approved, to Delta for sale, and Delta will purchase those
loans in the block that meet Delta's underwriting criteria.
RETAIL LOANS. The Company acquired its Fidelity Mortgage retail origination
network in 1997. For the year ended December 31, 1999, this channel accounted
for $319.3 million, or 22%, of Delta's loans purchases and originations compared
to $234.0 million, or 13%, of Delta's loan purchases and originations for the
year ended December 31, 1998 and $140.4 million, or 11%, of Delta's loan
purchases and originations for the year ended December 31, 1997. Through its
marketing efforts, Fidelity Mortgage is able to identify, locate and focus on
individuals who, based on historic customer profiles, are likely customers for
the Company's products. Fidelity Mortgage's telemarketing representatives
identify interested customers and refer these customers to loan officers at the
retail branch offices who then proceed to determine the applicant's
qualifications for the Company's loan products, negotiate loan terms with the
borrower and process the loan through completion.
LOAN UNDERWRITING
All of the brokers and correspondents who submit loans to the Company are
provided with the Company's underwriting guidelines. Loan applications received
from brokers, correspondents and retail customers are classified according to
particular characteristics, including but not limited to: ability to pay, credit
history of the applicant, loan-to-value ratio and general stability of the
applicant in terms of employment history and time in residence and condition and
location of the collateral. The Company has established classifications with
respect to the credit profile of the applicant, and each loan is placed into one
of four letter ratings "A" through "D", with subratings within those categories.
Terms of loans made by the Company, as well as maximum loan-to-value ratios and
debt-to-income ratios, vary depending on the classification of the applicant.
Loan applicants with less favorable credit ratings are generally offered loans
with higher interest rates and lower loan-to-value ratios than applicants with
more favorable credit ratings. The general criteria used by the Company's
underwriting staff in classifying loan applicants are set forth below.
8
DELTA'S UNDERWRITING CRITERIA
"A" RISK "B" RISK "C" RISK "D" RISK
---------------- ------------------- ------------------- -------------------
Credit Profile.......... Excellent credit Good overall credit Good to fair credit Fair to poor credit
history
Existing mortgage
history............... Current at Current at Up to 30 days 90 days delinquent
application time application time delinquent at or more
and a maximum of and a maximum of application time
two 30-day late four 30-day late and a maximum of
payments in the payments in the four 30-day late
last 12 months last 12 months payments and
one 90-day late
payment in the
last 12 months
Other credit............ Minor 30 day Some slow pays Slow pays, some Not a factor.
late items allowed allowed but open delinquencies Derogatory
with a letter of majority of credit allowed. Isolated credit must
explanation; no and installment charge-offs, collec- be paid with
open collection debt paid as agreed. tion accounts or proceeds. Must
accounts, charge- Small isolated judgments case- demonstrate
offs, judgments charge-offs, collec- by-case ability to pay
tion accounts or
judgments case-
by-case
Bankruptcy filings...... Discharged more Discharged more Discharged more May be open at
than three years than two years than one year closing, but must
prior to closing prior to closing prior to closing be paid off with
and excellent and excellent and good proceeds
reestablished reestablished reestablished
credit credit credit
Debt service to
Income ratio.......... 55% or less 55% or less 55% or less 55% or less
Maximum loan-to-value
ratio:
Owner-occupied........ Generally 80% Generally 80% Generally 75% Generally 65%
(up to 90%*) for (up to 85%*) for (up to 80%*) for (up to 70%*) for
a one- to four- a one- to four- a one- to four- a one- to four-
family residence family residence family residence family residence
Non-owner occupied.... Generally 75% Generally 70% Generally 65% Generally 55%
(up to 80%*) for (up to 80%*) for (up to 75%*) for (up to 60%*) for
a one- to four- a one- to four a one- to four- a one- to four-
family residence family residence family residence family residence
Employment............ Minimum 2 years Minimum 2 years No minimum No minimum
employment in the employment in the required required
same field same field
------------
* On an exception basis
The Company uses the foregoing categories and characteristics as guidelines
only. On a case-by-case basis, the Company may determine that the prospective
borrower warrants an exception, if sufficient compensating factors exist.
Examples of compensating factors are:
o low loan-to-value ratio,
o low debt ratio,
o long-term stability of employment and/or residence,
9
o excellent payment history on past mortgages, or
o a significant reduction in monthly expenses.
The following table sets forth certain information with respect to Delta's
originations and purchases of first and second mortgage loans by borrower
classification, along with weighted average coupons, for the periods shown and
highlights the improved credit quality of the Company's originations and
purchases.
(DOLLARS IN THOUSANDS)
PERCENT
YEAR CREDIT TOTAL OF TOTAL WAC(1) WLTV(2)
- ---- ------ ----- -------- ------ -------
1999 A $ 859,935 58.4% 9.8% 76.4%
B 298,253 20.3 10.7 72.9
C 245,862 16.7 11.3 69.5
D 67,288 4.6 13.0 57.3
--------- ---- ---- ----
Totals $1,471,338 100.0% 10.4% 73.7%
========= ===== ==== ====
1998 A $ 990,988 57.3% 9.7% 77.0%
B 425,056 24.6 10.4 73.2
C 248,488 14.4 11.3 69.0
D 63,061 3.7 12.7 57.2
--------- ---- ---- ----
Totals $1,727,593 100.0% 10.2% 74.2%
========= ===== ==== ====
1997 A $ 617,724 49.2% 10.4% 76.2%
B 349,166 27.8 11.0 72.0
C 222,854 17.8 11.8 67.7
D 64,867 5.2 13.2 56.7
--------- ---- ---- ----
Totals $1,254,611 100.0% 11.0% 72.5%
========== ===== ==== ====
- ------------------
(1) Weighted Average Coupon ("WAC").
(2) Weighted Average Initial Loan-to-Value Ratio ("WLTV").
The mortgage loans originated by the Company have amortization schedules
ranging from 5 years to 30 years, generally bear interest at fixed rates and
require equal monthly payments which are due as of a scheduled day of each month
which is fixed at the time of origination. Substantially all of the Company's
mortgage loans are fully amortizing loans. The Company primarily purchases fixed
rate loans which amortize over a period not to exceed 30 years. Loans that are
not fully amortizing generally provide for scheduled amortization over 30 years,
with a due date and a balloon payment at the end of the fifteenth year. The
principal amounts of the loans purchased or originated by the Company generally
range from a minimum of $10,000 to a maximum of $350,000. The Company generally
does not acquire or originate any mortgage loans where the combined
loan-to-value ratio exceeds 90%. The collateral securing loans acquired or
originated by the Company are generally one- to four-family residences,
including condominiums and townhouses, and these properties may or may not be
occupied by the owner. It is the Company's policy not to accept commercial
properties or unimproved land as collateral. However, the Company will accept
mixed-use properties of 1-4 units where a portion of the property is used for
residential purposes and the balance is used for commercial purposes, and will
accept small residential multifamily properties (5 to 8 units), both at reduced
loan-to-value ratios. The Company does not purchase loans where any senior
mortgage contains open-end advance, negative amortization or shared appreciation
provisions.
10
The Company's mortgage loan program includes:
o a full documentation program for salaried borrowers;
o a limited documentation program;
o a no-income verification program for self-employed borrowers; and
o a "stated" income program.
The total monthly debt obligations, which include principal and interest on
the new loan and all other mortgages, loans, charge accounts and scheduled
indebtedness, generally is 50% or less of the borrower's monthly gross income.
Loans to borrowers who are salaried employees must be supported by current
employment information in addition to employment history. This information for
salaried borrowers is verified based on written confirmation from employers, one
or more pay-stubs, recent W-2 tax forms, recent tax returns or telephone
confirmation from the employer. For the Company's limited documentation program,
the Company requires a job letter to be submitted which contains the same
information one would find on a standard verification of employment form:
o job position;
o length of time on job;
o current salary; and
o the job letter should appear on the employer's letterhead.
For the Company's no-income verification program, proof of self-employment in
the same business plus proof of current self-employed status is required. The
Company's stated income program, which represents a very small percentage of the
Company's loans, is only offered for better credit quality borrowers where a
telephone verification is done by an underwriter to verify that the borrower is
employed. The Company usually requires lower combined loan-to-value ratios with
respect to loans made under programs other than the full documentation program.
The Company employs experienced non-conforming mortgage loan credit
underwriters to scrutinize the applicant's credit profile and to evaluate
whether an impaired credit history is a result of adverse circumstances or a
continuing inability or unwillingness to meet credit obligations in a timely
manner. Personal circumstances including divorce, family illnesses or deaths,
and temporary job loss due to layoffs and corporate downsizing will often impair
an applicant's credit record. Assessment of an applicant's ability and
willingness to pay is one of the principal elements in distinguishing the
Company's lending specialty from methods employed by traditional lenders, such
as savings and loans and commercial banks. All lenders utilize debt ratios and
loan-to-value ratios in the approval process. Many lenders simply use software
packages to score an applicant for loan approval and fund the loan after
auditing the data provided by the borrower. All loans underwritten by Delta's
underwriters are underwritten with regard for the borrower's ability to repay,
and are not underwritten solely on the value of the collateral property or the
amount of equity therein. All loans are underwritten to ensure that the loan has
a solid purpose and provides tangible benefits to the borrower.
The Company has a staff of approximately 80 underwriters with an average of
five years of non-conforming lending experience. With the exception of the
Company's Atlanta, Georgia office, all underwriting functions for broker and
correspondent organizations are centralized in its Woodbury, New York office.
All underwriting functions for retail organizations are centralized in the
Company's two retail underwriting "hubs" located in Cincinnati, Ohio and West
Palm Beach, Florida. The Company does not delegate underwriting authority to any
broker or correspondent. The Company's underwriting department functions
independently of its business development and mortgage origination departments
and does not report to any individual directly involved in the origination
process. No underwriter at the Company is compensated on an incentive or
commission basis.
The Company has instituted underwriting checks and balances that are designed
to ensure that every loan is reviewed and approved by a minimum of two
underwriters, with some higher loan amounts requiring a third
11
approval. The Company believes that by requiring each file be seen by a minimum
of two underwriters, a high degree of accuracy and quality control is ensured
throughout the underwriting process and before funding.
The Company's underwriting of every loan submitted consists not only of a
thorough credit review, but also the following:
o a separate appraisal review conducted by the Company's appraisal review
department and/or underwriter; and
o a full compliance review, to ensure that all documents have been
properly prepared, all applicable disclosures given in a timely
fashion, and proper compliance with all federal and state regulations.
Appraisals are performed by third party, fee-based appraisers or by the
Company's approved appraisers and generally conform to current Fannie Mae and
Freddie Mac secondary market requirements for residential property appraisals.
Each appraisal includes, among other things, an inspection of both the exterior
and interior of the subject property and data from sales within the preceding 12
months of similar properties within the same general location as the subject
property.
The Company performs an appraisal review on each loan prior to closing or
prior to purchasing. While the Company recognizes that the general quality
control practices of conventional mortgage lenders is to perform only drive-by
appraisals after closings, the Company believes this practice does not provide
sufficient protection. In addition to reviewing each appraisal for accuracy, the
Company accesses other sources to validate sales used in the appraisal to
determine market value. These sources include:
o Multiple Listing Services in nine states;
o assessment and sales services, such as Comps, Inc., Pace, 1st American
and Transamerica;
o internet services such as Realtor.com; and
o other sources for verification, including broker price opinions and
market analyses by local real estate agents.
Post closing, in addition to its normal due diligence, the Company randomly
selects one out of every ten appraisals, and performs a drive-by appraisal. This
additional step gives the Company an added degree of comfort with respect to
appraisers with which the Company has had limited experience. The Company
actively tracks and grades, on criteria that it has developed over time, all
appraisers from which it accepts appraisals for quality control purposes and
does not accept work from appraisers who have not conformed to its review
standards.
Upon completion of a broker loan's underwriting and processing, the closing
of the loan is scheduled with a closing attorney or agent approved by the
Company. The closing attorney or agent is responsible for completing the loan
closing transaction in accordance with applicable law and the Company's
operating procedures. Title insurance that insures the Company's interest as
mortgagee and evidence of adequate homeowner's insurance naming the Company as
an additional insured party are required on all loans.
The Company performs a post-funding quality control review to monitor and
evaluate the Company's loan origination policies and procedures. The quality
control department is separate from the underwriting department, and reports
directly to a member of senior management.
At least 10% of all loan originations and purchases are subjected to a full
quality control re-underwriting and review, the results of which are reported to
senior management on a monthly basis. Discrepancies noted by the audit are
analyzed and corrective actions are instituted. A typical quality control review
currently includes:
o obtaining a new drive-by appraisal for each property;
o running a new credit report from a different credit report agency;
o reviewing loan applications for completeness, signatures, and for
consistency with other processing documents;
12
o obtaining new written verification of income and employment;
o obtaining new written verification of mortgage to re-verify any
outstanding mortgages; and
o analyzing the underwriting and program selection decisions.
The quality control process is updated from time to time as the Company's
policies and procedures change.
LOAN SALES
Delta sells substantially all the loans it originates or purchases through
one of two methods: (i) securitizations, which involve the private placement or
public offering by a securitization trust of asset-backed pass-through
securities; and (ii) whole loan sales, which include the sale of blocks of
individual loans to institutional or individual investors. Since 1991, the
Company has sold approximately $5.7 billion of the loans it originated or
purchased through securitization and $63 million through whole loan sales.
SECURITIZATIONS. During 1999, Delta completed three securitizations totaling
$1.50 billion. The following table sets forth certain information with respect
to Delta's securitizations (all of which have been rated AAA/Aaa by S&P and
Moody's, respectively) by offering size, which includes prefunded amounts,
duration weighted average pass-through rate and type of credit enhancement.
DURATION
OFFERING SIZE WEIGHTED AVERAGE CREDIT
SECURITIZATION COMPLETED (MILLIONS) PASS-THROUGH RATE ENHANCEMENT
- -------------- --------- ------------- ----------------- -----------
1999-1.............. 03/30/99 $375.0 6.20% Hybrid *
1999-2.............. 06/17/99 $420.0 6.72% Senior/Sub
Structure
1999-3.............. 11/30/99 $700.0 7.09% Hybrid *
- ------------------
* Senior/Sub Structure with Bond Insured AAA Tranche
When Delta securitizes loans, it sells a portfolio of loans to a trust (a
"Home Equity Loan Trust") for a cash payment and the Home Equity Loan Trust
sells various classes of pass-through certificates representing undivided
ownership interests in such Home Equity Loan Trust. As servicer for each
securitization, the Company collects and remits principal and interest payments
to the appropriate Home Equity Loan Trust which, in turn, passes through such
payments to certificateholders. For each of the 1999 securitizations, Delta
retained 100% of the interests in the residual certificates while selling the
interest-only certificates for cash. Management contemplates continuing to
retain residual certificates in the future as long as, in management's opinion,
this practice maximizes earnings while remaining within the Company's liquidity
requirements.
Each Home Equity Loan Trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which insures the timely payment of interest and the
ultimate payment of principal of the credit-enhanced investor certificate, or
both (known as a "hybrid"). In "senior-subordinated" structures, the senior
certificate holders are protected from losses by subordinated certificates,
which absorb any such losses first. In addition to such credit enhancement, the
Excess Servicing amounts are initially applied as additional payments of
principal for the investor certificates, thereby accelerating amortization of
the investor certificates relative to the amortization of the loans and creating
overcollateralization. Once the overcollateralization limit is reached, the use
of Excess Servicing to create overcollateralization stops unless it subsequently
becomes necessary to obtain or maintain required overcollateralization limits.
Overcollateralization is intended to create a source of cash (the "extra"
payments on the loans) to absorb losses prior to making a claim on the financial
guaranty insurance policy or the subordinated certificates.
WHOLE LOAN SALES WITHOUT RECOURSE. From time to time, the Company has found
that it can receive better execution by selling certain mortgage loans on a
whole loan, non-recourse basis, without retaining servicing rights, generally in
private transactions to institutional or individual investors. The Company
recognizes a gain or loss
13
when it sells loans on a whole loan basis equal to the difference between the
cash proceeds received for the loans and the Company's investment in the loans,
including any unamortized loan origination fees and costs.
In 1998, the Company sold $8.7 million of loans on a whole loan, non-recourse
basis, which represented 0.5% of its originations and purchases. In 1999 and
1997, the Company did not have any whole loan sales.
LOAN SERVICING AND COLLECTIONS
The Company has been servicing loans since its inception in 1982, and has
serviced or is servicing substantially all of the loans that it has originated
or purchased. Servicing involves, among other things, collecting payments when
due, remitting payments of principal and interest and furnishing reports to the
current owners of the loans and enforcing the current owners' rights with
respect to the loans, including, recovering delinquent payments, instituting
foreclosure and liquidating the underlying collateral. As of December 31, 1999,
the Company had a servicing portfolio of $3.6 billion.
The Company services all loans out of its headquarters in Woodbury, New York,
utilizing a leading in-house loan servicing system called LSAMS which it
purchased in 1995. LSAMS has provided the Company with considerably more
flexibility to adapt the system to the Company's specific needs as a
nonconforming home equity lender. As such, the Company has achieved significant
cost efficiencies by automating a substantial number of previously manual
servicing procedures and functions since its conversion to LSAMS.
In December 1999, Delta purchased a new default management sub-servicing
system, FORTRACS, with separate "modules" for foreclosure, bankruptcy, and REO
to provide it with the ability to more efficiently monitor and service loans in
default. These sub-servicing modules provide detailed tracking of all key events
in foreclosure and bankruptcy on a loan-by-loan and portfolio-wide basis; the
ability to track and account for all pre- and post-petition payments received in
bankruptcy from the borrower and/or trustee; and the ability to monitor, market
and account for all aspects necessary to liquidate an REO property after
foreclosure. Information entered on FORTRACS is automatically uploaded to LSAMS
on a daily basis. Further, information entered on LSAMS is automatically entered
on FORTRACS. Additionally, Delta's Management Information Systems Department has
created a market value analysis program to run with LSAMS, which provides Delta
with the ability to monitor its equity position on a loan-by-loan and/or
portfolio-wide basis. These features have led to cost savings through greater
automation and system upgrades and have helped mitigate loan losses as the
Servicing Department has been able to identify problem loans earlier, thus
allowing for earlier corrective action.
Centralized controls and standards have been established by the Company for
the servicing and collection of mortgage loans in its portfolio. The Company
revises such policies and procedures from time to time in connection with
changing economic and market conditions and changing legal and regulatory
requirements.
The Company's collections policy is designed to identify payment problems
sufficiently early to permit the Company to quickly address delinquency problems
and, when necessary, to act to preserve equity in a preforeclosure property. The
Company believes that these policies, combined with the experience level of
independent appraisers engaged by the Company, help to reduce the incidence of
charge-offs of a first or second mortgage loan.
Borrowers are billed on a monthly basis in advance of the due date.
Collection procedures commence upon identification of a past due account by the
Company's automated servicing system using the Company's proprietary payment
profiling software. If timely payment is not received, LSAMS automatically
places the loan in the assigned collector's auto queue and collection procedures
are generally initiated on the day determined by the proprietary software to be
after the borrower's typical payment date. This payment profiling allows the
Company to focus its collections efforts on those borrowers who are delinquent
and outside their typical payment date as opposed to those borrowers who are
delinquent but typically pay on or about a specific date each month. These loans
are automatically queued into LSAMS auto queue as well as a Davox predictive
dialer. The predictive dialer initiates the telephone calls and transfers the
calls to a collector when a borrower is reached. If the predictive dialer
determines a line is busy or receives a no answer, it automatically cycles those
calls through the same day at pre-
14
determined intervals. If the predictive dialer contacts an answering machine, an
automated message is left. The account remains in the queue unless and until
payment is received, at which point LSAMS automatically removes the loan from
the collector's auto queue until the next payment profile pattern is broken. In
the case of seriously delinquent accounts, collection calls can begin as soon as
two days after the payment due date.
When a loan appears in a collector's auto queue, a collector will telephone
to remind the borrower that a payment is due. Follow-up telephone contacts are
attempted until the account is current or other payment arrangements have been
made. Standard form letters are utilized when attempts to reach the borrower by
telephone fail and/or, in some circumstances, to supplement the phone contacts.
During the delinquency period, the collector will continue to contact the
borrower and property inspections are performed on or about the 45th day of
delinquency. The Company's collectors have computer access to telephone numbers,
payment histories, loan information and all past collection notes. All
collection activity, including the date collection letters were sent and
detailed notes on the substance of each collection telephone call, is entered
into a permanent collection history for each account on LSAMS. Additional
guidance with the collection process is derived through frequent communication
with the Company's senior management.
On or about the ninety-first day of delinquency, the loan is referred to the
loss mitigation department. This department is comprised of the collectors with
the ability to negotiate payment plans, deeds in lieu, short sales and other
cures. If their efforts have also been exhausted without success, the loss
mitigation representative responsible for the account recommends the loan be
sent to foreclosure at one of several foreclosure committee meetings held each
month. The foreclosure committee is comprised of the loss mitigation
representative, the foreclosure department manager and two members of the
executive department. This meeting is held to determine whether foreclosure
proceedings are appropriate, based upon the analysis of all relevant factors,
including a market value analysis, reason for default and efforts by the
borrower to cure the default.
Regulations and practices regarding the liquidation of properties and the
rights of a borrower in default vary greatly from state to state. As a result,
all foreclosures are assigned to outside counsel, located in the same state as
the secured property. Bankruptcies filed by borrowers are similarly assigned to
appropriate local counsel. All aspects of foreclosures and bankruptcies are
closely monitored by the Company through its sub-servicing loan system described
above and through monthly status reports from attorneys.
Prior to foreclosure sale, the Company performs an in-depth market value
analysis on all defaulted loans. This analysis includes:
o a current valuation of the property obtained through a drive-by appraisal
or broker's price opinion conducted by an independent appraiser or a
broker from the Company's network of real estate brokers, complete with a
description of the condition of the property, recent price lists of
comparable properties, recent closed comparables, estimated marketing time
and required or suggested repairs, and an estimate of the sales price;
o an evaluation of the amount owed, if any, for real estate taxes;
o an evaluation of the amount owed, if any, to a senior mortgagee; and
o estimated carrying costs, brokers' fee, repair costs and other related
costs associated with real estate owned properties. Delta bases the amount
it will bid at foreclosure sales on this analysis.
If Delta acquires title to a property at a foreclosure sale or otherwise, the
REO department immediately begins working the file by obtaining an estimate of
the sale price of the property by sending at least two local real estate brokers
to inspect the premises, and then hiring one to begin marketing the property. If
the property is not vacant when acquired, local eviction attorneys are hired to
commence eviction proceedings or negotiations are held with occupants in an
attempt to get them to vacate without incurring the additional time and cost of
eviction. Repairs are performed if it is determined that they will increase the
net liquidation proceeds, taking into consideration the cost of repairs, the
carrying costs during the repair period and the marketability of the property
both before and after the repairs.
The Company's loan servicing software also tracks and maintains homeowners'
insurance information and tax and insurance escrow information. Expiration
reports are generated bi-weekly listing all policies scheduled to expire within
the next 15 days. When policies lapse, a letter is issued advising the borrower
of that lapse and
15
notifying the borrower that the Company will obtain force-placed insurance at
the borrower's expense. The Company also has an insurance policy in place that
provides coverage automatically for the Company in the event that the Company
fails to obtain force-placed insurance.
DELINQUENCY AND LOSS EXPERIENCE
The following table sets forth information relating to the delinquency and
loss experience of the mortgage loans serviced by Delta (primarily for the
securitization trusts) for the periods indicated. Delta is not the holder of the
securitization loans, but generally holds residual or interest-only certificates
of the trusts, as well as the servicing rights, each of which may be adversely
affected by defaults. (See "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations Certain Accounting
Considerations"):
YEAR ENDED DECEMBER 31,
------------------------------------
1999 1998 1997
` ---- ---- ----
(DOLLARS IN THOUSANDS)
Total Outstanding Principal Balance
(at period end)................................... $ 3,631,830 $ 2,950,435 $ 1,840,150
Average Outstanding(1)................................ $ 3,362,377 $ 2,436,343 $ 1,376,109
DELINQUENCY (at period end) 30-59 Days:
Principal Balance................................. $ 208,302 $ 153,726 $ 90,053
Percent of Delinquency(2)......................... 5.73% 5.21% 4.89%
60-89 Days:
Principal Balance................................. $ 83,000 $ 50,034 $ 28,864
Percent of Delinquency(2)......................... 2.28% 1.70% 1.57%
90 Days or More:
Principal Balance................................. $ 56,435 $ 47,887 $ 17,695
Percent of Delinquency(2)......................... 1.55% 1.62% 0.96%
Total Delinquencies:
Principal Balance................................. $ 347,737 $ 251,647 $ 136,612
Percent of Delinquency(2)......................... 9.56% 8.53% 7.42%
FORECLOSURES
Principal Balance................................. $ 185,843 $ 145,679 $ 85,500
Percent of Foreclosures by Dollar(2).............. 5.11% 4.94% 4.65%
REO
Principal Balance................................ 36,663 $ 18,811 $ 10,292
Percent of REO.................................. 1.01% 0.64% 0.56%
Net Gains/(Losses) on liquidated loans................ $ (14,722) $ (8,704) $ (4,986)
Percentage of Net Gains/(Losses) on liquidated
loans (based on Average Outstanding Balance)...... (0.44%) (0.36%) (0.36%)
- ---------------
(1) Calculated by summing the actual outstanding principal balances at the end
of each month and dividing the total by the number of months in the
applicable period.
(2) Percentages are expressed based upon the total outstanding principal balance
at the end of the indicated period.
COMPETITION
As an originator and purchaser of mortgage loans, the Company faces intense
competition, primarily from mortgage banking companies, commercial banks, credit
unions, savings and loans, credit card issuers and finance companies. Many of
these competitors in the financial services business are substantially larger
and have more capital and other resources than the Company. Competition can take
many forms, including interest rates and costs of the loan, convenience in
obtaining a loan, service, marketing and distribution channels. Furthermore, the
level of gains realized by the Company and its competitors on the sale of the
type of loans originated and purchased has
16
attracted additional competitors into this market with the effect of lowering
the gains that may be realized by the Company on future loan sales. In addition,
efficiencies in the asset-backed market have generally created a desire for even
larger transactions giving companies with greater volumes of originations a
competitive advantage.
Competition may be affected by fluctuations in interest rates and general
economic conditions. During periods of rising rates, competitors which have
"locked in" low borrowing costs may have a competitive advantage. During periods
of declining rates, competitors may solicit the Company's borrowers to refinance
their loans. During economic slowdowns or recessions, the Company's borrowers
may have new financial difficulties and may be receptive to offers by the
Company's competitors. Furthermore, certain large national finance companies and
conforming mortgage originators have adapted their conforming origination
programs and allocated resources to the origination of non-conforming loans
and/or have otherwise begun to offer products similar to those offered by the
Company, targeting customers similar to those of the Company. Fannie Mae and
Freddie Mac have also expressed interest in adapting their programs to include
products similar to those offered by the Company. The entrance of these larger
and better capitalized competitors into the Company's market may have a material
adverse effect on the Company's results of operations and financial condition.
REGULATION
Delta's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and is subject to
various laws and judicial and administrative decisions imposing requirements and
restrictions on part or all of its operations. Delta'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 Equal
Credit Opportunity Act of 1974, as amended (ECOA), the Fair Credit Reporting Act
of 1970, as amended, the Real Estate Settlement Procedures Act (RESPA), and
Regulation X, the Home Mortgage Disclosure Act and the Federal Debt Collection
Practices Act, as well as other federal and state statutes and regulations
affecting Delta's activities. Delta is also subject to the rules and regulations
of, and examinations by HUD and state regulatory authorities with respect to
originating, processing, underwriting and servicing loans. These rules and
regulations, among other things, impose licensing obligations on Delta,
establish eligibility criteria for mortgage loans, prohibit discrimination,
provide for inspections and appraisals of properties, require 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, termination
or suspension of servicing contracts without compensation to the servicer,
demands for indemnifications or mortgage loans repurchases, certain rights of
rescission for mortgage loans, class action lawsuits and administrative
enforcement actions.
In September 1999, the Company settled allegations by the New York State
Banking Department and a lawsuit by the New York State Office of the Attorney
General alleging that Delta had violated various state and federal lending laws.
The global settlement was evidenced by that certain (a) Remediation Agreement by
and between Delta Funding and the NYSBD, dated as of September 17, 1999 and (b)
Stipulated Order on Consent by and among Delta Funding, Delta Financial and the
NYOAG, dated as of September 17, 1999. As part of the Settlement, Delta will,
among other things, implement agreed upon changes to its lending practices;
provide reduced loan payments aggregating $7.25 million to certain borrowers
identified by the NYSBD; and create a fund of approximately $4.75 million to be
financed by the grant of 525,000 shares of Delta Financial's common stock valued
at a constant assumed priced of $9.10 per share, which approximates book value.
The proceeds of the fund will be used, for among other things, to pay for a
variety of consumer educational and counseling programs.
In March 2000, the Company finalized an agreement with the U.S. Department of
Justice, the Federal Trade Commission and the Department of Housing and Urban
Development, to complete the global settlement it had reached with the NYSBD and
NYOAG. The Federal agreement mandates some additional compliance efforts for
Delta, but it does not require any additional financial commitment.
Delta believes it is in compliance in all material respects with applicable
federal and state laws and regulations.
17
ENVIRONMENTAL MATTERS
To date, Delta has not been required to perform any investigation or clean up
activities, nor has it been subject to any environmental claims. There can be no
assurance, however, that this will remain the case in the future. In the
ordinary course of its business, Delta from time to time forecloses on
properties securing loans. Although Delta primarily lends to owners of
residential properties, there is a risk that Delta could be required to
investigate and clean-up hazardous or toxic substances or chemical releases at
such properties after acquisition by Delta, and may be held liable to a
governmental entity or to third parties for property damage, personal injury and
investigation and cleanup costs incurred by such parties in connection with the
contamination. In addition, the owner or former owners of a contaminated site
may be subject to common law claims by third parties based on damages and costs
resulting from environmental contamination emanating from such property.
EMPLOYEES
As of December 31, 1999, Delta had a total of 1,134 employees (full-time and
part-time). None of Delta's employees are covered by a collective bargaining
agreement. Delta considers its relations with its employees to be good.
ITEM 2. PROPERTIES
Delta's executive and administrative offices are located at 1000 Woodbury
Road, Woodbury, New York 11797, where Delta leases approximately 120,000 square
feet of office space at an aggregate annual rent of approximately $2.4 million.
The lease provides for certain scheduled rent increases and expires in 2008.
Delta's servicing operations are located at 99 Sunnyside Boulevard, Woodbury,
New York 11797, where Delta leases approximately 40,000 square feet of office
space at an aggregate annual rent of approximately $0.9 million. The lease
provides for certain scheduled rent increases and expires in 2009.
Delta also maintains a full service office in Atlanta, Georgia and business
development offices in California, Delaware, Illinois, Michigan, Missouri, New
Jersey, Ohio, Pennsylvania, Rhode Island, and Virginia. Fidelity Mortgage
currently maintains fourteen retail mortgage origination offices in Florida (3),
Illinois, Indiana, Missouri, North Carolina, Ohio (4), Pennsylvania (2) and
Tennessee; one telemarketing hub in Ohio; and one corporate office in Ohio. The
terms of the leases vary as to duration and escalation provisions, with the
latest expiring in 2004.
ITEM 3. LEGAL PROCEEDINGS
Because the nature of the Company's business involves the collection of
numerous accounts, the validity of liens and compliance with various state and
federal lending laws, the Company is subject, in the normal course of business,
to numerous claims and legal proceedings. The Company's lending practices have
been the subject of several lawsuits styled as class actions and of
investigations by various regulatory agencies including the New York State
Banking Department (the "NYSBD"), the Office of the Attorney General of the
State of New York (the "NYOAG") and the United States Department of Justice (the
"DOJ"). The current status of these actions are summarized below.
o In or about November 1998, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Eastern District of New York. In December 1998, plaintiffs filed an
amended complaint alleging that the Company had violated the Home
Equity and Ownership Protection Act ("HOEPA"), the Truth in Lending Act
("TILA") and New York State General Business Lawss.349. The complaint
seeks (a) certification of a class of plaintiffs, (b) declaratory
judgment permitting rescission, (c) unspecified actual, statutory,
treble and punitive damages (including attorneys' fees), (d) certain
injunctive relief, and (e) declaratory judgment declaring the loan
transactions as void and unconscionable. On December 7, 1998,
plaintiff filed a motion seeking a temporary restraining order and
preliminary injunction, enjoining Delta from conducting foreclosure
sales on 11 properties. The District Court Judge ruled that in order
to consider such a motion, plaintiff must move to intervene on behalf
of these 11 borrowers. Thereafter, plaintiff moved to intervene on
behalf of 3 of these 11 borrowers and sought the
18
injunctive relief on their behalf. The Company opposed the motions.
On December 14, 1998, the District Court Judge granted the motion
to intervene and on December 23, 1998, the District Cour Judge
issued a preliminary injunction enjoining the Company from proceeding
with the foreclosure sales of the three intervenors' properties. The
Company has filed a motion for reconsiderationof the December 23, 1998
order. In January 1999, the Company filed an answer to plaintiffs'
first amended complaint. In July 1999, plaintiffs were granted leave, on
consent, to file a second amended complaint In August 1999, plaintiffs
filed a second amended complaint that, among other things, added
additional parties but contained the same causes of action alleged
in the first amended complaint. In September 1999, the Company filed
a motion to dismiss the complaint. Also in September 1999, plaintiffs
filed a motion for class certification. In February 2000, Delta
submitted opposition to Plaintiffs' motion. In or about October 1999,
plaintiffs filed a motion seeking an order preventing the Company, its
attorneys and/or the New York State Banking Department(the "NYSBD") from
issuing notices to certain of Delta's borrowers, in accordance
with a settlement agreement entered into by and between the Company
and the NYSBD. In or about October 1999 and November 1999, respectively,
Delta and the NYSBD submitted opposition to plaintiffs' motion. In
March 2000, the Court issued an order that permits Delta to issue an
approved form of the notice. The Company believes that it has
meritorious defenses and intends to defend this suit, but cannot
estimate with any certainty its ultimate legal or financial liability,
if any, with respect to the alleged claims.
o In or about March 1999, the Company received notice that it had been
named in a lawsuit filed in the Supreme Court of the State of New York,
New York County, alleging that Delta had improperly charged certain
borrowers processing fees. The complaint seeks (a) certification of a
class of plaintiffs, (b) an accounting, and (c) unspecified
compensatory and punitive damages (including attorneys' fees), based
upon alleged (i) unjust enrichment, (ii) fraud, and (iii) deceptive
trade practices. In April 1999, the Company filed an answer to the
complaint. In August 1999, plaintiffs filed a motion for class
certification. The Company's response to the motion for class
certification is not due until after class discovery is completed. In
September 1999, the Company filed a motion to dismiss the complaint,
which was opposed by plaintiffs, and in February 2000, the Court denied
the motion to dismiss. In April 1999, the Company filed a motion to
change venue and Plaintiff's opposed the motion. In July 1999, the
Court denied the motion to change venue. The Company appealed and in
March 2000, the Appellate Court granted Delta's appeal to change venue
from New York County to Nassau County. The Company believes that it has
meritorious defenses and intends to defend this suit, but cannot
estimate with any certainty its ultimate legal or financial liability,
if any, with respect to the alleged claims.
o In or about July 1999, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Western District of New York, alleging that amounts collected and
maintained by it in certain borrowers' tax and insurance escrow
accounts exceeded certain statutory (RESPA) and/or contractual (the
respective borrowers' mortgage agreements) ceilings. The complaint
seeks (a) certification of a class of plaintiffs, (b) declaratory
relief finding that the Company's practices violate applicable statutes
and/or the mortgage agreements, (c) injunctive relief, and (d)
unspecified compensatory and punitive damages (including attorneys'
fees). In October 1999, the Company filed a motion to dismiss the
complaint. In or about November 1999, the case was transferred to the
United States District Court for the Northern District of Illinois. In
February 2000, the plaintiff opposed the Company's motion to dismiss.
In March 2000, the Court granted the Company's motion to dismiss in
part, and denied it in part. The Company believes that it has
meritorious defenses and intends to defend this suit, but cannot
estimate with any certainty its ultimate legal or financial liability,
if any, with respect to the alleged claims.
o In or about August 1999, the Office of the Attorney General for the
State of New York (the "NYOAG") filed a lawsuit against the Company
alleging violations of (a) RESPA (by paying yield spread premiums), (b)
HOEPA and TILA, (c) ECOA, (d) New York Executive Lawss.296-a, and (e)
New York Executive Lawss. 63(12). In September 1999, Delta and the
NYOAG settled the lawsuit, as part of a global settlement by and among
Delta, the NYOAG and the NYSBD, evidenced by that certain (a)
Remediation Agreement by and between Delta and the NYSBD, dated as of
September 17, 1999 and (b) Stipulated Order on Consent by and among
Delta, Delta Financial and the NYOAG, dated as of September 17, 1999.
As part
19
of the Settlement, Delta will, among other things, implement
agreed upon changes to its lending practices; provide reduced loan
payments aggregating $7.25 million to certain borrowers identified by
the NYSBD; and create a fund of approximately $4.75 million to be
financed by the grant of 525,000 shares of Delta Financial's common
stock valued at a constant assumed priced of $9.10 per share, which
approximates book value. The proceeds of the fund will be used, for
among other things, to pay for a variety of consumer educational and
counseling programs. As a result, the NYOAG lawsuit has been dismissed
as against the Company.
The Remediation Agreement and Stipulated Order on Consent supersede the
Company's previously announced settlements with the NYOAG and the NY
Banking Dept. In March 2000, the Company finalizeda settlemen agreement
with the United States Department of Justice, the Federal Trade
Commission and the Department of Housing and Urban Renewal, to complete
the global settlement it had reached with the NYSBD and NYOAG. The
Federal agreement mandates some additional compliance efforts for Delta,
but it does not require any additional financial commitment.
o In November 1999, the Company received notice that it had been named in
a lawsuit filed in the United States District Court for the Eastern
District of New York seeking certification as a class action and
alleging violations of the federal securities laws in connection with
the Company's initial public offering in 1996 and its reports
subsequently filed with the Securities and Exchange Commission. The
complaint alleges that the scope of the violations alleged recently in
the consumer lawsuits and regulatory actions indicate a pervasive
pattern of action and risk that should have been more thoroughly
disclosed to investors in the Company's common stock. The Company has
learned of several other lawsuits that purportedly contain the same or
simila allegations agains the Company. The Company believes that it
has meritoriou defenses and intends to defend these suits, but has not
answered yet and cannot estimate with any certainty its ultimate legal
or financial liability, if any, with respect to the alleged claims.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The annual meeting of stockholders was held on May 12, 1999. At the
meeting, Hugh Miller was elected as a Class III Director for a term of three
years. Sidney A. Miller, Martin D. Payson, Richard Blass and Arnold B.
Pollard continue to serve as members of the Board of Directors.
Votes cast in favor of Mr. Miller's election totaled 14,125,210
while 26,985 votes were withheld.
The stockholders also voted to ratify the appointment of KPMG LLP as the
Company's independent public accountants for the fiscal year ending December 31,
1999. Votes cast in favor of this ratification were 14,140,984, while votes cast
against were 9,861 and abstentions totaled 1,350.
20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PRICE RANGE OF COMMON STOCK
The Company's Common Stock was listed on the New York Stock Exchange (the
"NYSE") under the symbol "DFC" on November 1, 1996. The following table sets
forth for the periods indicated the range of the high and low closing sales
prices for the Company's Common Stock on the NYSE.
1999 HIGH LOW
- ---- ---- ----
First Quarter ............................ $ 8.25 $ 4.75
Second Quarter ........................... 8.13 4.88
Third Quarter............................. 7.81 5.00
Fourth Quarter ........................... 5.06 3.63
1998 HIGH LOW
- ---- ---- ----
First Quarter ............................ $ 18.56 $ 9.56
Second Quarter ........................... 20.25 17.06
Third Quarter............................. 18.00 4.50
Fourth Quarter ........................... 7.75 3.13
On March 27, 2000, the Company had approximately 86 stockholders of record.
This number does not include beneficial owners holding shares through nominee or
"street" names. The Company believes the number of beneficial stockholders is
approximately 1,250.
DIVIDEND POLICY
The Company did not pay any dividends in 1999 and, in accordance with its
present general policy, has no present intention to pay cash dividends.
21
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------
1999 1998 1997 1996 1995
---- ---- ---- ---- ----
Income Statement Data: (DOLLARS IN THOUSANDS, EXCEPT FOR SHARE DATA)
Revenues:
Net gain on sale of mortgage loans............. $ 78,663 $ 91,380 $ 85,890 $ 46,525 $ 15,383
Interest....................................... 31,041 12,458 22,341 16,372 13,588
Servicing fees................................. 16,341 10,464 7,511 5,368 2,855
Origination fees (1) .......................... 28,774 25,273 18,108 5,266 4,309
----------- ---------- ---------- --------- ---------
Total revenues............................ 154,819 139,575 133,850 73,531 36,135
----------- ---------- ---------- --------- ---------
Expenses:
Payroll and related costs (1).................. 65,116 56,709 41,214 17,633 13,753
Interest....................................... 26,656 30,019 19,964 11,298 7,964
General & administrative (1)................... 55,318 34,351 21,522 11,112 9,832
----------- ---------- ---------- --------- ---------
Total expenses........................... 147,090 121,079 82,700 40,043 31,549
----------- ---------- ---------- --------- ---------
Income before income taxes and
extraordinary item............................. 7,729 18,496 51,150 33,488 4,586
Provision for income taxes(1)...................... 3,053 7,168 20,739 9,466 --
----------- ---------- ---------- --------- ---------
Income before extraordinary item................... 4,676 11,328 30,411 24,022 4,586
Extraordinary item:................................
Gain on extinguishment of debt................. -- -- -- 3,168 --
----------- ---------- ---------- --------- ---------
Net income......................................... $ 4,676 11,328 30,411 27,190 4,586
----------- ---------- ---------- --------- ---------
Pro forma information (2)(3):
Provision for pro forma income taxes
before extraordinary item...................... -- -- -- 14,400 1,972
----------- ---------- ---------- --------- ---------
Pro forma income before extraordinary item........ $ 4,676 11,328 30,411 19,088 2,614
----------- ---------- ---------- --------- ---------
Per share data(2)(4):
Earnings per common share -
basic and diluted........................ $ 0.30 0.74 1.98 1.46 0.21
Weighted average number of
shares outstanding....................... 15,511,214 15,382,161 15,359,280 13,066,485 12,629,182
Selected Balance Sheet Data:
Loans held for sale, net........................... $ 89,036 87,170 79,247 82,411 63,324
Capitalized mortgage servicing rights.............. 45,927 33,490 22,862 11,412 3,831
Interest-only and residual certificates............ 224,659 203,803 167,809 83,073 25,310
Total assets....................................... 556,835 481,907 393,232 231,616 139,293
Senior notes, warehouse financing and
other borrowings............................... 258,493 229,660 177,540 95,482 82,756
Investor payable................................... 82,204 63,790 40,852 20,869 13,444
Total liabilities.................................. 409,694 344,219 266,779 138,098 109,460
Stockholders' equity............................... 147,141 137,688 126,453 93,518 29,833
- ---------------
(1) In connection with the February 1997 acquisition of Fidelity Mortgage, the
Company incurred additional expenses normally associated with a retail
operation. Fidelity Mortgage's loan origination points when recognized are
reported as origination fee income.
(2) Figures for December 31, 1999, 1998 and 1997 are actual; pro forma
presentation for the years 1996 and 1995.
(3) Prior to October 31, 1996, Delta Funding (a wholly-owned subsidiary) was
treated as an S corporation for Federal and state income tax purposes. The
pro forma presentation reflects a provision for income taxes as if the
Company had always been a C corporation at an assumed tax rate of 43%.
(4) Pro forma earnings per common share has been computed by dividing pro
forma net income by the sum of (a) 10,653,000 shares of the Company's
common stock received by the former shareholders in exchange for their
shares of Delta Funding, and (b) the effect of the issuance of 1,976,182
shares of the Company's common stock issued in the Company's initial
public offering to generate sufficient cash for certain S corporation
distributions paid to the former shareholders, which shares are treated as
if they had always been outstanding.
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED
FINANCIAL STATEMENTS OF THE COMPANY AND ACCOMPANYING NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS SET FORTH THEREIN.
GENERAL
Delta Financial Corporation (the "Company" or "Delta"), through its
wholly-owned subsidiaries, engages in the consumer finance business by
originating, acquiring, selling and servicing non-conforming home equity loans.
Throughout its 18 years of operating history, the Company has focused on lending
to individuals who generally have impaired or limited credit profiles or higher
debt-to-income ratios for such purposes as debt consolidation, home improvement,
mortgage refinancing or education.
Through its wholly-owned subsidiary, Delta Funding Corporation ("Delta
Funding"), the Company originates home equity loans indirectly through licensed
mortgage brokers and other real estate professionals who submit loan
applications on behalf of the borrower ("Brokered Loans") and also purchases
loans from mortgage bankers and smaller financial institutions that satisfy
Delta's underwriting guidelines ("Correspondent Loans"). Delta Funding currently
originates and purchases the majority of its loans in 24 states, through its
network of approximately 1,600 brokers and correspondents.
Through its wholly-owned subsidiary, Fidelity Mortgage Inc., the Company
develops retail loan leads ("Retail Loans") primarily through its telemarketing
system and its network of 14 retail offices located in eight states. In March
2000, the Company decided to close a branch in Georgia. In March 2000, the
Company decided to close a branch in Georgia.
In June 1999, the Company announced a settlement in principle with the Office
of the Attorney General for the State of New York ("NYOAG"), which was to
provide for retrospective relief to certain borrowers in the form of reduced
monthly obligations aggregating $6 million and prospective changes to some of
the Company's lending practices. The NYOAG took issue with Delta's lending
practices, specifically which loans should and should not be made by Delta. The
settlement in principle was later expanded to include the New York State Banking
Department ("NYSBD") and the U.S. Department of Justice ("DOJ"), which had
raised similar concerns relating to Delta's lending practices. In September
1999, the Company finalized its settlements with the NYSBD and the NYOAG, but
only after the NYOAG filed suit against the Company in August 1999, as evidenced
by (1) a Remediation Agreement by and between the Company and the NYSBD, and (2)
a Stipulated Order on Consent by and among the Company and the NYOAG.
As part of the final global settlement (in lieu of the previously announced
$6 million settlement with the NYOAG), the Company agreed to, among other
things, implement agreed upon changes to its lending practices; provide reduced
loan payments aggregating $7.25 million to certain borrowers identified by the
NYSBD; and create a reversionary fund (the "fund"), administered by a trustee
named by the NYSBD, financed by the grant by Delta of 525,000 shares of Delta's
common stock, valued at an assumed constant price of $9.10 per share, which
approximates the book value of the shares. All proceeds raised through the fund
shall be used for restitution and/or to pay for a variety of educational and
counseling programs at the discretion of the NYSBD.
The twelve-month period ended December 31, 1999 includes a $12.0 million
pre-tax charge for the global settlement with the NYSBD and the NYOAG. The
Company recorded a $6.0 million pre-tax charge in the second quarter of 1999
when it reached a settlement in principle with the NYOAG. Subsequently, an
additional $6.0 million pre-tax charge was recorded in the third quarter of 1999
when the Company reached a global settlement with the NYSBD and the NYOAG. The
Company finalized its agreement with the DOJ subsequent to December 31, 1999.
The DOJ settlement, which parallels the NYSBD and NYOAG settlement agreements,
was also signed by the Federal Trade Commission and the U.S. Department of
Housing and Urban Development. See "Legal Proceedings" for a more detailed
discussion of the settlement.
23
CERTAIN ACCOUNTING CONSIDERATIONS
As a fundamental part of its business and financing strategy, Delta sells the
majority of its loans through securitization to a securitization trust and
derives a substantial portion of its income from these sales. In a
securitization, the Company sells a pool of loans it has originated or purchased
to a REMIC trust for a cash purchase price. The trust, in turn, finances the
purchase of the pool of loans it has acquired by selling "pass-through
certificates," or bonds, which represent undivided ownership interests in the
trust. Holders of the pass-through certificates are entitled to receive monthly
distributions of all principal received on the underlying mortgages and a
specified amount of interest, determined at the time of the offering.
When the Company sells a pool of loans to a securitization trust, it receives
the following economic interests in the trust: (a) the difference between the
interest payments due on the loans sold to the trust and the interest rate paid
to the pass-through certificateholders, less the Company's contractual servicing
fee and other costs and expenses of administering the trust, represented by
interest-only and residual certificates, and (b) the right to service the loans
on behalf of the trust and earn a servicing fee, as well as other ancillary
servicing related fees directly from the borrowers on the underlying loans.
The Company's net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate or acquire the
loan adjusted for (i) any direct loan origination costs incurred (an increase)
and loan origination fees received (a decrease) in connection with the loans,
which are treated as a component of the initial investment in a loan under
Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for
Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases," and (ii) the principal payments received, and
the amortization of the net loan fees or costs, during the period the Company
held the loans prior to their securitization. The Company's investment in the
loans also reflects adjustments for any gains (a decrease in the investment) or
losses (an increase in the investment) the Company has incurred on treasury rate
lock contracts which the Company has typically used to hedge against the effects
of changes in interest rates during the period it holds the loans prior to their
securitization. (See "Hedging.")
Upon the securitization of a pool of loans, the Company (i) recognizes in
income, as origination fees, the unamortized origination fees included in the
investment in the loans sold, and (ii) recognizes a gain on sale of loans equal
to the difference between cash received from the trust and the investment in the
loans remaining after the allocation of portions of that investment to record
interest-only and residual certificates and mortgage servicing rights received
in the securitization. The majority of the net gain on sale of mortgage loans
results from the fair value of the interest-only and residual certificates
retained by the Company in a securitization for each period and the market value
of the interest-only certificates sold in connection with each securitization.
The Company sold the interest-only certificates created in each of the 1999
securitizations for cash proceeds and intends to continue to sell the
interest-only certificate as long as the sale effectively maximizes cash flow
and profitability.
The interest-only and residual certificates received by the Company upon the
securitization of a pool of loans are accounted for as trading securities under
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." In accordance with SFAS No. 115, the amount initially allocated to
the interest-only and residual certificates at the date of a securitization
reflects the fair value of those interests. The amount recorded for the
certificates is reduced for distributions thereon which the Company receives
from the trust, and is adjusted for subsequent changes in the fair value of
interest-only and residual certificates, which are reflected in the statement of
operations. The Company assesses the fair value of interest-only and residual
certificates based upon updated estimates of prepayment and default rates
relating to loan groups comprised of loans of similar types, terms, credit
quality, interest rates, geographic location and value of loan collateral, which
represent the predominant risk characteristics that would affect prepayments and
default rates.
The Company values the mortgage servicing rights it retains in a
securitization under the provisions of SFAS No. 125, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities." In
accordance with SFAS No. 125, the amount of the investment in the loans
allocated to the retained servicing rights is measured at the allocated carrying
amount of such servicing rights, based on the fair value of the servicing
rights. The fair value of the servicing rights is determined by discounting to a
present value (using a discount rate which
24
management believes reflects the discount rate market participants would utilize
in purchasing similar loan servicing rights) the estimated future contractual
and ancillary servicing fees the Company will receive and the estimated costs of
servicing the loans. Those estimates are based on the stated terms of the
transferred loans adjusted for estimates of future prepayment rates made on the
basis of interest rate conditions and the availability of alternative financing,
and estimates of future defaults among those loans, each of which would
terminate the servicing of the loan and thus negatively affect servicing income.
The carry value of the servicing rights, which is classified on the balance
sheet as "Capitalized mortgage servicing rights," is then amortized over the
period of the estimated net future cash flows from the servicing income. SFAS
No. 125 also requires that the capitalized mortgage servicing rights be assessed
periodically to determine if there has been any impairment of the value of the
asset, based on the date of the assessment. The Company performs this assessment
based on the same prepayment and default estimates used to value interest-only
and residual certificates. A valuation allowance is provided for the capitalized
servicing rights relating to any pool of loans for which the recorded investment
exceeds the fair value of the servicing rights.
In recording and accounting for mortgage servicing rights and interest-only
and residual certificates, the Company makes estimates of rates of prepayments
and defaults, and the value of collateral, which it believes reasonably reflect
economic and other relevant conditions. The actual rate of prepayments, defaults
and the value of collateral generally will differ from the estimates used due to
subsequent changes in economic and other relevant conditions and the implicit
imprecision of estimates, and such differences can be material. Prepayment and
default rates, which are higher than those estimated, would adversely affect the
value of both the mortgage servicing rights (actual mortgage servicing income
will be less, and significant changes could require an impairment of the
capitalized mortgage servicing rights) and the interest-only and residual
certificates, for which changes in fair value are recorded in operations.
Conversely, prepayment and default rates, which are lower than those estimated,
would increase the servicing income earned over the life of the loans and
positively impact the value of the interest-only and residual certificates.
There are currently two methods used to calculate the present value of the
residual interests, the "cash-in" and "cash-out" methods. The "cash-in" method
assumes value as the residual cash flow is received by the securitization trust
even if it is used to create an overcollateralization provision. In contrast,
the "cash-out" method assumes value at the time the residual cash flow is
actually received by the residual certificate holder (Delta) from the
securitization trust, which is only after the required overcollateralization
provision has been met. As the Company receives residual cash flows from the
securitization trust, generally 12 to 20 months following the primary issuance,
these two methods will create dramatically different values. The Company uses
the more conservative "cash-out" method, which calculates value at the time the
residual cash flow is actually received by Delta.
The Financial Accounting Standards Board ("FASB") and the Securities and
Exchange Commission have issued proposals relating to SFAS No. 125 that would
require companies to use the "cash-out" (more conservative), not the "cash-in"
(more aggressive), method in accounting for the value of the retained interest
(residual) in securitizations and overcollateralization assets. This would
result in one-time residual asset write-downs for companies that currently use
the "cash-in" method. The Company always has used the more conservative
"cash-out" method for accounting and will not be susceptible to a write-down as
a result of this proposed accounting change.
FAIR VALUE ADJUSTMENTS
In accordance with SFAS No. 125, upon the sale or securitization of a loan, a
gain on sale and a corresponding asset is recognized for any interest-only and
residual certificates and capitalized mortgage servicing rights. The carrying
amount of the interest-only and residual certificates is classified as a trading
security and, as such, they are recorded at their fair value. The Company
implemented SFAS No. 134, "Accounting for Mortgage-Backed Securities after the
Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise"
in the first quarter of 1999. The implementation of SFAS 134 did not have a
material impact on the Company's financial condition or results of operations.
For capitalized mortgage servicing rights, a valuation allowance is recorded if
the fair value of such rights is less than the carrying amount.
25
The fair values of both interest-only and residual certificates and
capitalized mortgage servicing rights are significantly affected by, among other
factors, prepayments of loans and estimates of future prepayment rates. The
Company continually reviews its prepayment assumptions in light of company and
industry experience and makes adjustments to those assumptions when such
experience indicates.
The Company's review of its prepayment experience and assumptions at June 30,
1998 indicated that the prepayment rates during 1998, particularly for
adjustable-rate mortgages ("ARMs"), and in particular during the second quarter
of 1998, were higher than those historically experienced, or previously
projected, by the Company. The Company believes that these increases in
prepayment rates were attributable to the continuation, for a longer period than
historically experienced, of low interest rates, together with changes, to a
flatter or inverted curve, of the relationship between long-term and short-term
interest rates (the "yield curve").
As a result, at June 30, 1998, the Company adjusted its prepayment
assumptions, increasing the maximum prepayment rates for all loans, and changing
the rate at which prepayments are assumed to increase from the initial rate to
the maximum rate from a "ramp" to a "vector" curve. These revised prepayment
assumptions were used to estimate the fair value of the interest-only and
residual certificates and capitalized mortgage servicing rights retained by the
Company in securitizations completed prior to the second quarter of 1998. These
revised prepayment assumptions were also used in valuing and recording the
interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in its securitizations completed subsequent to
the first quarter of 1998.
During the second quarter of 1998, the Company recorded a $15.5 million
reduction in the carrying amount of its interest-only and residual certificates,
and also recorded a $1.9 million reduction in the carrying amount of its
capitalized mortgage servicing rights to reflect a provision for impairment (the
"fair value adjustments"). Both impairment provisions resulted from reductions
in the Company's estimates of the fair value of those assets. The reductions in
the estimated fair value resulted from the change in the prepayment assumptions
used by the Company to estimate the future cash flows to be derived from the
interest-only and residual certificates and the mortgage servicing rights.
The Company makes assumptions concerning prepayment rates and defaults based
upon the seasoning of its existing securitization loan portfolio. The following
table compares the prepayment assumptions used subsequent to the third quarter
of 1999 (the "new" assumptions"), with those used subsequent to the first
quarter of 1998 (the "2Q98" assumptions) and those used at December 31, 1997 and
through the first quarter of 1998 (the "old" assumptions):
LOAN TYPE MONTH 1 SPEED PEAK SPEED *
- --------- ------------------------- ---------------------
NEW 2Q98 OLD NEW 2Q98 OLD
--- ---- --- --- ---- ---
Fixed Rate Loans 4.0% 4.8% 4.8% 31% 31% 24%
Six-Mo. LIBOR ARMs 10.0% 10.0% 5.6% 50% 50% 28%
Hybrid ARMs 4.0% 6.0% 5.6% 50% 50% 28%
* Since the second quarter of 1998, the Company has utilized a "vector" curve,
instead of a "ramp" curve, which the Company believes will be more
representative of future loan prepayment experience.
In 1999, the Company continued, as part of its ongoing practice, to review
and assess its prepayment rate and loan loss reserve assumptions using a variety
of factors. Such factors included a review of its own loan portfolio performance
data, as well as management's current views on both the economic and competitive
environments. Based upon this review, the Company revised both its prepayment
rate and loan loss reserve assumptions in 1999 to better reflect its anticipated
future loan performance.
In the first quarter of 1999, the Company increased its loss reserve
initially established for both fixed- and adjustable-rate loans sold to the
securitizations trusts from 2.00% to approximately 2.20% of the issuance amount
securitized.
In the fourth quarter of 1999, the Company lowered its prepayment speed<