SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____________ to _____________
Commission File Number: 1-12109
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 registrant's principal executive offices including ZIP Code)
(516) 364 - 8500
(Registrant's telephone number, including area code)
NO CHANGE
---------
(Former name, former address and former fiscal year, if changed since last
report)
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 checkmark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [x]
As of September 30, 2003, 16,386,861 shares of the Registrant's common
stock, par value $0.01 per share, were outstanding.
INDEX TO FORM 10-Q
Page No.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Consolidated Balance Sheets as of September 30, 2003 and
December 31, 2002 .................................................. 1
Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2003 and September 30, 2002 .................... 2
Consolidated Statements of Changes in Stockholders' Equity for the
Nine Months Ended September 30, 2003 ............................... 3
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2003 and September 30, 2002 ....... .................. 4
Notes to Consolidated Financial Statements.......................... 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ............................................. 10
Item 3. Quantitative and Qualitative Disclosures about Market Risk......... 38
Item 4. Controls and Procedures ........................................... 39
PART II - OTHER INFORMATION
Item 1. Legal Proceedings ..................................................40
Item 2. Changes in Securities and Use of Proceeds ..........................42
Item 3. Defaults upon Senior Securities ....................................42
Item 4. Submission of Matters to a Vote of Security Holders ................42
Item 5. Other Information ..................................................42
Item 6. Exhibits and Current Reports on Form 8-K .......................... 43
Signatures ................................................................. 44
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS (UNAUDITED)
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
(DOLLARS IN THOUSANDS, EXCEPT FOR SHARE DATA) 2003 2002
------------ ------------
ASSETS (UNAUDITED) (AUDITED)
Cash and interest-bearing deposits $ 3,893 3,405
Accounts receivable 2,049 1,700
Loans held for sale, net 135,630 33,984
Excess cash flow certificates, net 19,566 24,565
Equipment, net 2,779 2,553
Prepaid and other assets 2,805 1,737
Deferred tax asset 35,743 5,600
--------- --------
Total assets $ 202,465 73,544
========= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Bank payable $ 1,292 1,369
Warehouse financing and other borrowings 84,372 16,352
Senior notes 10,757 10,844
Accounts payable and accrued expenses 14,898 12,327
Income taxes payable 2,074 3,155
-------- --------
Total liabilities 113,393 44,047
-------- --------
STOCKHOLDERS' EQUITY:
Preferred stock, Series A, $.01 par value.
Authorized 150,000 shares, 139,156 shares
outstanding at September 30, 2003 and
December 31, 2002 13,916 13,916
Common stock, $.01 par value. Authorized
49,000,000 shares; 16,503,661 and 16,022,349
shares issued and 16,386,861 and 15,905,549
shares outstanding at September 30, 2003
and December 31, 2002, respectively 165 160
Additional paid-in capital 99,755 99,482
Accumulated deficit (23,446) (82,743)
Treasury stock, at cost (116,800 shares) (1,318) (1,318)
--------- ---------
Total stockholders' equity 89,072 29,497
--------- ---------
Total liabilities and stockholders' equity $ 202,465 73,544
========= =========
See accompanying notes to consolidated financial statements.
1
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2002 2003 2002
------- ------- ------- -------
REVENUES
Net gain on sale of mortgage loans $ 24,006 15,716 66,522 42,779
Interest 3,516 2,267 9,735 9,394
Net origination fees and other income 8,368 3,840 20,264 10,871
--------- -------- --------- ---------
Total revenues 35,890 21,823 96,521 63,044
--------- -------- --------- ---------
EXPENSES
Payroll and related costs 16,780 10,211 43,469 29,987
Interest expense 1,373 1,223 3,848 4,239
General and administrative 6,597 5,827 19,363 17,787
--------- -------- --------- ---------
Total expenses 24,750 17,261 66,680 52,013
---------- -------- --------- ---------
Income before income
tax benefit 11,140 4,562 29,841 11,031
Income tax benefit (30,455) (2,136) (30,152) (1,884)
---------- ---------- ---------- ----------
Net income $ 41,595 6,698 59,993 12,915
========== ========== ========== ==========
PER SHARE DATA:
Basic -weighted average number of
shares outstanding 16,283,420 15,904,049 16,132,909 15,892,012
=========== ========== =========== ==========
Diluted -weighted average number of
shares outstanding 18,543,094 17,112,868 18,453,931 16,966,217
=========== ========== =========== ==========
Net income applicable to common shares $ 41,595 6,698 59,297 12,915
=========== ========== =========== ==========
Basic earnings per share - net income $ 2.55 0.42 3.68 0.81
=========== ========== =========== ==========
Diluted earnings per share - net income $ 2.24 0.39 3.21 0.76
=========== ========== =========== ==========
See accompanying notes to consolidated financial statements.
2
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2003
(UNAUDITED)
ADDITIONAL
PREFERRED CAPITAL PAID-IN ACCUMULATED TREASURY
(DOLLARS IN THOUSANDS) STOCK STOCK CAPITAL DEFICIT STOCK TOTAL
- -----------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002............... $13,916 160 99,482 (82,743) (1,318) 29,497
Stock options exercised.................... -- 1 273 -- -- 274
Warrants exercised......................... -- 4 -- -- -- 4
Preferred stock dividends.................. -- -- -- (696) -- (696)
Net income................................. -- -- -- 59,993 -- 59,993
- -----------------------------------------------------------------------------------------------------------------
Balance at September 30, 2003.............. $13,916 165 99,755 (23,446) (1,318) 89,072
- -----------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
3
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
(DOLLARS IN THOUSANDS) 2003 2002
------ ----
Cash flows from operating activities:
Net income $ 59,993 $ 12,915
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Provision for loan and recourse losses 88 453
Depreciation and amortization 1,245 2,585
Deferred tax benefit (30,143) --
Deferred origination costs (534) 571
Gain on sale of excess cashflow certificates (220) --
Excess cashflow certificates received in
securitization transactions, net (5,001) (6,470)
Changes in operating assets and liabilities:
Increase in accounts receivable (349) (232)
(Increase) decrease in loans held for sale, net (101,112) 62,263
Increase in prepaid and other assets (1,068) (1,103)
Increase (decrease) in warehouse lines of credit 68,657 (66,360)
Increase (decrease) in accounts payable and accrued expenses 2,483 (1,016)
Decrease in income taxes payable (1,081) (2,092)
--------- ---------
Net cash (used in) provided by operating activities (7,042) 1,514
--------- ---------
Cash flows from investing activities:
Proceeds on sale of excess cashflow certificates 10,220 --
Purchase of equipment (1,471) (471)
--------- ---------
Net cash provided by (used in) investing activities 8,749 (471)
--------- ---------
Cash flows from financing activities:
Decrease in bank payable (77) (657)
Repayments of other borrowings (637) (2,909)
Redemption of Senior Notes (87) --
Cash dividends paid on preferred stock (696) --
Proceeds from exercise of warrants 4 --
Proceeds from exercise of stock options 274 9
--------- ----------
Net cash used in financing activities (1,219) (3,557)
--------- ----------
Net increase (decrease) in cash and interest-bearing deposits 488 (2,514)
Cash and interest-bearing deposits at beginning of period 3,405 6,410
--------- ----------
Cash and interest-bearing deposits at end of period $ 3,893 3,896
========= ==========
Supplemental Information:
Cash paid during the period for:
Interest $ 4,094 2,916
========= ==========
Income taxes $ 853 121
========= ==========
See accompanying notes to consolidated financial statements.
4
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
Delta Financial Corporation (together with its subsidiaries, "Delta," "we" or
the "Company") is a Delaware corporation, which was organized in August 1996.
The accompanying unaudited consolidated financial statements include the
accounts of Delta and its wholly owned subsidiaries. In consolidation, we have
eliminated all significant inter-company accounts and transactions.
We have prepared the accompanying unaudited consolidated financial statements
in accordance with accounting principles generally accepted in the United States
of America (GAAP) for interim financial information and the instructions to Form
10-Q. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with GAAP have been condensed or
omitted pursuant to the rules and regulations of the Securities and Exchange
Commission. You should read the accompanying unaudited consolidated financial
statements and the information included under the heading "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
conjunction with our audited consolidated financial statements and related notes
for the year ended December 31, 2002, which were filed with the Securities and
Exchange Commission with our most recent annual report on Form 10-K. The results
of operations for the three-month and nine-month periods ended September 30,
2003 are not necessarily indicative of the results for the entire year.
We have made all adjustments that are, in the opinion of management,
considered necessary for a fair presentation of the financial position and
results of operations for the interim periods presented. We have reclassified
certain prior period amounts in the financial statements to conform to the
current year presentation.
(2) STOCK OPTION PLANS
We apply the intrinsic-value-based method of accounting prescribed by
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and related interpretations, to account for our fixed-plan stock
options. Under this method, compensation expense is recorded on the date of
grant only if the current market price of the underlying stock exceeds the
exercise price. Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation," established accounting and disclosure
requirements using a fair value-based method of accounting for stock-based
employee compensation plans. As allowed by SFAS No. 123, we have elected to
continue to apply the intrinsic-value-based method of accounting described
above, and have adopted only the disclosure requirements of SFAS No. 123. In
April 2003, the Financial Accounting Standards Board ("FASB") announced it will,
in the future, require all companies to expense the value of employee stock
options but has not decided how to measure the fair value of the options. As a
result, the financial statement impact of stock option expensing is not known at
this time. The following table illustrates the effect on net income if the
fair-value-based method had been applied:
5
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -----------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------
Net income, as reported $41,595 6,698 59,993 12,915
=========================================================================================
Deduct total stock-based employee
compensation expense determined
under fair-value-based method for
all awards, net of tax 125 117 360 352
- -----------------------------------------------------------------------------------------
Pro forma net income $41,470 6,581 59,633 12,563
=========================================================================================
Earnings per share:
Basic - as reported $2.55 0.42 3.68 0.81
Basic - pro forma $2.55 0.41 3.65 0.79
Diluted - as reported $2.24 0.39 3.21 0.76
Diluted - pro forma $2.24 0.38 3.19 0.74
(3) LOANS HELD FOR SALE, NET
Our inventory consists of first and second mortgages, which had a
weighted-average interest rate of 7.55% per annum at September 30, 2003 and
8.45% per annum at December 31, 2002. These mortgages are being held, at the
lower of their cost or their estimated fair value, for future sale. Certain of
these mortgages are pledged as collateral for a portion of our warehouse
financing and other borrowings. Mortgages are payable in monthly installments of
principal and interest and have maturities varying from five to thirty years.
Loans held for sale, net, are summarized as follows:
(DOLLARS IN THOUSANDS) September 30, 2003 December 31, 2002
- ------------------------------------------------------------------------------
Loans held for sale $ 135,281 $ 34,170
Net deferred origination cost 784 249
Valuation allowance (435) (435)
- ------------------------------------------------------------------------------
Loans held for sale, net $ 135,630 $ 33,984
- ------------------------------------------------------------------------------
(4) EXCESS CASHFLOW CERTIFICATES, NET
The activity related to our excess cashflow certificates, net is as follows:
(DOLLARS IN THOUSANDS) September 30, 2003 December 31, 2002
- ---------------------------------------------------------------------------------------------
Balance, beginning of year $ 24,565 16,765
New excess cashflow certificates 6,941 10,499
Cash received from excess cashflow certificates (3,705) (2,588)
Excess cashflow certificates sold (10,000) --
Net accretion of excess cashflow certificates 1,765 1,974
Fair value adjustments -- (2,085)
- ---------------------------------------------------------------------------------------------
Balance, end of period $ 19,566 24,565
- ---------------------------------------------------------------------------------------------
6
(5) DEFERRED TAX ASSET
As of September 30, 2003, we carried a net deferred tax asset of $35.7
million (assuming a 39% effective tax rate) on our consolidated financial
statements. Our deferred tax asset is comprised primarily of Federal and State
net operating losses, or "NOLs," net of the tax impact.
At September 30, 2003, we reversed a valuation allowance that we had
established in 2000 against our deferred tax asset. As of December 31, 2002, we
had a gross deferred tax asset of $48.0 million, a gross deferred tax liability
of $0.1 million and a valuation allowance of $42.3 million. Management and the
Audit Committee of the Board of Directors believed that the reversal was
appropriate at this time principally because of our eight consecutive quarters
of profitability and positive cash flow, together with the planned retirement of
all our long-term unsecured debt. We have recorded minimal taxes in our results
of operations over the prior seven quarters - from the fourth quarter of 2001
through the second quarter of 2003 - as a result of the valuation allowance
against our deferred tax asset, which was primarily generated by net operating
losses in 2000 and 2001.
Our deferred tax asset of $35.7 million consists primarily of (1) NOLs, net
of tax, totaling $27.0 million, which can be used to offset the tax liability
generated from approximately $69.2 million of pre-tax income (the NOLs will be
expiring in 2021), and (2) the excess of the tax basis over book basis on our
excess cashflow certificates, net of tax, of $6.9 million.
(6) WAREHOUSE FINANCING AND OTHER BORROWINGS
At September 30, 2003 and December 31, 2002, we had two warehouse credit
facilities providing for aggregate borrowings of $400.0 million. In May 2003, we
extended one of our warehouse lines of credit and allowed the second warehouse
line of credit to expire, replacing it with a new $200 million warehouse line of
credit from a new creditor. Both warehouse lines of credit are due to expire in
May 2004, have floating interest rates based on the one-month London Inter-Bank
Offered Rate ("LIBOR") + 1.125%, and are collateralized by specific mortgage
loans, the balances of which are equal to or greater than the outstanding
balances under the line at any point in time. Available borrowings under these
lines are based on the amount of the collateral pledged.
The following table summarizes certain information regarding warehouse
financing and other borrowings at the respective dates:
(DOLLARS IN MILLIONS)
BALANCE
Facility ------- Expiration
Facility Description Amount Rate 9/30/03 12/31/02 Date
- -------------------------------------------------------------------------------------------------------
Warehouse line of credit $200.0 LIBOR + 1.125% $ 76.8 -- May 2004
Warehouse line of credit $200.0 LIBOR + 1.125% 5.6 n/a May 2004
Warehouse line of credit n/a LIBOR + 1.125% n/a 13.8 May 2003
Capital leases n/a 3.76% - 12.50% 2.0 2.6 Oct. 2003 - July 2006
- -------------------------------------------------------------------------------------------------------
Total $ 84.4 16.4
- -------------------------------------------------------------------------------------------------------
Our warehouse agreements require us to comply with various operating and
financial covenants. The continued availability of funds under these agreements
is subject to, among other
7
conditions, our continued compliance with these covenants. We believe that we
are in compliance with these covenants as of September 30, 2003.
In October 2003, our warehouse financing providers increased their commitment
amounts, and lowered the financing rates, and one provider extended a maturity
date, as shown below:
Updated Facility Updated Expiration
Facility Description Amount Rate Date
- ------------------------------------------------------------------------------
Warehouse line of credit $250.0 LIBOR + 1.00% May 2004
Warehouse line of credit $250.0 LIBOR + 1.00% October 2004
(7) EARNINGS PER SHARE
The following is a reconciliation of the denominators used in the
computations of basic and diluted Earnings Per Share ("EPS"). The numerator for
calculating both basic and diluted EPS is net income available to common
shareholders.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
(DOLLARS IN THOUSANDS, EXCEPT EPS DATA) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------
Net income $ 41,595 6,698 59,993 12,915
Less preferred stock dividends -- -- 696 --
- -----------------------------------------------------------------------------------------------------------
Net income available to common shareholders 41,595 6,698 59,297 12,915
Basic - weighted-average shares 16,283,420 15,904,049 16,132,909 15,892,012
Basic EPS $2.55 0.42 3.68 0.81
Basic - weighted-average shares 16,283,420 15,904,049 16,132,909 15,892,012
Incremental shares-options 2,259,674 1,208,819 2,321,022 1,074,205
- -----------------------------------------------------------------------------------------------------------
Diluted - weighted-average shares 18,543,094 17,112,868 18,453,931 16,966,217
Diluted EPS $2.24 0.39 3.21 0.76
- -----------------------------------------------------------------------------------------------------------
(8) WARRANTS
In December 2000, as part of our first exchange offer, we issued warrants to
purchase 1,569,193 shares of our common stock, at an initial exercise price of
$9.10 per share, subject to adjustment. In December 2002, the exercise price for
the warrants was adjusted to $0.01 per share in accordance with the terms of the
warrant agreement pursuant to which the warrants were granted. During the nine
months ended September 30, 2003, 378,612 warrants were exercised. At September
2003, warrants to purchase 1,190,581 shares of common stock were outstanding.
In October 2003, 483,791 warrants were exercised and 706,790 warrants
remained unexercised. Following our redemption, on October 30, 2003, of the
Senior Notes issued on December 21, 2000, all unexercised warrants expired
pursuant to their terms.
(9) REDEMPTION OF 9.5% SENIOR NOTES DUE AUGUST 2004
On October 30, 2003, we redeemed, at par, all of our outstanding 9.5% Senior
Notes due August 2004. The aggregate redemption price, including principal and
accrued interest, was approximately $11.0 million. We used our existing cash to
fund the redemption.
8
Unexercised warrants issued in connection with Delta's 9.5% Senior Notes due
2004 under the Indenture Agreement of December 21, 2002 expired pursuant to
their terms (See Note No. 8 "Warrants").
(10) PREFERRED STOCK - SERIES A
In August 2001, as part of our second exchange offer, the holders of
approximately $139.2 million (of the initial $150.0 million) principal amount of
our 9.5% Senior Notes due 2004 exchanged their notes for, among other interests,
139,156 shares of our newly issued Series A preferred stock, having an aggregate
preference amount of $13.9 million.
Holders of the Series A preferred stock are entitled to receive cumulative
preferential dividends at the rate of 10% per annum of the preference amount,
payable in cash semi-annually on the first business date of January and July. On
June 30, 2003, we paid $695,780 for the first dividend payment to the Series A
holders due on July 1, 2003.
(11) IMPACT OF NEW ACCOUNTING STANDARDS
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150
addresses the accounting for certain financial instruments that, under previous
guidance, issuers could account for as equity. The statement requires that those
instruments be classified as liabilities in statements of financial position.
SFAS No. 150 is effective for all financial instruments entered into or modified
after May 31, 2003. However, the effective date of the statement's provisions
related to the classification and measurement of certain mandatory redeemable
non-controlling interests has been deferred indefinitely by the FASB, pending
further Board action. Management does not expect that the provisions of SFAS No.
150 will impact our results of operations or financial condition.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No.
133, "Accounting for Derivatives Instruments and Hedging Activities," for
certain decisions made by the Board as part of the Derivatives Implementation
Group process. This statement is effective for contracts entered into or
modified after June 30, 2003 and hedging relationships entered into after June
30, 2003. Management does not expect that the provisions of SFAS No. 149 will
impact our results of operations or financial condition.
In January 2003, the FASB issued Interpretation No. 46 ("FIN No. 46"),
"Consolidation of Variable Interest Entities," which is an interpretation of ARB
No. 51. This Interpretation addresses consolidation by business enterprises of
variable interest entities. The Interpretation applies immediately to variable
interest entities created after January 31, 2003, and to variable interest
entities in which an enterprise obtains an interest after that date. It applies
in the first fiscal year or interim period ending after December 15, 2003, to
various interest entities in which an enterprise holds a variable interest that
it acquired before February 1, 2003. Management does not expect that the
provisions of FIN No. 46 will impact our results of operations or financial
condition.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATED
FINANCIAL STATEMENTS AND NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INCLUDED IN
THIS REPORT AND IN OUR FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2002. SEE
"-FORWARD LOOKING STATEMENTS AND RISK FACTORS" BELOW.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
EXCESS CASHFLOW CERTIFICATES. Our excess cashflow certificates primarily
consist of the right to receive the future excess cash flows from pools of
securitized mortgage loans. These future excess cash flows generally consist of:
o The positive difference between the interest paid on the underlying
mortgage loans and the interest paid on the pass-through certificates sold
to investors in the securitization which, when we sell net interest margin
("NIM") notes - in a simultaneous transaction to the underlying
securitization - is only received after the NIM notes are paid in full;
o In most of our securitizations, prepayment penalties received from
borrowers who pay off their loans generally within the first few years of
their lives (which, when we sell NIM notes, is only received after the NIM
notes are paid in full); and
o Additional mortgage loans pledged as collateral in excess of the principal
amount of bonds issued and outstanding; the "overcollateralization" or
"O/C" is designed to provide additional assurance that the securities sold
in the securitization will be paid according to their terms (and which we
describe in greater detail under "-Securitizations").
The excess cash flows we receive are highly dependent upon the interest rate
environment, because "basis risk" exists between the securitization trust's
assets and liabilities. For example, in each of the securitizations that we
issued since 2002, the interest cost of the pass-through certificates sold to
investors is indexed against one-month LIBOR - as such, each month, the interest
rate received by the pass-through certificate holders, from the securitization
trust may adjust upwards or downwards as one-month LIBOR changes (liability) -
while the majority of the underlying mortgage loans in the securitization trust
have a fixed note rate for at least two to three years (asset). As a result, as
rates rise and fall, the amount of our excess cash flows will fall and rise,
respectively, which in turn will increase or decrease the value of our excess
cashflow certificates.
In each of our securitizations in which we sold NIM note(s), we purchased, on
behalf of the NIM owner trust at our expense, an interest rate cap for the
benefit of the NIM noteholder(s), which helps mitigate the basis risk for the
approximate time that the NIM notes are anticipated to be outstanding.
The accounting estimates we use to value excess cashflow certificates are a
"critical accounting estimate" because they can materially affect our net
income. The valuation of our excess cashflow certificates requires us to
forecast interest rates, mortgage principal payments, prepayments and loan loss
assumptions, each of which is highly uncertain and requires a large degree of
judgment. The rate used to discount the projected cash flows is also critical in
the valuation of our excess cashflow certificates. Management uses internal,
historical mortgage loan performance data and published forward LIBOR curves to
value future expected excess cash
10
flows. We believe that the value of our excess cashflow certificates is fair,
but can provide no assurance that future prepayment and loss experience, changes
in LIBOR or changes in their required market discount rate will not require
write-downs of our excess cashflow certificate asset. We have written down the
value of our excess cashflow certificates in the past. Write-downs would reduce
our income in future periods.
GENERAL
Delta Financial Corporation (together with its subsidiaries, "Delta," "we" or
the "Company") is a specialty consumer finance company that originates,
securitizes and sells non-conforming mortgage loans, which are primarily secured
by first mortgages on one- to four-family residential properties. Throughout our
21-year operating history, we have focused on lending to individuals who
generally do not satisfy the credit, documentation or other underwriting
standards set by more traditional sources of mortgage credit, including those
entities that make loans in compliance with conventional mortgage lending
guidelines established by Fannie Mae and Freddie Mac. We make loans to these
borrowers for such purposes as debt consolidation, refinancing, education and
home improvements.
Our mortgage business has two principal components. First, we make mortgage
loans to individual borrowers, which is a cash and expense outlay for us,
because our cost to originate a loan exceeds the fees we collect at the time we
originate the loan. At the time we originate a loan, and prior to the time we
sell the loan, we either finance the loan by borrowing under a warehouse line of
credit or self-fund it. Second, we sell loans, either through securitization or
on a whole loan basis, to generate cash and non-cash revenues, recording the
premiums received as revenues. We use the proceeds from these sales to repay our
warehouse lines of credit and for working capital.
ORIGINATION OF MORTGAGE LOANS. We make mortgage loans through two
distribution channels - wholesale (or broker) and retail. We receive loan
applications both directly from borrowers and from independent third-party
mortgage brokers who submit applications on a borrower's behalf. We process and
underwrite the submission and, if the loan complies with our underwriting
criteria, approve the loan and lend the money to the borrower. While we
generally collect points and fees from the borrower when a loan closes, our cost
to originate a loan typically exceeds any fees we may collect from the borrower.
INDEPENDENT MORTGAGE BROKER (WHOLESALE) CHANNEL. Through our wholesale
distribution channel, we originate mortgage loans indirectly through independent
mortgage brokers and other real estate professionals who submit loan
applications on behalf of borrowers. We currently originate the majority of our
wholesale loans in 26 states, through a network of approximately 1,500 brokers.
The broker's role is to source the business, identify the applicant, assist in
completing the loan application, and to process the loans, which includes the
gathering necessary information and documents, and serving as the liaison
between us and the borrower through the entire origination process. We review,
process and underwrite the applications submitted by the broker, approve or deny
the application, set the interest rate and other terms of the loan and, upon
acceptance by the borrower and satisfaction of all conditions that we impose as
the lender, lend the money to the borrower. Because brokers conduct their own
marketing and employ their own personnel to complete loan applications and
maintain contact with borrowers - for which they charge a broker fee that is
commensurate with their services - originating loans through our
11
broker network is designed to allow us to increase our loan volume without
incurring the higher marketing and employee costs associated with increased
retail originations.
RETAIL LOAN CHANNEL. Through our retail distribution channel, we develop
retail loan leads ("retail loans") primarily through our telemarketing system
and our network of eight retail offices and four origination centers located in
nine states. Our origination centers are typically staffed with considerably
more loan officers and cover a broader area than our retail offices. We
continually monitor the performance of our retail operations and evaluate
current and potential retail office locations on the basis of selected
demographic statistics, marketing analyses and other criteria developed by us.
In July 2003, we opened our eighth retail office in Kansas City, Kansas.
Typically, contact with the customer is initially handled through our
telemarketing center. On the basis of an initial screening conducted at the time
of the call, our telemarketer makes a preliminary determination of whether the
customer and the property meet our lending criteria. If the customer does meet
our criteria, the telemarketer will forward the customer to one of our local
branches or origination centers. The mortgage analyst at the local branch or
origination center may complete the application over the telephone, or schedule
an appointment in the retail loan office most conveniently located to the
customer or in the customer's home, depending on the customer's needs. The
mortgage analyst assists the applicant in completing the loan application,
ensures that an appraisal has been ordered from an independent third party
appraisal company, orders a credit report from an independent, nationally
recognized credit reporting agency and performs various other tasks in
connection with the completion of the loan package. Our mortgage analysts are
trained to structure loans that meet the applicant's needs while satisfying our
lending guidelines. The loan package is underwritten for loan approval on a
centralized basis. If the loan package is approved, we will fund the loan.
For the three months ended September 30, 2003, we originated $524.8 million
of loans, an increase of 145% over the $214.4 million of loans originated in the
comparable period in 2002. Of these amounts, approximately $314.8 million were
wholesale loans and $210.0 million were retail loans, compared to $126.7 million
and $87.7 million, respectively, during the three months ended September 30,
2002. Loan production in the third quarter of 2003 increased 51% from $348.2
million of mortgage loan originations in the second quarter of 2003. Our second
quarter 2003 loan production consisted of $194.7 million of wholesale loans and
$153.5 million of retail loans.
POOLING OF LOANS PRIOR TO SALE. After we close or fund a loan, we typically
pledge the loan as collateral under a warehouse line of credit to obtain
financing against that loan. By doing so, we replenish our capital so we can
make new loans. Typically, loans are financed though a warehouse line of credit
for only a limited time - generally, not more than three months - long enough so
we can pool enough loans to sell them either through a securitization or as
whole-loans. During this time, we earn interest paid by the borrower as income,
but this income is offset in part by the interest we pay to the warehouse
creditor for providing us with financing.
SALE OF LOANS. We derive the substantial majority of our revenues and cash
flows from selling mortgage loans through one of two outlets: (i)
securitization, which involves the public offering by a securitization trust of
asset-backed pass-through securities (and related interests including
securitization servicing rights on newly-originated pools of mortgage loans);
and (ii) whole loan sales, which includes the sale of pools of individual loans
to institutional investors,
12
banks and consumer finance-related companies on a servicing released basis. We
select the outlet depending on market conditions, relative profitability and
cash flows. We generally realize higher gain on sale when we securitize loans
than we do when we sell whole loans. We apply the proceeds from securitizations
and whole loan sales to pay down our warehouse lines of credit - in order to
make available capacity under these facilities for future funding of mortgage
loans - and utilize any additional funds for working capital.
We expect to continue to use a combination of securitizations and whole loan
sales, with the amounts of each dependent upon conditions in the marketplace and
our goal of maximizing earnings and liquidity.
The following table sets forth certain information regarding loans sold
through our securitizations and on a whole loan basis during the quarter ended
September 30, 2003 (dollars in thousands):
AMOUNT PERCENTAGE
-----------------------------
Loan securitizations $ 448,246 97%
Whole loan sales 12,242 3%
-----------------------------
Total securitizations and loans sold $ 460,488 100%
=============================
SECURITIZATION. When we securitize loans, we create securitization trusts in
the form of off-balance sheet qualified special purpose entities, or QSPEs.
These trusts are established for the limited purpose of buying our mortgage
loans. Typically once each quarter, we pool together loans, and sell these loans
to a newly formed securitization trust. We carry no contractual obligation
related to these trusts or the loans sold to them, nor do we have any direct or
contingent liability related to the trusts, except for the standard
representations and warranties typically made as part of a sale of loans on a
non-recourse basis. Furthermore, we provide no guarantees to investors with
respect to cash flow or performance for these trusts. These entities represent
qualified special purpose entities and are therefore not consolidated for
financial reporting purposes in accordance with SFAS No. 140 "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."
The securitization trust raises money to purchase the mortgage loans from us
by selling securities to the public. These securities, known as "asset-backed
pass-through securities," are secured, or backed, by the pool of mortgage loans
purchased by the securitization trust from us. These asset-backed securities, or
senior certificates, which are usually purchased for cash by insurance
companies, mutual funds and/or other institutional investors, represent senior
interests in the cash flows from the mortgage loans in the trust.
The securitization trust issues senior certificates, which entitle the
holders of these senior certificates to receive the principal collected,
including prepayments of principal, on the mortgage loans in the trust. In
addition, holders receive a portion of the interest paid on the loans in the
trust equal to the pass-through interest rate on the remaining principal balance
of the pass-through certificates. Depending upon the structure, the
securitization trust may also issue interest-only certificates, which entitle
the holders to receive payments of interest at a pre-determined rate over a
fixed period of time. The securitization trust also issues a subordinate
certificate or BIO certificate (referred to as an excess cashflow certificate),
and a P certificate. Each month, the P certificate holder is entitled to receive
prepayment penalties received from borrowers who payoff their loans early in
their life.
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For any monthly distribution, the holder of an excess cashflow certificate
receives payments only after all required payments have been made on all the
other securities issued by the securitization trust. In addition, before the
holder of the excess cash flow certificate receives payments, cash flows from
such excess cashflow certificates are applied in a "waterfall" manner as
follows:
o first, to cover any losses on the mortgage loans in the related mortgage
loan pool, because the excess cashflow certificates are subordinate in
right of payment to all other securities issued by the securitization
trust;
o second, to reimburse the bond insurer, if any, of the related series of
pass-through certificates for amounts paid by or otherwise owing to that
insurer;
o third, to build or maintain the overcollateralization provision described
below for that securitization trust at the required level by being
applied as an accelerated payment of principal to the holders of the
pass-through certificates of the related series;
o fourth, to reimburse holders of the subordinated certificates of the
related series of pass-through certificates for unpaid interest and for
any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates that was
not paid because of the imposition of a cap on their pass-through rates -
these payments being called basis risk shortfall amounts.
The overcollateralization provision is a credit enhancement that is designed
to protect the securities sold to the securitization pass-through investors from
credit losses, which arise principally from defaults on the underlying mortgage
loans. In short, overcollateralization is when the amount of collateral (I.E.,
mortgage loans) owned by a securitization trust exceeds the aggregate amount of
senior pass-through certificates. The O/C is created to absorb losses that the
securitization trust may suffer, as loans are liquidated at a loss.
Historically, we built up the O/C typically over the first 18 to 24 months of a
securitization (with the specific timing depending upon the structure, amount of
excess spread, and performance of the securitization), by utilizing the cash
flows from the excess cashflow certificates to make additional payments of
principal to the holders of the pass-through certificates until the required O/C
level was reached. Beginning in our 2002 securitizations, we created the O/C by
initially selling pass-through securities totaling approximately 98.5% of the
total amount of mortgage loans sold to the trust. In doing so, we create the
full amount of the O/C required by the trust at the time we complete the
securitization, instead of over time. For example, if a securitization trust
contains collateral of $100 million principal amount of mortgage loans, we sell
approximately $98.5 million in senior pass-through certificates. Prior to our
2002 securitization transactions, we typically issued pass-through certificates
for a par purchase price, or a slight discount to par - with par representing
the aggregate principal balance of the mortgage loans backing the asset-backed
securities. For example, if a securitization trust contains collateral of $100
million of mortgage loans, we typically received close to $100 million in
proceeds from the sales of these certificates, depending upon the structure we
use for the securitization.
The O/C is generally expressed as a percentage of the initial mortgage loan
or collateral principal balance sold to the securitization trust. The required
O/C is initially determined by either the rating agencies and/or the bond
insurer, if any, using various factors including (1) characteristics of the
mortgage loans sold to the trust, such as credit scores and loan-to-value
14
ratios; (2) the amount of excess spread between the interest rate on the pool of
mortgage loans sold to the securitization trust and the interest paid to the
pass-through certificate holders, less the servicing fee, and other related
expenses such as trustee fees and bond insurer fee, if any; and (3) the
structure of the underlying securitization (E.G., issuing BBB- certificates
creates greater credit enhancement in the securitization transaction, which
generally results in a lower O/C).
Our securitizations have typically required an O/C of between 1.20% and 3.0%
of the initial mortgage loans sold to the securitization trust. The required O/C
can increase or decrease throughout the life of the transaction depending upon
subordination levels, delinquency and/or loss tests and is subject to minimums
and maximums, as defined by the rating agencies and/or the bond insurer insuring
the securitization. In our securitizations prior to 2002, after the O/C
requirement is reached, the cash flows from the excess cashflow certificates are
then distributed to us as the holder of the excess cashflow certificates, in
accordance with the "waterfall" described above. Over time, if the cash
collected during the periods exceeds the amount necessary to maintain the
required O/C and all other required distributions have been made, and there is
no shortfall in the related required O/C, the excess is paid to us as holder of
the excess cashflow certificate.
We began utilizing a new securitization structure in 2002, in which we sold a
net interest margin certificate, or NIM, in lieu of selling an interest-only
certificate in each of our 2002 securitizations. In each of our 2003
securitizations, we continued utilizing the NIM structure in addition to selling
an interest-only certificate. The NIM is generally structured where we sell the
excess cashflow certificate and P certificate to a QSPE or owner trust. This
owner trust is referred to as a "NIM trust." The NIM trust in turn issues (1)
interest-bearing NIM note(s) (backed by the excess cashflow certificate and P
certificate), and (2) a NIM owner trust certificate evidencing ownership in the
NIM trust. We sell the excess cashflow certificate and P certificate without
recourse, except that we provide normal representations and warranties to the
NIM trust. One or more investors purchase the NIM note(s) and the proceeds from
the sale of the note(s), together with an owner trust certificate that is
subordinate to the note(s), represent the consideration to us for the sale of
the excess cashflow certificate.
The NIM note(s) entitles the holder to be paid a specified interest rate, and
further provides for all cash flows generated by the excess cashflow certificate
and P certificate to be used to pay all principal and interest on the NIM
note(s) until paid in full. This typically occurs approximately 22-25 months
from the date the NIM note(s) were issued. The NIM owner trust certificate
entitles us to all cash flows generated by the excess cashflow certificate and P
certificate after the holder of the NIM note(s) has been paid in full. As such,
we classify the NIM owner trust certificate on our balance sheet as an excess
cashflow certificate and value the NIM owner trust certificate using the same
assumptions that we utilize in valuing excess cashflow certificates.
As part of a NIM transaction, we were required to "fully fund" the O/C at
closing - as opposed to having it build up over time as we had in past
securitizations - which is why we sold senior pass-through certificates totaling
approximately 1.5% less than the collateral in the securitization trust. We use
a portion of the proceeds we receive from selling NIM note(s) to make up for the
difference between (1) the principal amount of the mortgage loans sold and (2)
the proceeds from selling the senior pass-through certificates.
In our third quarter 2003 securitization, we derived the following economic
interests:
15
o we received a cash purchase price from the sale of the NIM note(s) issued
by a NIM trust, to which we sold the excess cashflow certificates;
o we received a cash purchase price from the sale of two interest-only
certificates, which entitle the holders to receive payments of interest
at a pre-determined rate and over a fixed period of time - I.E., 11
months and 27 months in this case;
o we received a cash premium from selling the right to service the loans
that we securitized. This right entitles the contractual servicer to
service the loans on behalf of the securitization trust, and earn a
contractual servicing fee, and ancillary servicing fees, including
prepayment penalties for certain securitization servicing rights we
previously sold, in such capacity;
o we retained a NIM owner trust certificate, which entitles us to receive
cash flows generated by the excess cashflow certificates and the P
certificate issued in connection with the securitization after the holder
of the NIM note(s) has been paid in full. Although the cash flows
generated by excess cashflow certificates are received over time, under
GAAP, we must report as income at the time of the securitization the
present value of all projected cash flows we expect to receive in the
future from these excess cashflow certificates based upon an assumed
discount rate. Our valuation of these excess cashflow certificates is
primarily based on:
(1) our estimate of the amount of expected losses or defaults that will
take place on the underlying mortgage loans over the life of the
mortgage loans,
(2) the expected amount of prepayments on the mortgage loans due to the
underlying borrowers of the mortgage loans paying off their mortgage
loan prior to the loan's stated maturity,
(3) the LIBOR forward curve (using current LIBOR as the floor rate), and
(4) a discount rate;
While we retained an excess cashflow certificate on our $435 million
securitization completed in the quarter ended September 30, 2003, we did
not record it as an asset and corresponding revenue item due to the
securitization structure we used to maximize cash revenues. Historically,
in our securitizations, we have sold pass-through certificates with credit
ratings from the rating agencies that were rating the securitization
transactions ranging from AAA to BBB. In our securitization completed in
the third quarter, we issued a limited principal amount of certificates
rated BBB-. This structure reduced the amount of overcollateralization
required, compared to a structure without a BBB- certificate, because the
BBB- certificate replaces credit enhancement that would have otherwise
been achieved solely through overcollateralization and the corresponding
excess cashflow certificate. Had we not sold a BBB- certificate, the same
credit enhancement would have been produced through a higher
overcollateralization, which would have correspondingly led to a higher
valued excess cashflow certificate. The BBB- certificate made possible a
lower upfront overcollateralization than if we did not sell a BBB-
certificate, which, in turn, resulted in our receiving higher cash
proceeds from the securitization, as the senior certificates represent a
larger percentage of the aggregate value of the mortgage loans sold -
E.G., a 1.2% O/C results in $98.8 million of certificates being sold
against every $100 million of mortgage loans purchased by the
securitization trust, whereas a 2.2% O/C results in $97.8 million of
certificates being sold
16
against every $100 million of mortgage loans purchased by the
securitization trust. Hence, the lower the upfront overcollateralization,
the greater the upfront cash proceeds received. As a result of the cash
flow needed to pay the interest on and principal amount of BBB- rated
certificates, coupled with less overcollateralization and based upon our
gain on sale assumptions, we ascribed no value to the excess cashflow
certificate that we retained in this quarter's securitization. However, if
the loans underlying this securitization transaction perform better than
our expectations, we will recognize excess cash flows from the excess
cashflow certificate and record the cash and interest income as received.
As with all of our most recent securitization structures, we will not
receive excess cash flows, if any, from the excess cashflow certificate
until the NIM note is paid off in full.
At the time we completed the securitization in the third quarter of 2003, we
recognized as revenue each of the economic interests described above, which were
recorded as net gain on sale of mortgage loans in our consolidated statement of
income.
The gain on sale we recorded and cash we received from our securitizations in
the third quarter of 2003 and 2002 is summarized below. "Loans Sold" is the
principal amount of loans actually transferred to the securitization trusts
during the period.
THIRD QUARTER
GAIN ON SALE 2003 2002
------------ ---- ----
Loans Sold (in thousands) $448,246 $200,000
NIM Proceeds, Net of Up Front Overcollateralization 3.76 % 6.19 %
Interest-Only Certificate Proceeds 1.08 % -
Excess Cashflow Certificate (owner trust certificate)(1) 0.22 % 1.00 %
Mortgage Servicing Rights 0.60 % 0.85 %
Less: Transaction Costs (0.46)% (0.63)%
------ -------
Net Gain on Sale Recorded 5.20 % 7.41 %
====== =======
CASH RECEIVED
NIM Proceeds, Net of Up Front Overcollateralization 3.76 % 6.19 %
Interest-Only Certificate Proceeds 1.08 % -
Mortgage Servicing Rights 0.60 % 0.85 %
Less: Transaction Costs (0.46)% (0.63)%
------ -------
Cash at Closing 4.98 % 6.41 %
====== =======
(1) We did not record an excess cashflow certificate on our $435 million
securitization in the third quarter of 2003 due to the securitization
structure we used (see "-Excess Cashflow Certificates"). The 0.2% excess
cashflow certificate above represents the excess cashflow certificate
recorded on the loans delivered to the securitization trust in July 2003
relating to our securitization in the second quarter of 2003.
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Our net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate the loans,
adjusted for the following:
o any direct loan origination costs incurred (an increase in the
investment) and loan origination fees received (a decrease in the
investment) in connection with the loans, which are treated as a
component of the initial investment in loans;
o the principal payments received, and the amortization of the net loan
fees or costs, during the period we held the loans prior to their
securitization; and
o any gains (a decrease in the investment) or losses (an increase in the
investment) we incur on any hedging instruments that we may have utilized
to hedge against the effects of changes in interest rates during the
period we hold the loans prior to their securitization (See "-Hedging").
We allocate our basis in the mortgage loans and excess cashflow certificates
between the portion of the mortgage loans and excess cashflow certificates sold
through securitization and the portion retained (the NIM owner trust certificate
since 2002) based on the relative fair values of those portions on the date of
sale. We may recognize gains or losses attributable to the changes in fair value
of the excess cashflow certificates, which are recorded at estimated fair value
and accounted for as "trading" securities. Since there is no active market for
such excess cashflow certificates, we determine the estimated fair value of the
excess cashflow certificates by discounting the future expected cash flows.
Each securitization trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which helps ensure 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 cash flows that would otherwise be paid to the holder of the excess
cashflow certificate is used when and if it subsequently becomes necessary to
obtain or maintain required overcollateralization limits. Overcollateralization
is used to absorb losses prior to making a claim on the financial guaranty
insurance policy or the subordinated certificates.
WHOLE LOAN SALES. We also sell loans, without retaining the right to service
the loans, in exchange for a cash premium. The premiums we receive from the loan
sales are recorded as revenue at the time of sale under net gain on sale of
mortgage loans. The cash premiums ranged between 4.1% and 5.5% (prior to
reserve) of the principal amount of mortgage loans sold in the third quarter of
2003.
OTHER. In addition to the income and cash flows we earn from securitizations
and whole loan sales, we also earn income and generate cash flows from:
o the net interest spread earned on mortgage loans while we hold the
mortgage loans for sale (the difference between the interest rate on the
mortgage loan paid by the borrower less the financing costs we pay to our
warehouse lender to fund our loans);
o net loan origination fees on wholesale loans and retail loans;
o retained excess cashflow certificates;
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o distributions from Delta Funding Residual Exchange Company LLC (the
"LLC"), a limited liability company (unaffiliated to us). We have a
non-voting membership interest in the LLC, which entitles us to receive
15% of the net cash flows from the LLC through June 2004 and, thereafter,
10% of the net cash flows from the LLC. We have not received our
distributions since the second quarter due to a dispute with the LLC and
the President of the LLC, which has led us to commence a lawsuit to
recover all of the amounts due to us. (See "Part II, Item 1-Litigation");
and
o miscellaneous interest income, including prepayment penalties received on
certain of the loans we sold in securitizations prior to 2002.
EXCESS CASHFLOW CERTIFICATES, NET
We classify excess cashflow certificates that we receive upon the
securitization of a pool of loans as "trading securities." The amount initially
allocated to the excess cashflow certificates at the date of a securitization
reflects their fair value. The amount recorded for the excess cashflow
certificates is reduced for distributions which we receive as the holder of
these excess cashflow certificates, and is adjusted for subsequent changes in
the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the present
value of the related excess cashflow certificates (which, in the securitizations
we have issued since 2002, includes NIM owner trust certificates, and the
underlying BIO certificates and P certificates), using certain assumptions we
make regarding the underlying mortgage loans. The excess cashflow certificate is
then recorded on our consolidated financial statements at an estimated fair
value. Our estimates primarily include the following:
o future rate of prepayment of the mortgage loans - the expected amount of
prepayments on the mortgage loans due to the underlying borrowers paying
off their mortgage loan prior to the loan's expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of
expected losses or defaults that will take place on the underlying
mortgage loans over the life of the mortgage loans because the excess
cashflow certificates are subordinated to all other securities issued by
the securitization trust. Consequently, any losses sustained on mortgage
loans comprising a particular securitization trust are first absorbed by
the excess cashflow certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) - our
estimate of future interest rates, which affects both the rate paid to
the floating rate pass-through security investors (primarily the
one-month LIBOR index) and the adjustable rate mortgage loans sold to
the securitization trust (which provide for a fixed rate of interest for
the first 24 or 36 months and a six-month variable rate of interest
thereafter using the six-month LIBOR index); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the cash flow we
expect to receive in the future from such certificate based upon our best
estimate. We monitor the performance of the loans underlying each excess
cashflow certificate, and any changes in our estimates (and
19
consequent changes in value of the excess cashflow certificates) are reflected
in the line item called "interest income" in the quarter in which we make any
such change in our estimate. Although we believe that the assumptions we use are
reasonable, there can be no assurance as to the accuracy of the assumptions or
estimates.
In determining the fair value of each of the excess cashflow certificates, we
make the following underlying assumptions regarding mortgage loan prepayments,
mortgage loan default rates, the LIBOR forward curve and discount rates:
(A) PREPAYMENTS. We base our prepayment rate assumptions upon our ongoing
analysis of the performance of the mortgage pools we previously
securitized, and the performance of similar pools of mortgage loans
securitized by others in the industry. We apply different prepayment speed
assumptions to different loan product types because it has been our
experience that different loan product types exhibit different prepayment
patterns. Generally, our loans can be grouped into two loan products -
fixed-rate loans and adjustable-rate loans. With fixed-rate loans, an
underlying borrower's interest rate remains fixed throughout the life of
the loan. Our adjustable-rate loans are a "hybrid" between fixed- and
adjustable-rate loans, in that the interest rate generally remains fixed,
typically for the first two or three years of the loan, and then adjusts,
typically every six months thereafter. Within each product type, factors
other than interest rate can affect our prepayment rate assumptions. These
factors include:
o whether or not a loan contains a prepayment penalty - an amount that a
borrower must pay to a lender if the borrower prepays the loan within a
certain time after the loan was originated. Loans containing a
prepayment penalty typically are not repaid as quickly as those without
a penalty;
o as is customary in our industry with adjustable-rate mortgage loans,
the introductory interest rate we charge to the borrower is
artificially lower, between one and two full percentage points, than
the rate for which the borrower would have otherwise qualified.
Generally, once the interest rate begins to adjust, the interest rate
payable on that loan increases, at times fairly substantially. This
interest rate increase can be exacerbated if there is an absolute
increase in interest rates. As a result of these increases and the
potential for future increases, adjustable rate mortgage loans
typically are more susceptible to early prepayments.
There are several reasons why a loan may prepay prior to its maturity,
including but not limited to:
o a decrease in interest rates;
o improvement in the borrower's credit profile, which may allow the
borrower to qualify for a lower interest rate loan;
o competition in the mortgage market, which may result in lower interest
rates being offered to the borrower;
o the borrower's sale of his or her home;
o the borrower's need for additional funds; and
o a default by the borrower, resulting in foreclosure by the lender.
20
It is unusual for a borrower to prepay a mortgage loan during the first
few months because:
o it typically takes at least several months after the mortgage loans are
originated for any of the above events to occur;
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our current prepayment assumptions for the month
one and peak speed. The assumptions have not changed since September 2001.
LOAN TYPE MONTH ONE PEAK SPEED
--------- --------- ----------
Fixed Rate 4.00% 30.00%
Adjustable Rate 4.00% 75.00%
If mortgage loans prepay faster than anticipated, we will earn less income
in connection with the mortgage loans and receive less excess cash flow in
the future because the mortgage loans have paid off. Conversely, if
mortgage loans prepay at a slower rate than anticipated, we earn more
income and more excess cash flow in the future, subject to the other
factors that can affect the cash flows from, and our valuation of, the
excess cashflow certificates.
(b) DEFAULT RATE. At September 30, 2003 and 2002, on each newly issued
securitization, we apply a default reserve for both fixed- and
adjustable-rate loans sold to the securitization trusts totaling 5.00% of
the amount initially securitized. We apply a default or loss rate to the
excess cashflow certificate because it is the "first-loss" piece and is
subordinated in right of payment to all other securities issued by the
securitization trust. If defaults are higher than we anticipate, we will
receive less income and less excess cash flow than expected in the future.
Conversely, if defaults are lower than we expected, we will receive more
income and more excess cash flow than expected in the future, subject to
the other factors that can affect the cash flows from, and our valuation
of, the excess cashflow certificates.
(c) LIBOR FORWARD CURVE. The LIBOR forward curve is used to project future
interest rates, which affects both the rate paid to the floating rate
pass-through security investors (primarily the one-month LIBOR index) and
the adjustable rate mortgage loans sold to the securitization trust (a
fixed rate of interest for either the first 24 or 36 months then a
nine-month variable rate of interest thereafter using the six-month LIBOR
index). A significant portion of our loans are fixed-rate mortgages, and a
significant amount of the securities sold by the securitization trust are
floating-rate securities (the interest rate adjusts based upon an index,
such as one-month LIBOR). As such, our excess cashflow certificates are
subject to significant basis risk and a change in LIBOR will, impact our
excess spread. If LIBOR is lower than anticipated, we will receive more
income and more excess cash flows than expected in the future, subject to
the other factors that can affect the cash flows from, and our valuation
of, the excess cashflow certificates. Conversely, if LIBOR is higher than
expected, we will receive less income and less excess cash flows than
expected in the future. In each of our securitizations in which we sold
NIM note(s), we purchased, on behalf of the NIM owner trust, an interest
rate cap for
21
the benefit of the NIM noteholder(s), which helps mitigate the basis risk
for the approximate time that the NIM notes are outstanding.
(d) DISCOUNT RATE. We use a discount rate that we believe reflects the risks
associated with our excess cashflow certificates. Because quoted market
prices on comparable excess cashflow certificates are not available, we
compare our valuation assumptions and performance experience to our
competitors in the non-conforming mortgage industry. Our discount rate
takes into account the asset quality and the performance of our
securitized mortgage loans compared to that of the industry and other
characteristics of our securitized loans. We quantify the risks associated
with our excess cashflow certificates by comparing the asset quality and
payment and loss performance experience of the underlying securitized
mortgage pools to comparable industry performance. The discount rate we
use to determine the present value of cash flows from excess cashflow
certificates reflects increased uncertainty surrounding current and future
market conditions, including without limitation, uncertainty concerning
inflation, recession, home prices, interest rates and conditions in the
equity markets.
We utilized a discount rate of 15% at September 30, 2003 and 2002 on all
excess cashflow certificates.
During the nine months ended September 30, 2002, we recorded a charge to
interest income to reflect a fair value adjustment to our excess cashflow
certificates, totaling $2.1 million, relating to the timing of excess cash flows
that are to be received by our excess cashflow certificates after the release or
"stepdown" of the overcollateralization account.
Our valuation of retained excess cashflow certificates is highly dependent
upon the reasonableness of our assumptions and the predictiveness of the
relationships that drive the results of our valuation model. The assumptions we
utilize, described above, are complex, as we must make judgment calls about the
effect of matters that are inherently uncertain. As the number of variables and
assumptions affecting the possible future resolution of the uncertainties
increase, those judgments become even more complex.
In volatile markets, like those we have experienced over the past several
quarters, there is increased risk that our actual results may vary significantly
from our assumed results. The longer the time period over which the uncertainty
will exist, the greater the potential volatility for our valuation assumptions
and the fair value of our excess cashflow certificates.
For example, assumptions regarding prepayment speeds, defaults and LIBOR
rates are used in estimating fair values of our excess cashflow certificates. If
loans prepay faster than estimated, or loan loss levels are higher than
anticipated, or LIBOR is higher than anticipated, we may be required to write
down the value of such certificates. While we believe that our assumptions are
reasonable estimates using our historical loan performance and the performance
of similar mortgage pools from other lenders - in addition to accessing other
public information about market factors such as interest rates, inflation,
recession, unemployment and real estate market values, among other things -
these are just estimates and it is virtually impossible to predict the actual
level of prepayments and losses, which are also driven by consumer behavior.
In August 2003, we sold three of our excess cashflow certificates, which had
a $10.0 million carrying (book) value in the aggregate, for $10.2 million in
cash. We recorded the premium earned from the sale in interest income, and
reduced the value of our excess cashflow certificates
22
on our balance sheet accordingly. The net impact was an increase to interest
income of $0.2 million in the quarter ended September 30, 2003.
DEFERRED TAX ASSET
As of September 30, 2003, we carried a net deferred tax asset of $35.7
million (assuming a 39% effective tax rate) on our consolidated financial
statements. Our deferred tax asset is comprised primarily of Federal and State
net operating losses, or "NOLs," net of the tax impact.
At September 30, 2003, we reversed a valuation allowance that we had
established in 2000 against our deferred tax asset. As of December 31, 2002, we
had a gross deferred tax asset of $48.0 million, a gross deferred tax liability
of $0.1 million and a valuation allowance of $42.3 million. Management and the
Audit Committee of the Board of Directors believed that the reversal was
appropriate at this time principally because of our eight consecutive quarters
of profitability and positive cash flow, together with the planned retirement of
all our long-term unsecured debt. We have recorded minimal taxes in our results
of operations over the prior seven quarters - from the fourth quarter of 2001
through the second quarter of 2003 - as a result of the valuation allowance
against our deferred tax asset, which was primarily generated by net operating
losses ("NOLs") in 2000 and 2001.
The reversal of the valuation allowance has two significant effects:
o First, we have recorded additional income equal to the amount of the
valuation allowance reversal in the third quarter (which was partially
offset by a change in our effective tax rate) reflected in our
statement of income in the line item income tax benefit.
o Second, going forward, our financial statements will reflect an
effective income tax rate of 39%, even though we expect to continue to
pay only minimal cash taxes (either alternative minimum tax ("AMT") or
excess inclusion income tax, as well as minimal state taxes) until our
net operating losses are fully utilized.
Our deferred tax asset of $35.7 million consists primarily of (1) NOLs, net
of tax, totaling $27.0 million, which can be used to offset the tax liability
generated from approximately $69.2 million of pre-tax income (the NOLs will be
expiring in 2021), and (2) the excess of the tax basis over book basis on our
excess cashflow certificates, net of tax, of $6.9 million.
NON-GAAP PRESENTATION
At September 30, 2003, we reversed a deferred tax asset valuation allowance,
which we established in 2000. Management and the Audit Committee of the Board of
Directors believed that the reversal was appropriate at this time principally in
light of our eight consecutive quarters of profitability and positive cash flow,
together with our plan to redeem all of our long-term unsecured debt. We have
recorded minimal taxes in our results of operations over the prior seven
quarters - from the fourth quarter of 2001 through the second quarter of 2003 -
as a result of the valuation allowance against our deferred tax asset, which was
primarily generated by net operating losses in 2000 and 2001. The reversal of
the valuation allowance has two significant effects:
23
o First, we have recorded additional income equal to the amount of the
valuation allowance reversal in the third quarter (which was partially
offset by a change in our effective tax rate) reflected in our income
statement in the line-item income tax benefit;
o Second, in the future, our financial statements will reflect an effective
income tax rate of 39%, even though we expect to continue to pay only
minimal cash taxes (either alternative minimum tax ("AMT") or excess
inclusion income tax, as well as minimal state taxes) until our net
operating losses are fully utilized.
Because the foregoing effects of the reversal of the deferred tax asset
valuation allowance may make it difficult for investors to make a meaningful
period-over-period comparison, we have provided a Non-GAAP presentation in
addition to our actual results to assist our investors. The Non-GAAP
presentation excludes income produced by the reversal of the valuation allowance
in the third quarter of 2003 and an income tax benefit in the third quarter of
2002, as well as expense related to a change in our effective tax rate recorded
in the third quarter of 2003.
NON-GAAP EARNINGS RECONCILIATION TABLE
- -------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS, EXCEPT PER DILUTED EPS)
- -------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
----------------------------------------
Net income, as reported $ 41,595 6,698 59,993 12,915
Less: income tax benefit (30,455) (2,136) (30,152) (1,884)
Less: AMT/Excess Inclusion Income Tax (268) (64) (571) (316)
Non-GAAP net income $ 10,872 4,498 29,270 10,715
DILUTED EPS:
- ------------
Net income per diluted share, as reported $ 2.24 0.39 3.21 0.76
Non-GAAP EPS 0.59 0.26 1.55 0.63
- -------------------------------------------------------------------------------------
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2002
GENERAL
Our net income for the three months ended September 30, 2003 was $41.6
million, or $2.55 per share basic and $2.24 per share diluted, compared to $6.7
million, or $0.42 per share basic and $0.39 per share diluted, for the three
months ended September 30, 2002. The increase in net income was primarily due to
an income tax benefit of $30.5 million, or $1.64 per diluted share, in addition
to overall higher revenues resulting from significantly higher loan production.
The income tax benefit was the result of the reversal of the valuation allowance
as well as expense related to a change in our effective tax rate recorded in the
third quarter of 2003. Net income for 2002 was also increased due to an income
tax benefit of $2.2 million, or $0.13 per diluted share.
24
REVENUES
Total revenues increased $14.1 million, or 65%, to $35.9 million for the
three months ended September 30, 2003, from $21.8 million for the comparable
period in 2002. The increase in revenue was primarily attributable to our
originating and selling a larger number of mortgage loans during the period
ended September 30, 2003 compared to the same period in 2002, and the consequent
increase in net gain on sale of mortgage loans and net origination fees and
other income. This increase was partially offset by a decrease to our gain on
sale margin of approximately 2% for the quarter ended September 30, 2003,
primarily due to compression of our net interest margin resulting from lower
interest rates on our mortgage loans and an increase in the costs of the
interest rate caps purchased for the benefit of the securitization trusts due to
an increase in the forward (projected) 1 month LIBOR curve, compared to the same
period in 2002.
We originated $524.8 million of mortgage loans for the three months ended
September 30, 2003, representing a 145% increase from $214.4 million of mortgage
loans originated for the same period in 2002. During the three months ended
September 30, 2003, we securitized $448.2 million of mortgage loans and sold
$12.2 million of mortgage loans as whole loans compared to securitizing $200.0
million of mortgage loans and selling $18.5 million of mortgage loans as whole
loans during the same period in 2002.
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans
equals:
(1) the sum of:
(a) the cash purchase price we receive in connection with selling in
connection with our securitization(s) in a particular period: (i) a
NIM note, net of the overcollateralization amount and interest rate
cap cost and/or (ii) an interest-only certificates;
(b) the fair value of the excess cashflow certificates we retain in a
securitization for each period;
(c) the cash premium received from selling mortgage servicing rights in
connection with each securitization; and
(d) the cash premium earned from selling whole loans on a
servicing-released basis,
(2) less the (i) costs associated with securitizations, (ii) any hedge loss
(gain) associated with a particular securitization and (iii) any loss
associated with whole loans sold at a discount.
Net gain on sale of mortgage loans increased $8.3 million, or 53%, to $24.0
million for the three months ended September 30, 2003, from $15.7 million for
the comparable period in 2002. This increase was primarily due to an increase in
loans securitized and sold to $460.4 million, compared to $218.5 million in the
third quarter of 2002. This increase was partially offset by a decrease to our
gain on sale margin of approximately 2% for the quarter ended September 30,
2003, primarily due to compression of our net interest margin resulting from
lower interest rates on our mortgage loans and an increase in the costs of the
interest rate caps purchased for the benefit of the securitization trusts due to
an increase in the forward (projected) one-month LIBOR curve, compared to the
same period in 2002. Our weighted average net gain on sale margin was 5.2% for
the three months ended September 30, 2003 compared to 7.2% for the
25
comparable period in 2002. The weighted-average net gain on sale margin is
calculated by dividing the net gain on sale by the total amount of loans
securitized and sold.
INTEREST. Interest income primarily represents the sum of:
(1) the gross interest we earn on loans held for sale;
(2) the cash we receive from our excess cashflow certificates;
(3) the non-cash mark-to-market or non-cash valuation adjustments (up or
down) to our excess cashflow certificates to reflect changes in fair
value (including sales of our excess cashflow certificates for other
than their carrying value);
(4) cash interest earned on bank accounts; and
(5) miscellaneous interest income, including prepayment penalties received
on certain of our securitizations prior to 2002.
Interest income increased $1.2 million, or 52%, to $3.5 million for the three
months ended September 30, 2003, from $2.3 million for the comparable period in
2002. The increase in interest income is due to the higher average loan balance
on the loans we originated and held for sale and due to the $220,000 gain we
received on the sale of our three excess cashflow certificates, partially offset
by the lower weighted-average interest rate on loans held for sale and lower
prepayment penalties received in the third quarter of 2003, compared to the same
period in 2002.
NET ORIGINATION FEES AND OTHER INCOME. Origination fees represent the sum of:
(1) fees earned on broker and retail originated loans,
(2) distributions from the LLC, and
(3) other miscellaneous income, if any,
less premiums paid to originate mortgage loans.
Net origination fees and other income increased $4.6 million, or 121%, to
$8.4 million for the three months ended September 30, 2003, from $3.8 million
for the same period in 2002. The increase resulted primarily from higher
mortgage loan production, and consequently higher fees during the third quarter
of 2003, compared to the same period in 2002.
EXPENSES
Total expenses increased by $7.5 million, or 43%, to $24.8 million for the
three months ended September 30, 2003, from $17.3 million for the comparable
period in 2002. The increase was primarily related to higher payroll, including
commissions and related costs required to support the significant increase in
our mortgage loan production.
PAYROLL AND RELATED COSTS. Payroll and related costs include salaries,
benefits and payroll taxes for all employees.
Payroll and related costs increased by $6.6 million, or 65%, to $16.8 million
for the three months ended September 30, 2003, from $10.2 million for the same
period in 2002. The increase was primarily the result of (1) an increase in the
commissions and related expenses paid (I.E., payroll taxes and employer-paid
401(k) plan matching contributions) in the quarter ended
26
September 30, 2003 of approximately $7.0 million, compared to $3.0 million for
the same period in 2002, due to the significant increase in loan origination
volume, and (2) a higher number of employees needed to handle the increase in
our loan production. As of September 30, 2003, we employed 881 full- and
part-time employees, compared to 661 full- and part-time employees as of
September 30, 2002.
INTEREST EXPENSE. Interest expense includes the borrowing costs under our
warehouse credit facility to finance loan originations, equipment financing and
the Senior Notes.
Interest expense increased by $0.2 million, or 17%, to $1.4 million for the
three months ended September 30, 2003 from $1.2 million for the comparable
period in 2002. The increase was primarily due to an increase in loans
originated and financed during the quarter on our warehouse facilities,
partially offset by the lower borrowing costs under our warehouse facilities.
The average one-month LIBOR rate, which is the benchmark index used to determine
the funding cost for our borrowings, decreased on average to 1.1% for the third
quarter of 2003, compared to an average of 1.8% for the third quarter of 2002.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
consist primarily of office rent, insurance, telephone, depreciation, legal
reserves and fees, license fees, accounting fees, travel and entertainment
expenses, advertising and promotional expenses and the provision for loan losses
on the inventory of loans held for sale and recourse loans.
General and administrative expenses increased by $0.8 million, or 14%, to
$6.6 million for the three months ended September 30, 2003 from $5.8 million for
the same period in 2002. The increase was primarily due to an increase in
expenses associated with higher loan production and ongoing expansion of our
wholesale and retail divisions, partially offset by lower depreciation expenses
resulting from fully depreciated assets.
INCOME TAXES. Deferred tax assets and liabilities are recognized based upon
the income reported in the financial statements regardless of when such taxes
are paid. These deferred taxes are measured by applying current enacted tax
rates.
We recorded an income tax benefit of $30.5 million primarily related to our
reversing a deferred tax asset valuation allowance and expenses for a change in
our effective tax rate. For the period ended September 30, 2002, we also
recorded a tax provision of $0.3 million primarily related to excess inclusion
income generated by our excess cashflow certificates for the period ended
September 30, 2003.
For the same period in 2002, we recorded an income tax benefit of $2.2
million related to our obtaining a favorable resolution to tax issues for which
we had previously reserved and do not expect to recur. This was offset by a tax
provision of $0.1 million primarily related to excess inclusion income generated
by our excess cashflow certificates.
Excess inclusion income cannot be offset by our NOL's under the REMIC tax
laws. It is primarily caused by the REMIC securitization trust utilizing cash,
that otherwise would have been paid to us as holder of the excess cashflow
certificate, to make payments to other security holders, to create and/or
maintain overcollateralization by artificially paying down the principal balance
of the asset-backed securities. In the future, we expect to continue to incur a
modest amount of excess inclusion income, which we will be unable to offset with
our NOL's.
27
NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2002
GENERAL
Our net income for the nine months ended September 30, 2003 was $60.0
million, or $3.68 per share basic and $3.21 per share diluted, compared to $12.9
million, or $0.81 per share basic and $0.76 per share diluted for the nine
months ended September 30, 2002. Net income was favorably impacted by an income
tax benefit of $30.2 million, or $1.63 per diluted share. Net income for 2002
was also favorably impacted by an income tax benefit of $2.2 million, or $0.13
per diluted shares.
REVENUES
Total revenues increased $33.5 million, or 53%, to $96.5 million for the nine
months ended September 30, 2003, from $63.0 million for the comparable period in
2002. The increase in revenue was primarily attributable to our originating and
selling a larger number of mortgage loans during the nine months ended September
30, 2003, compared to the same period in 2002, and the consequent increase in
net gain on sale of mortgage loans and net origination fees and other income.
We originated $1.2 billion of mortgage loans for the nine months ended
September 30, 2003, representing a 95% increase from $614.5 million of mortgage
loans originated for the comparable period in 2002. We securitized $1.0 billion
of mortgage loans and sold $33.6 million of mortgage loans as whole loans during
the nine months ended September 30, 2003, compared to securitizing $575.0
million of mortgage loans and selling $92.5 million of mortgage loans as whole
loans during the same period in 2002.
NET GAIN ON SALE OF MORTGAGE LOANS increased $23.7 million, or 55%, to $66.5
million for the nine months ended September 30, 2003, from $42.8 million for the
comparable period in 2002. This increase was primarily due to an increase in the
amount of loans securitized and sold compared to the nine months ended September
30, 2002, partially offset by a decrease in our weighted-average net gain on
sale margin for the nine months ended September 30, 2003 to 6.1% from 6.4% for
the comparable period in 2002.
INTEREST INCOME increased $0.3 million, or 3%, to $9.7 million for the nine
months ended September 30, 2003, from $9.4 million for the comparable period in
2002. The increase in interest income was primarily due to a $2.1 million fair
value adjustment to our excess cashflow certificates during the nine months
ended September 30, 2002, partially offset by a lower weighted-average interest
rate (8.07%) for our loans held for sale during the nine months ended September
30, 2003 and, consequently, less interest earned on these loans, compared to the
same period in 2002 (9.58%). In addition, we received less prepayment penalties
in the nine months ended September 30, 2003 compared to the same period in 2002.
NET ORIGINATION FEES AND OTHER INCOME increased $9.4 million, or 86%, to
$20.3 million for the nine months ended September 30, 2003, from $10.9 million
for the comparable period in 2002. The increase was primarily the result of
higher mortgage loan production, and consequently higher fees earned during the
nine months ended September 30, 2003, compared to the same period in 2002.
28
EXPENSES
Total expenses increased by $14.7 million, or 28%, to $66.7 million for the
nine months ended September 30, 2003, from $52.0 million for the comparable
period in 2002. The increase was primarily related to higher payroll, including
commissions, and related costs required to support the significant increase in
our mortgage loan production.
PAYROLL AND RELATED COSTS increased by $13.5 million, or 45%, to $43.5
million for the nine months ended September 30, 2003, from $30.0 million for the
comparable period in 2002. The increase was primarily the result of (1) an
increase in the commissions and related expense paid (I.E., payroll taxes and
employer-paid 401(k) plan matching contributions) for the nine months ended
September 30, 2003 of approximately $16.8 million, compared to $11.4 million for
the prior period due to the significant increase in loan origination volume, and
(2) a higher number of employees needed to handle the increase in our loan
production.
INTEREST EXPENSE decreased by $0.4 million, or 10%, to $3.8 million for the
nine months ended September 30, 2003 from $4.2 million for the comparable period
in 2002. The decrease was due to lower borrowing costs under our warehouse
facilities. The average one-month LIBOR rate, which is the benchmark index used
to determine the funding cost for our borrowings, decreased on average to 1.2%
for the nine months ended September 30, 2003, compared to an average of 1.8% for
the same period in 2002.
GENERAL AND ADMINISTRATIVE EXPENSES increased by $1.6 million, or 9%, to
$19.4 million for the nine months ended September 30, 2003 from $17.8 million
for the comparable period in 2002. The increase was primarily due to an increase
in expenses associated with higher loan production and ongoing expansion of our
wholesale and retail divisions. This was partially offset by lower depreciation
expenses resulting from fully depreciated assets.
INCOME TAXES. We recorded an income tax benefit of $30.2 million, which was
primarily related to our reversing a deferred tax asset valuation allowance and
expenses for the change in our effective tax rate. For the period ended
September 30, 2003, we also recorded a tax provision of $0.5 million, which
primarily related to excess inclusion income generated by our excess cashflow
certificates.
For the same period in 2002, we recorded an income tax benefit of $2.2
million related to our obtaining a favorable resolution to tax issues for which
we had previously reserved and do not expect to recur. This was offset by a tax
provision of $0.3 million, which primarily related to excess inclusion income
generated by our excess cashflow certificates.
Excess inclusion income cannot be offset by our NOL's under the REMIC tax
laws. It is primarily caused by the REMIC securitization trust utilizing cash,
that otherwise would have been paid to us as holder of the excess cashflow
certificate, to make payments to other security holders, to create and/or
maintain overcollateralization by artificially paying down the principal balance
of the asset-backed securities. In the future, we expect to continue to incur a
modest amount of excess inclusion income, which we will be unable to offset with
our NOL's.
29
FINANCIAL CONDITION
SEPTEMBER 30, 2003 COMPARED TO DECEMBER 31, 2002
LOANS HELD FOR SALE, NET increased $101.6 million, or 299%, to $135.6 million
at September 30, 2003, from $34.0 million at December 31, 2002. This asset
represents mortgage loans held in inventory that we expect to sell in a
securitization or as whole loans. This increase was primarily due to the net
difference between loan originations and loans securitized or sold during the
nine months ended September 30, 2003.
EXCESS CASHFLOW CERTIFICATES, NET decreased $5.0 million, or 20%, to $19.6
million at September 30, 2003, from $24.6 million at December 31, 2002. This
decrease was primarily due to our sale of three excess cashflow certificates
with an aggregate carrying (book) value of $10.0 million, and to a lesser extent
the change in fair value of our remaining excess cashflow certificates,
partially offset by our recording two new excess cashflow certificates, totaling
$6.9 million from loans securitized during 2003. In the quarter ended September
30, 2003, we did not record an excess cashflow certificate on our $435 million
third quarter 2003 securitization due to the securitization structure we
utilized. Changes in fair value incorporate any change in value (accretion or
reduction) in the carrying value of the excess cashflow certificates and the
cash distributions we received from such excess cashflow certificates. (See
"-Footnote 4 to the Notes to Consolidated Financial Statements - Excess Cashflow
Certificates, net").
PREPAID AND OTHER ASSETS increased $1.1 million, or 65%, to $2.8 million at
September 30, 2003, from $1.7 million at December 31, 2002. This increase was
primarily due to prepaid expenses associated with the pre-funding feature in our
securitization transaction in the third quarter of 2003.
DEFERRED TAX ASSET increased $30.1 million, or 538%, to $35.7 million at
September 30, 2003, from $5.6 million at December 31, 2002. This increase was
primarily due to our reversal of the valuation allowance we maintained against
our deferred tax asset, which was established in 2000, partially offset by a
change to our effective tax rate in the third quarter of 2003. Management
believed that the reversal was appropriate at this time principally due to our
eight consecutive quarters of profitability and positive cash flow, and the
planned redemption of our remaining 9.5% Senior Notes due 2004.
WAREHOUSE FINANCING AND OTHER BORROWINGS increased $68.0 million, or 415%, to
$84.4 million at September 30, 2003, from $16.4 million at December 31, 2002.
This increase was primarily attributable to a higher amount of mortgage loans
held for sale (mortgage loans held in inventory that we plan to sell in a whole
loan sale or securitization) financed under our warehouse credit facilities.
ACCOUNTS PAYABLE AND ACCRUED EXPENSE increased $2.6 million, or 21%, to $14.9
million at September 30, 2003 from $12.3 million at December 31, 2002. This
increase was primarily the result of the timing of various operating accruals
and payables.
STOCKHOLDERS' EQUITY increased $59.6 million, or 202%, to $89.1 million at
September 30, 2003 from $29.5 million at December 31, 2002. This increase is
primarily due to the reversal of our deferred tax asset valuation allowance and
our positive earnings for the nine-month period.
30
LIQUIDITY AND CAPITAL RESOURCES
We require substantial amounts of cash to fund our loan originations,
securitization activities and operations. We have organically increased our
working capital over the last eight quarters. In the past, however, we operated
generally on a negative cash flow basis. Embedded in our current cost structure
are many fixed costs, which are not likely to be significantly affected by a
relatively substantial increase in loan originations. If we can continue to
originate a sufficient amount of mortgage loans and generate sufficient cash
revenues from our securitizations and sales of whole loans to offset our current
cost structure and cash uses, we believe we can continue to generate positive
cash flow in the next several fiscal quarters. However, there can be no
assurance that we will be successful in this regard. To do so, we must generate
sufficient cash from:
o the premiums we receive from selling NIM and/or interest-only certificates
in connection with our securitizations;
o the premiums we receive from selling our mortgage servicing rights in
connection with our securitizations;
o the premiums we receive from selling whole loans, servicing released;
o origination fees on newly closed loans;
o excess cashflow certificates we retain in connection with our
securitizations; and
o interest income we receive on our loans held for sale prior to
securitization and/or whole loans sales.
There can be no assurance, however, that we will continue generating positive
cash flow in 2003 or at all.
Currently, our primary uses of cash requirements include the funding of:
o interest expense on warehouse lines of credit and other financing;
o scheduled principal paydowns on other financing;
o expenses incurred in connection with our securitization program;
o general ongoing administrative and operating expenses, including the cost
to originate loans;
o tax payments on excess inclusion income generated from our excess cashflow
certificates; and
o preferred stock dividends.
Historically, we have financed our operations utilizing various secured
credit financing facilities, issuance of corporate debt (i.e., Senior Notes),
issuances of equity, and the sale of interest-only certificates and/or NIM notes
and mortgage servicing rights sold in conjunction with each of our
securitizations to offset our negative operating cash flow and support our
originations, securitizations, and general operating expenses.
31
Currently, our primary sources of liquidity, subject to market conditions,
continue to be:
o on-balance sheet warehouse financing and other secured financing
facilities, such as capital leasing;
o securitizations of mortgage loans and our corresponding sale of NIM
certificates and/or interest-only certificates, depending upon the
securitization structure, and mortgage servicing rights;
o sales of whole loans;
o cash flows from retained excess cashflow certificates;
o origination fees, interest income and other cash revenues; and
o utilizing NIM securitizations and/or selling or financing our retained
excess cashflow certificates.
To accumulate loans for securitization or sale, we borrow money on a
short-term basis through warehouse lines of credit. We have relied upon a few
lenders to provide the primary credit facilities for our loan originations and
at September 30, 2003, we had two warehouse facilities for this purpose. Both
credit facilities have a variable rate of interest and, as of September 30,
2003, were due to expire in May 2004. In October 2003, our warehouse financing
providers each increased their commitment amounts to $250.0 million, from $200.0
million and lowered the financing rate. In addition, we extended the maturity
date for one of the facilities to October 2004.
There can be no assurance that we will be able to either renew or replace
these warehouse facilities at their maturities at terms satisfactory to us or at
all. If we are not able to obtain financing, we will not be able to originate
new loans and our b